<PAGE>   1
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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q
(Mark One)

[X]      Quarterly report pursuant to Section 13 or 15(d) of the Securities
         Exchange Act of 1934

For the quarterly period ended June 30, 1998 or

[ ]      Transition report pursuant to Section 13 or 15(d) of the Securities
         Exchange Act of 1934

For the transition period from              to

                         Commission file number 0-19707

                                 INNERDYNE, INC.

             (Exact name of Registrant as specified in its charter)

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

                   1244 REAMWOOD AVENUE, SUNNYVALE, CA 94089
                    (Address of principal executive offices)

       Registrant's telephone number, including area code: (408) 745-6010

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

         The number of shares of Registrant's Common Stock issued and
outstanding as of July 31, 1998 was 21,840,155.


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<PAGE>   2

                                TABLE OF CONTENTS



<TABLE>
<CAPTION>
                                                                                                             PAGE
                                                                                                             ----
<S>                                                                                                          <C>
PART I.  FINANCIAL INFORMATION

Item 1.     Financial Statements

             Condensed Balance Sheets..................................................................         3
             
             Condensed Statements of Operations........................................................         4

             Condensed Statements of Cash Flows .......................................................         5

             Notes to Condensed Financial Statements...................................................         6


Item 2.      Management's Discussion and Analysis of Financial Condition and Results of Operations ....         7

Item 3.      Quantitative and Qualitative Disclosures About Market Risk................................        22

PART II.  OTHER INFORMATION............................................................................        23

Item 1.      Legal Proceedings                                                                                 23

Item 2.      Changes in Securities and Use of Proceeds                                                         23

Item 3.      Defaults upon Senior Securities                                                                   23

Item 4.      Submission of Matters to a Vote of Security Holders                                               23

Item 5.      Other Information                                                                                 24

Item 6.      Exhibits and Reports on Form 8-K                                                                  24

             Signature Page                                                                                    25
</TABLE>


                                      -2-


<PAGE>   3



                          PART I- FINANCIAL INFORMATION

Item 1. -  Financial Statements

                                 INNERDYNE, INC.
                            CONDENSED BALANCE SHEETS
                                     ASSETS
<TABLE>
<CAPTION>


                                                        JUNE 30,           DECEMBER 31,
                                                          1998                 1997
                                                       (UNAUDITED)         (*SEE NOTE)
                                                      ------------         ------------
<S>                                                   <C>                  <C>         
Current assets:

   Cash and cash equivalents .................        $  6,007,147         $  6,091,497
   Accounts receivable .......................           2,648,836            1,920,966
   Interest and other receivables ............             290,638              702,606
   Inventory .................................           1,187,846            1,454,266
   Prepaid expenses and other ................             116,519              116,821
                                                      ------------         ------------

     Total current assets ....................          10,250,986           10,286,156

Equipment and leasehold improvements, net ....             814,851              987,241
Other assets .................................              45,695               45,695
                                                      ------------         ------------

     Total assets ............................        $ 11,111,532         $ 11,319,092
                                                      ============         ============


                                LIABILITIES AND
                              STOCKHOLDERS' EQUITY

Current liabilities:

   Line of credit ............................        $    300,000         $    300,000
   Current installments of long-term debt ....             340,543              340,543
   Accounts payable ..........................             269,268              489,602
   Accrued liabilities .......................           1,572,759            1,504,336
                                                      ------------         ------------
        Total current liabilities ............           2,482,570            2,634,481

Long-term debt, excluding current installments             574,972              649,061

Stockholders' equity:
   Common stock ..............................             218,402              217,549
   Additional paid-in- capital ...............          60,143,155           60,000,046
   Accumulated deficit .......................         (52,307,567)         (52,182,045)
                                                      ------------         ------------
        Net stockholders' equity .............        $  8,053,990         $  8,035,550
                                                      ------------         ------------
Total liabilities and stockholders' equity ...        $ 11,111,532         $ 11,319,092
                                                      ============         ============
</TABLE>

* Condensed from audited financial statements.

See accompanying notes to condensed financial statements.



                                      -3-
<PAGE>   4





                                 INNERDYNE, INC.
                       CONDENSED STATEMENTS OF OPERATIONS
                                   (UNAUDITED)

<TABLE>
<CAPTION>

                                                                     THREE-MONTHS ENDED                       SIX-MONTHS ENDED
                                                             JUNE 30,            JUNE 30,            JUNE 30,             JUNE 30,
                                                               1998                1997                1998                 1997
                                                           ------------        ------------        ------------        ------------
<S>                                                        <C>                 <C>                 <C>                 <C>         
Product, licensing and contract revenue ............       $  4,372,636        $  3,694,778        $  8,578,408        $  6,645,982

Cost of sales ......................................          1,422,080           1,204,175           2,728,325           2,445,113

Research, development, regulatory and clinical .....            768,707             935,381           1,527,203           1,557,285

Sales and marketing ................................          1,749,421           1,491,258           3,484,860           2,763,038

General and administrative .........................            496,765             547,481           1,049,338           1,073,797
                                                           ------------        ------------        ------------        ------------
      Total costs and expenses .....................          4,436,973           4,178,295           8,789,726           7,839,233
                                                           ------------        ------------        ------------        ------------
      Operating loss ...............................            (64,337)           (483,517)           (211,318)         (1,193,251)

Interest/other income, net .........................             43,213              47,570              85,796             103,793
                                                           ------------        ------------        ------------        ------------

      Diluted and basic net loss ...................       $    (21,124)       $   (435,947)       $   (125,522)       $ (1,089,458)
                                                           ============        ============        ============        ============
Diluted and basic net loss per share ...............       $       (.00)       $       (.02)       $       (.01)       $       (.05)
                                                           ============        ============        ============        ============
Weighted average diluted and basic shares
   outstanding .....................................         21,813,294          21,656,410          21,785,097          21,637,357
                                                           ============        ============        ============        ============
</TABLE>


See accompanying notes to condensed financial statements.


                                      -4-
<PAGE>   5



                                 INNERDYNE, INC.
                       CONDENSED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)

<TABLE>
<CAPTION>

                                                                                                       SIX-MONTH PERIODS
                                                                                                              ENDED
                                                                                                   JUNE 30,              JUNE 30,
                                                                                                     1998                   1997
                                                                                                  -----------           -----------
<S>                                                                                               <C>                   <C>         
Cash flows from operating activities:
Net loss ...............................................................................          $  (125,522)          $(1,089,458)
Adjustments to reconcile net loss to net cash used in operating activities:
   Depreciation and amortization of equipment and leasehold improvements ...............              270,687               302,081
   Increase in receivables .............................................................             (315,902)             (755,870)
   Decrease in inventories .............................................................              266,420                84,072
   Decrease (increase) in prepaid expenses, and other assets ...........................                  302                (2,988)
   Increase (decrease) in accounts payable .............................................             (220,334)              101,375
   Increase (decrease) in accrued expenses .............................................               68,423               (43,461)
                                                                                                  -----------           -----------

Net cash used in operating activities ..................................................              (55,926)           (1,404,249)
                                                                                                  -----------           -----------

Cash flows from investing activities:
   Capital expenditures ................................................................              (98,297)             (160,179)
                                                                                                  -----------           -----------

Net cash used in investing activities ..................................................              (98,297)             (160,179)
                                                                                                  -----------           -----------

Cash flows from financing activities:
   Proceeds from issuance of common stock, net .........................................              143,962                66,672
   Proceeds from long-term debt ........................................................               58,467                67,846
   Principal payments on long-term debt ................................................             (132,556)              (32,312)
                                                                                                  -----------           -----------

Net cash provided by financing activities ..............................................               69,873               102,206
                                                                                                  -----------           -----------

Net  decrease in cash and cash equivalents .............................................              (84,350)           (1,462,222)

Cash and cash equivalents at beginning of period .......................................            6,091,497             7,270,285
                                                                                                  -----------           -----------

Cash and cash equivalents at end of period .............................................          $ 6,007,147           $ 5,808,063
                                                                                                  ===========           ===========
</TABLE>



See accompanying notes to condensed financial statements.

                                      -5-
<PAGE>   6



                                 INNERDYNE, INC.
                     NOTES TO CONDENSED FINANCIAL STATEMENTS



(1)  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

          The accompanying interim condensed financial statements and notes are
unaudited, but in the opinion of management reflect all adjustments (consisting
of normal recurring adjustments) necessary for a fair presentation of the
results of such periods. The results of operations for any interim period are
not necessarily indicative of results for the respective full year. These
condensed financial statements and Management's Discussion and Analysis of
Financial Condition and Results of Operations (MD&A) for the three and six month
periods ended June 30, 1998 should be read in conjunction with the audited
financial statements and notes thereto and MD&A included in the Company's Annual
Report on Form 10-K for the year ended December 31, 1997.


(2)  INVENTORIES

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

                              JUNE 30, 1998   DECEMBER 31, 1997

<S>                             <C>             <C>       
Raw materials and supplies      $  811,259      $1,110,989
Finished goods ...........         376,587         583,639
                                ----------      ----------

Net inventory ............      $1,187,846      $1,454,266
                                ==========      ==========
</TABLE>


(3)  COMPREHENSIVE INCOME (LOSS)

         The Company adopted Statement of Financial Accounting Standard No.130
("SFAS 130"), "Reporting Comprehensive Income," effective January 1, 1998. SFAS
130 establishes standards for reporting and display of comprehensive income and
its components in financial statements. For the periods ending June 30, 1998 and
1997, comprehensive loss was equal to the net loss as presented in the
accompanying statement of operations.




                                      -6-


<PAGE>   7



ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS.

         Except for the historical information contained in this Quarterly
Report on Form 10-Q, the matters discussed throughout this Quarterly Report on
Form 10-Q are forward-looking statements that are subject to certain risks and
uncertainties that could cause the actual results to differ materially from
those projected. Factors that could cause actual results to differ materially
include, but are not limited to, the impact of intense competition in the
Company's market, the extent of market acceptance of the Company's Step(TM)
family of products, the timely development and market acceptance of new
products, the compliance of the Company's manufacturing facilities with Good
Manufacturing Practices ("GMP") regulations, the continued acceptance of
minimally invasive surgical procedures, the Company's ability to further expand
into international markets, public policy relating to healthcare reform in the
United States and other countries, approval of the Company's products by
government agencies such as the United States Food and Drug Administration (the
"FDA") and the risks set forth in greater detail below under the heading
"Additional Factors that May Affect Future Results," as well as those set forth
in the Company's Annual Report on Form 10-K for the year ended December 31, 1997
and included from time to time in the Company's other Securities and Exchange
Commission ("SEC") reports and press releases, copies of which are available
from the Company upon request. The Company undertakes no obligation to publicly
release the result of any revisions to these forward-looking statements that may
be made to reflect events or circumstances after the date hereof or to reflect
the occurrence of unanticipated events.

INTRODUCTION

         InnerDyne, Inc. (the "Company" or "InnerDyne") is primarily focused
upon the development and commercialization of access products based on its
proprietary radial dilation technology used to perform minimally invasive
surgical ("M.I.S.") procedures. In December 1996, the Company announced the
signing of an agreement which grants United States Surgical Corporation ("U.S.
Surgical") exclusive worldwide sales and marketing rights for the Company's
proprietary thermal ablation technology. The Company also possesses
biocompatible coating technologies which have utility in enhancing the
compatibility and performance of devices placed in contact with human body
fluids and tissues, and in delivering selected pharmaceuticals and radioactive
isotopes to areas within a human body. The Company intends to continue
developing its radial dilation and biocompatible coating technologies,
internally or through strategic alliances.

Radial Dilation Technology

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

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

         Step. The Step device incorporates the Company's proprietary radial
dilation technology and was InnerDyne's first product to be launched on a
commercial basis. The Company has received 510(k) clearances from the FDA to
market this device for laparoscopic and thorascopic M.I.S. procedures. The
Company's Step access device replaces trocars, eliminating the risk of internal
organ damage from contact with the sharp surfaces of a bladed trocar. In
contrast to conventional trocars, the Step device utilizes a standard
insufflation needle for penetration through the abdominal wall at each site
where it is utilized, creating only a small puncture wound. Following removal of
the needle, a sheath that 



                                      -7-

<PAGE>   8

surrounds the needle is then dilated up to a larger working channel through the
insertion of a tapered dilator and cannula. Following dilation, the dilator is
removed, leaving a rigid sheath that serves as a working channel, with an
integral insufflation valve at the proximal end. The radial dilation of tissue
to an appropriately sized working channel holds the cannula in place and
obviates the need for an anchoring system, which may cause a larger residual
wound. After completion of a procedure, the rigid cannula is removed, and the
sheath retracts, permitting the opening in each of the muscular layers of the
abdominal wall to recover. The residual wound is approximately half the size of
that made using a conventional trocar of similar size. The Step is currently
utilized primarily in minimally invasive general, gynecological and pediatric
surgical procedures.

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

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

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

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

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



                                      -8-

<PAGE>   9

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

         Management believes that the positive attributes of the Step product
line may also enable minimally invasive access to organs within the abdominal
cavity. The current alternative for this type of access involves the insertion
of a long flexible channel and scope through a natural body orifice such as the
mouth or the rectum, and only limited procedures are possible due to the
restricted size of the channel and the tortuous path that must be navigated by
the scope. The Step product line has been shown to enable laparoscopic access
through the abdominal wall and across the peritoneal space into the stomach for
the treatment of benign tumors. InnerDyne believes that the use of Step products
could substantially reduce recovery times for these types of procedures. The
Company expects that the enhanced capabilities of radially expanding dilation
may enable additional surgical procedures to be performed through minimally
invasive techniques. The Company filed a 510(k) application for intra-organ
indications of its Step products with the FDA in 1998.

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

         In selected foreign countries, local distributors purchase products
from the Company for subsequent resale to their respective countries' health
care systems. Distributors in selected foreign markets can and have been changed
when the Company has deemed the performance of individual distributor
organizations to be unsatisfactory.

         Other Applications. InnerDyne announced an agreement covering the
development and potential use of its proprietary radial dilation technology for
specialized vascular access with EndoTex Interventional Systems in 1996. The
agreement covers the development of access products expected to be used in
conjunction with EndoTex's technologies to treat carotid disease and aortic
aneurysms.

         The Company entered into an agreement covering the development of a
less traumatic means of placing enteral feeding tubes with Sherwood-Davis & Geck
("SDG") in 1997. The Company announced that it had received the single
regulatory milestone payment associated with the SDG agreement during the second
quarter of 1997. In the first quarter of 1998, InnerDyne and SDG terminated the
development agreement coincident with the sale of SDG to another corporation.

         During the second quarter of 1997, InnerDyne established a business
unit to better define the value that radial dilation technology can bring to
interventional cardiology and radiology procedures, and to develop access
products based on this assessment. The Company proceeded with animal studies and
device refinements in the third and fourth quarters of 1997 and continued
testing the product concept in conjunction with cardiology advisors in the first
quarter of 1998. The study results were positive and human use trials to
demonstrate the clinical benefits were initiated in Europe during the second
quarter of 1998. If clinical benefits are confirmed in continuing usage, the
Company will explore alternative methods of effective distribution in the
interventional vascular marketplace and may launch a radial dilation vascular
access device in the United States in late 1998.

         InnerDyne also committed resources to an investigation of the potential
market opportunity in arthroscopic procedures during 1997 and early 1998.
Limited clinical usage of the initial design accompanied by substantial exposure
and feedback from arthroscopic surgeons was completed during the last half of
1997. InnerDyne completed the 

                                      -9-



<PAGE>   10

arthroscopic market opportunity assessment in the second quarter of 1998. The
Company is exploring the potential this product may have, if any, and
alternative distribution methods in the arthroscopic marketplace. It is unlikely
that an arthroscopic access product will be brought to market unless a suitable
distribution partner can be found.

Additionally, the Company is exploring the potential use of its proprietary
radial dilation technology in other applications, such as access for thoracic
and tracheal procedures, and is likely to increase resources associated with the
pursuit of one or more of these opportunities in the ensuing quarters.
Developmental expenditures for new applications for the Company's proprietary
radial dilation technology may impact the timing and achievement of sustained
profitability. There can be no assurance that these new applications will
demonstrate clinical benefits or that the Company can develop a product that
will be commercially accepted.

Thermal Ablation Technology

         The Company has developed proprietary technology that is intended to
thermally ablate the lining of a body organ. The Company's EnAbl(TM) Thermal
Ablation System (the "EnAbl(TM) System") is based on this proprietary technology
and is designed to treat menorrhagia, or excessive uterine bleeding, by
thermally ablating the endometrial lining of the uterus through the controlled
introduction and heating of a normal saline solution "in situ." The EnAbl(TM)
System, which includes a control console, a reusable handpiece, and a disposable
probe, enables the clinician to fill the uterus with normal saline solution,
which is then heated. The heated solution ablates -- or destroys -- the uterine
lining, the source of the abnormal bleeding. The EnAbl(TM) System is designed to
help physicians treat women suffering from this common and often debilitating
condition in a minimally invasive and less costly manner, with potentially fewer
complications. The system is expected to be easy for the physician to use, and
to offer the possibility to conduct the procedure under local anesthesia. As a
result, the procedure may take less time than currently available therapies and
can potentially be performed in an outpatient surgery center or a physician's
office. Although this procedure is expected to result in the infertility of the
patient, the Company believes that the EnAbl(TM) System has the potential to
result in fewer complications and adverse side effects and reduced recovery
times compared to many alternative therapies. For these reasons the Company also
believes that the EnAbl(TM) System has the potential to be more cost-effective
than many alternative therapies. The Company has completed initial safety and
preliminary efficacy trials with this system. The results of these limited
trials indicate that the EnAbl(TM) System may represent a safe means of ablating
uterine tissue. However, there can be no assurance that the feasibility of this
technology will be satisfactorily demonstrated in expanded efficacy trials or
that the system will be successfully commercialized.

         In December 1996, InnerDyne announced that it had signed an agreement
which granted U.S. Surgical exclusive worldwide sales and marketing rights for
the EnAbl(TM) System. Under the terms of the agreement, in exchange for initial
license fees, milestone payments, and royalties based upon future sales, U.S.
Surgical gained the rights to complete development of the EnAbl(TM) system and
to manufacture and market the technology on a worldwide basis. The agreement
also provides U.S. Surgical with an option to purchase rights to the technology
for defined applications. In July 1997, the Company announced that U.S. Surgical
had made the first milestone payment due under the terms of the agreement. As of
March 31, 1998, the Company had effectively transferred all technology and
related development responsibility for the project to U.S. Surgical.

Biocompatible Coating Technologies

         The Company possesses certain proprietary technologies in the area of
biocompatible coatings. The technologies that comprise the Company's
thromboresistant coating ("TRC") capability are believed to have application
when foreign objects remain in contact with various areas of the body,
particularly within the blood stream, for sustained periods of time. These
technologies include the ability to deposit an extremely thin layer
(approximately one micron) of siloxane on a surface and the ability to graft a
bioactive substance, such as the drug heparin, to that siloxane layer. The
Company's TRC utilizes a "tether" molecule to attach heparin, other bioactive
molecules or radioisotopes to the previously applied siloxane subsurface. One
end of the tether molecule is covalently bonded to the siloxane coating, and the
other end of the tether molecule is covalently bonded to the bioactive molecule
or radioisotope. Because both points of attachment utilize 

                                      -10-


<PAGE>   11

covalent bonds, the Company believes that its coating process may result in a
stronger bond to the surface of a device than many other methods presently in
use, which it believes generally use a weaker ionic bond in at least one of the
attachment points. TRC coatings, employed with the siloxane layer alone or in
combination with bioactive substances, can extend the life of blood-gas exchange
devices or provide the capability to extend the duration of contact of a coated
device with blood or other body fluids while minimizing the physiological
impacts of such contact. The Company developed a less complex method of coating
devices with a TRC coating which was commercially introduced in the first
quarter of 1998. InnerDyne is developing a proprietary coating technology to
which rhenium-188 or other radioisotopes can be attached just prior to a
therapeutic intervention to possibly reduce restenosis in patients who have had
interventional vascular procedures. The isotope coating chemistry may also have
applications in the fields of oncology and the treatment of arthritis.

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

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

         In December 1997, InnerDyne and Oak Ridge National Laboratory ("ORNL")
announced that the Department of Energy had awarded ORNL and Brookhaven National
Laboratories ("BNL") a cooperative research and development agreement for the
development of InnerDyne's proprietary method of labeling or attaching
radioactivity to implantable devices. The ORNL researchers will help to optimize
chemical methods required to efficiently attach a radioactive source to stents.
Generators from ORNL and this new technology will be provided to investigators
at BNL who will, in conjunction with the Interventional Cardiology Group at the
State University of New York at Stonybrook, prepare the radioactive stents and
implant them into the arteries of swine or rabbits to evaluate the effectiveness
of this new approach to inhibit restenosis. Management believes that the
combination of InnerDyne and Oak Ridge National Laboratory technologies may
positively impact the overall costs associated with stenting procedures, if
successful, by providing a method of attaching a radioisotope just prior to
implantation.

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

         Because of the strength of the covalent bonds used in the Company's TRC
technology, and other properties noted above, the Company believes that its
technology may have advantages over presently available bioactive coating


                                      -11-


<PAGE>   12

technologies in several potential applications, including the coating of
vascular stents, grafts, vena cava filters and other implantable devices. The
Company has undertaken a number of discussions with potential licensees of the
Company's coating technologies, in addition to those mentioned above, and
samples of coated products have been provided to several companies. These
discussions have been with parties interested in the use of the technologies to
enhance gas exchange, as well as third parties interested in the possible
coating of in-dwelling devices for various applications. There can be no
assurances that such discussions and trials will result in additional revenue,
or that the potential revenue from current agreements or research efforts will
ever be realized.



RESULTS OF OPERATIONS

          Total revenue for the three and six month periods ended June 30, 1998
was $4,372,636 and $8,578,408 respectively, compared to $3,694,778 and
$6,645,982 for the corresponding periods in 1997. Total revenue is comprised of
revenue from product sales and licensing and contract revenue. Revenue from
product sales increased to $3,948,933 and $7,749,973 for the three and six month
periods ended June 30, 1998, respectively, from $2,842,610 and $5,361,764 for
the corresponding periods in 1997, reflecting increased sales of the Company's
Step devices. Licensing and contract revenue for the three and six month periods
ended June 30, 1998 were $423,703 and $828,435 respectively, compared to
$852,168 and $1,284,218 for the corresponding periods in 1997. Licensing and
contract revenue for the periods related to agreements with third parties
covering the development of the Company's proprietary thermal ablation
technology, and the licensing of the Company's proprietary biocompatible coating
technology. Licensing and contract revenue for the 1997 periods also related to
the development of non-competing applications for the Company's radial dilation
technology. Licensing and contract revenue fluctuates from quarter to quarter,
based upon the number of agreements in effect and the amount and timing of the
payments to be made to InnerDyne pursuant to such agreements.

         Cost of sales were $1,422,080 and $2,728,325, respectively, for the
three and six month periods ended June 30, 1998, compared to $1,204,175 and
$2,445,113 for the same periods in 1997. The increase in cost of sales for the
three and six month periods ended June 30, 1998 is mainly attributable to the
increase in production and sales volumes compared to the same periods in 1997.



         Research, development, regulatory and clinical expenses ("R&D") for the
three and six month periods ended June 30, 1998 were $768,707 and $1,527,203,
respectively, compared to $935,381 and $1,557,285 for the corresponding periods
in 1997. In the 1997 and 1998 periods, a significant part of the R&D expenses
were reimbursed by development partners, thereby generating off-setting
licensing and contract revenue. The reduction in R&D expenditures is primarily
the result of a transfer of the EnAbl (TM) thermal ablation program to US
Surgical in the first quarter of 1998. The Company expects that research,
development, regulatory and clinical expenditures will increase in absolute
dollars in future periods, though it is possible that expenses associated with
one or more research programs could be funded from outside the Company, thereby
possibly reducing expected costs.

         Sales and marketing expenses were $1,749,421 and $3,484,860,
respectively, for the three and six month periods ended June 30, 1998, compared
to $1,491,258 and $2,763,038 for the corresponding periods in 1997, reflecting
the growth of the Company's sales and marketing functions to support
commercialization of its M.I.S. products. InnerDyne expects that sales and
marketing expenses will generally continue to increase in absolute dollars in
future periods.

         General and administrative expenses were $496,765 and $1,049,338,
respectively, for the three and six month periods ended June 30, 1998, compared
to $547,481 and $1,073,797 for the corresponding periods in 1997. The reduction
in general and administrative expenses was the result of a reduction in
insurance premiums and strict application of cost controls. The Company
anticipates that general and administrative expenses will generally increase in
absolute dollars in future periods to support expanding operations.


                                      -12-

<PAGE>   13

         Interest/other income net decreased to $43,213 and $85,796,
respectively, for the three and six month periods ended June 30, 1998, compared
to $47,570 and $103,793 for the same periods in 1997, primarily as a result of
decreased interest income earned on lower average cash and cash equivalents
balances.

         The Company incurred a net loss of $21,124 or $.00 cents per share, and
$125,522 or $.01 cents per share, for the three and six month periods ended June
30, 1998, compared to a net loss of, $435,947 or $.02 per share and $1,089,458
or $.05 per share, respectively for the same periods in 1997. Management
believes the Company could incur operating losses through 1998.

                                      -13-

<PAGE>   14



LIQUIDITY AND CAPITAL RESOURCES

         From its inception to June 30, 1998, the Company has incurred a
cumulative net loss of approximately $52 million. Since inception, the Company's
cash expenditures have exceeded its revenues. Prior to 1992, the Company was
funded primarily through private placements of equity securities. In 1992, the
Company completed an initial public offering of 2,875,000 shares of its Common
Stock at $11.00 per share, which raised approximately $28.8 million (net of
underwriter's commissions and offering expenses). The 1994 acquisition of
InnerDyne Medical, Inc. was accomplished through the issuance of additional
Common Stock of the Company. In June 1995, the Company closed a private
placement of 1,435,599 shares of the Company's Common Stock and warrants to
purchase 287,200 additional shares of Common Stock, with gross proceeds to the
Company of approximately $3.2 million. In March and April of 1996, holders of
warrants to purchase an aggregate of 242,952 shares of Common Stock exercised
such warrants, resulting in gross proceeds to the Company of $704,561. The
Company concluded a public offering on May 20, 1996, with the sale of 2,650,000
shares of Common Stock at $3.50 per share, which raised $8,015,268 (net of
underwriter's commissions and offering expenses).

         At June 30, 1998, cash and cash equivalents totaled $6,007,147 compared
to a total cash and cash equivalents balance of $5,120,127 at March 31, 1998.
The Company had $98,297 and $427,276 in capital expenditures in the six months
ended June 30, 1998 and the year ended December 31, 1997, respectively. Working
capital totaled $7,768,416 at June 30, 1998, and the Company had long-term debt,
excluding current installments, totaling $574,972 relating to financing of
equipment.



         In June 1998, the Company renewed its credit facility with Silicon
Valley Bank. Subject to certain covenants and conditions, the Company may borrow
up to $2,000,000 through June 18, 1999 on a revolving credit basis at prime plus
 .75% based on eligible receivables. The Company also has an equipment advance
line of credit, which allows the Company to borrow up to $750,000 per year based
on eligible equipment purchases. Amounts outstanding on this equipment advance
line of credit are periodically converted to 48 month term loans bearing
interest at prime plus .75%. As of June 30, 1998, the Company had drawn $300,000
for financing of working capital needs on the revolving line of credit, secured
by certain accounts receivable, and had borrowed $275,210 under the 1997
agreement with Silicon Valley Bank for the financing of capital expenditures.
Debt balances as of June 30, 1998 on the Company's balance sheet also include
amounts loaned to the Company under previous equipment lines of credit
agreements with Silicon Valley Bank.

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

         The Company's capital requirements will depend on numerous factors,
including market acceptance and demand for its products; the resources the
Company devotes to the development, manufacture and marketing of its products;
the progress of the Company's clinical research and product development
programs; the receipt of and the time required to obtain regulatory clearances
and approvals; the resources required to protect the Company's intellectual
property; and other factors. The timing and amount of such capital requirements
cannot be accurately predicted. Funds may also be used for the acquisition of
businesses, products and technologies that are complementary to those of the
Company. Consequently, although the Company believes that the proceeds of the
public offering of shares of its Common Stock completed in May 1996, together
with revenues, credit facilities and other sources of liquidity, will provide
adequate funding for its capital requirements through at least 1998, the Company
may be required to raise additional funds through public or private financings,
collaborative relationships or other arrangements. There can be no assurance
that the 

                                      -14-



<PAGE>   15

Company will not require additional funding or that such additional funding, if
needed, will be available on terms attractive to the Company, or at all. Any
additional equity financings may be dilutive to stockholders, and debt
financing, if available, may involve restrictive covenants.

ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS

         History of Losses; Profitability Uncertain. InnerDyne has generally
experienced operating losses since its inception in December 1985. InnerDyne
reported net losses of $0.125 million on revenues of $8.6 million, $0.9 million
on revenues of $15.7 million, $4.6 million on revenues of $9.1 million and $5.6
million on revenues of $5.3 million for the six months ended June 30, 1998 and
the fiscal years ended December 31, 1997, 1996 and 1995, respectively. As of
June 30, 1998, InnerDyne had an accumulated deficit of approximately $52
million.

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

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

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

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

         In the thermal ablation market, the primary competition for the EnAbl
(TM) System is current therapies for the treatment of excessive menstrual
bleeding, including drug therapy, dilatation and curettage, surgical endometrial
ablation and hysterectomy. The EnAbl(TM) System will also compete against other
techniques under development and initial introduction for the treatment of
excessive menstrual bleeding, including endometrial ablation techniques that
employ RF 


                                      -15-


<PAGE>   16

energy or freezing techniques ("cryoablation") and the uterine balloon therapy
system being commercialized by GyneCare, Inc., a unit of Johnson & Johnson.

         Additionally, there are other companies developing alternative methods
of uterine tissue ablation that compete with the EnAbl(TM) System. There can be
no assurance that these companies will not succeed in developing technologies
and products that are more effective than any which have been or are being
developed by the Company and U.S. Surgical or that would render the Company's
technologies or products obsolete or not competitive. Such competition could
have a material adverse effect on the Company's business, financial condition
and results of operations. As a result of the entry of large and small companies
into the market, the Company expects competition for devices and systems used to
treat excessive menstrual bleeding to increase.

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

         Reliance on Future Products and New Applications; Uncertainty of
Technology Changes. The medical device industry is characterized by innovation
and technological change. The Company has made significant investments in
researching and developing its proprietary technologies, including radial
dilation, thermal ablation and biocompatible coatings. During 1998, the Company
introduced the Open-Step product and expects to commercially introduce the
OneStep, which is a further enhancement of its Step product line. The future
success of the Company will depend in part on the timely commercial introduction
and market acceptance of these products. There can be no assurance that these
products will be timely introduced in commercial quantities, if at all, or that
such products will achieve market acceptance. A failure by the Company to timely
introduce such products or a failure of such products to achieve market
acceptance could have a material adverse effect on the Company's business,
financial condition and results of operations. The future success of the Company
will also depend upon, among other factors, the ability to develop and gain
regulatory clearance for new and enhanced versions of products in a timely
fashion. There can be no assurance that the Company will be able to successfully
develop new products or technologies, manufacture new products in commercial
volumes, obtain regulatory approvals on a timely basis or gain market acceptance
of such products. Delays in development, manufacturing, regulatory approval or
market acceptance of new or enhanced products could have a material adverse
impact on the Company's business, financial condition and results of operations.

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


                                      -16-


<PAGE>   17

Company's ability to continue to manufacture and distribute its products and, in
the most serious cases, result in the seizure or recall of products. Failure to
maintain production volumes or increase production volumes in a timely or
cost-effective manner would have a material adverse effect on the Company's
business, financial condition and results of operations.

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

         The Company's expense levels are based, in part, on its expectations of
future revenues. Because a substantial portion of the Company's revenue in each
quarter normally results from orders booked and shipped in the final weeks of
that quarter, revenue levels are extremely difficult to predict. If revenue
levels are below expectations, net income will be disproportionately affected
because only a small portion of the Company's expenses varies with its revenue
during any particular quarter. In addition, the Company typically does not
operate with any material backlog as of any particular date.

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

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

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

                                      -17-


<PAGE>   18

sales personnel or independent sales representatives, or failure to attract
additional personnel, could have a material adverse effect on the Company's
business, financial condition and results of operations.

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

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

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

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

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



                                      -18-

<PAGE>   19

         Before a new device can be introduced in the market, the manufacturer
must generally obtain FDA clearance of 510(k) notification or approval of a PMA.
A PMA application must be filed if a proposed device is not substantially
equivalent to a legally marketed Class I or Class II device, or if it is a Class
III device for which the FDA has called for PMAs. The PMA process can be
expensive, uncertain and lengthy, and a number of devices for which FDA approval
has been sought by other companies have never been approved for marketing. The
EnAbl(TM) System is subject to the PMA approval process prior to marketing by
U.S. Surgical within the United States. There can be no assurance that U.S.
Surgical will be able to obtain the necessary regulatory approval on a timely
basis, or at all, and a delay in receipt of or failure to receive such approval
could have a material adverse effect on the Company's business, financial
condition and results of operations.

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

         The Company has received clearance from the FDA for the marketing of
its Step device for use in accessing the abdominal and thoracic cavities for the
performance of minimally invasive surgical procedures. The Company has also
received FDA clearance for the marketing of its R.E.D. product for use in the
areas of gastrostomy, cystostomy, cholecystotomy, the dilation of biliary and
urethral strictures, laparoscopy and enterostomy. The Company has also received
market clearance for alternative versions of its Step and R.E.D. products,
including products designed to employ its radial dilation technology in vascular
and arthroscopic applications and for biliary indications. Although the Company
has been successful in preparing requests for 510(k) clearance, there can be no
assurance that 510(k) clearances for future products or product modifications
can be obtained in a timely manner or at all, or that any existing clearance can
be successfully maintained. A delay in receipt of, or failure to receive or
maintain, such clearances would have a material adverse effect on the Company's
business, financial condition and results of operations. Although the Company is
strictly limited to marketing its products for the indications for which they
were cleared, physicians are not prohibited by the FDA from using the products
for indications other than those cleared by the FDA. There can be no assurance
that the Company will not become subject to FDA action resulting from physician
use of its products outside of their approved indications.

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

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

         The Company is registered as a manufacturer of medical devices with the
FDA. The Company is subject to routine inspection by the FDA and certain state
agencies for compliance with GMP requirements, MDR requirements and 

                                      -19-


<PAGE>   20

other applicable regulations. Failure of the Company to maintain satisfactory
GMP compliance could have a significant adverse effect on the Company's ability
to continue to manufacture and distribute its products and, in the most serious
cases, could result in the seizure or recall of products, injunctions and/or
civil fines.

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

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

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

         Dependence on International Sales. In the future, the Company expects
to derive an increasing portion of its revenue from international sales. To the
extent that the Company's international sales increase in future periods, a
significant portion of the Company's revenues could be subject to the risks
associated with international sales, including economic or political
instability, shipping delays, changes in applicable regulatory policies,
fluctuations in foreign currency exchange rates and various trade restrictions,
all of which could have a significant impact on the Company's ability to deliver
products on a competitive and timely basis. Future imposition of, or significant
increases in the level of, customs duties, import quotas or other trade
restrictions could have an adverse effect on the Company's business, financial
condition and results of operations. The regulation of medical devices,
particularly in the European Economic 

                                      -20-
<PAGE>   21

Community, continues to expand, and there can be no assurance that new laws or
regulations will not have an adverse effect on the Company.

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

         Product Liability; Claims in Excess of Insurance Coverage. The
development, manufacture and sale of the Company's products entail the risk of
product liability claims, involving both potential financial exposure and
associated adverse publicity. The Company's current product liability insurance
coverage limits are $2,000,000 per occurrence and $2,000,000 in the aggregate,
and there can be no assurance that such coverage limits are adequate to protect
the Company from any liabilities it might incur in connection with the
development, manufacture and sale of its current and potential products. In
addition, the Company may require increased product liability insurance. Product
liability insurance is expensive and may not be available in the future on
acceptable terms, or at all. In addition, if such insurance is available, there
can be no assurance that the limits of coverage of such policies will be
adequate. A successful product liability claim in excess of the Company's
insurance coverage could have a material adverse effect on the Company's
business, financial condition and results of operations.

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

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

         Control by Directors and Principal Stockholders. As of June 30, 1998,
directors and principal stockholders of the Company, and certain of their
affiliates, beneficially owned approximately 25% of the Company's outstanding
Common Stock. Accordingly, these persons, as a group, may be able to control the
Company and significantly affect the direction of the Company's affairs and
business, including any determination with respect to the acquisition or
disposition of assets by the Company, future issuances of Common Stock or other
securities by the Company and the election of directors. 


                                      -21-


<PAGE>   22

Such concentration of ownership may also have the effect of delaying, deferring
or preventing a change in control of the Company.

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

         Year 2000. The Company has conducted a review of its computer systems
to identify the systems that could be affected by the "Year 2000" issue and is
developing an implementation plan to resolve the issue. The Year 2000 problem is
the result of computer programs being written using two digits rather than four
to define the applicable year. Any of the Company's programs that have
time-sensitive software may recognize a date using "00" as the year 1900 rather
than the year 2000. This could result in a major system failure or
miscalculations. The Company presently believes that, with modifications to
existing software and converting to new software, the Year 2000 problem will not
pose significant operational problems for the Company's computer systems as so
modified and converted. However, if such modifications and conversions are not
completed in a timely manner, the Year 2000 problem could have a material impact
on the operations of the Company.



ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

           Not Applicable.


                                      -22-
<PAGE>   23




PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

                  Not Applicable.

ITEM 2.  CHANGES IN SECURITIES

         (a)      Not Applicable.

         (b)      Not Applicable.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

                  Not Applicable.

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

                   (a)     At the Annual Meeting of Stockholders of the
                           Registrant, held on May 22, 1998, the stockholders
                           approved the following proposals with the vote
                           indicated below.

                   (b)     Not Applicable

                   (c)     Voting:

                           (1)  Election of Directors
<TABLE>
<CAPTION>

                                NOMINEE                   FOR              WITHHELD
                                -------                   ---              --------

<S>                                                       <C>                <C>    
                                Edward W. Benecke         18,320,902         105,672
                                Robert M. Curtis          18,341,074          85,500
                                Eugene J. Fischer         18,341,074          85,500
                                William G. Mavity         18,341,074          85,500
                                Guy P. Nohra              18,341,074          85,500
                                Steven N. Weiss           18,340,974          85,600
</TABLE>

                         (2) The amendment of the Company's 1996 Stock Option
                   Plan to increase the number of shares of Common Stock
                   reserved for issuance thereunder by 1,000,000 shares to an
                   aggregate of 2,000,000 shares.

<TABLE>
<CAPTION>
                                 IN FAVOR           OPPOSED            ABSTAIN
                                 --------           -------            -------
<S>                                                 <C>                <C>   
                                 10,398,126         1,743,105          96,935
</TABLE>

                         (3) The amendment of the Company's 1991 Employee Stock
                   Purchase Plan to increase the number of shares of Common
                   Stock reserved for issuance thereunder by 250,000 shares to
                   an aggregate of 550,000 shares.

<TABLE>
<CAPTION>
                                 IN FAVOR           OPPOSED            ABSTAIN
                                 --------           -------            -------
<S>                                                 <C>                <C>   
                                 11,883,815         265,679            88,672
</TABLE>


                                      -23-

<PAGE>   24

                         (4) The selection of KPMG Peat Marwick as independent
                   auditors for the Company for the fiscal year ending December
                   31, 1998.

<TABLE>
<CAPTION>
                                 IN FAVOR           OPPOSED            ABSTAIN
                                 --------           -------            -------
<S>                                                 <C>                <C>   
                                 18,318,317         53,951             54,306
</TABLE>

ITEM 5.  OTHER INFORMATION

                  Not Applicable.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

(a)      Exhibits:

         Exhibit Number 10.38:   Loan Modification Agreement dated as of 
                                 June 18, 1998 by and between the Registrant 
                                 and Silicon Valley Bank


                        27.01:   Financial Data Schedule


(b)      Reports on Form 8-K: None





                                      -24-



<PAGE>   25

                                   SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.


INNERDYNE, INC.



/s/ Robert A. Stern
Robert A. Stern
Vice President and Chief
Financial Officer
(Duly Authorized Signatory,
Principal Financial and Accounting Officer)





Date:    August 11, 1998




                                      -25-
<PAGE>   26


                               INDEX TO EXHIBITS


<TABLE>
<CAPTION>

Exhibit                                
Number                         Description
--------                       -----------
<S>                            <C>
 10.38                         Loan Modification Agreement dated as of 
                               June 18, 1998 by and between the Registrant
                               and Silicon Valley Bank

 27.01                         Financial Data Schedule

</TABLE>