<PAGE>

                                                                      Exhibit 13


Contents
   9 -- Contents

  10 -- Selected Financial Data 

  11 -- Management's Discussion & Analysis 

  15 -- Balance Sheets 

  16 -- Statements of Stockholders' Equity 

  18 -- Statements of Operations 

  19 -- Statements of Cash Flows 

  20 -- Notes to Financial Statements

  28 -- Report of Independent Auditors

 IBC -- Corporate Directory

Focal, Inc. 1998 Annual Report
  

                                                                               9
<PAGE>

Selected Financial Data
(In thousands, except per share data)

<TABLE>
<CAPTION>
                                                                            Year ended December 31,
------------------------------------------------------------------------------------------------------------------------------------

                                                1994             1995              1996              1997             1998
------------------------------------------------------------------------------------------------------------------------------------
Statement of Operations Data:
Revenues:
<S>                                           <C>              <C>            <C>                   <C>                <C>     
  Collaborative research revenues             $      50        $     968      $      3,098          $  17,489          $  5,114
  Product revenues                                   --               --                --                 --             3,071
                                              ---------        ---------      ------------          ---------          ----------   
Total revenues                                       50              968             3,098             17,489             8,185
Costs and expenses:
  Cost of product revenues                           --               --                --                 --             3,740
  Research and development                       11,890            9,665            11,680             15,712            15,590
  General and administrative                      2,034            2,098             2,175              3,058             3,815
                                              ---------        ---------      ------------          ---------          ----------   
Total costs and expenses                         13,924           11,763            13,855             18,770            23,145
Interest income                                     668              443               691                968             1,765
Interest expense                                    (79)            (107)              (92)              (129)             (212)
                                              ---------        ---------      ------------          ---------          ----------   
Net loss                                      $ (13,285)       $ (10,459)     $    (10,158)         $    (442)         $(13,407)
                                              ---------        ---------      ------------          ---------          ----------   
Basic and diluted
  net loss per share (1)                                                      $      (1.26)         $   (0.04)      $     (1.01)
                                                                              ------------          ---------          ----------   
Shares used in computing basic and
  diluted net loss per share                                                     8,088,898         10,410,091        13,291,182
                                                                              ------------          ---------          ----------   
</TABLE>

<TABLE>
<CAPTION>

                                                                            Year ended December 31,
-------------------------------------------------------------------------------------------------------------------

                                                1994             1995              1996              1997             1998
-------------------------------------------------------------------------------------------------------------------
<S>                                           <C>             <C>             <C>               <C>              <C>           
Balance Sheet Data:
Cash, cash equivalents and
  marketable securities                       $  12,240       $    6,948      $     12,208      $      33,239    $       25,346
Working capital                                  10,159            4,401             9,003             30,867            22,188
Total assets                                     15,331            9,306            14,089             39,606            30,461
Capital lease obligations, long-term portion        934              462               315              1,422             1,391
Total stockholders' equity                       11,626            5,995            10,099             32,512            23,776
</TABLE>



(1) PRO FORMA IN 1997 AND 1996.
SEE NOTE 1 TO THE FINANCIAL STATEMENTS.
Management's Discussion


10
<PAGE>

The following discussion should be read in conjunction with the financial
statements, including the notes thereto, appearing elsewhere in this Annual
Report on Form 10-K.

     This Management's Discussion and Analysis contains certain forward looking
statements regarding future events with respect to Focal. Actual events and/or
future results of operations may differ materially as a result of the factors
described herein and in Focal's Report on Form 10-K for the year ended December
31, 1998, into which this Management's Discussion and Analysis is incorporated
by reference. Those factors described under "Business--Product and Product
Development Programs," "--Strategic Alliances," "--Patents and Proprietary
Rights," "--Government Regulation," "--Competition and Technological Change,"
"--Sales and Marketing," "--Manufacturing," "--Competition and Technological
Change," "--Third Party Reimbursement" and "Factors Affecting Operating Results"
in the Report on Form 10-K should be read in conjunction with this Management's
Discussion and Analysis.


OVERVIEW
Focal was founded in 1991, and is focused on the development, manufacture and
commercialization of synthetic, absorbable, liquid surgical sealants based on
Focal's proprietary polymer technology. Since inception, Focal has funded its
operations primarily through the private placement of equity securities and most
recently, in December 1997, through an initial public offering of common stock.
In addition, Focal has entered into strategic alliances with corporate partners
and has recorded revenues totalling $27 million through December 31, 1998, in
connection with these alliances.

     Focal has incurred net losses in each year since its inception, including
net losses of approximately $13.4 million during 1998. At December 31, 1998,
Focal had an accumulated deficit of $59.3 million. Focal's operating losses have
resulted primarily from expenses incurred in connection with its research and
development activities, including preclinical and clinical trials, development
of manufacturing processes and general and administrative expenses. Focal
expects to incur net losses at least through 1999 and may incur net losses in
subsequent periods although the amount of future net losses and the time
required by Focal to reach profitability are highly uncertain. Focal is
dependent upon corporate partners for funding of a significant portion of
research and development expenses. If Focal does not continue to receive funding
from its current corporate partner, or is unable to otherwise obtain third-party
funding, net losses will continue to increase. The Company's ability to achieve
and sustain profitability will be dependent upon obtaining regulatory approval
for and successfully commercializing its FocalSeal surgical sealants, and
developing the manufacturing capacity and sales and marketing capability for its
products. There can be no assurance that Focal will obtain required regulatory
approvals, or successfully develop, manufacture, commercialize and market
products or that Focal will ever achieve profitability.

     Focal introduced its first commercial product, FocalSeal-L surgical sealant
for lung surgery indications, in Europe in March 1998 through its strategic
marketing alliance with Ethicon Inc., a division of Johnson & Johnson. Focal
recorded its initial revenues from the sale of products in the first quarter of
1998. Focal anticipates that revenues derived from European sales of FocalSeal
surgical sealants will account for a substantial majority of the Company's
near-term product revenues.


RESULTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 1998, COMPARED TO YEAR ENDED
DECEMBER 31, 1997
Revenues for the year ended December 31, 1998 were $8.2 million compared with
$17.5 million for the year ended December 31, 1997. Revenues in 1998 included
$3.1 million in product revenues and $5.1 million in collaborative research
revenues. Revenues in 1997 of $17.5 million consisted exclusively of
collaborative research revenues.

     Higher collaborative revenues were realized in 1997 than in 1998 in
connection with Focal's strategic alliance with Ethicon, including a one-time,
non-refundable payment of $7.0 million, as well as funding of $5.0 million for
research and development activities and a milestone payment of $2.0 million for
obtaining a CE mark for FocalSeal-L sealant for lung surgery. In addition,
during 1997, Focal recorded $3.4 million in revenues from its local drug
delivery partnership with Novartis. This alliance was terminated in early 1998.

     During 1998, Focal recorded $3.0 million in collaborative research revenues
from Ethicon for the development of its lung surgery and neurosurgery sealant
products and $1.5 million for the development of its cardiovascular sealant
product. In addition, $0.6 million in collaborative research revenues were
realized from other sources, including a grant from the National Institutes of
Health.

     Product revenues of $3.1 million realized in 1998 represented Focal's
shipments of AdvaSeal surgical sealant products to Ethicon for its distribution
in Europe and other markets outside North America. Focal realizes a combined
royalty and transfer price as a percentage of Ethicon
  
     Cost of product revenues for the year ended December 31, 1998 totalled $3.7
million. These costs were recorded in connection with commercial sales of
AdvaSeal surgical sealant product to Ethicon. Gross margins were negative due to
the startup phase of Focal's manufacturing operations and the resulting lack of
economies of scale and certain fixed overhead costs being amortized over the
limited volume 


                                                                              11
<PAGE>

MANAGEMENT'S DISCUSSION (CONT'D) SALES.



experienced in the year of launch. Additionally, costs of
approximately $150,000 were incurred relating to a voluntary product recall
announced in August 1998.

     Research and development expenses were $15.6 million for the year ended
December 31, 1998, compared with $15.7 million for the year ended December 31,
1997. Staffing levels in the research and development group were at
approximately the same levels in 1997 and 1998. Clinical and regulatory expenses
increased in 1998 due to clinical trials ongoing in both Europe and the United
States. Manufacturing scale-up costs decreased in 1998 from 1997 levels. During
1997, manufacturing scale-up costs were charged to research and development,
since the lung sealant product CE mark approval had not yet been received.
During 1998, the majority of manufacturing scale-up costs were capitalized as
inventory, and charged to cost of sales upon product shipment.

     General and administrative expenses increased to $3.8 million for the year
ended December 31, 1998 from $3.1 million for the year ended December 31, 1997.
General and administrative expenses during these years consisted primarily of
personnel costs, which increased due to the hiring of additional administrative
and finance personnel. In addition, in 1998, certain general and administrative
expenses, including public and investor relations, insurance and legal expenses,
increased as a result of Focal's transition to a publicly traded company.

     Interest income increased to $1.8 million for the year ended December 31,
1998, from $1.0 million for the year ended December 31, 1997, as a result of
higher average cash balances, including the proceeds from the initial public
offering.

     The Company recorded a net loss of approximately $13.4 million for the year
ended December 31, 1998, compared with a net loss of $0.4 million for the same
period in 1997. This increased net loss was primarily the result of receipt of a
one-time payment of $7.0 million in 1997 and higher collaborative research and
development funding in 1997. The Company anticipates that it will incur net
operating losses at least through 1999.

YEAR ENDED DECEMBER 31, 1997, COMPARED TO YEAR ENDED DECEMBER 31, 1996 
Revenues for the year ended December 31, 1997 increased to $17.5 million, from
$3.1 million for the year ended December 31, 1996, due to higher collaborative
research and development funding, which comprised all of the Company's revenues
during both years. The increase in 1997 was due primarily to a strategic
alliance for surgical sealants entered into with Ethicon in January 1997.
Revenues recorded in connection with this strategic alliance for the year ended
December 31, 1997 included a one-time, non-refundable payment of $7.0 million,
as well as funding of $5 million during 1998 for research and development
activities and a milestone payment of $2.0 million for obtaining a CE mark for
FocalSeal-L for lung surgery. 

     Research and development expenses increased to $15.7 million for the year
ended December 31, 1997, from $11.7 million for the year ended December 31,
1996. This increase resulted from the hiring of additional research and
development personnel in 1997, as well as increased clinical trials and
manufacturing start-up costs. 

     General and administrative expenses increased to $3.1 million for the year
ended December 31, 1997 from $2.2 million for the year ended December 31, 1996.
General and administrative expenses during these years consisted primarily of
personnel costs, which increased due to the hiring of additional administrative
personnel. 

     Interest income increased to $1.0 million for the year ended December 31,
1997, from $.7 million for the year ended December 31, 1996, as a result of
higher average cash balances. 

     The Company recorded a net loss of approximately $442,000 for the year
ended December 31, 1997. The Company's modest net loss was primarily the result
of receipt of a one-time payment of $7.0 million and collaborative research and
development funding by Ethicon.


YEAR 2000 DISCLOSURE
The Company is preparing for the impact of the arrival of the Year 2000 on its
business, as well as on the businesses of its customers, suppliers and business
partner. The "Year 2000 Issue" is a term used to describe the problems created
by systems that are unable to accurately interpret dates after December 31,
1999. These problems are derived predominantly from the fact that many software
programs have historically categorized the "year" in a two-digit format. The
Year 2000 Issue creates potential risks for the Company, including potential
problems in the Company's products as well as in the Information Technology
("IT") and non-IT systems that the Company uses in its business operations. The
Company may also be exposed to risks from third parties with whom the Company
interacts who fail to adequately address their own Year 2000 Issues.

     The Company's plan for IT systems consists of four phases: (1)
inventory-identifying all IT systems; (2) assessment --identifying IT systems
that use date functions and assessing them for Year 2000 functionality; (3)
remediation--reprogramming, or replacing where necessary, inventoried items to
ensure they are Year 2000 ready; and (4) testing and certification--testing the
code modifications and new inventory with other associated systems, including
extensive date testing and performing quality assurance testing to ensure
successful operation in the post-1999 environment.



                                       12
<PAGE>

     The Company completed the inventory and assessment phases for substantially
all of its IT systems by year-end 1998. The Company's IT systems are currently
in the remediation and testing and certification phases. The Company plans to
complete the remediation of substantially all of its IT systems by June 30,
1999, and the testing and certification of all of its IT systems by September
30, 1999.

     The Company also faces the risk that one or more of its critical suppliers
or customers ("external relationships") will not be able to interact with the
Company due to the third party's inability to resolve its own Year 2000 issues,
including those associated with its own external relationships.

     The Company has initiated a formal process designed to determine the
overall Year 2000 readiness of its external relationships. In the case of
important suppliers, the Company is engaged in discussions with those suppliers
and is attempting to obtain detailed information as to those parties' Year 2000
plans and state of readiness. Although the Company is not aware of any problems
that would materially impact results of operations, liquidity or capital
resources, the Company does not have sufficient means to determine whether its
external relationships will be Year 2000 ready. The inability of those parties
to complete their Year 2000 remediation could have a material adverse effect on
Focal.

     Total Year 2000 project costs are currently estimated to be $300,000 to
$400,000 in 1999. A large majority of these costs are expected to be incremental
expenses that will not recur in the Year 2000 or thereafter. The Company's
current estimates primarily reflect increased remediation and testing efforts,
increased use of outside resources, and certain software and hardware
expenditures related to remediation. Focal is currently evaluating fully
integrated enterprise resource planning systems ("ERP system") and expects to
install such an ERP system during 1999. A key requirement of an ERP system will
be Year 2000 compliance. Also, affecting the cost estimates are expenses related
to upgrading much of the Company's Analytical Chemistry equipment to full Year
2000 compliance. During 1998, the Company upgraded many of the personal
computers and software used by employees, and the Company now believes that the
majority of the computers currently in use are Year 2000 ready. The costs
incurred in 1998 relating to this upgrade of personal computers and software was
approximately $200,000.

     Focal believes that the potential risks associated with unresolved Year
2000-related issues are limited in that the Company has relatively few
sophisticated systems that drive the Company's business at this time. Focal is
prepared to develop contingency plans to address any unresolved Year 2000 issues
or to address key suppliers' failures to respond to the Company's request for
state of readiness disclosure from those suppliers.

     Any critical unresolved Year 2000 issues at the Company or its external
relationships could have a material adverse effect on the Company's results of
operations, liquidity or financial condition. In addition, the Company's
expectations about the future costs and timely and successful completion of its
Year 2000 program are subject to uncertainties that could cause actual results
to differ materially from what has been discussed above under "Year 2000."
Factors that could influence the amount of future costs and the completion dates
and effectiveness of remediation, testing and certification and contingency
planning efforts include the Company's success in identifying IT systems and
embedded systems that contain two-digit year codes, the nature and amount of
required reprogramming, testing and certification, the rate and magnitude of
related labor and consulting costs, the availability of qualified personnel and
the success of the Company's external relationships in addressing their own Year
2000 issues.


LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed operations primarily from the sale
of preferred stock in private place Management's Discussion (cont'd) ments as
well as the Company's 1997 initial public offering. Through December 31, 1998,
the Company has raised approximately $83.5 million from equity financings and
has received $7.0 million in equipment lease financing. In addition, the Company
has received funding from Ethicon and other corporate partners totaling
approximately $26.7 million through December 31, 1998.

     Cash used in operations totalled $11.1 million in the year ended December
31, 1998, as compared to the use of $0.1 million for the same period of 1997.
The change in cash from operations was due to significantly higher net losses
incurred in 1998, compared to 1997. Cash used in operations is equal to the net
loss incurred for each period, plus non-cash charges such as depreciation and
amortization of property and equipment plus any changes in working capital.

     Capital expenditures from inception through December 31, 1998 totalled $7.6
million, representing laboratory equipment, office furniture and equipment,
computers and certain leasehold improvements. The majority of these purchases


                                                                              13
<PAGE>

MANAGEMENT'S DISCUSSION (CONT'D) SALES.

have been financed through either direct financing leases or sale and leaseback
arrangements. As of December 31, 1998, the Company did not have any material
commitments for future capital expenditures. In the next 12 to 24 months, the
Company anticipates capital expenditures of approximately $2.5 million for
manufacturing facilities and related equipment. The Company has commitments from
lenders in the form of lease lines totalling $1.5 million to provide for its
expected capital needs during 1999 and the first half of 2000.

     Under certain agreements with universities and consultants, the Company is
obligated to make payments for sponsored research and consulting services. The
Company's research funding commitments under these agreements totalled
approximately $118,000 at December 31, 1998. Payments under these agreements are
typically made on a quarterly or monthly basis.

     Under the Company's surgical sealant collaborative agreement with Ethicon,
a total of $21.6 million has been committed to Focal and $20.1 million had been
received as of December 31, 1998. Additional payments may be made under this
agreement for research and development activities and upon achievement of
specified development milestones. However, there can be no assurance as to the
receipt or timing of any such payments. The Company believes that its existing
capital resources, interest income and future payments due under strategic
alliances, will be sufficient to satisfy its current and projected funding
requirements for at least 15 months.

     There can be no assurance that the Company's capital resources will be
sufficient to enable the Company to conduct its research and development
programs as planned. The Company's future capital requirements will depend on
many factors, including continued progress in its research and development
programs, progress with preclinical testing and clinical trials, the time and
costs involved in obtaining regulatory approvals, if any, the costs involved in
filing and prosecuting patent applications and enforcing patent claims,
competing technological and market developments, the establishment of additional
strategic alliances, the cost of manufacturing facilities and of
commercialization activities and arrangements, and the cost of product
in-licensing and any possible acquisitions. There can be no assurance that the
Company's cash, cash equivalents and marketable securities and interest income
earned thereon, together with funding that may be received under the Company's
strategic alliances, will be adequate to satisfy its capital and operating
requirements.

     The Company intends to seek additional funding through strategic alliances,
and may seek additional funding through public or private sales of the Company's
securities, including equity securities. In addition, the Company has obtained
equipment lease financing and other forms of debt financing and may continue to
pursue opportunities to obtain additional lease or debt financing in the future.
There can be no assurance, however, that additional equity or debt financing
will be available on reasonable terms, if at all. Any additional equity
financing would be dilutive to the Company's stockholders. If adequate funds are
not available, the Company may be required to curtail significantly one or more
of its research and development programs and/or obtain funds through
arrangements with corporate partners or others that may require the Company to
relinquish rights to certain of its technologies or product candidates.
        



14
<PAGE>

BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                                        December 31,
-------------------------------------------------------------------------------------------------------------------

                                                                                                1997                  1998
-------------------------------------------------------------------------------------------------------------------
<S>                                                                                         <C>                    <C>         
Assets
Current assets:
  Cash and cash equivalents                                                                 $ 26,810,777           $  8,516,936
  Marketable securities                                                                        6,428,374             16,829,291
  Accrued interest receivable                                                                    201,225                359,911
  Contract revenues receivable                                                                 2,046,641                     --
  Accounts receivable                                                                                 --                587,380
  Inventories, net                                                                               566,989                937,017
  Prepaid expenses and other assets                                                              485,718                252,086
                                                                                            ------------           ---------------
Total current assets                                                                          36,539,724             27,482,621

Notes receivable from related parties                                                            343,480                282,442

Property and equipment                                                                         6,438,098              7,568,435
Less accumulated depreciation and amortization                                                 3,727,585              4,886,037
                                                                                            ------------           ---------------
Net property and equipment                                                                     2,710,513              2,682,398
Other assets                                                                                      12,696                 13,368
                                                                                            ------------           ---------------
Total assets                                                                                $ 39,606,413           $ 30,460,829

Liabilities and stockholders' equity Current liabilities:
  Accounts payable                                                                          $  1,577,105           $  1,105,585
  Accrued liabilities                                                                          2,454,702              2,752,359
  Deferred revenue                                                                               750,000                550,000
  Current portion of capital lease obligations                                                   890,451                886,517
                                                                                            ------------           ---------------
Total current liabilities                                                                      5,672,258              5,294,461

Capital lease obligations                                                                      1,421,983              1,390,821

Commitments and contingent liabilities

Stockholders' equity:
  Preferred stock, $.01 par value; 5,000,000 shares authorized;
  none issued and outstanding                                                                         --                     --
  Common stock, $.01 par value; 50,000,000 shares authorized;
  12,868,570, and 13,367,767 shares issued and outstanding at
  December 31, 1997 and 1998, respectively                                                       128,686                133,678
  Additional paid-in capital                                                                  80,777,780             84,884,786
  Accumulated deficit                                                                        (45,920,014)           (59,327,360)
  Notes receivable from related parties                                                       (1,688,057)            (1,443,133)
  Deferred compensation                                                                         (768,865)              (464,206)
  Accumulated other comprehensive income                                                         (17,358)                (8,218)
                                                                                            ------------           ---------------
Total stockholders' equity                                                                    32,512,172             23,775,547
Total liabilities and stockholders' equity                                                  $ 39,606,413           $ 30,460,829
                                                                                            ------------           ---------------
                                                                                            ------------           ---------------
</TABLE>

SEE ACCOMPANYING NOTES.


15
<PAGE>

STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                                             Convertible
                                                                           Preferred Stock                  Common Stock
-------------------------------------------------------------------------------------------------------------------
                                                                        Shares          Amount          Shares         Amount
-------------------------------------------------------------------------------------------------------------------
<S>                                                                   <C>              <C>             <C>             <C>     
Balances at December 31, 1995                                          14,561,046      $ 145,610         664,504       $  6,645
Net issuance of Series E convertible
  preferred stock at $1.74 per share                                    9,784,201         97,842
Exercise of stock options                                                                                 58,840            588
Deferred compensation
Amortization of deferred compensation
Comprehensive income
  Unrealized gain on marketable securities
  Net loss
    Total comprehensive income
                                                                      ------------     ----------      ---------       -----------
Balances at December 31, 1996                                          24,345,247        243,452         723,344          7,233
                                                                      ------------     ----------      ---------       -----------
Exercise of stock options for notes receivable                                                         1,494,775         14,948
Net proceeds from initial public offering                                                              2,500,000         25,000
Conversion of preferred stock upon IPO                                (24,345,247)      (243,452)      8,117,803         81,178
Exercise of stock options and warrants                                                                    32,648            327
Deferred compensation
Amortization of deferred compensation
Comprehensive income
  Unrealized gain on marketable securities
  Net loss
    Total comprehensive income
                                                                      ------------     ----------      ---------       -----------
Balances at December 31, 1997                                                                         12,868,570        128,686
Net proceeds from exercise of over-allotment option                                                      375,000          3,750
Exercise of stock options                                                                                 92,578            926
Shares repurchased and retired                                                                           (24,884)          (249)
Principal payments on notes receivable
Shares issued under ESPP                                                                                  56,503            565
Amortization of deferred compensation
Comprehensive income:
  Unrealized gain on marketable securities
  Net loss
    Total comprehensive income
                                                                      ------------     ----------      ---------       -----------
Balances at December 31, 1998                                                                $--      13,367,767       $133,678
</TABLE>


16
<PAGE>

SEE ACCOMPANYING NOTES.

<TABLE>
<CAPTION>

                                                   Notes                                      Accumulated
   Additional                                   Receivable                                       Other                 Total
     Paid-in            Accumulated            From Related             Deferred             Comprehensive         Stockholders'
     Capital              Deficit                 Parties             Compensation              Income                Equity
  --------------      --------------          -------------           -------------          ---------------       ---------------- 
  <S>                 <C>                     <C>                     <C>                    <C>                   <C>             
  $ 41,215,682        $ (35,320,380)                                                           $(52,400)            $ 5,995,157

    13,959,510                                                                                                       14,057,352
        54,129                                                                                                           54,717
     1,074,637                                                         (1,074,637)
                                                                          140,533                                       140,533

                                                                                                  9,357                   9,357
                        (10,158,089)                                                                                (10,158,089)
                                                                                                                    (10,148,732)
  --------------      --------------          -------------           -------------          ---------------       ---------------- 
    56,303,958          (45,478,469)                                     (934,104)              (43,043)             10,099,027
     1,673,109                                  (1,688,057)
    22,471,550                                                                                                       22,496,550
       162,274
        13,849                                                                                                           14,176
       153,040                                                           (153,040)
                                                                          318,279                                       318,279

                                                                                                 25,685                  25,685
                           (441,545)                                                                                   (441,545)
                                                                                                                       (415,860)
  --------------      --------------          -------------           -------------          ---------------       ---------------- 
    80,777,780          (45,920,014)            (1,688,057)              (768,865)              (17,358)             32,512,172
     3,545,750                                                                                                        3,549,500
       118,539                                                                                                          119,464
       (29,675)                                     29,923
                                                   215,001                                                              215,001
       472,392                                                                                                          472,957
                                                                          304,659                                       304,659

                                                                                                  9,140                   9,140
                        (13,407,346)                                                                                (13,407,346)
                                                                                                                    (13,398,206)
  --------------      --------------          -------------           -------------          ---------------       ---------------- 
   $84,884,786         $(59,327,360)           $(1,443,133)            $ (464,206)             $ (8,218)           $ 23,775,547
</TABLE>


                                                                              17
<PAGE>



STATEMENTS OF OPERATIONS



<TABLE>
<CAPTION>
                                                                                          Year ended December 31,
-----------------------------------------------------------------------------------------------------------------------------------

                                                                              1996                1997                1998
-----------------------------------------------------------------------------------------------------------------------------------
Revenues:
  <S>                                                                 <C>                    <C>                   <C>         
  Collaborative research revenues                                         $   3,098,289       $  17,489,264        $  5,113,953
  Product revenues                                                                  --                  --            3,071,490
                                                                      ----------------        ---------------      ---------------- 
Total revenues                                                               3,098,289          17,489,264            8,185,443
Costs and expenses:
  Cost of product revenues                                                          --                  --            3,739,807
  Research and development                                                  11,679,942          15,711,504           15,590,647
  General and administrative                                                 2,174,911           3,058,424            3,815,432
                                                                      ----------------        ---------------      ---------------- 
Total costs and expenses                                                    13,854,853          18,769,928           23,145,886
Other income (expense):
  Interest income                                                              690,745             968,141            1,765,420
  Interest expense                                                             (92,270)           (129,022)            (212,323)
                                                                      ----------------        ---------------      ---------------- 
                                                                               598,475             839,119            1,553,097
Net loss                                                                  $(10,158,089)       $   (441,545)        $(13,407,346)
Basic and diluted net loss per share (pro forma
  in 1996 and 1997)                                                       $      (1.26)       $      (0.04)        $      (1.01)
Shares used in computing basic and diluted
  net loss per share                                                         8,088,898          10,410,091           13,291,182
</TABLE>

SEE ACCOMPANYING NOTES.




18
<PAGE>

STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                          Year ended December 31,
-------------------------------------------------------------------------------------------------------------------

                                                                              1996                1997                1998
-------------------------------------------------------------------------------------------------------------------
Operating activities
<S>                                                                       <C>                 <C>                  <C>          
Net loss                                                                  $(10,158,089)         $ (441,545)        $(13,407,346)
Adjustments to reconcile net loss to net cash
  used in operating activities:
    Depreciation and amortization                                              969,868           1,128,923            1,158,452
    Amortization of deferred compensation                                      140,533             318,279              304,659
    Interest accrued on notes receivable                                       (10,604)           (112,238)            (103,280)
    Loss on sale of property and equipment                                       3,647                  --                   --
    Changes of operating assets and liabilities:
      Accrued interest receivable                                             (110,006)            (42,790)            (158,686)
      Contract revenues receivable                                                  --          (2,046,641)           2,046,641
      Accounts receivable                                                           --                  --             (587,380)
      Inventories                                                                   --            (566,989)            (370,028)
      Prepaid expenses and other assets                                        (58,146)           (173,837)             233,632
      Accounts payable                                                        (112,894)          1,075,501             (471,520)
      Accrued liabilities                                                      315,969             589,712              297,657
      Deferred revenue                                                         655,333              94,667             (200,000)
      Other assets                                                             565,666                (647)                (672)
      Notes receivable                                                         (88,000)             33,908              164,318
                                                                          -------------       -------------        ----------------
Net cash used in operating activities                                       (7,886,723)           (143,697)         (11,093,553)

Investing activities
Purchase of marketable securities                                          (12,760,761)         (9,589,782)         (27,762,163)
Maturities of marketable securities                                          7,975,000           9,929,811           17,370,386
Purchase of property and equipment                                            (388,683)         (2,326,008)          (1,130,337)
Proceeds from sale of property and equipment                                     2,150                  --                   --
                                                                          -------------       -------------        ----------------
Net cash used in investing activities                                       (5,172,294)         (1,985,979)         (11,522,114)

Financing activities
Proceeds from issuance of common stock, net                                     54,717          22,510,726            3,549,500
Proceeds from lease financing                                                  372,356           2,029,382            1,077,336
Principal payments on capital lease obligations                               (960,243)         (1,065,126)          (1,112,432)
Proceeds from the issuance of convertible preferred
  stock, net of issuance costs                                              14,057,352                  --                   --
Proceeds from exercise of stock options                                             --                  --              119,464
Proceeds from issuance of common stock under
  the employee stock purchase plan                                                  --                  --              472,957
Principal payments on notes receivable                                              --                  --              215,001
                                                                          -------------       -------------        ----------------
Net cash provided by financing activities                                   13,524,182          23,474,982            4,321,826
Net increase in cash and cash equivalents                                      465,165          21,345,306          (18,293,841)
Cash and cash equivalents at beginning of the year                           5,000,306           5,465,471           26,810,777
                                                                          -------------       -------------        ----------------
Cash and cash equivalents at end of the year                              $  5,465,471         $26,810,777         $  8,516,936

Supplemental disclosure of cash flow information:
  Property acquired under capital lease obligations                          $ 408,943          $  379,639            $       0
                                                                          -------------       -------------        ----------------
  Interest paid                                                              $  92,270          $  129,022            $ 212,323
</TABLE>

SEE ACCOMPANYING NOTES.


                                                                              19
<PAGE>

NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1998


NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

ORGANIZATION AND BUSINESS
Focal, Inc. (the Company) develops, manufactures and commercializes synthetic,
absorbable, liquid surgical sealants based on the Company's proprietary polymer
technology. The Company's family of FocalSeal surgical sealant products is
currently being developed for use inside the body to seal air and fluid leaks
resulting from lung surgery, neurosurgery, cardiovascular surgery and
gastrointestinal surgery.

REVERSE STOCK SPLIT
On October 16, 1997, the Board of Directors approved a 1 for 3.25 reverse stock
split of common shares, effected in the form of a reverse stock dividend which
became effective on December 11, 1997. All common share and per common share
amounts included in the accompanying financial statements and notes thereto have
been retroactively restated to give effect to a 1 for 3.25 reverse stock split.

USE OF ESTIMATES
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.

CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES
Cash and cash equivalents include funds held in investments with original
maturities of three months or less. Marketable securities consist of investments
in agencies of the U.S. government, investment grade corporate notes and other
investments with original maturities of greater than three months.

     The Company determines the appropriate classification of cash equivalents
and marketable securities at the time of purchase and reevaluates such
designation as of each balance sheet date. The Company has classified such
holdings as available-for-sale securities, which are carried at fair value, with
unrealized gains and losses reported as a separate component of stockholders'
equity.

CONCENTRATION OF CREDIT RISK
The Company invests its cash equivalents and marketable securities with
institutions that have strong credit ratings. The Company has developed
guidelines relative to investment risk and liquidity.

     All product revenues and accounts receivable are derived from one customer.

FAIR VALUE OF FINANCIAL INSTRUMENTS
Carrying amounts of financial instruments held by the Company, which include
cash equivalents, accounts receivable, accounts payable and accrued expenses,
approximate fair value due to their short duration.

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

PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and are depreciated using the
straight-line method over estimated useful lives of 3-5 years. Property and
equipment under capital leases are amortized using the straight-line method over
the lease term, typically 4 years.

REVENUE RECOGNITION
Revenues from collaborative research agreements are
recognized as earned upon the incurrence of reimbursable expenses or the
achievement of certain milestones. Payments received in advance of research
performed are designated as deferred revenue. Reimbursable expenses incurred or
milestones achieved but not yet reimbursed are designated as contract revenues
receivable.

     Product revenues are recognized upon shipment to the customer (see Note 8).

RESEARCH AND DEVELOPMENT COSTS AND PATENT COSTS
All research and development costs, including the cost of acquiring patents and
licensing fees paid in connection with university technology licensing
agreements, are expensed as incurred.
      
STOCK BASED COMPENSATION
The Company accounts for its stock based compensation arrangements under the
provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees. The
Company has adopted the disclosure provisions only of Statement of Financial
Accounting Standards No. 123, Accounting for Stock-Based Compensation (FAS 123).



20
<PAGE>

NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1998

INCOME TAXES
The liability method is used to account for income taxes. Deferred tax assets
and liabilities are determined based on differences between the financial
reporting and income tax basis of assets and liabilities as well as net
operating loss carryforwards, and are measured using the enacted tax rates and
laws that will be in effect when the differences are expected to reverse.
Deferred tax assets may be reduced by a valuation allowance to reflect the
uncertainty associated with their ultimate realization.

BASIC AND DILUTED NET LOSS PER SHARE
Basic and diluted net loss per share is presented in accordance with the
provisions of Statement of Financial Accounting Standards No. 128, Earnings Per
Share. Basic net loss per share is computed based on the weighted average number
of shares of common stock outstanding. Diluted net loss per share does not
differ from basic net loss per share since potential common shares to be issued
upon exercise of stock options are anti-dilutive for the periods presented. Pro
forma net loss per share for 1996 and 1997 is computed using the weighted
average number of outstanding common shares and convertible preferred shares,
assuming conversion at date of issuance. Historical earnings per share for 1996
and 1997 have not been presented since such amounts are not deemed meaningful
due to the significant change in the Company's capital structure that occurred
in connection with the initial public offering in 1997.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In 1998, the Company adopted Statement of Financial Accounting Standards No.
130, Reporting Comprehensive Income (FAS 130). FAS 130 establishes standards for
the reporting and display of comprehensive income and its components. FAS 130
did not have a material impact on the Company's financial statements.

    In 1998, the Financial Accounting Standards Board issued Statement No. 133
Accounting for Derivative Instruments and Hedging Activities (FAS 133). FAS 133
requires companies to record derivatives on the balance sheet as assets or
liabilities, measured at fair value. Gains or losses resulting from changes in
values of those derivatives would be accounted for depending on the use of the
derivative and whether it qualifies for hedge accounting. FAS 133 is effective
for the Company in fiscal 2000. The Company does not believe that the adoption
of FAS 133 will have a material effect on the Company's financial statements.

RECLASSIFICATIONS
Certain amounts in 1996 and 1997 have been reclassified to permit comparison
with 1998 amounts.


NOTE 2: MARKETABLE SECURITIES
Available-for-sale marketable securities consisted of the following at December
31:

<TABLE>
<CAPTION>

--------------------------------------------------------------------------------
                                     1997
--------------------------------------------------------------------------------

                                Gross      Gross
                             Unrealized Unrealized  Estimated
                     Cost       Gains     Losses   Fair Value
--------------------------------------------------------------------------------
<S>               <C>         <C>      <C>         <C>       
U.S. government
  securities due
within one year   $2,000,000  $ 4,200  $ (19,300)  $1,984,900
Corporate notes
  due within
one year           4,445,732       --     (2,258)   4,443,474
                  ----------  -------  ----------  -----------

Total debt
  securities
included in
marketable
securities        $6,445,732  $ 4,200  $ (21,558)  $6,428,374
                  ----------  -------  ----------  -----------
</TABLE>

<TABLE>
<CAPTION>

--------------------------------------------------------------------------------
                                     1998
--------------------------------------------------------------------------------

                                Gross      Gross
                             Unrealized Unrealized  Estimated
                     Cost       Gains     Losses   Fair Value
--------------------------------------------------------------------------------
<S>              <C>           <C>      <C>        <C>        
U.S. government
  securities due
within one year  $ 1,000,000   $  490   $      0   $ 1,000,490
Corporate notes
  due within
one year          15,837,508    5,384    (14,091)   15,828,801
                 -----------   ------   ---------  -----------

Total debt
  securities
included in
marketable
securities       $16,837,508   $5,874   $(14,091)  $16,829,291
                 -----------   ------   ---------  -----------
</TABLE>

     Amortized cost basis was used in computing the cost of marketable
securities sold.




                                                                              21
<PAGE>


NOTES TO FINANCIAL STATEMENTS(CONT'D) DECEMBER 31, 1998

        


NOTE 3: INVENTORIES
Inventories consist of the following at December 31:


<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
                                         1997          1998
--------------------------------------------------------------------------------

<S>                                    <C>           <C>     
Purchased parts and sub assemblies     $566,989      $219,298
Work in process                              --       672,928
Finished goods                               --        44,791
                                       --------      --------
                                       $566,989      $937,017
                                       --------      --------
                                       --------      --------
</TABLE>



NOTE 4: PROPERTY AND EQUIPMENT
Property and equipment consist of the following at December 31:

<TABLE>
<CAPTION>

--------------------------------------------------------------------------------
                                      1997            1998
--------------------------------------------------------------------------------

<S>                                <C>             <C>       
Leasehold improvements             $1,094,980      $1,118,916
Laboratory equipment                3,905,092       4,678,566
Office equipment, computers
  and software                        867,667       1,157,125
Furniture and fixtures                570,359         613,828
                                   -----------     -----------
                                   $6,438,098      $7,568,435
                                   -----------     -----------
</TABLE>



NOTE 5: ACCRUED LIABILITIES
Accrued liabilities consist of the following at December 31:

<TABLE>
<CAPTION>

--------------------------------------------------------------------------------
                                      1997            1998
--------------------------------------------------------------------------------
<S>                                <C>             <C>       
Accrued university research funding
  and outside scientific services  $  950,107      $1,022,264
Accrued payroll-related expenses      453,481         669,140
Accrued professional fees             349,988         217,900
Accrued other                         701,126         843,055
                                   ----------      -----------
                                   $2,454,702      $2,752,359
                                   ----------      -----------
                                   ----------      -----------
</TABLE>


NOTE 6: STOCKHOLDERS' EQUITY

PREFERRED STOCK
The Company is authorized to issue up to 5,000,000 shares of preferred stock,
$.01 par value, in one or more series, each of such series to have such rights
and preferences, including voting rights, dividend rights, conversion rights,
redemption privileges and liquidation preferences, as shall be determined by the
Board of Directors.

     In 1997, the Company adopted a Shareholder Rights Plan (the Rights Plan)
designed to protect shareholders from unsolicited attempts to acquire the
Company on terms that do not maximize stockholder value. In connection with the
Rights Plan, the Board of Directors will designate a certain number of shares of
the Company's preferred stock as Series A Participating Preferred Stock. Under
the Rights Plan, a right to purchase one one-thousandth of one share of the
Series A Preferred Stock (the Rights) will be distributed as a dividend for each
share of common stock. The terms of the Rights Plan provide that the Rights will
become exercisable upon the earlier of the tenth day after any person or group
acquires 15% or more of the Company's outstanding common stock or the tenth
business day after any person or group commences a tender or exchange offer
which would, if completed, result in the offer or owning 15% or more of the
Company's outstanding common stock. The Rights may generally be redeemed by
action of the Board of Directors at $.001 per Right at any time prior to the
tenth day following the public announcement that any person or group has
acquired 15% or more of the outstanding common stock of the Company. The Rights
expire on January 28, 2007. The Rights have certain anti-takeover effects in
that they would cause substantial dilution to the party attempting to acquire
the Company.

     In certain circumstances, the Rights allow the Company's stockholders to
purchase the number of shares of the Company's common stock having a market
value at the time of the transaction equal to twice the exercise price of the

     Rights, or in certain circumstances, the stockholders would
be able to acquire that number of shares of the acquirer's common stock having a
market value, at the time of the transaction, equal to twice the exercise price
of the Rights. The Company will continue to issue Rights with future issuances
of common stock.



22
<PAGE>

       

WARRANTS
Prior to the initial public offering, the Company granted warrants to secure
lease financing, to raise capital, to obtain letters of credit and as a form of
compensation to various consultants. At December 31, 1998, the Company has
common stock warrants outstanding covering 51,878 shares at exercise prices
ranging from $5.66 to $13.83 per share expiring at various dates through
February 2006.

STOCK OPTIONS
The 1992 Incentive Stock Plan (the 1992 Plan) authorizes the grant of incentive
stock options and nonqualified stock options to employees and nonqualified stock
options to consultants. A total of 2,600,000 shares have been reserved for
issuance under the 1992 Plan. The exercise price of incentive stock options
granted under the 1992 Plan may not be less than 100% of the fair market value
of the common stock as of the grant date, as determined by the Board of
Directors. The exercise price of nonqualified stock options may not be less than
85% of the fair market value of the common stock as of the grant date. Options
issued under the 1992 Plan generally have a four year vesting period, unless
otherwise determined by the Board of Directors. The term of stock options
granted under the 1992 Plan may not exceed ten years. Subject to the approval of
the Board of Directors, the Plan allows option holders the right to immediately
exercise outstanding options (both vested and unvested), with the subsequent
share issuances being subject to a repurchase option by the Company under
certain conditions according to the original vesting schedule and exercise
price.

     For certain options granted, the Company recognizes
as compensation expense the excess of the deemed fair value for accounting
purposes of the common stock issuable upon exercise of such options over the
aggregate exercise price of such options. In connection with these grants,
$1,074,637 and $153,040 of deferred compensation was recorded in the years ended
December 31, 1996 and 1997, respectively. No deferred compensation was incurred
during 1998. This compensation expense is being amortized over the vesting
period of each option.

     In January 1997, the Board of Directors approved a program under which
directors, executive officers and certain other key employees were permitted to
exercise options to purchase 1,494,775 common shares in exchange for four-year
notes with an interest rate of 6% per annum as permitted by the 1992 Plan. The
notes are full recourse and principal and accrued interest are payable upon the
maturity of the note. Under certain conditions, the shares are subject to a
repurchase option by the Company according to the original vesting schedule. At
December 31, 1998, a total of 388,236 shares issued under the 1992 Plan are
subject to the Company's repurchase option and $1,443,133 of notes receivable
are outstanding and included in the stockholders' equity section of the
accompanying financial statements.

     The 1997 Employee Stock Purchase Plan (the Purchase Plan) has 200,000
shares of common stock reserved for issuance thereunder. Under the Purchase Plan
eligible employees may purchase common shares at a price per share equal to 85%
of the lower of the fair market value of the common stock at the beginning of a
two year offering period or the end of each six month purchase period included
in such offering period. Participation in the offering period is limited to 15%
of the employee's compensation or $25,000 in any calendar year. The first
offering period commenced in January 1998 and the Purchase Plan will terminate
in 2007.

     The 1997 Non-Employee Director Option Plan (the Director Plan) has 150,000
shares of common stock reserved for issuance thereunder. Effective with the 1998
annual meeting of stockholders and annually thereafter, each non-employee
director is automatically granted a nonstatutory option to purchase 5,000 shares
of common stock. The exercise price of each of these options will be equal to
the fair market value of the common stock on the date of grant. Each option
granted under the Director Plan will vest on a cumulative monthly basis over a
four-year period. The Director Plan will terminate in September 2007, unless
terminated earlier in accordance with the provisions of the Director Plan.



                                                                              23
<PAGE>




  
NOTES TO FINANCIAL STATEMENTS(CONT'D) DECEMBER 31, 1998


     The following table presents the activity of all of the stock option plans
for the years ended December 31, 1996, 1997 and 1998:

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------------------
                                                  1996                            1997                           1998
-----------------------------------------------------------------------------------------------------------------------------------

                                                       Weighted                        Weighted                      Weighted
                                                        Average                         Average                       Average
                                        Options     Exercise Price      Options     Exercise Price    Options     Exercise Price
-----------------------------------------------------------------------------------------------------------------------------------

<S>                                   <C>           <C>              <C>            <C>               <C>         <C>  
Outstanding at beginning of year        557,894         $ .94         1,712,650          $1.14        497,267          $4.42
Granted                               1,275,691          1.20           313,058           6.40        394,778           9.87
Exercised                               (58,840)          .85        (1,510,287)          1.13        (92,578)          1.26
Canceled                                (62,095)         1.17           (18,154)          2.01        (19,105)          4.66
                                      ----------     ---------       -----------     ----------       -------      -----------

Outstanding at end of year            1,712,650         $1.14           497,267          $4.42        780,362          $7.55
                                      ----------     ---------       -----------     ----------       -------      -----------
Options exercisable at end of year      537,121         $1.01           184,052          $2.74        189,439          $5.07
V
Weighted average fair value per share
  of options granted during the year                    $ .46                            $3.69                         $5.84
                                                     ---------                       ----------                    -----------
</TABLE>

     The following table presents weighted average price and life information
about significant option groups outstanding at December 31, 1998:

<TABLE>
<CAPTION>

                                                Options Outstanding                                    Options Exercisable
-----------------------------------------------------------------------------------------------------------------------------------

                                                     Weighted
                                                      Average             Weighted                                     Weighted
                                                     Remaining             Average                                      Average
   Range of                      Number             Contractual           Exercise               Number                Exercise
Exercise Prices                Outstanding          Life (Yrs.)             Price              Exercisable               Price
-----------------------------------------------------------------------------------------------------------------------------------

  <S>                          <C>                  <C>                  <C>                   <C>                     <C>  
     $0.72                        6,528                4.4                 $0.72                  6,528                 $0.72
     1.20                       106,938                7.0                  1.20                 73,614                  1.20
   4.06-5.69                     74,488                8.5                  4.68                 27,312                  4.59
     7.64                       197,230                8.8                  7.64                 54,625                  7.64
  8.13-10.88                    315,573                9.8                  8.67                 21,482                 10.63
  11.00-13.13                    44,000                9.4                 12.71                  1,066                 12.95
  15.00-18.00                    35,605                9.3                 17.13                  4,812                 17.32
                                -------                                                         ----------                          
                                780,362                                                         189,439
                                -------                                                         ----------                          
</TABLE>



24
<PAGE>

     If the compensation cost for the option plans had been determined based on
the fair value at the grant date for grants in 1996, 1997 and 1998, consistent
with the provisions of FAS 123, the pro forma net loss and net loss per share
for 1996, 1997 and 1998, would be as follows (in thousands except per share):

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
                  1996             1997             1998
--------------------------------------------------------------------------------

              As           Pro      As       Pro       As        Pro
           Reported       Forma  Reported   Forma   Reported    Forma
--------------------------------------------------------------------------------

<S>        <C>         <C>        <C>       <C>     <C>        <C>      
Net loss   $(10,158)   $(10,287)  $(442)    $(792)  $(13,407)  $(14,121)
Basic and
  diluted
net loss
per share  $  (1.26)   $ (1.27)   $(.04)    $(.08)  $  (1.01)  $ (1.06)
</TABLE>

     The fair value of options and warrants issued at the date of grant were
estimated using the Black-Scholes model with the following weighted average
assumptions:

<TABLE>
<CAPTION>
                                          Options Granted
--------------------------------------------------------------------------------

                                     1996      1997      1998
--------------------------------------------------------------------------------

<S>                                   <C>       <C>       <C>
Expected life (years)                 5.0       5.0       5.0
Interest rate                         6.6       6.0       4.5
Volatility                            30%       60%       66%
</TABLE>

     The Company has never declared nor paid dividends on any of its capital
stock and does not expect to do so in the foreseeable future.


     The effects on 1996, 1997 and 1998 pro forma net loss and net loss per
share of expensing the estimated fair value of stock options are not necessarily
representative of the effects on reporting the results of operations for future
years as the periods presented include only one, two and three years,
respectively, of option grants under the Company's plans.

COMMON STOCK RESERVED FOR ISSUANCE
At December 31, 1998, the Company has reserved 1,257,168 shares of common stock
for issuance upon the exercise of all outstanding warrants and options
authorized under the 1992 Plan, Purchase Plan and the Director Plan.

NOTE 7: COMMITMENTS
The Company has a ten-year lease agreement expiring in 2004 for its principal
facility. In connection with this lease, the lessor funded approximately
$4,367,000 of leasehold improvements which are reimbursed as part of the minimum
lease payments. The Company has certain options to purchase the building and the
leasehold improvements.


     The Company leases the majority of its equipment, furniture and fixtures
under capital leases. Included in property and equipment at December 31, 1997
and 1998, respectively, were assets with a cost basis of $6,057,532 and
$7,253,337 acquired under capital leases. Accumulated amortization as of
December 31, 1997 and 1998, respectively, related to these assets was $3,599,571
and $4,742,226.


     As of December 31, 1998, the future minimum lease payments under capital
and operating leases are as follows:

<TABLE>
<CAPTION>

                                  Capital         Building
                                  Leases       Operating Lease
--------------------------------------------------------------------------------

<S>                             <C>               <C>      
Year ended December 31,1999     1,037,914         1,109,337
                       2000       864,445         1,147,974
                       2001       497,711         1,147,974
                       2002       152,711         1,147,974
                       2003            --         1,147,974
                 Thereafter            --           860,980
                                ----------       -----------                    

Total minimum lease payments     2,552,781        $6,562,213

Less interest                     275,443

Present value of minimum
  lease payments                2,277,338
Less capital lease obligations
  due within one year             886,517
                                ----------     

Capital lease obligations--
  long-term portion            $1,390,821
                                ----------     
</TABLE>




                                                                              25
<PAGE>



     Total rent expense was $1,078,803, $1,090,332 and $1,114,389 in 1996, 1997,
and 1998, respectively.

     The Company has a lease commitment totaling $1.5 million from a leasing
company for the financing of equipment and leasehold improvements. Under this
agreement, the term for financing equipment purchases and leasehold improvements
is 48 months and 36 months, respectively. The interest rate is established as of
the commencement date for each new drawdown, based on a treasury security index,
and is fixed for the term of the financing. There is a fixed percentage buy-out
provision at the end of the lease period. The lease financings are
collateralized by the equipment and leasehold improvements being financed. As of
December 31, 1998, there were $762,456 in outstanding borrowings under this
financing arrangement. There are no financial covenants in connection with this
lease financing.


NOTE 8: RESEARCH AND DEVELOPMENT AND 
        LICENSING AGREEMENTS
In January 1997, the Company entered into a distribution and licensing agreement
with Ethicon, Inc., a Johnson & Johnson company ("Ethicon") for the research,
development and commercialization of the Company's surgical sealant products.
Ethicon received marketing rights to all territories outside North America in
exchange for (a) a one-time, nonrefundable payment to the Company for past
research and development expenditures; (b) fixed quarterly funding for two years
to be applied toward research and development costs for lung surgery and
neurosurgery surgical sealant products; (c) funding of certain additional
research and development expenses; (d) payments upon achievement of specific
milestones; and (e) specified percentages of product sales representing a
combined royalty and product cost payment. The Company retained worldwide
manufacturing rights and North American marketing rights. The term of the
Ethicon Agreement extends until January 2007, subject to one year extensions at
Ethicon's discretion. In addition, Ethicon may terminate the agreement at any
time after January 2000 upon 12 months' prior written notice with or without
cause. The Company began shipping its surgical sealant product to Ethicon in
1998. In August 1998, the Ethicon agreement was expanded to include research and
development funding for a cardiovascular surgical sealant.

     The Company has collaborative research agreements and technology licensing
agreements with certain universities. The Company has worldwide exclusive
licenses to the technologies developed under these agreements in exchange for
funding certain research and payment of licensing fees and royalties on
applicable product sales. Research and development expense and licensing fees
incurred under these agreements during the years ended December 31, 1996, 1997,
and 1998, totaled $156,000, $144,000, and $150,000, respectively. In connection
with these agreements, the Company has research funding commitments totaling
approximately $118,000 at December 31, 1998.


NOTE 9: INCOME TAXES
Due to net losses incurred by the Company in each year since its inception, no
provision for income taxes has been recorded. At December 31, 1998, the Company
had tax net operating loss carryforwards of approximately $56 million and
federal and state research and development tax credit carryforwards of
approximately $3.3 million, which expire at various times through 2018.
     Significant components of the Company's deferred tax assets as of December
31 are as follows:

<TABLE>
<CAPTION>

--------------------------------------------------------------------------------
                                     1997            1998
--------------------------------------------------------------------------------

<S>                               <C>           <C>         
Deferred tax assets:
  Net operating loss carryforwards$ 17,327,000  $ 22,468,000
  Research and development
  tax credits                      2,363,000       3,290,000
  Other                              735,000         885,000
                                  ------------  -------------

                                  20,425,000      26,643,000
  Valuation allowance            (20,425,000)    (26,643,000)
                                  ------------  -------------

Net deferred tax assets                 $ --            $ --
                                  ------------  -------------
</TABLE>

     For financial reporting purposes, a valuation allowance has been provided
since realization of such deferred tax assets is uncertain at this time. The
valuation allowance increased by $6,218,000 during 1998, due primarily to the
increase in tax credits and net operating loss carryforwards. The future
utilization of the net operating loss carryforwards may be subject to
limitations under the change in stock ownership provisions of the Internal
Revenue Code.




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<PAGE>




NOTE 10: RELATED PARTY TRANSACTIONS
In connection with an employment agreement, interest-bearing loans aggregating
$120,000 were made to an officer of the Company. Principal and accrued interest
on this loan were paid in full by December 31, 1998. Other officer and
non-officer employee notes receivable, certain of which notes contain similar
repayment terms as those described above, are outstanding and included in notes
receivable from related parties in the accompanying financial statements.

     Certain participants in the Company's preferred stock financing
transactions include venture capital funds affiliated with members of the
Company's board of directors.


NOTE 11: SUBSEQUENT EVENTS
On February 24, 1999, the Board of Directors adopted the 1999 Stock Incentive
Plan (the 1999 Plan) and reserved 875,000 shares of common stock for issuance
thereunder subject to the approval of the Company's shareholders. The exercise
price of incentive stock options may not be less than 100% of the fair market
value of the common stock on the date of grant. The exercise price of the
non-qualified options may not be less than 85% of the fair market value of the
common stock on the date of grant. Options granted under the 1999 Plan will
generally vest over a four year period and will expire no later than 10 years
from the date of grant.



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<PAGE>

  
REPORT OF INDEPENDENT AUDITORS




The Board of Directors and Stockholders
Focal, Inc.

We have audited the accompanying balance sheets of Focal, Inc. as of December
31, 1997 and 1998, and the related statements of operations, stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1998. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

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

     In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Focal, Inc. at December 31,
1997 and 1998, and the results of its operations and its cash flows for each of
the three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles.





                                                          /s/ ERNST & YOUNG LLP



Boston, Massachusetts 
January 26, 1999, except for Note 11, 
as to which the date is February 24, 1999
        


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