10-K405

 
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               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
 
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                                   FORM 10-K
 
[X]Annual Report Pursuant to Section 13 or 15 (d) of the Securities Exchange
   Act of 1934
  For the Fiscal Year Ended December 31, 1998 or
 
[_]Transition Report Pursuant to Section 13 or 15 (d) of the Securities
   Exchange Act of 1934
 
Commission File Number: 0-21371
 
                             APPLIED IMAGING CORP.
            (Exact name of registrant as specified in its charter)
 


                     Delaware                                     77-0120490
                                                
         (State or other jurisdiction of                       (I.R.S. Employer
          incorporation or organization)                     (Identification No.)
 

   2380 Walsh Avenue, Building B, Santa Clara,
                    California                                       95051
                                                
     (Address of principal executive offices)                     (Zip Code)
 
Registrant's telephone number, including area code: (408) 562-0250
 
Securities registered pursuant to Section 12 (b) of the Act:
 

                                                             Name of each exchange
               Title of each class                            on which registered
                                                
                       None                                           N/A

 
Securities registered pursuant to Section 12 (g) of the Act:
 
                        Common Stock, $0.001 par value
                               (Title of Class)
 
  Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the 90 days. Yes [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
 
  The aggregate market value of voting stock held by non-affiliates of the
registrant, based upon the closing sale price of the Common Stock on March 8,
1999, as reported on the NASDAQ National Market, was approximately
$11,529,537.
 
  The number of shares of Common Stock outstanding as of March 8, 1999:
11,529,537 shares.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Part III of this Form 10-K incorporates information by reference from the
Registrant's definitive proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the close of the fiscal
year.
 
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                                    PART I
 
Item 1. BUSINESS
 
  This Report on Form 10-K contains certain forward looking statements
regarding future events with respect to Applied Imaging Corp. Actual events or
results may differ materially as a result of the factors described herein and
in the documents incorporated herein by reference, including, in particular,
those factors described under "Additional Risk Factors."
 
The Company
 
  Applied Imaging Corp ("Applied Imaging" or the "Company") was incorporated
in California in July 1986, and reincorporated in Delaware in October 1996.
Applied Imaging designs, develops, manufactures and markets automated image
analysis systems used by cytogenetic laboratories for prenatal, cancer and
other genetic testing applications. The Company's cytogenetic instrumentation
and reagent business, which has sold systems to over 650 sites in more than 35
countries since its inception, markets computer-based microscopic image
analysis systems that enable laboratories to automate the analysis of
chromosomal abnormalities associated with conditions such as Down Syndrome.
The Company is also developing a proprietary genetic screening technology
designed to facilitate prenatal screening for genetic abnormalities by
isolating "fetal blood cells" from a routine maternal blood sample. This new
technology is designed to improve current prenatal testing methods by
providing a timely and cost-effective screening procedure without the risks of
miscarriage or fetal damage associated with invasive prenatal tests such as
amniocentesis or chorionic villus sampling. In addition, the company has under
development a system to detect micrometastatic cells from bone marrow, lymph
node and blood samples from cancer patients as a means to better determine the
initial staging of the cancer and then detect relapses after treatment earlier
than is currently possible.
 
  According to the Company's own analysis of its primary competitors' publicly
available financial data, Applied Imaging is a leading provider of automated
chromosomal image analysis systems to clinical and research laboratories
worldwide. The Company's CytoVisionTM systems are utilized because of their
ability to analyze standard human chromosome preparations using powerful
software classification algorithms along with a specialized cytogenetic user
interface. The CytoVision systems also incorporate the capability to analyze
and record images derived from advanced genetic research assays employing
fluorescent in situ hybridization ("FISH") or comparative genomic
hybridization ("CGH") methods. The Company has introduced its first
proprietary assay for color chromosome analysis (called RxFISHTM), a rapidly
developing area of research interest. Based upon a novel method developed by
scientists at The University of Cambridge, the Company's RxFISHTM assay
develops a unique fluorescent color banding pattern for human chromosomes that
is then analyzed by the CytoVisionTM system. The future development of
specialized reagent products that can be optimized for use on the Company's
installed base of over 1100 chromosome analysis workstations worldwide is one
aspect of the Company's business strategy.
 
  The Company's prenatal genetic screening development program is focused on
the isolation of specific fetal cells from a blood sample taken from the
expectant mother using normal venipuncture techniques. This allows prenatal
genetic testing to be performed without the need to obtain a fetal tissue
sample by an invasive procedure, such as amniocentesis, which can pose a
physical risk to the fetus. The Company's proprietary screening technology
incorporates (i) a hematological procedure to enrich the concentration of
fetal blood cells found in maternal blood, (ii) a fetal hemoglobin test kit,
(iii) automated image analysis instrumentation to identify fetal blood cells
and (iv) third-party DNA probes to identify certain chromosomal abnormalities
present in these fetal blood cells. This prenatal screening system is expected
to be both safe and accurate because it evaluates actual fetal cells while
posing no direct risk to the fetus. The Company's prenatal screening products
are currently under development. The Company has received notice from the U.S.
Food and Drug Administration, ("FDA"), that it may market either of two
components utilized in its prenatal screening method (the ENRICH Kit and its
WinScan Automated Image Analysis System). The Company has chosen not to market
these components on a stand-alone basis at the present time. The Company
believes that certain of its new cell enrichment, identification and image
 
                                       1

 
analysis products may also have utility for cancer testing as in the case of
the detection of micrometastatic disease at the time of initial patient
diagnosis and treatment.
 
Genetic Disorders
 
  All genetic information in an organism is contained in its chromosomes, made
up of strands of DNA and associated protein molecules. DNA is comprised of
paired nucleotide bases and genetic information is encoded by the specific
order of the nucleotide bases within units called genes. Genes are organized
linearly along the chromosomes and carry the required information for the
synthesis of the proteins that provide the structural components of cells and
tissues, as well as the enzymes needed for the basic biochemical and
physiological functions of the cells.
 
 Chromosomal Disorders
 
  The nuclei of normal human cells (except sperm and egg cells) contain two
sets of 23 different chromosomes, one set provided by each parent. Sperm and
egg cells are formed in a special cell division process called meiosis, and
they each contain only one set of the 23 individual chromosomes. When these
cells unite during fertilization, each contributes its set of 23 chromosomes
to the genetic information for a new human fetus, and the fertilized egg then
has the two sets of 23 chromosomes. Chromosomal disorders may occur when genes
or portions of genes move between chromosomes (chromosomal translocations),
when portions of chromosomes and the genes they contain are missing, or when
an abnormal number of chromosomes are present in the cell. Certain chromosomal
disorders are thought to occur during meiosis when the division of the
chromosomes to form the egg cell or the sperm cell takes place. During this
process the chromosomes may not divide properly resulting in an extra
chromosome being present in the cell, an extra piece of genetic material being
attached to a chromosome, or a piece of chromosome being broken.
 
  Chromosomes can be seen under a microscope and, when stained with certain
dyes, reveal light and dark bands reflecting regional variations in the DNA of
the cell. Differences in size and banding pattern allow the chromosomes to be
distinguished from each other or may identify a chromosomal disorder. The most
common chromosomal disorder, Down Syndrome, also known as trisomy 21, occurs
when there are three copies of chromosome 21 in the human cell. Syndromes
caused by the most common chromosomal abnormalities may result in mental
retardation, impaired physical development and abnormal sexual development.
 
  There are approximately four million births in the United States annually.
Of these, approximately 90% are to women under the age of 35. The Company
estimates that there are approximately 11 million births in industrialized
countries where prenatal screening and diagnostic testing is routine.
Approximately 2% of newborns have birth defects, approximately 12% of which
are caused by chromosomal genetic disorders. The risk of bearing a child with
a chromosomal abnormality increases with maternal age and more than doubles
from one in 526 births for mothers of age 20 to more than one in 192 births
for mothers of age 35.
 
 Single Gene Disorders
 
  In addition to chromosomal disorders caused by an abnormal number of
chromosomes, single gene disorders may occur when the DNA sequences of
individual genes are altered, resulting in the disruption of the normal
balance or function of essential human proteins. Single gene disorders are
responsible for many inherited diseases such as cystic fibrosis, sickle cell
anemia and Tay-Sachs disease.
 
 Cancer Cytogenetics
 
  Chromosomal analysis is also performed for clinical research purposes for
the precise characterization of certain types of cancers. Cancerous cells
frequently demonstrate complex chromosomal abnormalities. The patterns of
these chromosomal abnormalities may be associated with certain well-defined
cancers. The chromosomal analysis of leukemia and lymphomas, for example, may
provide researchers with supplementary
 
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information useful in the staging or classification of the disease and may
also provide useful prognostic indicators. Similarly, advanced chromosomal
analysis may allow a researcher to assess the sources of new disease in a
patient to determine if this is a recurrence of a previous cancer or an
entirely different neoplasm.
 
Prenatal Testing
 
  Prenatal testing is the process of detecting certain types of chromosomal
disorders in a fetus at an early stage of pregnancy. Prenatal testing is
currently performed either invasively, by extracting fetal cells and
inspecting the chromosomes within such cells to diagnose specific disorders or
non-invasively, by an analysis of a maternal blood sample.
 
  The invasive diagnostic procedures yield accurate results on a broad range
of chromosomal disorders because actual fetal cells are obtained and analyzed.
However, these procedures involve the risk of spontaneous miscarriage and
other complications. Due to the risk of spontaneous miscarriage, invasive
diagnostic procedures are usually recommended only to those women who are age
35 or older (at which ages the risk of having a child with a chromosomal
disorder is greater than the risk of spontaneous miscarriage due to the
procedure) or who have another specific risk factor for fetal abnormalities.
 
  Those women younger than 35 are typically screened initially using non-
invasive techniques. For this group, an invasive diagnostic procedure is
generally recommended to confirm the result of a non-invasive blood test if
such test indicates a heightened risk of a chromosomal disorder. The blood
test presents no risk to the fetus, but is less accurate since it does not
diagnose chromosomal genetic disorders by direct analysis of fetal cells.
These non-invasive tests are known to produce relatively high levels of false
negative and false positive test results. A false negative test result is seen
as a failure to identify a chromosomal disorder when it is actually present,
while a false positive test result occurs when a test result indicates the
presence of a chromosomal disorder that is actually not present.
 
  Women under the age of 35 have a lower statistical risk of giving birth to
an infant with a chromosomal disorder than do women age 35 or older. However,
because the majority of all births are among women under the age of 35, the
total number of newborns with chromosomal disorders born to women in this age
group is much higher than that among women age 35 and older. Consequently,
women younger than 35 bear over 75% of all infants with Down Syndrome.
 
 Invasive Diagnostic Procedures
 
  Amniocentesis. Amniocentesis, usually performed between the 14th and 20th
weeks of pregnancy, is the most common procedure used to obtain fetal cell
samples for prenatal genetic testing. In an amniocentesis procedure a small
amount of amniotic fluid is withdrawn from the amniotic sac via a long needle
inserted through the mother's abdominal wall. During the procedure, the
physician typically uses ultrasound instrumentation to guide the needle in
order to minimize potential harm to the unborn child. Once the amniotic sample
is extracted, it is forwarded to a cytogenetic laboratory, where the cells are
cultured and deposited on a microscope slide. The slide is then examined under
a microscope in order to locate and analyze a number of fetal cells in
metaphase (undergoing cell division). During metaphase, a cell's chromosomes
are individually visible under the microscope.
 
  Chromosome analysis without the advantage of an automated imaging system is
both tedious and time consuming. Typically, a laboratory technologist scans
the slide manually to locate cells in metaphase. Once metaphase cells are
found, they are photographed using a camera attached to the microscope. This
photograph is then printed and each photographed chromosome is manually cut
out of the photograph, arranged in order and pasted on a sheet to show the two
sets of 23 chromosomes present in the cell. This visual presentation of the
chromosomes is called a karyotype. Alternatively, laboratories may eliminate
many of these steps by using an automated image analysis system to scan the
slides for cells in metaphase, to automatically classify the chromosomes, to
present them on a video display for review and acceptance and to print final
karyotype copies.
 
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  Once the karyotype is completed it is then visually analyzed by a trained
geneticist or genetic counselor to determine if any chromosomal abnormalities
are present. The processing and analysis of prenatal genetic samples obtained
by amniocentesis generally requires seven to 14 days. A significant portion of
this time is required to culture the fetal cells for use in the visual
karyotype. In the United States, amniocentesis generally costs more than
$1,000 for the procedure itself, tissue culture and karyotypic assessment.
With an estimated fetal loss rate of approximately 0.5% (one in every 200
procedures) one normal fetus will be lost by spontaneous miscarriage resulting
from amniocentesis for every one or two fetuses with chromosomal disorders
detected by this procedure for women at age 35.
 
  Amniocentesis is the most common and accurate of all prenatal screening
procedures. All principal chromosomal disorders can be detected and the Down
Syndrome detection rate is greater than 99%.
 
  Chorionic Villus Sampling (CVS). CVS, typically performed between the 9th
and 12th weeks of pregnancy, involves the extraction of placental tissue
samples, generally through the pregnant woman's cervix. The tissue, which is
genetically representative of the fetus, is analyzed in the same manner as the
fetal cells obtained by amniocentesis to determine if chromosomal disorders
are present. CVS is an alternative to amniocentesis and can be performed
earlier in the pregnancy, but poses a risk of miscarriage that is one in every
100 CVS procedures, double that of amniocentesis. CVS is generally as accurate
as amniocentesis for detecting chromosomal abnormalities. With an estimated
fetal loss rate of approximately 1% (one in every 100 procedures), two normal
fetuses will be lost by spontaneous miscarriage resulting from CVS for every
one or two fetuses with chromosomal disorders detected by this procedure for
women at age 35. Due to its higher associated risk and procedural complexity
CVS is used less frequently than amniocentesis for prenatal diagnostic
purposes.
 
 Non-invasive Screening Procedures
 
  In the United States, approximately 2,000,000 pregnant women under the age
of 35 are screened each year for chromosomal disorders and other birth
defects. Of those screened, a majority are tested using the non-invasive serum
tests described below.
 
  Alpha-Fetoprotein Test. A common serum prenatal screening test for certain
chromosomal disorders involves the analysis of alpha-fetoprotein ("AFP") in
the maternal blood. This test is performed on a standard blood sample taken
from the mother that is tested for levels of serum AFP. Down Syndrome and
other similar chromosomal disorders are associated with low levels of AFP.
Although this serum test is relatively accurate in detecting open neural tube
defects (such as spina bifida), studies indicate that the AFP test can detect
only 20-30% of fetuses with Down Syndrome.
 
  Triple Test. In recent years, the accuracy of the AFP test has been improved
by combining it with additional blood chemistry tests. This combination is
commonly referred to as "triple marker screening" or the "triple test." This
test identifies Down Syndrome in 60% of the pregnancies where Down Syndrome is
present. In 40% of the cases where Down Syndrome is present, this test
inaccurately concludes that Down Syndrome is not present (a false negative
result). In approximately 5% of the cases, the triple test suggests the
presence of a chromosomal disorder where it is not present (a false positive
result).
 
  Women whose triple test screening results indicate a heightened risk of
chromosomal disorder are usually recommended to have an amniocentesis
procedure to confirm these results. Due to the high false positive rate
associated with the triple test, clinically unnecessary amniocentesis
procedures are performed in many cases where no chromosomal disorder exists.
Assuming two million serum screening tests per year and a 5% false positive
rate, as many as 100,000 unnecessary amniocentesis procedures may be performed
on women with healthy fetuses each year in the U.S. In addition, assuming an
average cost of $1,500 per amniocentesis, the unnecessary cost to the health
care system associated with these false positive triple test results could be
as high as $150 million per year. With an estimated fetal loss rate of 0.5%,
approximately 500 normal fetuses may be lost each year as a direct result of
such unnecessary amniocentesis procedures.
 
                                       4

 
 New Serum Markers
 
  In order to improve the specificity and sensitivity of the serum screening
tests, new markers are being identified and tested on an ongoing basis. These
new markers can be substitutes for one of the triple marker tests or additions
to the testing panel. No general consensus has yet been reported in scientific
literature regarding which new markers may offer the most cost-effective
improvements to current screening procedures.
 
 Summary
 
  The most accurate prenatal testing involves direct analysis of fetal cells,
which contain the chromosomes of the fetus. The only routinely available
procedures to extract fetal cells in order to examine the fetal chromosomes
are invasive and pose risks of injury to the fetus and/or spontaneous
miscarriage. The non-invasive serum screening procedures, which do not pose
such risks, are much less accurate because they do not allow for the direct
examination of fetal chromosomes. The Company believes that there is a
significant need for a prenatal testing procedure which would allow direct
analysis of the fetal cells without the risks associated with the currently
available invasive procedures.
 
  Fetal blood cells exist in minute quantities in samples of maternal blood.
In contrast to adult red blood cells, many of these fetal red blood cells are
nucleated. That is, they contain a nucleus with fetal chromosomes. A number of
companies and research groups are attempting to isolate these fetal blood
cells for testing through a variety of methods, including immunologically-
based separation techniques using monoclonal antibodies, flow cytometry, or
magnetic separation techniques. Although the feasibility of genetic analysis
of fetal blood cells isolated from maternal blood has been demonstrated,
obtaining a sufficient number of fetal blood cells for analysis has been
difficult and must be adapted further for routine clinical applications.
 
Applied Imaging's Prenatal Screening Products
 
  The Company is developing a prenatal screening test to detect chromosomal
abnormalities by identifying fetal blood cells from a routine maternal blood
sample. The Company's proprietary screening technology incorporates: (i) a
hematological procedure to enrich the concentration of fetal blood cells
utilizing the Company's consumable enrichment kit, (ii) a fetal hemoglobin
identification kit, (iii) automated image analysis instrumentation to identify
the fetal blood cells and (iv) the use of third-party DNA probes to identify
certain chromosomal disorders present in fetal blood cells. This new approach
is designed to improve current prenatal screening procedures by providing an
accurate, timely and cost-effective technique without the risks of miscarriage
or fetal damage associated with invasive prenatal screening techniques.
 
  In contrast to immunologically based procedures to isolate fetal blood cells
from maternal blood, the Company is developing a hematologically based
procedure for enriching the concentration of fetal blood cells from maternal
blood samples. The Company's enrichment process is designed to increase the
concentration of fetal blood cells in a maternal sample approximately 10,000
times. The fetal cell enriched sample is then harvested and deposited on a
microscope slide. The fetal hemoglobin in the cell is stained using the
identification kit to facilitate examination through image analysis. The
Company has developed a semi-automated system to automatically identify fetal
cells on the slide based on adaptations of the image analysis, pattern
recognition, and slide-scanning technologies incorporated in the Company's
current cytogenetic products.
 
  Once fetal cells are stained by the fetal hemoglobin identification kit,
fluorescent DNA probes are added that specifically bind to certain DNA
sequences within the fetal cells indicating the presence or absence of
chromosomal disorders. DNA probes can be designed to locate specific
chromosomal changes, additions, or deletions that result in genetic disorders.
The results of the DNA probe analysis are captured and processed using the
Company's automated visualization technology for the detection, analysis, and
documentation of the DNA probe results.
 
 Clinical/Regulatory Matters
 
  In December 1996, the Company submitted two 510(k) medical device
applications to the FDA. The first submission is for a product that isolates
mononuclear cells with the use of a gel gradient separation medium.
 
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The product is based on the Company's patented hematological techniques. The
Company received notification from the FDA on December 15, 1997 that this
product may be marketed in the US and, as labeled, is exempt from further
510(k) premarket notification regulatory requirements. The second submission
is for an automated image analysis instrument, (WinScan) which is a general
laboratory tool able to automatically detect and locate nucleated red blood
cells on a microscope slide. The instrument presents these cells for operator
review, further analysis, and eventual use in a diagnostic or screening
procedure. On June 15, 1998, the Company received notification from the FDA
that it received 510(k) clearance to market WinScanTM for the identification
and enumeration of nucleated red blood cells from peripheral blood.
 
  In June of 1997, the Company submitted an additional 510(k) notification for
the fetal hemoglobin identification kit. This submission has been withdrawn in
anticipation of being combined with a later DNA probe submission.
 
  The DNA probe components of the Company's products will require either FDA
clearance of a 510(k) with a tier III level of review or FDA approval of a
pre-market approval application ("PMA"). The Company plans to market its
prenatal screening products internationally upon receipt of required
regulatory clearances or approvals.
 
 Commercialization Strategy
 
  The Company's prenatal screening techniques under development are currently
expected to be introduced first in Europe and subsequently in the United
States and the Pacific Rim, subject to receipt of required clearances or
approvals in such jurisdictions.
 
  The technology is being designed to initially screen for chromosomal
abnormalities resulting in conditions such as Down Syndrome and certain sex
chromosome abnormalities such as Turner Syndrome, Klinefelter Syndrome, Triple
X Syndrome and certain other conditions. These abnormalities account for a
vast majority of the incidence of all birth defects which result from
chromosome-based genetic disorders. The proprietary prenatal screening
products under development will consist of: (i) a prepackaged kit to enrich
the concentration of nucleated fetal red blood cells in the maternal blood
sample; (ii) a reagent kit to identify the hemoglobins in fetal cells; (iii)
the Company's instrumentation to automate the identification of fetal blood
cells and the acquisition and presentation of the DNA probe analysis; and (iv)
a DNA probe kit that is comprised of DNA probes that may or may not be
provided by third parties.
 
Future Applications of the Prenatal Screening Products
 
  The Company's prenatal screening products are being designed to accommodate
various chromosome-specific DNA probes, which are currently commercially
available. The Company believes that its cell identification and enrichment
technology developed for prenatal screening could have future applications for
cancer diagnosis and monitoring via the isolation of tumor cells from bone
marrow or peripheral blood and the genetic analysis of such cells. Because
evaluations of future applications are at an early stage, no assurance can be
given when, if ever, the Company's fetal cell identification and enrichment
technology may facilitate the early detection of other disorders.
 
Micrometastases Detection
 
  The Company is developing a micrometastases detection system designed to
provide researchers and clinicians with the ability to identify
micrometastatic cells in bone marrow, lymph nodes or blood specimens. The
Company is currently involved in a collaborative study with a leading European
cancer center to determine the prognostic significance of micrometastatic
staging in a population of nine hundred cancer patients.. The micrometastasis
system incorporates (i) an automated image analysis system, (ii) monoclonal
primary antibodies specific to micrometastatic cells and (iii) a colorimetric
detection reagent. Micrometastasis is the spread of cancer away from the
primary tumor that is not detectable on routine screening tests. Typically,
the metastases are too
 
                                       6

 
limited to have created enough mass to be observed using routine examination
techniques. The majority of cancers with micrometastases are attributable to a
subset of cancer known as carcinomas, a malignant growth that arises from
epithelial cells, found in skin or, more commonly, the lining of body organs
(i.e., breast, prostate, stomach or bowel). Carcinomas tend to infiltrate into
adjacent tissue and then spread (metastasize) to distant organs such as bone,
liver, lung or the brain. The initial application for micrometastases testing
will be performed on patients at the time of initial diagnosis for breast,
prostate, colorectal and gastric carcinomas. This testing will be an adjunct
to normal staging parameters and will aid in the appropriate diagnosis and
treatment of these patients.
 
Current Cytogenetic Products
 
  In the United States, approximately 500,000 total cytogenetic test
procedures are performed annually. Cytogenetic testing includes prenatal
screening for genetic disorders using amniotic fluid obtained through
amniocentesis or fetal tissue samples obtained through CVS. Other cytogenetic
testing includes tests for the diagnosis and prognosis of cancerous conditions
using bone marrow, blood and tumor samples. The Company currently
manufactures, markets and sells its CytoVision family of automated instruments
for cytogenetic applications. The Company's primary cytogenetic products are
described below. The Company has sold systems to over 650 sites worldwide in
more than 35 countries. The Company's primary cytogenetic products currently
sell for prices ranging from $25,000 to $125,000, depending upon the
instrument's capabilities and final configurations.
 
 CV ChromoScan(TM) System
 
  The Cyto Vision ChromoScan is the Company's most comprehensive system for
automated chromosome analysis. The ChromoScan integrates many of the key
features of the Company's earlier products into one system capable of
automated microscope slide scanning, advanced chromosome analysis, and
fluorescent image processing. The ChromoScan allows laboratories to
automatically scan slides in either brightfield or fluorescent modes to locate
specific cells for chromosome analysis. This eliminates one of the most
tedious and time-consuming aspects of cytogenetic analysis: that of manual
slide scanning. The system accomplishes this in the background while
simultaneously allowing the technologist to process and analyze images
previously identified. The Company believes that no other commercially
available system for cytogenetic analysis incorporates this same range of
features in one integrated and automated package.
 
 CV ChromoFluor(TM) System
 
  The CytoVision ChromoFluor is a comprehensive chromosome analysis system
that integrates standard karyotyping capability with advanced FISH imaging
technologies including color chromosome analysis techniques. The system is
based on computerized image capture and analysis capabilities incorporating
pattern recognition and automated chromosome classification algorithms. The
system provides automated karyotyping capabilities, automatic separation of
touching or overlapping chromosomes (a common occurrence), a variety of user-
defined image enhancement features, report annotation capabilities and full
screen display options. The DNA probe imaging capability of the CytoVision
ChromoFluor utilizes the same imaging equipment to detect and analyze signals
from DNA probes that have been applied to cell nuclei. CytoVision Chromofluor
systems enhance images of often-faint fluorescent DNA probes and provide the
operator with a range of optimized analytical tools. The system may also be
upgraded to detect genetic amplifications and deletions in tumor cells
utilizing a research technique known as comparative genomic hybridization
("CGH").
 
 CytoVision(TM) System
 
  The CytoVision System incorporates the most commonly-required chromosome
analysis tools and FISH imaging capabilities into a standard workstation
suitable for widespread laboratory usage. The system provides automated
karotyping capabilities, automatic separation of touching or overlapping
chromosomes (a common occurrence), a variety of user-defined image enhancement
features, report annotation capabilities and full screen
 
                                       7

 
display options. This system entirely replaces the manual processing of
photographic images that previously included photographing individual cells in
metaphase, photographic development, the manual "cut-and-paste" of each
chromosome, identifying the individual chromosomes, arranging them in order
and preparation of the final karyotype report. This manual process may take 30
minutes to one hour of a technologist's time to process an individual sample.
The comparable CytoVision process requires only 10 minutes or less of the same
technologist's time. The DNA probe imaging capability of the Cyto VisionTM
system detects and analyzes signals from DNA probes that have been applied to
cell nuclei.
 
 RxFISH(TM) DNA Probe Reagents
 
  The first reagent product offered by the Company allows laboratories to
process color banded chromosome images using the Company's RxFISH research
reagent system. This system takes advantage of a novel DNA probe technique for
identifying each human chromosome with a unique color bar code that allows the
Company's proprietary image analysis software to rapidly and accurately
identify specific chromosomes, even in cases containing complex or cryptic
rearrangements.
 
  All of the products in the CytoVision family are compatible with one another
and can be integrated into a network with common data management protocols. In
addition to its analysis systems, the Company also sells a number of
peripherals including a range of high quality printers. A typical installation
will include a number of interconnected CytoVision systems and components.
 
Sales, Distribution and Marketing
 
  The Company currently sells its cytogenetic products to government and
private clinical cytogenetic laboratories, hospital laboratories, research
institutions, universities and pharmaceutical companies. The Company has sold
such systems to over 650 customers in more than 35 countries. These customers
utilize the Company's cytogenetic products for prenatal genetic screening as
well as for certain cancer research studies. If regulatory clearance or
approval is received, the Company initially plans to sell and distribute its
prenatal screening products directly and through its established worldwide
network of distributors and agents through which it sells and distributes its
current products.
 
  In North America, the Company sells its cytogenetic products directly to its
customers. The North American sales team is comprised of six sales and
application support specialists. Outside of North America, the Company sells
its products either directly through local agents who are remunerated on a
commission basis or through independent distributors. The Company manages its
international sales and distribution activities from Applied Imaging
International Ltd., the Company's wholly owned subsidiary located in the
United Kingdom. The international sales team is comprised of ten sales and
application support individuals, based in the United Kingdom and France. The
Applied Imaging International Ltd. sales team supports all distributors and
agents upon request. The Company's distributors are located in Australia, Hong
Kong, Japan, Italy and South Korea. In addition, the Company has agents
selling its cytogenetic products in a number of other countries primarily
within Europe, the Middle East and the Pacific Rim.
 
  Because the Company's products are technically sophisticated, the Company's
sales staff is supported by scientifically qualified and highly trained
product specialists. The Company offers an annual maintenance program to its
customers through its own support organization. The Company's marketing
activities include telemarketing, product advertising and participation in
trade shows and product seminars.
 
Manufacturing
 
  The Company assembles and tests components and subassemblies made by outside
vendors to the Company's specifications and manufactures only when it believes
significant value can be added. The Company's current products are assembled
from a combination of (i) commodity technology components such as computers
and monitors, (ii) custom subassemblies, such as automated filter wheels, and
(iii) operating
 
                                       8

 
systems and application software. Any disruption or delay in the supply of
components or custom subassemblies will have a material adverse effect on the
Company. While the Company typically uses components and subassemblies that
are available from alternate sources, any unanticipated interruption of the
supply of these components or subassemblies could require the Company to
redesign its products.
 
  The Company orders components and subassemblies to forecast and assembles
specific configurations on receipt of firm orders. The Company's research,
investigational and clinical products are subject to regulation by the FDA and
all products are subject to regulation by the U.S. Department of Commerce
export controls, primarily as they relate to the associated computers and
peripherals. The Company has experienced no material difficulties in obtaining
necessary export licenses to date.
 
  The Company plans to initially subcontract third parties to manufacture the
consumable enrichment kit components of its fetal cell screening technology
under development and may ultimately manufacture such components on its own.
For clinical trials, the Company intends to purchase the consumable enrichment
kit from a third party contracted to manufacture the kit. The Company has no
experience manufacturing such components. The Company may encounter
difficulties in scaling up production of the consumable component of its fetal
cell screening technology under development or in hiring and training
additional personnel to manufacture its consumable enrichment kit products in
commercial quantities.
 
  Under current law, if the Company manufactures finished devices in the
United States, it will be required to comply with the FDA's Quality System
Regulation and the State of California's current Good Manufacturing Practice
("GMP") regulations. In addition, the FDA and/or the California authorities
will inspect the Company's manufacturing facilities on a regular basis to
determine such compliance. Failure to comply with applicable FDA or other
regulatory requirements can result in fines, injunctions, civil penalties,
recalls or seizures of products, total or partial suspensions of production or
criminal prosecutions.
 
Research and Development
 
  The Company's research and development efforts include various research,
product development, clinical evaluation and testing, quality assurance,
regulatory and process development activities. The current focus of the
Company's research and development efforts is the continued development of the
Company's prenatal screening products and particularly the initiation of
clinical trials. In addition, the Company is analyzing different methods for
facilitating image analysis of fetal cell enriched samples. The Company's
future research and development efforts are expected to include development of
additional applications of the Company's current cytogenetic products and
additional applications of the fetal cell screening technology under
development. These potential additional applications may include the use of
technology developed for fetal cell analysis for the characterization and
monitoring of certain cancers and the diagnosis of certain single gene
disorders. Development of these applications would require substantial
additional funds and will be subject to technological, clinical, regulatory
and other risks associated with new medical technologies. There can be no
assurance that the Company will develop its prenatal screening products or any
other future applications of such technology.
 
  Research and development expenses were approximately $6.7 million, $7.4
million and $3.7 million in 1998, 1997 and 1996 respectively.
 
Patents and Proprietary Rights
 
  The Company actively seeks, when appropriate, protection for its products
and proprietary information by means of United States and foreign patents and
trademarks. The Company has one issued United States patent relating to its
CytoVision System and has corresponding issued patents in certain European
countries. The Company also has one United States patent relating to
Multicolor Fluorescent in situ Hybridization ("M-FISH") imaging techniques. In
addition, the Company has three United States patents concerning its
technology for enriching the concentration of fetal nucleated red blood cells
from maternal blood samples. Corresponding applications were filed through the
Patent Cooperation Treaty and preserve for the Company the right to file
 
                                       9

 
applications in various countries. The Company relies upon trade secrets,
know-how and contractual arrangements to protect certain of its proprietary
information and products.
 
  The fields of life science instrumentation and genetic screening processes
are covered by many issued patents and patent applications. The Company has
been notified that it may be infringing on certain patents pertaining to
specialized cytogenetic applications and the Company is currently reviewing
the merits of this claim. The Company is not aware of any other patents which
it may be infringing; however, patent applications in the United States remain
confidential until a patent is issued, and, therefore, the Company's products
could infringe patents to be issued in the future. If the Company's technology
is determined to use products, processes or other subject matter that is
claimed under other existing U.S. or foreign patents, or if other patents
claiming subject matter utilized by the Company are issued, such companies may
bring infringement actions against the Company. The Company may be required to
obtain licenses to patents or proprietary rights of others. There can be no
assurance that any such license would be made available or, if available,
would be available on commercially acceptable terms. Failure to obtain a
required license could prevent the Company from commercializing its products
resulting in a material adverse affect on the Company's business, financial
condition and results of operations.
 
  The Company generally enters into confidentiality agreements with its
employees and consultants designed to both protect the Company's confidential
information and prevent the disclosure of confidential information of prior
employers and other parties. There can, however, be no assurance that the
Company's trade secrets or proprietary technology will not become known or be
independently developed by competitors in such a manner that the Company has
no practical recourse. Certain employees of and consultants to the Company are
subject to the terms of confidentiality agreements with respect to proprietary
information of their former employers. The failure of these persons to comply
with the terms of their agreements could result in assertion of claims against
the Company and such persons which, if successful, might restrict their roles
within the Company.
 
  In 1996, the Company entered into a collaborative research agreement with
Leiden University ("Leiden") in the field of enrichment, isolation and
analysis of fetal cells derived from maternal blood. Under the terms of the
agreement, the Company has sole ownership of any jointly developed inventions
and has an exclusive license to any issued patents owned solely by Leiden. The
royalty rate for the exclusive license shall not be more than 5% of associated
sales. In 1996, the Company entered into an agreement to acquire an invention
for the use of certain antibodies in the identification of fetal cells from
maternal blood. The agreement provides for the Company to pay certain expenses
associated with obtaining a U.S. patent for the invention and a royalty of not
more than 2% of net sales. In 1998, the Company entered in an option agreement
to acquire ownership of patents for the enrichment of fetal cells. The
agreement provides for payments of $1.1 million if the option is exercised and
products using the technology are successful in clinical trials.
 
  In October 1997, the Company entered into an exclusive worldwide licensing
agreement with the University of Cambridge for the commercialization of DNA-
probe technology developed by Cambridge researchers. The technology, known as
Cross Species Color Banding, is being utilized by the Company in an effort to
develop research test reagents to detect and analyze chromosomal aberrations.
The Company has developed an initial test kit for color banding analysis of
human chromosomes that will be made available for research use. The agreement
requires minimum annual royalty payments of $30,000 and the payment for
specific research related projects. The agreement will remain in full force
and effect until the expiration of the last patent right or ten years
whichever is later.
 
  In January 1998, the Company entered into a non-exclusive worldwide
agreement with Vysis, Inc. for the right to use certain CGH software products.
The agreement requires an initial payment of $5,000 and a royalty payment of
$500 for each CGH software product sold.
 
  In March 1998, the Company entered into a non-exclusive worldwide agreement
with Amersham Pharmacia Biotech Inc for the right to use certain technologies
in conjunction with its DNA probe technology. The
 
                                      10

 
agreement requires minimum annual royalty payments of $10,000. The agreement
will remain in full force and effect until the expiration of all patents or
eight years; which ever is the later.
 
  The Company also relies upon trademarks to protect certain of its products,
and holds a United States trademark registration for the mark "CYTOSCAN."
Registration for this mark and the mark "CYTOVISION" are held by the Company
in certain foreign jurisdictions.
 
  The Company also has certain other trademark rights in the United States and
other foreign countries. It is possible that third parties may allege superior
rights to one or more of the Company's trademarks, or close variations, for
those countries in which the Company is presently conducting business or may
do so in the future. The Company's rights to use and register its marks in a
given jurisdiction may depend on its rights relative to a third party's rights
as governed by the laws of the pertinent country. Factors utilized to
determine the relevant rights between parties include priority of the use or
registration of the mark, how close the respective marks are in appearance,
sound and/or meaning, as well as the goods to which they are applied. It is
possible that the Company could be prevented from using or registering its
trademarks in certain countries due to a superior third party right.
 
Competition
 
  The market for the Company's current cytogenetic products is highly
competitive. The Company believes that its primary competitors in this market
include Perceptive Scientific Instruments, Inc. (a subsidiary of International
Remote Imaging Systems, Inc.), and Vysis Inc. The principal competitive
factors in this market are product features offered, ease of use, clarity of
output, customer service capabilities, price and installed base. The Company
believes it competes favorably with regard to these factors.
 
  With respect to its prenatal screening products under development, the
Company is aware of other companies that are in the process of developing
genetic screening products based on competing technologies designed to
specifically isolate fetal blood cells in maternal blood samples. Certain of
these companies have greater research and development, marketing and financial
resources than the Company. These companies include Genzyme Inc. and
Bioseparations Inc. Genzyme, through its Genetics subsidiary, specializes in
providing genetic testing services and Bioseparations is a research-stage
company focusing on fetal cell isolation methods.
 
  The medical diagnostic and biotechnology industries are subject to intense
competition. The Company's fetal cell screening technology, if commercially
marketed, will also be subject to intense competition from existing procedures
such as the triple test. There can be no assurance that the Company's fetal
cell screening technology under development will replace any existing
procedures. The Company expects the principal competitive factors in the fetal
cell screening market to be risk to the fetus, reliability, accuracy, range of
disorders detected, cost savings to health care systems and payers and the
price of testing.
 
  Certain of the Company's competitors have greater financial and technical
resources and production and marketing capabilities than the Company. There
can be no assurance that these competitors will not succeed in developing
technologies and products that are more effective, easier to use or less
expensive than those which are currently offered or being developed by the
Company or that would render the Company's technology and products obsolete
and noncompetitive. In addition, some of the Company's competitors have
significantly greater experience than the Company in conducting clinical
investigations of new diagnostic products and in obtaining FDA and other
regulatory clearances and approvals of products. Accordingly, the Company's
competitors may succeed in developing and obtaining regulatory approvals for
such products more rapidly than the Company.
 
Government Regulation
 
  The testing, manufacturing, labeling, distribution, sales, and marketing of
the Company's products are subject to government regulation in the United
States and in other countries. The Company believes that its future success
will be significantly dependent upon commercial sales of its prenatal
screening products under
 
                                      11

 
development. The Company will not be able to market these products for
commercial use in the United States until the Company obtains clearance or
approval from the FDA and will not be able to market such products overseas
until it meets the safety and quality regulations of each foreign jurisdiction
in which the Company seeks to sell such products. In the United States, the
Company's products are also subject to regulation by state authorities. The
State of California's requirements in this area require registration with the
state and compliance with state GMP regulations.
 
  Noncompliance with applicable FDA requirements can result in, among other
things, fines, injunctions, civil penalties, recall or seizure of products,
total or partial suspension of production, distribution, sales, and marketing,
refusal of the government to grant approval of a PMA or clearance of a 510(k),
withdrawal of marketing approvals or clearances, a recommendation by the FDA
that the manufacturer or distributor not be permitted to enter into government
contracts, and criminal prosecution. In certain circumstances, the FDA also
has the authority to order the manufacturer or distributor of a device to
repair, replace or refund the cost of the device. Failure to comply with
regulatory requirements in the United States or abroad could have a material
adverse effect on the Company's business, financial condition and results of
operations.
 
  Before a new medical device can be introduced into the market, the
manufacturer must obtain FDA clearance of a 510(k) or approval of a PMA,
unless the device is exempt from the requirement of such clearance or
approval. A 510(k) clearance will be granted if the submitted information
establishes that the device is substantially equivalent to a legally marketed
Class I or II medical device or to a legally marketed Class III device that
does not itself require an approved PMA prior to marketing ("predicate
device"). A 510(k) must contain information to support a claim of substantial
equivalence, which may include laboratory test results or the results of
clinical studies of the device in humans. Commercial distribution of a device
for which a 510(k) is required may begin only after the FDA issues a finding
that the device is "substantially equivalent" to a predicate device. A 510(k)
for a device incorporating new technology may be given a tier III level of
review, which requires the submission of data from human clinical trials. The
FDA is required to review 510(k) submissions within 90 days, but it generally
takes from five to twelve months from the date of submission to obtain 510(k)
clearance from the FDA; it may take longer and 510(k) clearance may never be
obtained. The FDA may determine that a device is not "substantially
equivalent" to a predicate device, or that additional information is needed
before a substantial equivalence determination can be made.
 
  If a device is not found by the FDA to be substantially equivalent to a
predicate device, the Company may be required to submit a PMA application. A
PMA must be supported by valid scientific evidence that typically includes
data from preclinical testing and human clinical trials to demonstrate the
safety and effectiveness of the device. Upon submission of a PMA, the FDA
makes a threshold determination regarding whether the application is
sufficiently complete to permit filing for a substantive review. An FDA review
of a PMA generally takes one to two years from the date the PMA is accepted
for filing, but may take significantly longer if the FDA requires the Company
to file any major amendment to the PMA. The review time is often significantly
extended by the FDA's asking for additional information. An Advisory Panel,
primarily composed of clinicians, is convened to review and evaluate the
application and provide recommendations to the FDA regarding whether the PMA
should be approved. The FDA is not bound by the recommendations of the
Advisory Panel. The FDA also conducts an inspection of the manufacturer's
facilities to ensure that the facilities are in compliance with GMP
requirements.
 
  The Company submitted a protocol for clinical trials of the DNA probe
product to the FDA in November of 1996. The Company intends to initiate a
multisite, United States and international, clinical trial of the DNA probe
component of its prenatal testing technology to detect chromosomal disorders
in isolated fetal cells. There can be no assurance regarding the timing or
nature of the FDA response regarding the DNA probe related protocol or the
timing for the commencement of clinical trials. There can be no assurance that
510(k) clearance for any of the prenatal screening products under development
or any other future product or modification of an existing product will be
granted or that the clearance process will not be unduly lengthy and subjected
to a thorough FDA review. The FDA has stated that the DNA probe product will
require at least a 510(k) tier III level of review. Further, in its draft
guidance for in vitro diagnostic devices utilizing cytogenetic in situ
 
                                      12

 
hybridization technology for the detection of genetic mutations, the FDA
states that when such devices are intended for use as a "stand-alone" for test
reporting based on interphase analysis, they will require a PMA that must be
reviewed and approved by the FDA prior to sales, distribution and marketing of
these products in the United States. The PMA process is typically more
complex, expensive and time consuming than the 510(k) process. While the
Company has made determinations regarding the appropriate form of approval, if
any, required for its products, there can be no assurance that such
determinations are correct, that the FDA will concur with such determinations
or that such determinations may not be altered due to new interpretations or
new data that may become available or changes in the FDA's policies.
 
  Export sales of investigational devices that are subject to PMA or
investigational device exemption application requirements and have not
received FDA marketing approval generally may be subject to FDA export permit
requirements depending upon, among other things, the purpose of the export
(investigational or commercial), the country to which the device is intended
for export, and on whether the device has valid marketing authorization in a
country listed in the FDA Export Reform and Enhancement Act of 1996. In order
to obtain such a permit, when one is required, the Company must provide the
FDA with documentation from the medical device regulatory authority of the
country in which the purchaser is located, stating that the device has the
approval of the country. In addition, the FDA must find that exportation of
the device is not contrary to the public health and safety of the country in
order for the Company to obtain the permit.
 
  In addition to domestic regulation of medical devices, the Company's current
products and its products under development are subject to corresponding
regulations governing safety processes, manufacturing processes and quality in
foreign jurisdictions in which it operates or such products are sold. The sale
of the fetal cell screening products under development may be materially
affected by the policies of regulatory bodies or the domestic politics of the
countries involved. There can be no assurance that an early prenatal screening
test for genetic disorders will not be prohibited or restricted in some
jurisdictions. In addition, FDA export permits may be required for shipment of
the Company's fetal cell screening products under development to certain
foreign countries. Failure to comply with applicable regulatory requirements
can, among other consequences, result in fines, injunctions, civil penalties,
suspensions or loss of regulatory approvals, product recalls, seizure of
products, operating restrictions and criminal prosecution. In addition, future
governmental regulations may be established that could prevent or delay
regulatory approval of the Company's products. The regulation of medical
devices in a number of such jurisdictions continues to develop and there can
be no assurance that new laws or regulations will not have a material adverse
effect on the Company's business. Upon the adoption of the "In Vitro
Diagnostic Medial Device Directive of October 27, 1998, the European Community
and its member countries currently are imposing more substantial regulation on
in vitro diagnostic devices and equipment-like medical devices, and such
regulation may affect the Company's current products and products under
development.
 
  Delays in receipt of clearances or approvals to market its products, failure
to receive these clearances or approvals, the loss of previously received
clearances or approvals or the determination that 510(k) clearance, pre-market
approval or other approval is required for a product being marketed without
such clearance or approval could have a material adverse effect on the
Company's business, financial condition and results of operations.
 
  In addition, laboratories who purchase the Company's current products and/or
the prenatal screening products under development could be subject to the
Clinical Laboratory Improvement Amendments of 1988 ("CLIA"), which are
intended to ensure the quality and reliability of medical testing conducted in
laboratories in the United States. The Company's products should comply with
CLIA regulations or the Company's ability to market its products could be
negatively affected.
 
  Marketed devices are subject to pervasive and continuing regulatory
oversight by the FDA and other agencies, including record-keeping requirements
and reporting of adverse experiences with the use of the device. Device
manufacturers are required to register their establishments and list their
devices with the FDA and certain state agencies. The Federal Food, Drug and
Cosmetic Act and certain state laws require that medical devices be
manufactured in accordance with the Quality System Regulations ("QSregs").
Manufacturing facilities are
 
                                      13

 
subject to periodic inspection by the FDA and certain state agencies on a
periodic basis to monitor compliance with GMP, QSregs and other requirements.
If violations of the applicable regulations are noted during such inspections
of manufacturing facilities, the Company can be prohibited from conducting
further manufacturing, distribution and sale of the devices until the
violations are cured.
 
  The Company is also subject to other federal, state, local and foreign laws,
regulations and recommendations relating to safe working conditions and good
laboratory practices. The extent of government regulation that might result
from any future legislation or administrative action cannot be accurately
predicted. Failure to comply with any federal or state regulatory requirements
could have a material adverse effect on the Company's business, financial
condition and results of operations.
 
Third-Party Reimbursement and Health Care Reform
 
  In the United States, the Company's products are purchased primarily by
medical institutions which then bill various third-party payors, such as
private insurance plans, Medicare, Medicaid, and other government programs
("Third-Party Payors") for the health care services provided to their
patients. Third-Party Payors may deny reimbursement if they determine that the
device used in a treatment was unnecessary, inappropriate, experimental or
investigational, used for a non-approved indication, or not cost-effective and
typically do not reimburse for devices used for research and investigational
purposes. Accordingly, physicians must determine that the new clinical
benefits of genetic screening procedures justify the additional cost. The
market for the Company's current cytogenetic products could be adversely
affected by changes in governmental and private third-party payors' policies
and the market for the Company's fetal cell screening technology under
development could be materially adversely effected by the failure of
governmental and Third-Party Payors adopting policies to reimburse health care
providers for the use of the Company's fetal cell screening technology under
development. The unavailability of third-party coverage or the inadequacy of
the reimbursement for medical procedures using the Company's products would
adversely affect the Company's business, financial condition and results of
operations. In both the United States and internationally, Third-Party Payors
are increasingly challenging the prices charged for medical products and
services. There can be no assurance that reimbursement for the procedures
using the Company's products will be available or, if currently available,
will continue to be available, or that future reimbursement policies of payors
will not adversely affect the Company's ability to sell its products on a
profitable basis. In addition, there can be no assurance that third-party
reimbursement will be available for diagnostic procedures based on the
Company's prenatal screening products under development.
 
  The levels of revenues and profitability of medical device companies may be
affected by the continuing efforts of governmental and Third-Party Payors to
contain or reduce the costs of health care through various means. In the
United States, there have been, and the Company expects that there will
continue to be, a number of federal and state proposals to implement
government regulation of health care costs. It is uncertain what legislative
proposals will be adopted or what actions federal, state or private payers for
health care goods and services may take in response to any health care reform
proposals or legislation. The Company cannot predict the effect health care
reforms may have on its business, and no assurance can be given that any such
reforms will not have a material adverse effect on the Company's business,
financial condition and results of operations. Further, to the extent that
such proposals or reforms have a material adverse effect on the business,
financial condition and profitability of the clinical and research
laboratories, hospitals and other institutions that comprise the Company's
customer base, the Company's business, financial condition and results of
operations could be adversely affected.
 
Product Liability and Insurance
 
  The Company's business may involve the risk of product liability claims,
including those relating to inaccurate results from its screening products.
Although the Company has not experienced any product liability claims to date,
any such claims could have a material adverse impact on the Company. The
Company maintains product liability insurance at coverage levels which it
deems commercially reasonable; however, there can be no assurance that product
liability or other claims will not exceed such insurance coverage limits or
that such
 
                                      14

 
insurance will continue to be available on commercially acceptable terms, or
at all. The Company intends to evaluate, depending on the circumstances that
exist at the time, whether or not to obtain any additional product liability
insurance coverage prior to the time that the Company engages in any extensive
marketing of its fetal cell screening technology under development. Even if
the Company obtains additional product liability insurance, there can be no
assurance that it would prove adequate or that a product liability claim,
insured or uninsured, would not have a material adverse effect on the
Company's business, financial condition and results of operations. Even if a
product liability claim is not successful, the time and expense of defending
against such a claim may adversely affect the Company's business, financial
condition and results of operations.
 
Employees
 
  As of December 31, 1998, the Company had 92 employees, of whom 33 were
involved in research and development, 9 in manufacturing and manufacturing
engineering, 37 in sales, marketing and customer service and 13 in finance and
administration. As of December 31, 1998, 40 of the employees were based in the
United Kingdom, 49 in the United States, 1 in Israel, and 2 in France. A total
of 5 employees hold Ph.Ds, and 1 employee is an M.D. The Company's employees
include a number of professional cytogeneticists who support and sell its
product range. The Company believes its relationship with its employees to be
good.
 
Additional Risk Factors
 
Prenatal Screening Products in Early Stage of Development; No Assurance of
Successful Development or Commercialization
 
  The Company's prenatal screening products are in an early stage of
development and testing. The isolation, identification, enrichment and
analysis of fetal cells from a maternal blood sample is difficult and poses a
significant technical challenge due to their rarity in maternal blood. The
Company has not yet determined how many fetal cells, if any, can be routinely
obtained using its process. In addition, fetal cells that circulate in
maternal blood are not yet completely understood in terms of their variety and
characteristics, such as longevity in maternal blood and fragility when
exposed to various processes to enrich their concentration in a maternal blood
sample. The Company has refined, and continues to refine, its processes and
test reformulated enrichment media to determine if concentrations of fetal
cells can be increased, but there can be no assurance that these efforts will
prove successful. In addition, there can be no assurance that the Company's
prenatal screening products will be able to detect fetal cells in amounts
sufficient to allow for the detection and analysis of chromosomal
abnormalities. There can be no assurance that the Company's prenatal screening
products will be able to effectively and accurately detect Down Syndrome or
other chromosomal abnormalities. The development and potential
commercialization of the Company's prenatal screening products will require
significant research and development, substantial investment and clinical
testing and regulatory clearances or approvals. The Company plans to continue
to conduct preclinical testing in order to analyze the feasibility of its
prenatal screening products. Such efforts may disclose significant technical
obstacles that need to be overcome prior to pursuing clinical trials and
seeking necessary regulatory approvals. Such obstacles could have the effect
of delaying or preventing the successful development of the Company's prenatal
screening products. There can be no assurance that the Company will be able to
develop this technology into reliable and effective prenatal screening
products, that required regulatory clearances or approvals for
commercialization will be obtained in a timely manner, or at all, or that the
Company's prenatal screening products or other products under development, if
introduced commercially, will be successful. If the Company is unable to
successfully develop and market its prenatal screening products, the Company's
business, financial condition and results of operations would be materially
and adversely affected.
 
Lack of Clinical Data
 
  The Company has conducted no clinical trials of its prenatal screening
products pursuant to FDA reviewed protocols. There can be no assurance that
the Company will commence such clinical testing, or once commenced, that such
testing can be completed successfully within the Company's expected time frame
and budget, if at all,
 
                                      15

 
or that the Company's products will prove to be reliable and effective in
clinical trials. If clinical trials are initiated, such trials may disclose
significant technical obstacles having the effect of delaying or preventing
the development, testing, regulatory approval and commercialization of the
Company's prenatal screening products. There can be no assurance that the
results of such clinical trials will be consistent with the Company's limited
preclinical results to date or would be sufficient to obtain regulatory
clearance or approval or clinical acceptance. If the Company is unable to
initiate and conclude successfully clinical trials of its prenatal screening
products, the Company's business, financial condition and results of
operations would be materially and adversely affected.
 
No Assurance of Clinical Acceptance
 
  The isolation of fetal cells from maternal blood is a new and novel
development. The clinical acceptance of the Company's prenatal screening
products will depend upon its acceptance by the medical community and third-
party payors as clinically useful, reliable, accurate, and cost-effective
compared to existing and future procedures. Clinical acceptance will depend on
numerous factors, including the establishment of the product's ability to
isolate sufficient numbers of fetal cells during the early stages of
pregnancy, to adequately enrich the concentration of nucleated fetal cells,
and to reliably analyze and detect the presence of chromosomal abnormalities.
Clinical acceptance will also depend on the receipt of regulatory clearances
in the United States and internationally, the availability of third-party
reimbursement and the Company's ability to adequately train laboratory
technicians and cytogeneticists on how to use the prenatal screening products.
In addition, there can be no assurance that the Company's prenatal screening
products will be a preferable alternative to existing procedures such as the
maternal AFP test or the triple test which detect neural tube defects in
addition to chromosomal abnormalities, or that the prenatal screening products
will not be rendered obsolete or noncompetitive by products under development
by other companies. The Company's products are intended to initially screen
for Down Syndrome and may not compete favorably with widely accepted
methodologies such as amniocentesis or CVS that are highly accurate and
diagnose a broader range of abnormalities from one sample of fetal cells.
Patient acceptance of the Company's prenatal testing products will depend in
part upon physician recommendations as well as other factors, including the
effectiveness and reliability of the procedure as compared to amniocentesis,
CVS and serum marker procedures. Even if the Company's prenatal screening
products are clinically adopted, physicians may elect not to recommend the
procedure unless acceptable reimbursement from health care payors is
available. There can be no assurance that the Company's prenatal screening
products under development will be accepted by the medical community or that
market demand for such products will be sufficient to allow the Company to
achieve profitable operations. Failure of the Company's prenatal screening
procedure, for whatever reason, to achieve significant clinical adoption or
failure of the Company's products to achieve any significant market acceptance
would have a material adverse effect on the Company's business, financial
condition and results of operations.
 
Accumulated Deficit; Future Losses
 
  From its inception in July 1986 through the end of 1998, the Company has
generated an accumulated deficit of approximately $28.0 million. The Company
expects its operating losses to continue to increase as it continues its
efforts to develop and test its prenatal screening products. There can be no
assurance that its prenatal screening products under development will be
commercially marketed or, if commercially marketed, that the Company will ever
receive sufficient revenue to achieve profitability and failure to do so would
have a material adverse effect on the Company's business, financial condition
and results of operations.
 
Quarterly Fluctuations
 
  The Company has experienced and expects to continue to experience
significant fluctuations in its quarterly operating results. Factors which may
have an influence on the Company's operating results in a particular quarter
include (i) demand for the Company's products, new product introductions by
the Company or its competitors or transitions to new products, (ii) the
results of preclinical or planned clinical trials and, if ever received, the
timing of regulatory and third-party reimbursement approvals; (iii) the timing
of orders and shipments; (iv) the mix of sales between distributors and the
Company's direct sales force; (iv) competition, including pricing pressures;
 
                                      16

 
(v) the timing and amount of research and development expenses, including
clinical trial-related expenditures; (vi) seasonal factors; (vii) foreign
currency fluctuation; and (viii) the delay between incurrence of expenses to
develop new products, including related marketing and service capabilities,
and realization of benefits from such efforts. The Company believes the
pattern of fluctuating revenues is influenced by the budgetary spending
practices of the Company's customer base which consists primarily of public
and private cytogenetic laboratories, research organizations and hospitals
operating on annual budgets. In addition, currency devaluations and lower
economic growth in Asia has decreased and are expected to continue to decrease
demand for the Company's products in Asian markets. Due to all the foregoing
factors, it is likely that in some future quarter the Company's operating
results will 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 adversely affected.
 
Additional Capital Requirements; No Assurance Future Capital will be Available
 
  The Company has expended and will continue to expend substantial funds for
research and development, preclinical testing, planned clinical
investigations, capital expenditures and manufacturing and marketing of its
products. The timing and amount of spending of such capital resources cannot
be accurately determined at this time and will depend upon several factors,
including the progress of its research and development efforts and planned
clinical investigations, competing technological and market developments,
commercialization of products currently under development, and market
acceptance and demand for the Company's products. To the extent required, the
Company may seek to obtain additional funds through equity or debt financing,
collaborative or other arrangements with other companies and from other
sources. If additional funds are raised by issuing equity securities, further
dilution to stockholders would occur. There can be no assurance that
additional financing will be available when needed or on terms acceptable to
the Company. If adequate funds are not available, the Company could be
required to delay development or commercialization of certain of its products,
to license to third parties the rights to commercialize certain products or
technologies that the Company would otherwise seek to commercialize for
itself, or to reduce the marketing, customer support or other resources
devoted to certain of its products each of which could have a material adverse
effect on the Company's business, financial condition and results of
operations.
 
Dependence on Prenatal Screening Products; Rapid Technological Change and Risk
of Technological Obsolescence
 
  The Company is dependent on the successful development and commercialization
of the Company's prenatal screening products. Unfavorable preclinical or
clinical results, failure to obtain regulatory clearances or approvals in a
timely manner, or at all, or failure to gain widespread market acceptance for
the products would have a material adverse effect on the Company's business,
financial condition and results of operations.
 
  The medical device industry, particularly the prenatal testing, diagnostic,
and screening markets, is characterized by rapid and significant technological
change. The sale of the Company's current products is largely dependent upon
the continued use of prenatal testing methodologies that require the location
of fetal cells in metaphase and the karyotyping of chromosomes identified in
the metaphase cells. In addition, the Company's current products require a
testing laboratory to make a large one-time investment, and the availability
of less expensive automated cytogenetic equipment could have a material
adverse effect on the Company's business financial condition, and results of
operations. The Company's future success will depend in large part on the
Company's ability to continue to respond to such changes. There can be no
assurance that the Company will be able to respond to such changes or that new
or improved competing products will not be developed that render the Company's
products obsolete. Product research and development will require substantial
expenditures and will be subject to inherent risks, and there can be no
assurance that the Company will be successful in developing products that have
the characteristics necessary to screen or diagnose particular indications or
that any new product introduced will receive regulatory clearance or approval
or will be successfully commercialized.
 
Uncertainty of FDA or Other Regulatory Clearances or Approvals
 
  The testing, manufacturing, labeling, distribution, sale, and marketing, of
the Company's products are subject to government regulation in the United
States and other countries. The Company's future success will be
 
                                      17

 
significantly dependent upon commercial sales of its prenatal screening
products under development. The Company will not be able to market these
prenatal screening products for commercial use in the United States until the
Company obtains clearance or approval from the United States Food and Drug
Administration ("FDA") for each device and will not be able to market such
products overseas until it meets the safety and quality regulations of each
foreign jurisdiction in which the Company seeks to sell such products.
Noncompliance with applicable FDA requirements can result in severe
administrative, civil and criminal sanctions.
 
  The Company's Cytoscan products were marketed until 1994 in the United
States pursuant to pre-market notifications to the FDA under Section 510(k) of
the Federal Food, Drug and Cosmetic Act ("510(k)"). A 510(k) pre-market
notification must be supported by appropriate data establishing, to the
satisfaction of the FDA, that a newly developed device is "substantially
equivalent" to a legally marketed device that does not itself require FDA
approval of a PMA. The Company's CytoVision product is the current model of
the Cytoscan product, marketed pursuant to the original 510(k) filing.
 
  The Company has applied for three separate 510(k) clearances for the
enrichment product, automated scanning product and the Fetal Hemoglobin
Identification Kit. The Company has been notified by the FDA that the Enrich
Kit and WinScan Automated Image Analysis System may be marketed in the U.S.
The DNA probe product will require either FDA clearance of a 510(k) with a
tier III level of review or a PMA.
 
  The Company submitted a protocol for clinical trials of the DNA probe
product to the FDA in November of 1996. The Company intends to initiate a
multisite, U.S. and international clinical trial of the DNA probe product to
detect chromosomal disorders in isolated fetal cells, based upon the review of
the protocol by the FDA. There can be no assurance regarding the timing or
nature of the FDA response regarding the DNA probe related protocol or the
timing for the commencement of clinical trials. There can be no assurance that
510(k) clearance for any of the Company's products under development or any
other future product or modification of an existing product will be granted or
that the clearance process will not be unduly lengthy and subjected to a
thorough FDA review. The FDA has stated that the DNA probe product will
require at least a 510(k) tier III level of review. Further, in its draft
guidance for in vitro diagnostic devices utilizing cytogenetic in situ
hybridization technology for the detection of genetic mutations, the FDA
states that when such devices are intended for use as a "stand-alone" for test
reporting based on interphase analysis, they will require a PMA that must be
reviewed and approved by the FDA prior to sales, distribution and marketing of
these products in the United States.
 
  The regulation of medical devices continues to develop and there can be no
assurance that new laws or regulations will not have a material adverse effect
on the Company's business, financial condition and results of operations.
Delays in receipt of clearance or approvals to market its products, failure to
receive these clearances or approvals, the loss of previously received
clearances or approvals, the determination that 510(k) clearance, pre-market
approval or other approval is required for a product being marketed without
such clearance or approval, or failure to comply with existing or future
regulatory requirements could have a material adverse effect on the Company's
business, financial condition and results of operations.
 
Need to Comply with International Government Regulation
 
  The regulatory review process varies from country to country. Currently, the
Company's products are subject to pre-market approval in several of the
countries that are members of the European Union ("EU") and subject to other
regulatory requirements in those and other countries. In addition, the
regulation of in vitro diagnostic devices ("IVDs") and other medical devices
continues to change. The Company may rely, in some circumstances, on its
international distributors for compliance with regulatory requirements in
those countries where the Company intends to use distributors. Any enforcement
action by regulatory authorities with respect to regulatory noncompliance may
have a material adverse effect on the Company's business, financial condition
and results of operations.
 
 
                                      18

 
  The time required to obtain approval for sale in foreign countries may be
longer or shorter than that required for FDA clearance and the requirements
may differ. In addition, there may be foreign regulatory barriers other than
approval for sale.
 
  The Company has brought its currently sold instruments, as required, into
compliance with the European Parliament's Electromagnetic Compatibility
Directive (89/336/EEC) (the "ECD") and is entitled to apply the CE mark, with
respect to the ECD, to such instruments. The European Parliament has made a
distinction between Medical Devices ("MDs") and IVDs. The Company's
instruments are subject to the requirements or advantages of the In Vitro
Diagnostic Medical Device Directive (98/79/ec). There can be no assurance,
however, that some or all of the Company's products will not be redefined as
M.D.'s and made subject to this Directive by the EU or its member states,
which may have a material adverse effect on the Company's business, financial
condition, and results of operations. There can be no assurance, moreover,
that member states, or any other European country, will not adopt other
statutes or regulations that could require approval to sale the Company
products, or that will otherwise have a material adverse effect on the
Company's business, financial condition, or results of operations.
 
  As required by the In Vitro Diagnostics medical Device Directive, the
Company's medical device products have the right to affix the CE mark
approved, and the Company is entitled to apply the CE mark. Depending on the
complexity of the electromagnetic compatibility of each product, the testing
and certification process may take a day to months and cost from the several
hundred to several thousand dollars.
 
Dependence upon Patents and Proprietary Technology; Risk of Infringement
 
  The Company holds two issued U.S. patents that materially relate to the
prenatal screening system, patent no. 5,432,054, issued July 11, 1995 and
entitled "Method for Separating Rare Cells from a Population of Cells," and
patent no. 5,731,156, issued March 24, 1998 and entitled "Use of Anti-
Embryonic Hemoglobin Antibodies to Identify Fetal Cells." These patents expire
in July 2012 and March 2015, respectively. Additionally, the Company relies on
trade secret protection and on its unpatented proprietary know-how in the
development and manufacturing of its products. There can be no assurance that
the Company's trade secrets or proprietary technology will not become known or
be independently developed by competitors in such a manner that the Company
has no practical recourse. Nor can there be any assurance that others will not
develop or acquire equivalent expertise or develop products that render the
Company's current or future products noncompetitive or obsolete. There can be
no assurance that the claims allowed under its patents will be sufficiently
broad to protect what the Company believes to be its proprietary rights. In
addition, there can be no assurance that issued patents will not be disallowed
or circumvented by competitors, or that the rights granted thereunder will
provide competitive advantages to the Company. Companies have filed
applications for, or have been issued patents relating to, products or
processes that may be competitive with certain of the Company's products or
processes. The Company is unable to predict how the courts would resolve
issues relating to the validity and scope of such patents.
 
  The validity and breadth of claims in medical technology patents involve
complex legal and factual questions and, therefore, may be highly uncertain.
No assurance can be given that any issued patent or patents based on pending
patent applications or any future patent application will exclude competitors,
that any of the Company's patents in which it has licensed rights will be held
valid if subsequently challenged or that others will not claim rights in or
ownership of the patents and other proprietary rights held or licensed by the
Company. Furthermore, no assurance can be given that others have not developed
or will not develop similar products, duplicate any of the Company's products
or design around any patents issued to or licensed by the Company or that may
be issued in the future to the Company. Since patent applications in the
United States are maintained in secrecy until patents issue, the Company also
cannot be certain that others did not first file applications for inventions
covered by the Company's pending patent applications, nor can the Company be
certain that it will not infringe any patents that may issue to others on such
applications.
 
 
                                      19

 
  In addition, patent applications in foreign countries are maintained in
secrecy for a period after filing. Publication of discoveries in the
scientific or patent literature tends to lag behind actual discoveries and the
filing of related patent applications. The Company has not conducted an
extensive search of patents issued to other companies, research or academic
institutions, or others, and no assurances can be given that such patents do
not exist, have not been filed, or could not be filed or issued, which contain
claims relating to the Company's technology, products or processes. Patents
issued and patent applications filed in the United States or internationally
relating to medical devices are numerous and there can be no assurance that
current and potential competitors and other third parties have not filed or in
the future will not file applications for, or have not received or in the
future will not receive, patents or obtain additional proprietary rights
relating to products or processes used or proposed to be used by the Company.
There are pending applications, which if issued with claims in their present
form, might provide proprietary rights to third parties relating to products
or processes used or proposed to be used by the Company. The Company may be
required to obtain licenses to patents or proprietary rights of others.
 
  The medical device industry in general, and the industry segment that
includes products for prenatal diagnostic screening in particular, have been
characterized by substantial competition. Litigation regarding patent and
other intellectual property rights, whether with or without merit, could be
time consuming and expensive to respond to and could divert the Company's
technical and management personnel. The Company may be involved in litigation
to defend against claims of infringement by the Company, to enforce patents
issued to the Company, or to protect trade secrets of the Company. If any
relevant claims of third-party patents are held as infringed and not invalid
in any litigation or administrative proceeding, the Company could be prevented
from practicing the subject matter claimed in such patents, or would be
required to obtain licenses from the patent owners of each such patent, or to
redesign its products or processes to avoid infringement. In addition, in the
event of any possible infringement, there can be no assurance that the Company
would be successful in any attempt to redesign its products or processes to
avoid such infringement. Accordingly, an adverse determination in a judicial
or administrative proceeding or failure to obtain necessary licenses could
prevent the Company from manufacturing and selling its products, which would
have a material adverse effect on the Company's business, financial condition
and results of operations. Costly and time-consuming litigation brought by the
Company may be necessary to enforce patents issued to the Company, to protect
trade secrets or know-how owned by the Company, or to determine the
enforceability, scope and validity of the proprietary rights of others.
 
Limited Manufacturing Experience; No Manufacturing Experience for the
Consumable Enrichment Kit
 
  To date, the Company's manufacturing activities have consisted primarily of
the assembly and testing of its cytogenetic products. If the Company obtains
necessary regulatory clearances, registrations and approvals for its prenatal
screening products and such technology is successfully introduced, the Company
will be required to increase its manufacturing capacity. The Company has no
experience in manufacturing the Enrichment Kit, WinscanTM or fetal hemoglobin
identification kit portions of its prenatal screening products. Manufacturers
often encounter difficulties in commencing and increasing production,
including problems involving production yields, adequate supplies of
components, quality control and assurance (including failure to comply with
the FDA's and State of California's GMP regulations, international quality
standards and other regulatory requirements) and shortages of qualified
personnel. Difficulties experienced by the Company in manufacturing could have
a material adverse effect on its business, financial condition and results of
operations. There can be no assurance that the Company will be successful in
commencing manufacture of the prenatal screening products in commercial
quantities, increasing manufacturing capacity or that it will not experience
manufacturing difficulties or product recalls in the future.
 
Need to Manage Growth
 
  Significant future growth in the Company's sales and expansion in the scope
of its operations, should they occur, may place considerable strain on the
Company's management, financial, manufacturing and other capabilities,
procedures and controls. There can be no assurance that any existing or
additional capabilities,
 
                                      20

 
procedures or controls will be adequate to support the Company's operations or
that its capabilities, procedures or controls will be designed, implemented or
improved in a timely and cost-effective manner. Failure to implement, improve
and expand such capabilities, procedures and controls in an efficient manner
at an appropriate pace could have a material adverse effect on the Company's
business, financial condition and results of operations.
 
Single Source Components; Dependence on Key Distributors
 
  Certain components of the Company's prenatal screening products under
development are expected to be in consumable enrichment kit form. The Company
intends to initially subcontract the manufacture of such consumable enrichment
kits; however, given the stage of the product's development, neither internal
nor third party manufacturing processes have been established. The Company
currently relies on a sole supplier for the DNA probe component of its
consumable enrichment kit. There can be no assurance that reliable, high
volume commercial supplies of such component can be established at
commercially reasonable costs or that a new supplier could be qualified in a
timely manner if the supply of such component were interrupted. There can be
no assurance that reliable high volume manufacturing of such gradients can be
established at commercially reasonable costs or that a new supplier could be
qualified in a timely manner if the supply of such gradients were interrupted.
In addition, the Company proposes to use DNA probes in a prenatal screening
kit under development, which are currently provided by a limited number of
vendors. The Company purchases certain types of DNA probes from a particular
supplier subject to such supplier meeting various performance standards. Such
probes require FDA clearance or approval for marketing for clinical diagnostic
procedures in the United States and may require FDA approval for export. The
DNA probe market is characterized by extensive patent litigation and any court
order with respect to infringement of intellectual property could adversely
affect the supply of available and cost-effective DNA probes. While the
Company believes that other sources for such DNA probes are available, if
there were to be interruptions in obtaining supplies from its present source,
the Company would have to qualify new sources of approved supply.
 
Dependence on Key Distributors
 
  Outside of North America and the United Kingdom, the Company relies
substantially on independent distributors and sales agents to market and sell
its products. There can be no assurance that distributors and agents will
devote adequate resources to support sales of the Company's products.
Moreover, agreements with a number of its distributors require that the
Company indemnify such distributors against costs, expenses and liabilities
relating to litigation regarding the Company's products and, despite these
obligations of the Company, distributors may decide to reduce or end their
selling efforts until an infringement dispute is resolved or settled.
 
Reliance on International Sales and Operations
 
  The Company has significant international operations based in the United
Kingdom, employing at December 31, 1998, approximately 40 employees. In 1998,
1997 and 1996, approximately 63%, 59% and 60% respectively, of the Company's
total revenues were derived from customers and distributors outside of the
United States and Canada. Until such time, if ever, as the FDA clears or
approves the Company's fetal cell screening technology for marketing in the
United States, the Company expects that international sales of cytogenetic
products will continue to account for a significant portion of its revenues.
Changes in overseas economic conditions, currency exchange rates, foreign tax
laws, or tariffs or other trade regulations could have a material adverse
effect on the Company's business, financial condition and results of
operations. The international nature of the Company's business subjects it and
its representatives, agents and distributors to laws and regulations of the
foreign jurisdictions in which it operates or in which its products are sold.
The regulation of medical devices in a number of such jurisdictions,
particularly in the European Community, continues to develop and there can be
no assurance that new laws or regulations will not have a material adverse
effect on the Company's business. The laws of certain foreign countries may
not protect the Company's intellectual property rights to the same extent, as
do the laws of the United States.
 
 
                                      21

 
  Currently, most of the Company's international sales are denominated in U.S.
dollars or the U.K. pound sterling. The Company has significant operations in
the U.K., and therefore, incurs significant operating expenses denominated in
U.K. pounds. Accordingly, the Company has not historically attempted to reduce
the risk of currency fluctuations by hedging, as changes in exchange rates
between the U.S. dollar and the U.K. pound sterling immaterially affect the
Company's results of operations. However, there can be no assurance that the
Company will not be disadvantaged with respect to its competitors operating in
a foreign country by foreign currency exchange rate fluctuations that make the
Company's products more expensive relative to those of local competitors.
 
  Asian countries, particularly Japan and Korea, continue to experience
banking, currency and other difficulties that are contributing to economic
slowdowns or recessions in those countries. The region does not appear to be
responding quickly to significant efforts to stimulate its economies. If Asian
economies remain stagnant or continue to deteriorate, capital investment by
Asian customers could decrease from current levels. Customers in Japan and
Korea have already canceled or delayed a significant amount of orders for the
Company's products and may cancel or delay additional orders in the future.
For 1998, net sales to customers located in Asian countries decreased 4% from
1997 to 15%, of the Company's total revenues.
 
  For 1998, net sales to customers located in European countries accounted for
45% of the Company's total sales. The unification of the European countries,
including the standardization of European currencies, as well as other
factors, could contribute to certain countries in the region experiencing
banking, currency and other difficulties that could, ultimately, impact the
Company's sales in Europe.
 
International Availability of Third-Party Reimbursement; Health Care Reform
and Related Matters
 
  In the United States, hospitals, physicians and other health care providers
that purchase medical devices generally rely on Third-Party Payors, and other
sources of reimbursement for health care costs to reimburse all or part of the
cost of the procedure in which the medical device is being used. Certain
Third-Party Payors are moving toward a managed care system in which they
contract to provide comprehensive health care for a fixed cost per person. The
fixed cost per person established by these Third-Party Payors may be
independent of the hospital's cost incurred for the specific case and the
specific devices used. Medicare and other Third-Party Payors are increasingly
scrutinizing whether to cover new products and the level of reimbursement for
covered products. Because the Company's fetal cell screening technology is
currently under development and has not received FDA clearance or approval,
uncertainty exists regarding the availability of third-party reimbursement for
procedures that would use the Company's fetal cell screening technology.
Failure by physicians, hospitals and other potential users of the Company's
products or products currently under development to obtain sufficient
reimbursement from Third-Party Payors for the procedures in which the
Company's products or products currently under the development are intended to
be used could have a material adverse effect on the Company's business,
financial condition and results of operations.
 
  Third-Party Payors that do not use prospectively fixed payments increasingly
use other cost-containment processes that may pose administrative hurdles to
the use of the Company's products and products currently under development. In
addition, Third-Party Payors may deny reimbursement if they determine that the
device used in a treatment is unnecessary, inappropriate, experimental, used
for a non-approved indication or is not cost-effective. Potential purchasers
must determine that the clinical benefits of the Company's products justify
the additional cost or the additional effort required to obtain prior
authorization or coverage and the uncertainty of actually obtaining such
authorization or coverage.
 
  If the Company obtains the necessary foreign regulatory registrations or
approvals, market acceptance of the Company's products and products currently
under development 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. There can be no assurance that any
international reimbursement approvals will be obtained in a timely manner, if
at all. Failure to receive international
 
                                      22

 
reimbursement approvals could have a material adverse effect on market
acceptance of the Company's products in the international markets in which
such approvals are sought.
 
  The Company believes that in the future, reimbursement will be subject to
increased restrictions both in the United States and in international markets.
The Company believes that the overall escalating cost of medical products and
services will continue to lead to increased pressures on the health care
industry, both foreign and domestic, to reduce the cost of products and
services, including the Company's products and products currently under
development. There can be no assurance in either United States or
international markets that third-party reimbursement and coverage will be
available or adequate, that future legislation, regulation or reimbursement
policies of Third-Party Payors will not otherwise adversely affect the demand
for the Company's products or products currently under development or its
ability to sell its products on a profitable basis. The unavailability of
Third-Party Payor coverage or the inadequacy of reimbursement could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, fundamental reforms in the health care
industry in the United States and Europe continue to be considered, and there
can be no assurance that such reform will not materially adversely affect the
Company's business, financial condition and results of operations.
 
Risk of Removal From the NASDAQ National Market
 
  The shares of the Company's Common Stock are quoted on the NASDAQ National
Market. If the Company should continue to experience losses from operations,
it may be unable to maintain the standards for continued quotation on the
NASDAQ National Market, and the shares of Common Stock could be subject to
removal from the NASDAQ National Market. Trading, if any, in the Common Stock
would therefore be conducted on the NASDAQ SmallCap Market, which is a
significantly less liquid market than the NASDAQ National Market. As a result,
an investor could find it more difficult to dispose of the Company's Common
Stock. NASDAQ has recently promulgated new rules which make continued listing
of companies on both the NASDAQ National Market and the NASDAQ SmallCap Market
more difficult and has significantly increased its enforcement efforts with
regard to the standards for such listing. In addition, if the Company's Common
Stock were removed from the NASDAQ National Market and not qualify for listing
on the NASDAQ SmallCap Market, the Company's Common Stock could be subject to
the so-called "penny stock" rules that impose additional sales practice and
market making requirements on broker-dealers who sell and/or make a market in
such securities. Consequently, failure to qualify for listing on, or removal
from, the NASDAQ SmallCap Market, if it were to occur, could affect the
ability or willingness of broker-dealers to sell and/or make a market on the
Company's Common Stock and the ability of purchasers of the Company's Common
Stock to sell their securities in the secondary market. In addition, if the
market price of the Company's Common Stock is less than $5.00 per share, the
Company may become subject to certain penny stock rules even if still quoted
on the NASDAQ SmallCap Market. Such rules may further limit the market
liquidity of the Common Stock and the ability of investors to sell such Common
Stock in the secondary market.
 
Dependence Upon Key Personnel
 
  The Company's future success depends in significant part upon the continued
service of certain key scientific, technical and management personnel, and its
continuing ability to attract and retain highly qualified scientific,
technical and managerial personnel. Competition for such personnel is intense
and there can be assurance that the Company can retain its key scientific,
technical and managerial personnel or that it can attract, assimilate or
retain other highly qualified scientific, technical and managerial personnel
in the future. Key employees of the Company include Jack Goldstein, Ph.D., its
Chief Executive Officer, Michael Zoccoli, Ph.D., Vice President of Research
and Development, Leslie G. Grant, Ph.D., Executive Vice President, and Carl
Hull, Vice President Sales and Marketing. The Company has no key man
insurance. The Company has taken steps to retain its key employees, including
the granting of stock options that vest over time. Additionally, the Company
has entered into employment agreements with Dr. Goldstein, Dr. Grant and Mr.
Hull. The loss of key personnel especially if without advanced notice, or the
inability to hire or retain qualified personnel could have a material adverse
effect upon the Company's business, results of operations and financial
condition.
 
                                      23

 
Risk of Software Defects
 
  The Company's cytogenetic and prenatal screening products currently under
development involve a software component that facilitates the detection of
chromosomal and genetic abnormalities through the interaction of certain
imaging algorithms with the genetic sample under examination. The software,
including any new versions that may be released, may contain undetected errors
or failures. There can be no assurance that, despite testing by the Company
and current and potential customers, errors will not be found in the software
components of the Company's cytogenetic or prenatal screening products,
resulting in loss or delay in market acceptance, which could have a material
adverse effect on the Company's business, financial condition and results of
operations.
 
Product Liability Risk; Possible Insufficiency of Insurance
 
  The manufacture and sale of the Company's products involves the risk of
product liability claims. There can be no assurance that the coverage limits
of the Company's insurance policies will be adequate. The Company intends to
evaluate its coverage on a regular basis and in connection with the
introduction of products currently under development. Such insurance is
expensive and may not be available on acceptable terms, in sufficient amount
of coverage, or at all. A successful claim brought against the Company in
excess of its insurance coverage would have a material adverse effect on the
Company's business, results of operations and financial condition.
 
Control by Certain Stockholders
 
  Certain stockholders, including certain executive officers and directors of
the Company and their affiliates, own approximately 65% of the outstanding
Common Stock. As a result, these stockholders will, to the extent they act
together, continue to have the ability to exert significant influence and
control over matters requiring the approval of the Company's stockholders,
including the election of a majority of the Company's Board of Directors.
 
Possible Volatility of Stock
 
  The market prices for securities of medical diagnostic instrument companies
have historically been highly volatile. Announcements of technological
innovations or new products by the Company or its competitors, developments
concerning proprietary rights, including patents and litigation matters,
publicity regarding actual or potential results with respect to products under
development by the Company or others, regulatory developments in both the
United States and foreign countries and public concern as to the safety of new
technologies, changes in financial estimates by securities analysts or failure
of the Company to meet such estimates and other factors, may have a
significant impact on the market price of the Common Stock. In addition, the
Company believes that fluctuations in its operating results may cause the
market price of its Common Stock to fluctuate, perhaps substantially.
 
Potential Adverse Effect of Shares Eligible for Future Sale
 
  According to Forms 13D and 13G filed by the Company's stockholders,
approximately 3,048,305 shares of the Company's Common Stock (representing
approximately 26% of the total shares outstanding) are held by affiliates and
are therefore subject to volume limitations pursuant to Rule 144. In the event
any of such stockholders cease to be affiliates (for example, by resigning
from the Board of Directors and holding less than 10% of the shares
outstanding), (i) certain of the shares held by such stockholders will be
eligible for immediate resale in the public market and (ii) pursuant to Rule
144(k), certain of such shares will no longer be subject to the manner of sale
and volume limitations of Rule 144 and will be eligible for resale in the
public market after 90 days from the date such stockholder ceases to be an
affiliate. Any sale of a substantial number of shares may have the effect of
depressing the trading price of the Company's publicly traded stock, which
would lower the Company's value and make it more difficult for the Company to
raise capital.
 
                                      24

 
Significant Restrictions on Change in Control
 
  Certain provisions of the Company's current Certificate of Incorporation and
Bylaws may have the effect of making it more difficult for a third party to
acquire, or discouraging a third party from attempting to acquire, control of
the Company. Such provisions could limit the price that certain investors
might be willing to pay in the future for shares of the Company's Common
Stock. Certain of these provisions provide for the elimination of the right of
stockholders to act by written consent without a meeting and specify
procedures for director nominations by stockholders and submission of other
proposals for consideration at stockholder meetings. In addition, the Company
has adopted a Preferred Shares Rights Agreement, sometimes referred to as a
poison pill, designed to prevent hostile takeovers not approved by the Board
of Directors. Also, the Company is authorized to issue 6,000,000 shares of
undesignated Preferred Stock. Such shares of Preferred Stock may be issued by
the Company without stockholder approval upon such terms as the Company's
Board of Directors may determine. The issuance of Preferred Stock may have the
effect of delaying, deferring or preventing a change of control of the
Company, may discourage bids for the Company's Common Stock at a premium over
the market price of the Common Stock and may adversely affect the market price
of the voting and other rights of, the holders of Common Stock. At present,
the Company has no plans to issue any of the Preferred Stock. The rights of
the holders of Common Stock will be subject to, and may be adversely affected
by, the rights of the holders of any Preferred Stock that may be issued in the
future. The issuance of Preferred Stock, while providing desirable flexibility
in connection with possible acquisitions and other corporate purposes, could
have the effect of making it more difficult for a third party to acquire a
majority of the outstanding voting stock 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 of the Delaware General Corporation Law, 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.
 
Item 2. PROPERTIES
 
  In the United States, Applied Imaging leases an approximately 14,000 square
foot facility in Santa Clara, California, under a lease, which terminates in
November 30, 2000. The Company also leases approximately 2,700 square foot
facility in Pittsburgh, Pennsylvania, under a lease that terminates in March
1999. In the United Kingdom, Applied Imaging International Ltd. ("AII") leases
approximately 12,500 square foot facility in Newcastle , which lease
terminates in July 2008. The Company believes that its facilities are adequate
to meet its requirements through 2000.
 
Item 3. LEGAL PROCEEDINGS
 
  The Company is not party to any legal proceedings.
 
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  Not applicable.
 
                                      25

 
                                    PART II
 
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
  The Company's Common Stock is traded on the NASDAQ National Market under the
symbol "AICX." The following table sets forth the range of the high and low
sale prices by quarter as reported on the NASDAQ National Market from November
1996, when the Company's Common Stock commenced trading.
 


                                                                   High    Low
                                                                  ------ -------
                                                                   
     1998
       First Quarter............................................. 4 1/4  1 7/8
       Second Quarter............................................ 3 9/16 1 7/8
       Third Quarter............................................. 3      2
       Fourth Quarter............................................ 3 1/8  1 1/4
     1997
       First Quarter............................................. 9 1/2  5
       Second Quarter............................................ 6 7/8  3 3/8
       Third Quarter............................................. 6 7/8  4 1/8
       Fourth Quarter............................................ 6 1/8  1 13/16

 
  As of March 8, 1999, the number of common stockholders of record was 177.
The Company currently intends to retain any earnings for use in its business
and does not anticipate paying any cash dividends in the foreseeable future.
 
                                      26

 
Item 6. SELECTED FINANCIAL DATA
 


                                       Year Ended December 31,
                           ---------------------------------------------------
                             1998       1997       1996       1995      1994
                           ---------  ---------  ---------  ---------  -------
                                (In thousands, except per share data)
                                                        
Statement of Operations
 Data:
Revenues:
 Product sales............ $   9,034  $  10,457  $   9,259  $   8,106  $ 7,021
 Software maintenance and
  service.................     2,650      2,677      2,663      2,692    2,550
                           ---------  ---------  ---------  ---------  -------
  Total revenues..........    11,684     13,134     11,922     10,798    9,571
Cost of revenues..........     6,010      6,284      5,974      5,484    5,350
                           ---------  ---------  ---------  ---------  -------
  Gross profit............     5,674      6,850      5,948      5,314    4,221
Operating Expenses:
 Research and
  development.............     6,662      7,381      3,667      2,919    2,821
 Sales and marketing......     4,950      3,740      3,088      2,918    2,524
 General and
  administrative..........     2,721      3,639      2,088      2,094    1,898
 Restructuring costs......       353         --         --         --       --
                           ---------  ---------  ---------  ---------  -------
  Total operating
   expenses...............    14,686     14,760      8,843      7,931    7,243
                           ---------  ---------  ---------  ---------  -------
  Operating loss..........    (9,012)    (7,910)    (2,895)    (2,617)  (3,022)
Other income, net.........       541        398         14         71       52
                           ---------  ---------  ---------  ---------  -------
Net loss.................. $  (8,471) $  (7,512) $  (2,881) $  (2,546) $(2,970)
                           =========  =========  =========  =========  =======
Net loss per share--Basic
 and diluted.............. $   (0.86) $   (1.03) $   (1.43) $   (2.46) $ (3.07)
                           =========  =========  =========  =========  =======
Shares used to calculate
 Basic and diluted net
 loss per share........... 9,850,293  7,324,194  2,020,369  1,033,020  967,686
                           =========  =========  =========  =========  =======
 

                                            December 31,
                           ---------------------------------------------------
                             1998       1997       1996       1995      1994
                           ---------  ---------  ---------  ---------  -------
                                           (In thousands)
                                                        
Balance Sheet Data:
 Cash, cash equivalents
  and short-term
  investments............. $  11,728  $   8,378  $  12,318  $   5,156  $ 2,503
 Working capital..........    10,753      7,171     10,700      3,249    1,712
 Total assets.............    18,808     14,714     16,473      9,373    7,441
 Non-current portion of
  long-term debt and
  capital lease
  obligations.............        64         89        229        231      336
 Accumulated deficit......   (28,004)   (19,533)   (12,021)    (9,140)  (6,594)
 Total stockholders'
  equity(1)...............    12,343      8,943     12,005      4,714    2,811

- --------
(1) No cash dividends have been declared with respect to the Company's Common
    and Preferred Stock.
 
                                       27

 
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS
 
  The information set forth in this Item 7 below contains forward-looking
statements, (designated by an *), and the Company's actual results could
differ materially from those anticipated in these forward-looking statements
as a result of certain factors, including those set forth below under "Factors
That May Affect Future Results," and those set forth under Item One on this
document, including "Additional Risk Factors".
 
Overview
 
  Since its inception in 1986, the Company has principally been engaged in the
design, development, manufacture and marketing of automated clinical analysis
systems used by cytogenetic laboratories for prenatal and other genetic
screening. The Company's cytogenetic instrumentation products include systems
that enable laboratories to automate aspects of the detection of chromosomal
abnormalities associated with conditions such as Down Syndrome. The Company
sells its cytogenetic systems to government and private clinical cytogenetic
laboratories, research institutions, universities and pharmaceutical
companies, and has sold such systems to approximately 650 sites in over 35
countries.
 
  In 1993, the Company established a research project to develop proprietary
prenatal screening products to detect chromosomal genetic disorders through
the enrichment and analysis of fetal blood cells from a routine maternal blood
sample. Since that time, the Company has devoted substantial resources to the
development of these prenatal screening products. The Company's prenatal
screening products, which the Company is developing, incorporate (i) a
hematological procedure to enrich the concentration of the fetal blood cells
found in maternal blood, (ii) a fetal hemoglobin test kit, (iii) automated
image analysis instrumentation to identify the fetal blood cells and (iv)
third-party DNA probes to identify certain chromosomal abnormalities present
in these fetal cells. The Company intends that preclinical and clinical
evaluations of the products be done in such a way so as to establish them as a
broadly applicable prenatal screening procedure. The Company anticipates that
sales of the products, if cleared or approved by the FDA, will include a
consumable enrichment kit used to separate fetal blood cells from maternal
blood, a consumable hemoglobin identification kit and imaging instrumentation
used to analyze these cells. The implementation of the Company's strategy is
dependent upon the successful development and commercialization of the
Company's prenatal screening products. In addition, the company has under
development a system to detect micrometastatic cells from bone marrow, lymph
node and blood samples from cancer patients as a means to better determine the
initial staging of the cancer and then detect relapses after treatment earlier
than is currently possible.
 
  The operating results of the Company have fluctuated significantly in the
past on an annual and quarterly basis. The Company expects that its operating
results will fluctuate significantly from quarter to quarter and year to year
in the future and will depend on a number of factors, some of which may affect
future sales of the Company's cytogenetic products. These factors include, but
are not limited to, demand for the Company's products, timing of orders and
shipments, competition and its related pricing pressures, and seasonal
factors, many of which are outside the Company's control. If FDA clearance or
approval is received, the Company intends to increase the amount of
expenditures for research and development and sales and marketing activities,
principally for the commercial launch of its prenatal screening system. If
additional funding is obtained, the Company intends to increase its research
and development expenses related to follow-on products and additional
applications of its prenatal screening technology.
 
  The Company markets its products worldwide from its operations in the United
States and the United Kingdom and performs research and development in the
United States. Sales from the United States are primarily to customers within
the United States. Revenues in the United Kingdom result from drop shipments
of products from the United States directly to customers and from direct
shipments from the United Kingdom.
 
Results of Operations
 
Fiscal 1998 Compared With Fiscal 1997
 
  Revenues. Revenues decreased to $11.7 million in 1998 from $13.1 million in
1997. The decrease in revenues is principally due to the economic crisis in
Asia, particularly Japan, as well as lower sales in North
 
                                      28

 
America. Software and service contract pricing is derived from product
pricing, and with unit selling prices of the Company's CytoVision systems,
sold since 1994, significantly lower than earlier generation products,
software and service contract pricing has decreased accordingly. In 1998 the
Company recorded $287,000 of grant proceeds as revenues. For 1998 and 1997
revenues derived outside of North America were approximately 63% and 59% of
total revenues, respectively.
 
  Cost of Revenues. Cost of revenues as a percent to total sales increased to
51% in 1998, from 48% in 1997. The increase in cost of revenues as a
percentage of total revenues is attributable to lower selling prices, as a
result of increased price competition for the cytogenetic instrumentation
products, lower service revenues and increases to inventory reserves for
certain discontinued products.
 
  Research and Development Expenses. Research and development expenses of $6.7
million decreased $719,000 over 1997. The decrease is primarily due to cost
saving programs implemented throughout the year Research and development costs
were 57% and 56% of total revenues for 1998 and 1997, respectively.
 
  Sales and Marketing Expenses. Sales and marketing expenses increased to $5.0
million in 1998 from $3.7 million in 1997. In 1998 and 1997 sales and
marketing expenses as a percentage of total revenues were 42% and 28%,
respectively. The increase in 1998 is primarily attributable to investment
spending for additional marketing and sales personnel to support the launch of
the new instrumentation systems and RxFISH.
 
  General and Administrative Expense. General and administrative expenses in
1998 amounted to $2.7 million, decreasing $918,000 over 1997. The decrease is
primarily due to lower corporate staffing levels and lower costs for
recruiting and relocation.
 
  Restructuring. During the quarter ended June 30, 1998, plans were developed
to reduce operating costs by eliminating thirteen positions in the Company.
The reductions were made at both the United States and United Kingdom
facilities. The consolidated statement of operations for 1998 includes a
$353,000 charge relating to the severance costs of these terminated employees.
Substantially all of the costs have been paid.
 
Fiscal 1997 Compared With Fiscal 1996
 
  Revenues. Revenues increased to $13.1 million in 1997 from $11.9 million in
1996. The increase in revenues is primarily attributable to demand by
cytogenetic laboratories to automate aspects of otherwise labor-intensive
analyses, to increase capacity of existing systems, or to replace older
generation systems with the Company's CytoVision products. Software and
service contract revenues remained relatively flat at $2.7 million for 1997
and 1996 and as a percentage of total revenues, decreased to 20% in 1997 from
22% in 1996. For 1997 and 1996 revenues derived outside of North America
remained relatively consistent at approximately 59% and 60% of total revenues,
respectively.
 
  Cost of Revenues. Cost of revenues increased $6.3 million in 1997, from $6.0
million in 1996, or 48% and 50% as a percentage of total revenues,
respectively. This decrease in cost of revenues as a percentage of total
revenues from year to year was attributable to increased product shipment
volume and engineering design changes to reduce direct material and production
costs. The decrease in cost of software maintenance and service is primarily
due to lower staffing and material costs as a result of improved components
which reduced the number of service calls.
 
  Research and Development Expenses. Research and development expenses
increased to approximately $7.4 million in 1997 from $3.7 million in 1996. The
increase was due to increasing expenditures on the development of the prenatal
screening products.
 
  Sales and Marketing Expenses. Sales and marketing expenses increased to $3.7
million in 1997 from $3.1 million in 1996. In 1997 and 1996 sales and
marketing expenses as a percentage of total revenues were 28% and 26%
respectively. The increase in 1997 is primarily attributable to additional
marketing and sales management personnel and the associated recruitment and
relocation costs.
 
                                      29

 
  General and Administrative Expenses. General and administrative expenses in
1997 amounted to $3.6 million, increasing $1.6 million over 1996. The increase
is primarily due to increased administrative and management staff and
associated costs related to public company reporting requirements and
management infrastructure changes in anticipation of future growth. In
addition, the Company incurred a charge of $480,000 in 1997 associated with
executive management changes. In 1997 and 1996 general and administrative
expenses were 28% and 18% of total revenue, respectively.
 
Factors That May Affect Future Results
 
  The Company's operating results may vary significantly depending on certain
factors, including the effect of delays in its research and development
program, adverse results in its clinical studies, delay in the introduction or
shipment of new products, increased competition, adverse changes in the
economic conditions in any of the several countries in which the Company does
business, a slower growth rate in the Company's target markets, order
deferrals in anticipation of new product releases, lack of market acceptance
of new products, the uncertainty of FDA or other domestic and international
regulatory clearances or approvals.
 
  Due to the factors noted above, the Company's future earnings and stock
price may be subject to significant volatility, particularly on a quarterly
basis. Any shortfall in revenues or earnings from levels expected by security
analysts could have an immediate and significant adverse effect on the trading
price of the Company's common stock.
 
Liquidity and Capital Resources
 
  The Company strengthened in financial position in 1998 by raising $11.4
million of equity net of issuance costs, via private placements of its common
stock. As of December 31, 1998, the Company had cash, cash equivalents and
short-term investments of $11.7 million and working capital of $10.8 million,
compared to $8.4 million and $7.2 million, respectively, at December 31, 1997.
For the year ended December 31, 1998, cash used by operations totaled $8.2
million, compared to $7.1 million for the corresponding prior year. The
increase in cash used by operations was primarily attributable to an increased
loss, and increases in accounts receivable and inventories of $463,000 and
$320,000 respectively. In addition, the Company consumed $744,000 in 1998 for
purchases of capital equipment compared to $1.1 million for the comparable
prior year.
 
  Since its inception in July 1986 through December 1998, the Company has
generated an accumulated deficit of approximately $28 million. The Company
expects negative cash flow from operations to continue into at least 2000, as
it continues the development of its fetal cell and micrometastasis programs,
conducts clinical trials required for FDA clearance of the DNA probe portion
of the fetal cell technology, expands its marketing, sales and customer
support capabilities, and adds administrative infrastructure .* The Company
currently estimates that its capital resources will enable it to meet its
short-term capital needs and sustain it through the middle of 2000 .* Long-
term capital needs of the Company will require it to raise additional debt or
equity financing . If adequate funds are not available, the Company could be
required to delay development or commercialization of certain products, to
license to third parties the rights to commercialize certain products or
technologies that the Company would otherwise seek to commercialize itself, or
to reduce the marketing, customer support, or other resources devoted to
certain products .* There can be no assurance, however, that the Company will
not be required to seek capital at an earlier date. The timing and amount of
spending of such capital resources cannot be accurately determined at this
time and will depend on several factors, including but not limited to, the
progress of its research and development efforts and clinical investigation,
the timing of regulatory approvals or clearances, competing technological and
market developments, commercialization of products currently under development
and market acceptance and demand for the Company's products. In addition, as
opportunities arise, proceeds may also be used to acquire businesses,
technologies or products that complement any such acquisitions . * The Company
may seek to obtain additional funds through equity or debt financing,
collaborative or other arrangements with other companies, and from other
sources.* No assurance can be given that additional financing will be
available when needed or on terms acceptable to the Company.
 
 
                                      30

 
  In 1998, the Company entered into an Option Agreement to acquire ownership
of patents for the enrichment of fetal cells. The agreement provides for a
series of payments of approximately $1.1 million if the option is exercised
and products using the technology are successful in clinical trials. The final
payment of $250,000 would be paid in common stock based on the market value of
the common stock as of the date the clinical trials are successfully
completed.
 
 Year 2000 Compliance
 
  The Company is knowledgeable of the issues associated with the programming
code in existing computer systems as the year 2000 approaches. The Company
began in 1997 and 1998 with a Year 2000 problem assessment, establishing Year
2000 Company Policy, and initiating the product upgrade solution. The Company
is using a four phase approach to address the Year 2000 compliance and issues.
The first phase consisted of the inventorying of all potential business
interruption problems, including those with products and systems, as well as
potential disruption from suppliers and other third parties. The second phase
consists of prioritization of potential problems and allocating the
appropriate level of resources to the most critical areas. The third phase
addresses the remediation programs to solve or mitigate any identified Year
2000 problems. The fourth phase, if necessary, will be to develop and
implement contingency plans if there are significant Year 2000 problems from
the Company or its key suppliers.
 
  The Company has completed an assessment of its internal Year 2000 risks. The
assessment included a review of products the Company produces and sells to
third parties, its telecommunication systems and its internal computer and
management information systems. The Company has determined that its current
products are Year 2000 compliant. The Company has recently upgraded its
telecommunication equipment and accounting systems to be Year 2000 compliant.
In February 1999, the Company released Year 2000 Upgrades to bring Pentium-
based systems currently installed at customer sites into Year 2000 compliance.
* Should unanticipated Year 2000 problems occur, the Company is prepared to
develop and execute contingency plans to satisfy customers on an as needed
basis.
 
  The Company has commenced its external assessment of Year 2000 risks. In
early 1998, the Company contacted its key third party manufacturing suppliers
to assess exposure to Year 2000 problems. The initial assessment was that the
key supplier products were Year 2000 complaint. Currently, the Company is
contacting its key suppliers, vendors, financial service organizations (third
party suppliers) to confirm their continuing Year 2000 compliance of their
products and business programs to ensure the Company will not incur any Year
2000 business disruptions. Additionally, new key suppliers are also being
contacted. The Company expects to complete its 1999 external assessment on or
before the end of June 1999. At present, the Company is not aware of any
issues with any of its third party suppliers. * However, uncertainty exists
and significant Year 2000 compliance problems from its third party supplies,
partners, or customers that could materially have adverse affect on the
Company's business, results of operation, financial condition and prospects.
 
  The Company has and will continue to expend resources to continue to monitor
and upgrade its products and services and for the upgrade to its
telecommunication and management information systems. * To date the Company
estimates that its has expended approximately $90,000 for costs associated
with its year 2000 compliance and estimates it will spend an additional
$75,000 to $110,000 inclusive of non-incremental costs that will be incurred
by reallocation of existing resources in bringing the Company into Year 2000
compliance.* However, there may be unforeseeable issues with unseen costs that
are outside of the Company's control that could have a negative impact.
 
 New Accounting Pronouncements
 
  The Financial Accounting Standards Board recently issued Statement of
Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative
Instruments and Hedging Activities. SFAS No. 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts (collectively referred to as
derivatives), and for hedging activities. It requires that an entity
 
                                      31

 
recognize all derivatives as either assets or liabilities in the balance sheet
and measure those instruments at fair value. For a derivative not designated
as a hedging instrument, changes in the fair value of the derivative are
recognized in earnings in the period of change. The Company must adopt SFAS
No. 133 by January 1, 2000. Management does not believe that the adoption of
SFAS No. 133 will have a material effect on the financial position or results
of operations of the Company.
 
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
         DERIVATIVES AND FINANCIAL INSTRUMENTS
 
 Foreign currency hedging instruments
 
  The Company transacts business in various foreign currencies. Accordingly,
the Company is subject to exposure from adverse movements in foreign currency
exchange rates. This exposure is primarily related to revenues and operating
expenses in the U.K. denominated in the respective local currency.
 
  The Company currently does not use financial instruments to hedge operating
expenses in the U. K. denominated in the respective local currency. Instead,
the Company believes that a natural partial hedge exits, because local
currency revenues will substantially offset the operating expenses denominated
in the respective local currency. The company assesses the need to utilize
financial instruments to hedge currency exposure on a ongoing basis. As of
December 31, 1998 the Company had no hedging contracts outstanding.
 
The Company does not use derivative financial instruments for speculative
trading purposes, nor does the Company hedge its foreign currency exposure in
a manner that entirely offsets the effects of changes in foreign exchange
rates. The Company regularly reviews its hedging program and may as a part of
this review determine at any time to change its hedging program. See "Risk
Factors--Reliance on International Sales and Operations
 
 Fixed income investments
 
  The Company's exposure to market risks for changes in interest rates relates
primarily to investments in debt securities issued by U.S. government agencies
and corporate debt securities. The Company places its investments with high
credit quality issuers and, by policy, limits the amount of the credit
exposure to any one issuer.
 
  The company's general policy is to limit the risk of principal loss and
ensure the safety of invested funds by limiting market and credit risk. All
highly liquid investments with a maturity of three months or less at the date
of purchase are considered to be cash equivalents; investments with maturities
over three months are considered to be short-term investments. The weighted
average pre-tax interest rate on the investment portfolio is approximately
5.7%.
 
                                      32

 
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
              Report of Independent Certified Public Accountants
 
The Board of Directors
Applied Imaging Corp.:
 
  We have audited the accompanying consolidated balance sheets of Applied
Imaging Corp. and subsidiaries as of December 31, 1998 and 1997, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for each of the years in the three-year period ended December 31, 1998.
In connection with our audits of the consolidated financial statements for the
periods indicated above, we have also audited the consolidated financial
statement schedule as listed in the Index at Item 14(a)(2) . These
consolidated financial statements and financial statement schedule are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these consolidated financial statements and financial statement
schedule 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Applied
Imaging Corp. and subsidiaries as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1998, in conformity with generally
accepted accounting principles. Also in our opinion, the related consolidated
financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein.
 
                                          KPMG LLP
 
Mountain View, California
February 5, 1999
 
                                      33

 
                             APPLIED IMAGING CORP.
                                AND SUBSIDIARIES
 
                          Consolidated Balance Sheets
 


                                                           December 31,
                                                      ------------------------
                                                         1998         1997
                                                      -----------  -----------
                                                             
                       Assets
Current assets:
  Cash and cash equivalents.......................... $ 5,480,000  $ 2,918,000
  Short-term investments.............................   6,248,000    5,460,000
  Trade accounts receivable (less allowance for
   doubtful accounts of $162,000 and $191,000 at
   December 31, 1998 and 1997, respectively).........   3,821,000    3,358,000
  Inventories........................................   1,169,000      849,000
  Prepaid expenses and other assets..................     436,000      268,000
                                                      -----------  -----------
    Total current assets.............................  17,154,000   12,853,000
Property and equipment...............................   1,569,000    1,793,000
Other assets.........................................      85,000       68,000
                                                      -----------  -----------
                                                      $18,808,000  $14,714,000
                                                      ===========  ===========
 
        Liabilities and Stockholders' Equity
 
Current liabilities:
  Bank debt.......................................... $ 1,045,000  $   299,000
  Current portion of capital lease obligation........      34,000       34,000
  Accounts payable...................................   1,572,000    1,754,000
  Accrued expenses...................................   2,519,000    2,434,000
  Deferred revenue...................................   1,231,000    1,161,000
                                                      -----------  -----------
    Total current liabilities........................   6,401,000    5,682,000
Capital lease obligation, less current portion.......      64,000       89,000
Commitments
Stockholders' equity:
  Common stock; $0.001 par value; 20,000,000 shares
   authorized; 11,529,537 and 7,667,956 shares issued
   and outstanding at December 31, 1998 and 1997,
   respectively......................................      12,000        8,000
  Additional paid-in capital.........................  41,121,000   29,636,000
  Accumulated deficit................................ (28,004,000) (19,533,000)
  Deferred stock compensation........................    (419,000)    (801,000)
  Accumulated other comprehensive income.............    (367,000)    (367,000)
                                                      -----------  -----------
    Total stockholders' equity.......................  12,343,000    8,943,000
                                                      -----------  -----------
                                                      $18,808,000  $14,714,000
                                                      ===========  ===========

 
          See accompanying notes to consolidated financial statements.
 
                                       34

 
                             APPLIED IMAGING CORP.
                                AND SUBSIDIARIES
 
                     Consolidated Statements of Operations
 


                                               Year ended December 31,
                                         -------------------------------------
                                            1998         1997         1996
                                         -----------  -----------  -----------
                                                          
Revenues:
  Product sales........................  $ 9,034,000  $10,457,000  $ 9,259,000
  Software maintenance and other.......    2,650,000    2,677,000    2,663,000
                                         -----------  -----------  -----------
    Total revenues.....................   11,684,000   13,134,000   11,922,000
                                         -----------  -----------  -----------
Cost of revenues:
  Product sales........................    4,953,000    5,188,000    4,501,000
  Software maintenance and service.....    1,057,000    1,096,000    1,473,000
                                         -----------  -----------  -----------
  Total cost of revenues...............    6,010,000    6,284,000    5,974,000
                                         -----------  -----------  -----------
  Gross profit.........................    5,674,000    6,850,000    5,948,000
                                         -----------  -----------  -----------
Operating expenses:
  Research and development.............    6,662,000    7,381,000    3,667,000
  Sales and marketing..................    4,950,000    3,740,000    3,088,000
  General and administrative...........    2,721,000    3,639,000    2,088,000
  Restructuring costs..................      353,000           --           --
                                         -----------  -----------  -----------
  Total operating expenses.............   14,686,000   14,760,000    8,843,000
                                         -----------  -----------  -----------
  Operating loss.......................   (9,012,000)  (7,910,000)  (2,895,000)
Other income, net......................      541,000      398,000       14,000
                                         -----------  -----------  -----------
  Net loss.............................  $(8,471,000) $(7,512,000) $(2,881,000)
                                         ===========  ===========  ===========
Net loss per share--basic and diluted..  $     (0.86) $     (1.03) $     (1.43)
                                         ===========  ===========  ===========
Shares used to calculate basic and
 diluted net loss per share............    9,850,293    7,324,194    2,020,369
                                         ===========  ===========  ===========

 
 
          See accompanying notes to consolidated financial statements.
 
                                       35

 
                     APPLIED IMAGING CORP. AND SUBSIDIARIES
 
                Consolidated Statements of Stockholders' Equity
 


                                                                                                  Accumulated
                   Preferred stock       Common stock    Additional                  Deferred        other        Total
                  ------------------  ------------------   paid-in   Accumulated      stock      comprehensive stockholder
                    Shares    Amount    Shares   Amount    capital     deficit     compensation     income       equity
                  ----------  ------  ---------- ------- ----------- ------------  ------------  ------------- -----------
                                                                                    
Balances as of
 December 31,
 1995............  3,919,179  $4,000   1,067,785 $ 1,000 $14,216,000 $ (9,140,000)          --     $(367,000)  $ 4,714,000
 Exercise of
  common stock
  options........         --      --      89,250      --     161,000           --           --            --       161,000
 Initial public
  offering (IPO)
  of common
  stock, net of
  $1,829,000
  offering
  costs..........         --      --   1,650,000   2,000   9,719,000           --           --            --     9,721,000
 Preferred stock
  converted to
  common stock in
  connection with
  IPO............ (3,919,179) (4,000)  3,960,017   4,000          --           --           --            --            --
 Net exercise of
  110,416 Series
  F preferred
  stock warrants
  in connection
  with IPO.......         --      --      56,783      --          --           --           --            --            --
 Deferred
  employee stock
  option
  compensation...         --      --          --      --   1,473,000           --  (1,.473,000)           --            --
 Amortized of
  deferred stock
  compensation...         --      --          --      --          --           --      290,000            --       290,000
 Net Loss........         --      --          --      --          --   (2,881,000)          --            --    (2,881,000)
                  ----------  ------  ---------- ------- ----------- ------------  -----------     ---------   -----------
Balances as of
 December 31,
 1996............         --      --   6,823,835   7,000  25,569,000  (12,021,000)  (1,183,000)     (367,000)   12,005,000
 Exercise of
  common stock
  options........         --      --      34,003      --      72,000           --           --            --        72,000
 Private
  placement of
  common stock,
  net of $59,000
  offering
  costs..........         --      --     796,020   1,000   3,940,000           --           --            --     3,941,000
 Stock issued in
  connection with
  employee stock
  purchase plan..         --      --      14,098      --      55,000           --           --            --        55,000
 Amortization of
  deferred stock
  compensation...         --      --          --      --          --           --      382,000            --       382,000
 Net Loss........         --      --          --      --          --   (7,512,000)          --            --    (7,512,000)
                  ----------  ------  ---------- ------- ----------- ------------  -----------     ---------   -----------
Balances as of
 December 31,
 1997............         --      --   7,667,956   8,000  29,636,000  (19,533,000)    (801,000)     (367,000)    8,943,000
 Exercise of
  common stock
  options........         --      --       8,247      --      17,000           --           --            --        17,000
 Private
  placement of
  common stock
  net of $100,000
  offering
  costs..........         --      --   3,833,330   4,000  11,396,000           --           --            --    11,400,000
 Stock issued in
  connection with
  employee stock
  purchase plan..         --      --      20,004      --      48,000           --           --            --        48,000
 Stock warrants
  extended.......         --      --          --      --      24,000           --           --            --        24,000
 Amortized of
  deferred stock
  compensation...         --      --          --      --          --           --      382,000            --       382,000
 Net loss........         --      --          --      --          --   (8,471,000)          --            --    (8,471,000)
                  ----------  ------  ---------- ------- ----------- ------------  -----------     ---------   -----------
Balances as of
 December 31,
 1998............         --      --  11,529,537 $12,000 $41,121,000 $(28,004,000) $  (419,000)    $(367,000)  $12,343,000
                  ==========  ======  ========== ======= =========== ============  ===========     =========   ===========

 
          See accompanying notes to consolidated financial statements.
 
                                       36

 
                             APPLIED IMAGING CORP.
                                AND SUBSIDIARIES
 
                     Consolidated Statements of Cash Flows
 


                                                Year ended December 31,
                                          -------------------------------------
                                             1998         1997         1996
                                          -----------  -----------  -----------
                                                           
Cash flows from operating activities:
 Net loss...............................  $(8,471,000) $(7,512,000) $(2,881,000)
 Adjustments to reconcile net loss to
  net cash used for operating
  activities:
  Depreciation and amortization.........      939,000      695,000      583,000
  Unrealized exchange (gain) loss.......           --           --       33,000
  Compensation expense related to
   employee stock options...............      382,000      382,000      290,000
  Loss on sale of other assets..........        5,000       29,000           --
  Changes in operating assets and
   liabilities:
   Trade accounts receivable............     (463,000)  (1,904,000)      47,000
   Inventories..........................     (320,000)     (18,000)      49,000
   Prepaid expenses and other assets....     (168,000)      68,000     (196,000)
   Accounts payable.....................     (182,000)      75,000      538,000
   Accrued expenses.....................      (15,000)   1,130,000     (126,000)
   Deferred revenue.....................       70,000      (62,000)    (163,000)
                                          -----------  -----------  -----------
   Net cash used for operating
    activities..........................   (8,223,000)  (7,117,000)  (1,826,000)
                                          -----------  -----------  -----------
Cash flows from investing activities:
  Purchase of short-term investments....   (4,997,000)  (7,456,000)          --
  Proceeds from sales and maturities of
   short term investments...............    4,209,000    1,996,000    2,997,000
  Proceeds from sales of fixed assets...       24,000           --           --
  Purchase of equipment.................     (744,000)  (1,119,000)    (498,000)
  Other assets..........................      (17,000)     203,000       71,000
                                          -----------  -----------  -----------
   Net cash provided by (used for)
    investing activities................   (1,525,000)  (6,376,000)   2,570,000
                                          -----------  -----------  -----------
Cash flows from financing activities:
  Net proceeds from issuance of common
   stock................................   11,565,000    4,068,000    9,882,000
  Proceeds from stock warrants
   extended.............................       24,000           --           --
  Bank loan proceeds/(payments)--net....      746,000       38,000     (467,000)
  Capital lease payments................      (25,000)     (13,000)          --
                                          -----------  -----------  -----------
   Net cash provided by financing
    activities..........................   12,310,000    4,093,000    9,415,000
                                          -----------  -----------  -----------
Net increase (decrease) in cash and cash
 equivalents............................    2,562,000   (9,400,000)  10,159,000
Cash and cash equivalents at beginning
 of year................................    2,918,000   12,318,000    2,159,000
                                          -----------  -----------  -----------
Cash and cash equivalents at end of
 year...................................    5,480,000  $ 2,918,000  $12,318,000
                                          ===========  ===========  ===========
Supplemental disclosure of cash paid for
 interest...............................  $    92,000  $    39,000  $    86,000
                                          ===========  ===========  ===========
Supplemental disclosure of non-cash
 investing and financing activities:
  Equipment acquired through capital
   leases...............................           --  $   135,000           --
                                          ===========  ===========  ===========
  Deferred compensation relating to
   employee stock options...............           --           --  $ 1,473,000
                                          ===========  ===========  ===========
  Conversion of preferred stock and
   preferred stock warrants into common
   stock................................           --           --  $     4,000
                                          ===========  ===========  ===========

 
          See accompanying notes to consolidated financial statements.
 
                                       37

 
                             APPLIED IMAGING CORP.
                               AND SUBSIDIARIES
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
(1) Summary of the Company and Significant Accounting Policies
 
 The Company
 
  Applied Imaging Corp. (the Company) was incorporated in 1986 to develop,
manufacture, and market automated clinical analysis systems used by
cytogenetic laboratories in prenatal genetic screening. The Company sells its
products to government and private clinical cytogenetic laboratories, research
institutions, universities, and pharmaceutical companies located primarily in
the United States, Canada, Europe, and the Pacific Rim. The Company is
currently devoting significant resources to the development of a new prenatal
screening designed to enable the detection of prenatal chromosomal disorders
through the analysis of fetal blood cells drawn from maternal blood. There
have been no revenues earned in relation to this new prenatal screening
system.
 
 Principles of Consolidation
 
  The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries, Applied Imaging International,
Limited (United Kingdom) and Applied Imaging, Limited (Israel). All
significant intercompany accounts and transactions have been eliminated in
consolidation.
 
 Foreign Exchange
 
  The Company accounts for its foreign operations in accordance with Statement
of Financial Accounting Standards (SFAS) No. 52, Foreign Currency Translation.
Prior to April 1994, the functional currency for Applied Imaging
International, Limited was the British pound and, accordingly, translation
adjustments resulting from the conversion of the subsidiary's financial
statements into U.S. dollars were accumulated and reported as a separate
component of stockholders' equity. Beginning in April 1994, certain
operational and organizational changes within the Company caused the
functional currency for the Company's subsidiary to become the U.S. dollar.
Therefore, monetary assets and liabilities of the subsidiary are remeasured to
the U.S. dollar at year-end exchange rates while nonmonetary items are
remeasured at historical rates. Revenue and expense accounts related to
monetary assets and liabilities are remeasured at the average rates in effect
during the year. Revenue and expenses related to non-monetary assets and
liabilities are translated at historical rates. Foreign currency gains and
losses resulting from the conversion of the subsidiary's financial statements
into U.S. dollars are currently recognized in the consolidated statement of
operations. The functional currency of Applied Imaging, Limited is also the
U.S. dollar.
 
 Use of Estimates
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, the
disclosure of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
 
 Comprehensive Income
 
  In accordance with Statement of Financial Accounting Standards (SFAS) No.130
Reporting Comprehensive Income, the Company is required to classify items of
other comprehensive income, by their nature (e.g. unrealized gains or losses
on securities) in a financial statement. There were no components of other
comprehensive income for the years ended December 31, 1998, 1997 and 1996. The
accumulated balance of other comprehensive income from periods prior to 1996
are reported as Accumulated other comprehensive
 
                                      38

 
                    APPLIED IMAGING CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
income' and displayed separately from retained earnings and additional paid-in
capital in the equity section of the balance sheet.
 
 Revenue Recognition
 
  The company recognizes revenue on product sales upon shipment and
concurrently accrues for expected hardware warranty expenses and establishes
reserves for product returns. Revenue attributable to software maintenance and
support, is deferred and recognized ratably over the term of the maintenance
agreement, generally one year.
 
  In October 1997, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 97-2, Software Revenue
Recognition. SOP 97-2 applies to the sales of products that contain software
elements that are more than incidental to the product as a whole. The Company
adopted SOP 97-2 effective January 1, 1998. SOP 97-2 generally requires
revenue attributable to software elements to be allocated to the elements
based on their fair values. The fair value of an element must be based on the
evidence which is specific to the vendor. The revenue allocated to software
products is recognized upon shipment of the product. The revenue attributable
to maintenance and support is recognized ratably over the term of the
maintenance agreement. There was no change to the Company's accounting for
revenues as a result of the adoption of SOP 97-2.
 
  In February 1998, the AICPA issued SOP 98-4, Deferral of the Effective Date
of SOP 97-2. The SOP defers the effective date for applying the provisions
regarding vendor-specific objective evidence of fair value ("VSOE") until the
AICPA can reconsider what constitutes such VSOE. There was no change to the
Company's accounting for revenues as a result of the adoption of SOP 98-4.
 
  In December 1998, the AICPA issued SOP 98-9, Software Revenue Recognition,
with Respect to Certain Arrangements, which requires recognition of revenue
using the "residual method" in a multiple-element arrangement when fair value
does not exist for one of more of the delivered elements in the arrangement.
Under the residual method, the total fair value of the undelivered elements is
deferred and subsequently recognized in accordance with SOP 97-2. The Company
does not expect a change to its accounting for revenues as a result of the
provisions of SOP 98-9.
 
 Research and Development Expenditures
 
  Research and development expenditures are charged to expense as incurred.
 
 Earnings (loss) per Share
 
Basic and diluted net loss per share are computed using the weighted average
number of outstanding shares of common stock. There were no reconciling items
of the numerators and denominators of the basic and diluted EPS computation.
Shares excluded from the computation of EPS because their effect on EPS was
antidilutive, but could dilute basic EPS in future periods are as follows:
 


                                        1998                     1997                    1996
                              ------------------------ ------------------------ ----------------------
                                           Weighted                 Weighted               Weighted
                                           average                  average                average
                               Shares   exercise price  Shares   exercise price Shares  exercise price
                              --------- -------------- --------- -------------- ------- --------------
                                                                      
     Options................. 1,787,405     $2.32      1,199,272     $4.04      481,250     $2.48
     Warrants................   577,909      5.17        681,744      5.18      508,734      4.97
                              ---------                ---------                -------
       Total................. 2,365,314                1,881,016                989,984
                              =========                =========                =======

 
                                      39

 
                    APPLIED IMAGING CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
 Cash Equivalents and Short-Term Investments
 
  All investments with original maturities at date of purchase of three months
or less are considered by the Company to be cash equivalents.
 
 Inventories
 
  Inventories are stated at the lower of cost (first in, first out) or market.
 
 Property and Equipment
 
  Property and equipment are stated at cost less accumulated depreciation.
Depreciation is provided using the straight-line method over the estimated
useful lives of the respective assets, generally three to five years.
Recoverability of property and equipment is measured by comparison of its
carrying amount to future net cash flows the property and equipment are
expected to generate. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the property and equipment exceeds its fair market value. To date,
the Company has made no adjustments to the carrying values of its long-lived
assets.
 
 Short-Term Investments
 
  Short-term investments consist of investments acquired with maturities
exceeding three months. While the Company's intent is to hold debt securities
to maturity, consistent with SFAS No. 115, Accounting for Certain Investments
in Debt and Equity Securities, the Company has classified all securities as
available-for-sale, as the sale of such securities may be required prior to
maturity to implement management strategies. Such securities are reported at
fair value with unrealized gains or losses excluded from earnings and reported
as a separate component of shareholder's equity, net of applicable taxes. As
of December 31, 1998, the difference between the fair value and the amortized
cost of available-for-sale securities was not significant, therefore, no
unrealized gains or losses have been recorded in shareholders equity.
 
  As of December 31, 1998 and 1997, the Company's short-term investments
consisted of certificates of deposit and corporate bonds with the following
contractual maturities::
 


                                                                    1998   1997
                                                                   ------ ------
                                                                    
     Corporate bonds.............................................. $6,248 $2,191
     Certificates of deposit......................................     --  3,269
                                                                   ------ ------
       Total...................................................... $6,248 $5,460
                                                                   ====== ======

 
  As of December 31, 1998, the maturities of the short-term investments are as
follows: $3,166 within one year and $3,082 more than one year.
 
 Capitalized Software Costs
 
  Computer software development costs incurred subsequent to the determination
of product technological feasibility are capitalized in accordance with the
provisions of SFAS No. 86, Accounting for the Cost of Computer Software to be
Sold, Leased or Otherwise Marketed. Amortization of these capitalized costs is
provided using the greater of the ratio of revenues generated in the period
over total future revenues of the product, or the straight-line method over
the estimated market life of the related products, generally three years,
commencing when the product becomes generally available to customers. For the
years ended December 31,
 
                                      40

 
                    APPLIED IMAGING CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
1998, 1997 and 1996, software development costs incurred subsequent to the
establishment of technological feasibility have not been material. The net
book value of capitalized costs is not significant and is included in other
assets in the consolidated balance sheets.
 
 Stock Based Compensation
 
  The Company uses the intrinsic-value method to account for its stock-based
compensation arrangements.
 
 Income Taxes
 
  The Company uses the asset and liability method of accounting for income
taxes. Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amount of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax
rates expected to apply to taxable income in the years in which those
temporary differences are expected to be recovered or settled. A valuation
allowance is provided to reduce the deferred tax assets when it is more likely
than not that all or a portion of the deferred tax assets will not be
realized.
 
 Fair Value of Financial Instruments
 
  Financial instruments consist principally of cash equivalents, short-term
investments, trade receivables, notes receivable, accounts payable, and bank
debt. The carrying amounts of these financial instruments approximate fair
value.
 
  Financial instruments that potentially subject the Company to concentrations
of credit risk are accounts receivable, cash equivalents and short-term
investments which the Company places with high-credit qualified financial
institutions and, by policy, limits the amount of credit exposure to any one
financial institution. The Company sells its products to government and
private clinical cytogenetic laboratories, research institutions,
universities, and pharmaceutical companies located primarily in the United
States, Canada, Europe, and the Pacific Rim. The Company's credit risk is
concentrated primarily in the United States and Europe. The Company does not
have a significant concentration of credit risk with any single customer. The
Company performs on-going credit evaluations of its customer's financial
condition and, generally requires no collateral from its customers. The
Company maintains an allowance for doubtful accounts to cover potential credit
losses.
 
(2) Inventories
 
  A summary of inventories follows:
 


                                                                December 31,
                                                             -------------------
                                                                1998      1997
                                                             ---------- --------
                                                                  
     Raw materials.......................................... $  999,000 $721,000
     Work in process........................................     96,000   85,000
     Finished goods.........................................     74,000   43,000
                                                             ---------- --------
                                                             $1,169,000 $849,000
                                                             ========== ========

 
                                      41

 
                    APPLIED IMAGING CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
(3) Property and Equipment
 
  A summary of property and equipment follows:
 


                                                              December 31,
                                                          ---------------------
                                                             1998       1997
                                                          ---------- ----------
                                                               
     Equipment........................................... $2,726,000 $2,793,000
     Demonstration equipment.............................  1,173,000  1,275,000
     Furniture and fixtures..............................    626,000    489,000
                                                          ---------- ----------
                                                           4,525,000  4,557,000
     Less accumulated depreciation.......................  2,956,000  2,764,000
                                                          ---------- ----------
                                                          $1,569,000 $1,793,000
                                                          ========== ==========

 
  In 1998, the Company reduced the carrying amount of property and equipment
and the related accumulated depreciation by $569,000 related to fully
depreciated property and equipment that is no longer in use.
 
(4) Accrued Expenses
 
  A summary of accrued expenses follows:
 


                                                              December 31,
                                                          ---------------------
                                                             1998       1997
                                                          ---------- ----------
                                                               
     Compensation and related costs...................... $  523,000 $  649,000
     Royalties ..........................................    367,000    267,000
     Severance ..........................................    226,000    480,000
     Other ..............................................  1,403,000  1,038,000
                                                          ---------- ----------
                                                          $2,519,000 $2,434,000
                                                          ========== ==========

 
(5) Bank Debt
 
  Applied Imaging International, Limited has a (Pounds)750,000 gross and
(Pounds)500,000 net unsecured line of credit with an international bank which
is guaranteed by the Company. Under the line of credit the Company also has
the ability to borrow additional amounts based on cash deposits held by the
bank up to a maximum additional amount of (Pounds)250,000. The line of credit
is available until April 30, 1999, and bears interest at 3% above the bank's
base rate, for borrowings up to (Pounds)500,000 and 6% for borrowings over
(Pounds)500,000. The base rate was 6.25% as of December 31, 1998. As of
December 31, 1998 amounts outstanding under this facility amounted to
$1,045,000.
 
(6) Stockholders' Equity
 
 Common Stock
 
  The Company is authorized to issue 20,000,000 shares of common stock. As of
December 31, 1998, there were warrants outstanding to purchase 173,010 shares
of common stock at $5.78 per share, 264,899 shares at $5.25 per share and
140,000 shares at $4.25 per share. These warrants expire in 2000, 1999 and
2000, respectively. During 1998, the Company extended the exercise period of
warrants to purchase 264,899 shares of common stock at $5.05 per share
originally scheduled to expire in 1998 such that the warrants now expire in
1999. The Company received proceeds of $24,000 from the warrant holders equal
to the fair value of the extended warrants using the Black-Scholes option
pricing model.
 
                                      42

 
                    APPLIED IMAGING CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
  As of December 31, 1998, 950,000 shares of common stock were reserved for
issuance under the Company's 1998 Stock Plan. Under the 1998 Stock Plan, stock
options may be granted to Board members, officers, key employees, and
consultants at the fair market value of the common stock at the date of the
grant, as determined by the Board. Options are exercisable over 5 to 10 years
from the date of grant, and typically vest ratably over 4 years. In October
1998, the Company's 1988 Amended and Restated Incentive Stock Option Plan
expired. In 1994, the Company enacted a Directors Option Plan designed to
encourage participation on the Company's Board. Under this plan, 5,000 shares
per year are automatically granted to non-employee directors. The terms of the
plan allow the granting of stock options upon initial election to the Board
and for each subsequent term on the Board. As of December 31, 1998 there were
60,000 shares reserved for issuance under this plan and a total of 60,000
options have been granted.
 
  On June 19, 1996, the Board adopted, effective upon the closing of the IPO,
the Company's Employee Stock Purchase Plan (the Plan) whereby eligible
employees may purchase common stock through payroll deductions of up to 10% of
compensation, at a per share price of 85% of the fair market value of the
Company's common stock on the enrollment date or the exercise date six months
later, whichever is lower. As of December 31, 1998 there were 165,898 shares
reserved for issuance under the Plan. The compensation expense measured for
the difference between the fair value of the Company's common stock on the
enrollment date and the date of purchase is not material for the years ended
December 31, 1998, 1997 and 1996.
 
 Accounting for Stock-Based Compensation
 
  As of December 31, 1998, there were 351,250 options available for grant
under the 1998 Stock Plan. In 1996, the Company recorded a deferred charge of
$1,473,000, representing the difference between the exercise price and the
deemed fair value of the Company's common stock for 246,750 shares subject to
common stock options granted in the 12-month period preceding the IPO. The
deferred stock compensation is being amortized to compensation expense over
the period during which the options become exercisable, generally four years.
 
  The Company has adopted the pro forma disclosure provisions of SFAS No. 123
for the 1998 Stock Plan and Employee Stock Purchase Plan. Had compensation
cost for the Company's stock-based compensation plans been determined in a
manner consistent with the fair value approach described in SFAS No. 123
'Accounting for Stock-Based Compensation', the Company's net loss and pro
forma net loss per share as reported would have been increased to the pro
forma amounts indicated below.
 


                                                      Year ended December 31,
                                                      -------------------------
                                                       1998     1997     1996
                                                      -------  -------  -------
                                                               
     Net loss:
       As reported................................... $(8,471) $(7,512) $(2,881)
       Pro forma..................................... $(9,206) $(8,218) $(2,965)
     Net loss per share:
       As reported:
         Basic and diluted........................... $  (.86) $ (1.03) $ (1.43)
       Pro forma:
         Basic and diluted........................... $  (.93) $ (1.12) $ (1.47)

 
  On February 2, 1998, the Company's board of directors approved an amendment
to reprice options outstanding under the Company's 1988 Stock Option Plan with
exercise prices over $3.00 per share. On February 2, 1998, holders of such
options were offered the choice of retaining their existing options without
amendment or accepting the amendment of their stock options. The exercise
price of the amended options is $2.44 per share, which equals the fair market
value of the Company's common stock on February 2, 1998.
 
                                      43

 
                    APPLIED IMAGING CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
Vesting of the amended options occurs over four years and begins on February
2, 1998. Holders of the options had until March 30, 1998 to make an
irrevocable decision to either retain their existing options without amendment
or accept the amendment to their options. The amendment of the options is
treated for accounting purposes as if the Company cancelled the existing
options and issued new options with the lower exercise price and new vesting
schedule. The compensation expense measured for the difference between the
fair value of the Company's common stock on the date employees elected to
accept new repriced options and the exercise price of the repriced options
($2.44 per share) was not significant.
 
  The fair value of each option is estimated on the date of grant using the
fair value method with the following weighted-average assumptions: volatility
of 60%, no dividends, an expected life of three years, and risk-free interest
rates of 4.66 %, 6.16% and 5.71% for the years ended December 31, 1998, 1997
and 1996 respectively. All of the above assumptions were used for the Employee
Stock Purchase Plan except the expected life is six months.
 
  A summary of the status of the Company's stock option activity for the years
ended December 31, 1998, 1997 and 1996, is as follows:
 


                                                            Weighted- Weighted-
                                                             average   average
                                                            exercise    fair
                                                  Shares      price     value
                                                 ---------  --------- ---------
                                                             
   Outstanding at December 31, 1995............    356,250    $2.24
   Granted--Exercise price equals market
    value......................................    238,750     2.66     $7.38
   Granted--Exercise prices less than market
    value......................................     53,750     2.66      2.90
   Canceled....................................    (78,250)    2.80
   Exercised...................................    (89,250)    1.80
                                                 ---------
   Outstanding at December 31, 1996............    481,250     2.48
   Granted--Exercise price equals market
    value......................................    443,750     5.67      2.93
   Granted--Exercise prices greater than market
    value......................................    269,400     3.87      1.88
   Granted--Exercise prices less than market
    value......................................     60,250     4.05      2.15
   Canceled....................................    (21,375)    3.90
   Exercised...................................    (34,003)    2.15
                                                 ---------
   Outstanding at December 31, 1997............  1,199,272     4.04
   Granted--Exercise price equals market
    value......................................    714,750     2.43      1.05
   Granted--Exercise price greater than market
    value......................................    520,250     1.91       .83
   Granted--Exercise price less than market
    value......................................     16,000     3.19     $1.44
   Canceled....................................   (654,016)    5.30
   Exercised...................................     (8,851)    1.82
                                                 ---------    -----
   Outstanding at December 31, 1998............  1,787,405    $2.32
                                                 =========

 
  Approimately 604 shares that were exercised in 1998 were issued in 1999.
 
                                      44

 
                    APPLIED IMAGING CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
  The following table summarizes information about fixed stock options
outstanding as of December 31, 1998:
 


                                                                                Options
                                            Options outstanding               exercisable
                                ------------------------------------------- ----------------
                                                                                    Weighted
                                            Weighted average    Weighted            average
                                  Number       remaining        average             exercise
     Range of exercise prices   outstanding contractual life exercise price Number   price
     ------------------------   ----------- ---------------- -------------- ------- --------
                                                                     
     From $1.80 to $2.50.....    1,463,005     8.74 years        $2.09      313,281  $2.03
     From $2.75 to $3.25.....      271,400     8.35 years         2.87       94,446   2.85
     From $4.88 to $6.30.....       53,000     7.95 years         5.99       43,250   6.20
                                 ---------                                  -------
                                 1,787,405     8.66 years         2.32      450,977   2.60
                                 =========                                  =======

 
(7) Income Taxes
 
  The Company has not recorded an income tax benefit in 1998, 1997, and 1996
due to the recording of a valuation allowance as an offset to net deferred tax
assets. A valuation allowance is provided due to uncertainties surrounding the
realization of deferred tax assets due to the history of operating losses
incurred by the Company. The tax effects of temporary differences that give
rise to significant portions of deferred tax assets are presented below:
 


                                                        December 31,
                                              ---------------------------------
                                                 1998        1997       1996
                                              ----------- ---------- ----------
                                                            
   Deferred tax assets:
   Accounts receivable, principally due to
    the allowance for doubtful accounts...... $    31,000 $   43,000 $   43,000
   Inventories, principally due to the
    allowance for obsolete inventory, and
    additional costs inventoried for tax
    purposes.................................     162,000    146,000    131,000
   Tangible and intangible assets,
    principally due to differences in
    depreciation and amortization............     100,000         --         --
   Revenue deferred for financial statement
    purposes, not for tax reporting
    purposes.................................          --         --    220,000
   Deferred compensation not currently
    deductible...............................     122,000    122,000    101,000
   Accrued expenses, not currently
    deductible...............................     237,000    415,000     90,000
   Net operating loss carryforwards..........   8,740,000  6,109,000  4,055,000
   Business credit carryforwards.............   1,186,000    540,000    386,000
                                              ----------- ---------- ----------
   Total gross deferred tax assets...........  10,578,000  7,375,000  5,026,000
   Less valuation allowance..................  10,578,000  7,368,000  4,967,000
                                              ----------- ---------- ----------
   Net deferred tax assets................... $        -- $    7,000 $   59,000
   Deferred tax liabilities:
   Tangible and intangible assets,
    principally due to differences in
    depreciation and amortization............          --      7,000     59,000
                                              ----------- ---------- ----------
   Total gross deferred tax liability........          --      7,000     59,000
                                              ----------- ---------- ----------
   Net deferred tax assets................... $        -- $       -- $       --
                                              =========== ========== ==========

 
  As of December 31, 1998, the Company had net operating loss carryforwards
for U.S. federal, U.K., and California state tax return purposes of
approximately $22,166,000, $2,803,000, and $4,765,000, respectively. The
 
                                      45

 
                    APPLIED IMAGING CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
federal and California net operating loss carryforwards expire in the years
between 2004 and 2018 and between 1998 and 2004, respectively. The Company's
U.K. net operating loss carryforward is available indefinitely to offset its
U.K. trading profits arising from distribution operations. The difference
between the tax loss carryforwards and the accumulated deficit primarily
relates to timing differences in the recognition of deferred revenue, accrued
compensation, and certain reserves.
 
  The Internal Revenue Code of 1986 and the California Conformity Act of 1987
substantially restrict the ability of a corporation to utilize existing net
operating losses and credits in the event of an "ownership change". The
several issuances of preferred stock and the initial public offering have
resulted in multiple ownership changes since inception of the Company.
Approximately $10,300,000 of the federal net operating loss carryforward will
be subject to an annual limitation in the aggregate of $800,000. Any unused
annual limitation can be carried over and added to the succeeding year's
annual limitation within the allowable carryforward period.
 
(8) Commitments
 
  The Company has various noncancelable operating leases for equipment,
vehicles, and facilities expiring through 2008. The facility leases generally
contain renewal options for periods ranging from two to five years and require
the Company to pay all executory costs such as maintenance, property taxes,
and insurance. Rent expense under operating leases aggregated $481,000,
$351,000 and $264,000 during 1998, 1997 and 1996, respectively. The Company's
primary lease commitments are for its facilities in the United Kingdom, which
aggregate approximately (Pounds)119,000 per year through 2003, with a five-
year renewal option held by the Company, and for its facilities in the United
States, which aggregate approximately $291,000 and $267,000 for 1999 and 2000,
respectively.
 
  The Company has a capital lease commitment of $116,000, including interest
of $17,000 at 10%, which calls for annual payments of $34,000 through the year
2001 and a payment of $15,000 in 2002.
 
  In October 1997, the Company entered into an exclusive worldwide licensing
agreement with the University of Cambridge for the commercialization of DNA-
probe technology recently developed by the Cambridge researchers. The
agreement requires minimum annual royalty payments of $30,000 and the payment
for specific research related projects. The agreement will remain in full
force and effect until the expiration of the last patent right or ten years
whichever is later.
 
  In March 1998, the Company entered into a non-exclusive world-wide agreement
with Amersham Pharmacia Biotech Inc. for the right to use certain technologies
in conjunction with its DNA probe technology. The agreement requires minimum
annual royalty payments of $10,000. The agreement will remain in full force
and effect until the expiration of all patents or eight years, whichever is
later.
 
  In December 1998, the Company entered into an option agreement to acquire
ownership of patents for the enrichment of fetal cells. The agreement provides
for payments of $1.1 million if the option is exercised and products using the
technology are successful in clinical trials. The final payment of $250,000
would be paid in common stock based on the market value of the common stock as
of the date the clinical trials are successfully completed.
 
(9) Employee Benefit Plans
 
  In January 1994, the Company implemented a retirement savings and investment
plan that is intended to qualify under Section 401(k) of the Internal Revenue
Code (the 401(k) Plan) covering all of the Company's United States-based
employees. An employee may elect to defer, in the form of contributions to the
401(k) Plan
 
                                      46

 
                    APPLIED IMAGING CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
on his or her behalf, up to 15% of the total compensation that would otherwise
be paid to the employee, not to exceed the amount allowed by applicable
Internal Revenue Service guidelines. The Company matches 100% of the amounts
deferred by the employee participants up to 3% of such employee's total
compensation and such matching amounts vest over a three-year period from the
initial participation date. The Company contributed, $90,000, $85,000 and
$69,000 in 1998, 1997 and 1996, respectively.
 
  The Company's United Kingdom-based employees are covered by retirement
savings plans (the International Retirement Plans). Under such plans, an
employee may elect to make contributions of 3.5% of such employee's earnings.
Amounts contributed by the Company range from 5.5% to 10.5% of such employee's
earnings. During 1998, 1997 and 1996, respectively, the Company made
contributions to the Internal Retirement Plans totaling $66,000, $60,000,
$47,000, respectively.
 
(10) Other Income, Net
 
  The components of other income, net are as follows:
 


                                                         December 31,
                                                 ------------------------------
                                                   1998      1997       1996
                                                 --------  ---------  ---------
                                                             
     Interest income............................ $579,000  $ 595,000  $ 208,000
     Interest expense...........................  (92,000)   (49,000)   (86,000)
     Gain (loss) on foreign exchange............   58,000   (163,000)  (112,000)
     Miscellaneous income (expense).............   (4,000)    15,000      4,000
                                                 --------  ---------  ---------
                                                 $541,000  $ 398,000  $  14,000
                                                 ========  =========  =========

 
(11) Foreign Operations
 
  The Company has adopted the provision of SFAS No. 131, Disclosure About
Segments of an Enterprise and Related Information. SFAS No 131 establishes
standards for the reporting by public business enterprises of information
about operating segments, products and services, geographic areas, and major
customers. The method for determining what information to report is based on
the way management organizes the operating segments within the Company for
making operating decision and assessing financial performance.
 
  The Company's chief operating decision maker is considered to be the
Company's Chief Executive Officer (CEO"). The CEO reviews financial
information presented on a consolidated basis for purposes of making operating
decisions and assessing financial performance. The consolidated financial
information is identical to the information presented in the accompanying
consolidated statements of operations. Therefore, the Company operates in a
single operating segment: prenatal instrumentation and screening.
 


                               United States United Kingdom Israel  Consolidated
                               ------------- -------------- ------- ------------
                                                        
     Revenues:
      1998....................  $ 4,304,000    $7,380,000        -- $11,684,000
      1997....................    5,328,000     7,806,000        --  13,134,000
      1996....................    4,797,000     7,125,000        --  11,922,000
     Identifiable assets:
      1998....................  $13,762,000    $4,498,000   $48,000 $18,808,000
      1997....................   11,051,000     3,438,000   225,000  14,714,000

 
  No single customer accounted for greater than 10% of revenues in any period
reported.
 
                                      47

 
                    APPLIED IMAGING CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
(12) Research and Development Arrangement
 
  During 1995, the Company was awarded a grant by the Israel-United States
Binational Industrial Research and Development (BIRD) Foundation. With the
funding received from the grant, the Company began research operations in its
Israel subsidiary relating to its fetal cell program. All funds received by
the Company in advance of performing the related research and development are
recorded as a deferred credit in the accompanying consolidated balance sheets
and, as expenses are incurred, the deferred credit is depleted. Over the life
of the grant, the Company could receive up to $543,000 in matching funds.
These funds, as well as any accrued interest, will be required to be paid back
to the BIRD Foundation if future revenues are realized from the related
research and development activities, at the rate of 2 1/2 % of such future
revenues generated in the first year such revenues occur, and 5% of revenues
in succeeding years, over a six-year period, up to a maximum of 150% of the
funds received. As of December 31, 1997, the Company has received a total of
$492,000 in funding and no further funding is expected. The Company recognized
credits to research and development expenses of approximately $34,000 during
1997 and $361,000 during 1996.
 
(13) Restructuring
 
  During the quarter ended June 30, 1998, the Company developed plans to
reduce operating costs by eliminating thirteen employee positions in the
Company. The employee reductions were made at both the United States and
United Kingdom facilities. The consolidated statement of operations for the
year ended December 31, 1998 includes a $353,000 charge related to the
severance costs for these terminated employees. Substantially all of the
severance costs had been paid as of December 31, 1998.
 
(14) Private Placement Transaction
 
  On June 3, 1998, the Company consummated a private sale of 3,333,331 shares
of its common stock to certain accredited investors at $3.00 per share. The
price exceeded the closing price of the Company's common stock as reported on
the NASDAQ National Market System. Included in the sale was 1,000,000 shares
sold to New Enterprise Associates, a principal owner of the Company. Thomas C.
McConnell, a director of the company, is an affiliate of New Enterprise
Associates.
 
  On July 7, 1998 and July 15, 1998, the Company consummated private sales of
collectively 499,999 shares of its common stock to certain accredited
investors at $3.00 per share. The price exceeded the closing price of the
Company's common stock as reported on the NASDAQ National Market System.
 
  On May 22, 1997, the Company consummated a private sale of 796,020 shares of
its common stock to certain partnerships affiliated with New Enterprise
Associates, at $5.025 per share. The price per share was calculated as the
average of the closing prices of the Company's common stock as reported on the
NASDAQ National Market System for the previous five trading days prior to the
day of the transaction closing date. In connection with this transaction, the
Company also issued warrants, which may be exercised within a three-year
period ending May 21, 2000 to acquire an aggregate of 173,010 shares of the
Company's common stock at a purchase price of $5.78 per share. The Company
allocated a portion of the proceeds to the warrants based on the fair value
using the Black-Scholes pricing model and such amount is included within
common stock.
 
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
  None.
 
                                      48

 
                                   PART III
 
  Certain information required by Part III is omitted from this Report on Form
10-K in that the Registrant will file a definitive proxy statement within 120
days after the end of its fiscal year pursuant to Regulation 14A with respect
to the 1998 Annual Meeting of Stockholders (the "Proxy Statement") and certain
information included therein is incorporated herein by reference.
 
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  Certain of the information required by this item relating to directors is
incorporated by reference to the information under the caption "Proposal No. 1
- -- Election of Directors" in the Proxy Statement.
 
  The executive officers of the Registrant, who are elected by the board of
directors, are as follows:
 


 Name                            Age Position
 ----                            --- --------
                               
 Jack Goldstein, Ph.D..........   51 Chief Executive Officer and President
 Michael A. Zoccoli, Ph.D......   48 Vice President Research and Development
 Leslie G. Grant, Ph.D.........   45 Executive Vice President
 Carl Hull.....................   40 Vice President Sales and Marketing

 
  Jack Goldstein, Ph.D. joined the Company as Chief Executive Officer and
President in April 1997. Dr. Goldstein has 23 years of management experience
at leading healthcare companies. From 1986 to 1997, Dr. Goldstein worked for
Johnson & Johnson in various executive management positions including
President of Ortho Diagnostic Systems and Executive Vice President of
Professional Diagnostics at Johnson & Johnson World Headquarters. Prior to his
tenure at Johnson & Johnson, Dr. Goldstein served in management positions at
Baxter Healthcare Corporation and American Home Products Corporation. Dr.
Goldstein holds a B.A. degree in Biology from Rider University, an M.S. in
Immunology and a Ph.D. in Microbiology from St. John's University.
 
  Michael A. Zoccoli, Ph.D. has been Vice President of Research and
Development since July 1998. He joined the Company in October 1997 as Vice
President of Product Development. From 1991 to 1997, Dr. Zoccoli held various
senior management positions with Roche Molecular Systems. Dr. Zoccoli has over
16 years of experience in research and development of immunoassay and P C R
reagent products for the clinical and research markets and is a co-inventor on
three US Patents. Dr. Zoccoli holds a B.A. in Chemistry from the University of
Connecticut and a Ph.D. in Chemistry from Dartmouth College.
 
  Leslie G. Grant Ph.D., has been President and Chief Operating Officer of the
Company's Cytogenetics Division since February 1992. In 1997 he became an
Executive Vice President of the Company. He joined the Company in October 1991
as Managing Director of Applied Imaging International Ltd. From 1980 to 1991,
Dr. Grant held various general management and senior engineering positions
with GEC-Marconi. Dr. Grant has 20 years experience in the instrumentation and
medical industry, including 11 years in senior management positions. Dr. Grant
holds a B.S. in Mathematics and a Ph.D. in Mathematics and Electronic
Engineering from the University of Hull, United Kingdom.
 
  Carl Hull joined the Company as Vice President of Worldwide Marketing in
August 1997. In January 1999 he also became Vice President of Sales. Prior to
joining the Company, Mr. Hull served as Vice President of Marketing and
Business Development for Ventana Medical Systems. From 1982 to 1996, he served
in various marketing and sales management positions at Abbott Laboratories,
including Vice President and General Manager of Abbott Laboratories, Puerto
Rico. He also served as Marketing Manager Far-East, Marketing manager for
Hematology Products, District Sales Manager as well as Product Manager for
several diagnostic product lines. Mr. Hull received his MBA from University of
Chicago and a B.A. in Political Science and International Relations at Johns
Hopkins University.
 
                                      49

 
Item 11. EXECUTIVE COMPENSATION
 
  The information required by this item is incorporated by reference to the
information under the caption "Executive Compensation" in the Proxy Statement.
 
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The information required by this item is incorporated by reference to the
information under the caption "Record Date and Stock Ownership" in the Proxy
Statement.
 
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  The information required by this item is incorporated by reference to the
information under the caption "Certain Transactions" in the Proxy Statement.
 
                                       50

 
                                    PART IV
 
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
   (a) 1. Financial Statements
 
  The following Financial Statements of Applied Imaging Corp. and Report of
KPMG LLP, have been provided as Item 8, above:
 
  Report of KPMG LLP
 
  Consolidated Balance Sheets, 1998 and 1997
 
  Consolidated Statements of Operations, Years Ended December 31, 1998, 1997
  and 1996
 
  Consolidated Statements of Stockholders' Equity, Years Ended December 31,
  1998, 1997 and 1996
 
  Consolidated Statements of Cash Flows, Years Ended December 31, 1998, 1997
  and 1996
 
  Notes to Consolidated Financial Statements
 
2. Financial Statement Schedules
 
  The financial statement schedule entitled "Valuation and Qualifying
Accounts" is included at page 54 of this Form 10-K.
 
  All other schedules are omitted because they are not applicable or the
required information is shown in the Financial Statements or the notes
thereto.
 
3. Exhibits
 
  Refer to (c) below.
 
   (b) Reports on Form 8-K
 
  The Company was not required to and did not file any reports on Form 8-K
during the three months ended December 31, 1998.
 
   (c) Exhibits
 


 Exhibit No. Description
 ----------- -----------
          
  3.1(1)     Restated Certificate of Incorporation of the Registrant.
  3.2(2)     Bylaws of the Registrant as amended.
  4.1(1)     Specimen Common Stock Certificate.
  4.2(3)     Preferred Shares Rights Agreement dated as of May 29, 1998 between
             Applied Imaging Corp. and Norwest Bank Minnesota, N.A., including
             the form of Rights Certicate and the Certificate of Designation,
             the summary of Rights Attached thereto as Exhibits A, B and C,
             respectively. Form 8-A, 6/5/98.
  4.3(5)     Preferred Shares Rights Agreement dated as of May 29, 1998,
             between the Registrant and Norwest Bank Minnesota, N.A. including
             the form of Rights Certificate, the Certificate of Designation and
             the summary of Rights attached thereto as Exhibits A, B, and C,
             respectively.
 10.1(1)     Form of Indemnification Agreement for directors and officers.
 10.2(a)(1)  Amended and Restated 1988 Incentive Stock Option Plan and form of
             agreement thereunder.
 10.2(b)(4)  1998 Incentive Stock Option Plan and form of Stock Option
             Agreement thereunder.
 10.3(1)     1994 Director Option Plan and form of subsequent agreement
             thereunder.
 10.4(1)     Employee Stock Purchase Plan.
 10.5(1)     Amended and Restated Registration Rights Agreements.
 10.6(1)     License Agreement dated December 1, 1993 between the Registrant
             and Chronomed, Inc.

 
                                      51

 


 Exhibit No. Description
 ----------- -----------
          
 10.7(1)     Assignment dated December 1, 1993 by and between the Registrant
             and Alex Saunders, M.D.
 10.8(a)(1)  Lease dated February 15, 1994 for the Registrant's headquarters in
             Santa Clara, CA.
 10.8(b)     Lease renewal dated December 8, 1998 for the Registrants
             headquarters in Santa Clara, CA.
 10.9        Lease dated July 1998 between Bio Science Center and Applied
             Imaging International Ltd.
 10.10(1)    Employment Letter Agreement dated August 12, 1991 between the
             Registrant and Leslie G. Grant.
 10.11(1)    Amendment to Employment Letter Agreement between the Registrant
             and Leslie G. Grant, dated February 12, 1996.
 10.12(1)    Know-How License Agreement dated November 1989 between Medical
             Research Council and Shandon Scientific Limited (assigned to the
             Registrant in November 1989), as amended, July 5, 1994.
 10.13(1)    Cooperative Research and Development Agreement, dated June 10,
             1995 between Registrant and the National Institute of Health.
 10.14(1)    Supply & Distribution Agreement dated March 3, 1994 between
             Cytocell Ltd. and Registrant.
 10.15(1)    Research Purchase Agreement dated March 26, 1996 between Pharmacia
             Biotech AB and Registrant.
 10.16(1)    Development Agreement dated February 5, 1996 between EM Industries
             and Registrant.
 10.17(1)    Security and Loan Agreement dated September 5, 1995 between
             Registrant and Imperial Bank.
 10.18(1)    Extension to Security and Loan Agreement dated September 16, 1996
             between Registrant and Imperial Bank.
 10.19(2)    License Agreement dated October 24, 1997 between Cambridge
             University and the Registrant.
 10.20(2)    Employment Letter Agreement dated July 21, 1997 between the
             Company and Carl Hull.
 10.21(2)    Employment Letter Agreement dated April 2, 1997 between the
             Company and Jack Goldstein, Ph.D. and amendment dated April 4,
             1997.
 10.22(6)    Stock and Warrant Purchase Agreement dated May 22, 1997 between
             the Registrant and partnership affiliates of New Enterprise
             Associates and exhibits thereto.
 10.23(7)    Stock and Warrant Purchase Agreement dated May 22, 1997 between
             the registrant and certain investors
 10.24(8)    Form of Stock Purchase Agreement between the Registrant and
             certain investors used in connection with sales of Common Stock on
             July 7 and July 15, 1998.
 21.1(1)     List of Subsidiaries of the Registrant.
 23.1        Consent of KPMG LLP.
 24.1        Power of Attorney (included at page 53 below).
 27.1        Financial Data Schedule.

- --------
(1) Filed as an Exhibit to the Company's Registration Statement on Form S-1
    (File No. 333-06703) and incorporated herein by reference.
(2) Filed as an exhibit to the Company's Form 10-K for the year ending
    December 31, 1997 and incorporated herein by reference.
(3) Filed as exhibit 3 to the Registrant's Report on Form 8-A with the
    Commission on June 5, 1998 and incorporated herein by reference.
(4) Filed as exhibit 4.1 to the registrant's Report on Form S-8 filed with the
    Commission on June 26,1998 and incorporated herein by reference.
(5) Filed as an Exhibit to the Registrant's Registration Statement on form 8-A
    filed with the Commission on June 5, 1998 and incorporated herein by
    reference.
(6) Filed as exhibit 10.1 to the Registrant's Report on form 8-K filed with
    the Commission on June 4, 1997 and incorporated herein by reference.
(7) Filed as exhibit 10.1 to the registrant's Report on form 8-K filed with
    the Commission on June 16, 1998 and incorporated herein by reference.
(8) Filed as exhibit 10.1 to the Registrant's Report on form 8-K filed with
    the Commission on July 28, 1998 and incorporated herein by reference.
 
                                      52

 
                                  SIGNATURES
 
  Pursuant to the requirements of the Securities Act, the Registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
 
                                          Applied Imaging Corp.
 
                                          By: /s/ Jack Goldstein
                                            -----------------------------------
                                                     Jack Goldstein
                                                 Chief Executive Officer
 
Date: March 25, 1999
 
                               POWER OF ATTORNEY
 
  Know All Men And Women by these Presents, that each person whose signature
appears below constitutes and appoints Jack Goldstein and Thomas Klein his or
her attorney-in-fact, with the power of substitution, for him or her in any
and all capacities, to sign any amendments to this Report on Form 10-K, and to
file the same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby ratifying and
confirming all that said attorneys-in-fact, or his or her substitute or
substitutes, may do or cause to be done by virtue thereof.
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the date indicated.
 


             Signature                           Title                    Date
             ---------                           -----                    ----
 
                                                             
/s/ Jack Goldstein                   Chief Executive Officer and     March 25, 1999
____________________________________  Director (Principal
   (Jack Goldstein)                   Executive Officer)
 
/s/ Michael J. Braden                Corporate Controller            March 25, 1999
____________________________________  (Principal Accounting
   (Michael J. Braden)                Officer)
 
/s/ John F. Blakemore, Jr.           Director                        March 25, 1999
____________________________________
   (John F. Blakemore, Jr.)
 
/s/ Gilbert J.R. McCabe              Director                        March 25, 1999
____________________________________
   (Gilbert J.R. McCabe)
 
/s/ Thomas C. McConnell              Director                        March 25, 1999
____________________________________
   (Thomas C. McConnell)
 
/s/ Andre F. Marion                  Director                        March 25, 1999
____________________________________
   (Andre F. Marion)
 
/s/ Robert C. Miller                 Director                        March 25, 1999
____________________________________
   (Robert C. Miller)
 
/s/ G. Kirk Raab                     Director                       March 25 , 1999
____________________________________
   (G. Kirk Raab)

 
                                      53

 
                             APPLIED IMAGING CORP.
 
                 SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
                                 (In thousands)
 


                               Balance at  Charged to               Balance at
                              Beginning of Costs and  (Deductions)/   End of
                                  Year      Expenses   Recoveries      Year
                              ------------ ---------- ------------- ----------
                                                        
Allowance for doubtful
 accounts:
  Year ended December 31,
   1998......................     $191        $--         $(29)        $162
  Year ended December 31,
   1997......................     $228        $10         $(47)        $191
  Year ended December 31,
   1996......................     $166        $76         $(14)        $228

 
                                       54

EX-10.8(B)

 
                                                                 EXHIBIT 10.8(b)

                       [Commerce Communities Letterhead]

December 08, 1998

Mike Braden
c/o Applied Imaging
2380 Walsh Avenue
Santa Clara, CA  95051

Re:  Lease renewal 2380 Walsh Ave., Santa Clara, CA

Dear Mike:

     This letter will serve as our written agreement to extend your Lease two
(2) years.  The Lease Extension is for that certain Lease dated April 17, 1997
by and between San Tomas Investors II, Landlord, and Applied Imaging Corp.,
Tenant, covering those certain premises known and numbered as stated above,
which Lease was to terminate November 30, 1998.

Landlord and Tenant hereby agree:

     1.  The term of said Lease shall be extended through November 30, 2000.

     2.  The base rent, as provided in paragraph 3, shall be increased to twenty
four thousand two hundred fifty dollars ($24,250.00) per month beginning
December 1, 1998 and continuing to November 30, 2000.

     3.  The security deposit shall be increased from $18,541.00 to $24,250.00.

     4.  Tenant acknowledges that there exists a license from the Principal
Mutual Life Insurance Company which permits the Tenant to pay rent to San Tomas
Investors II. Tenant further acknowledges that the Principal Mutual Life
Insurance Company has the right to revoke such license and that upon such
revocation the Tenant will pay rent at such address as the Principal Mutual Life
Insurance Company may direct by written notice to Tenant.

     5.  Landlord will provide the following improvements at Landlord's expense:

            a.  new restroom floor tile
            b.  repaint restroom walls and toilet partitions
            c.  install new building standard light fixtures in restrooms
            d.  repair or replace carpet as shown on "Exhibit 1" to this renewal
   
     6.  All other terms and conditions of said Lease shall remain the same and
in full force and effect.

 
If the foregoing is acceptable, please have the appropriate party sign and
return both copies to me at your earliest convenience.  A fully executed copy
will be returned to you.

Sincerely,                               AGREED & ACCEPTED:

                                              /s/ Richard Gatley
COMMERCE COMMUNITIES CORP.               By:  /s/ Peggy Lafferty, Trustees
                                            ------------------------------
                                            San Tomas Investors II, Landlord

/s/ Richard V. Treakle                      Date:

Richard V. Treakle
President
                                         By:  /s/ Michael Braden
                                            ------------------------------
                                            Applied Imaging Corp., Tenant

                                         Date: 12/3/98
                                              ----------------------------

EX-10.9

 
                                                                    EXHIBIT 10.9
                               DATED JULY 1,1998
                               -----------------

                INTERNATIONAL CENTRE FOR LIFE (PROPERTY) LIMITED

                                       to

                     APPLIED IMAGING INTERNATIONAL LIMITED

                                   L E A S E
                                   ---------

                    relating to first floor premises within
                         Bio Science Centre comprising
                   part of the International Centre for Life
               Newcastle upon Tyne in the County of Tyne and Wear

                                   EVERSHEDS
                      Sun Alliance House 35 Mosley Street
                          Newcastle upon Tyne NE1 1XX
                             (RJN.LK : 31.03.1998)

 
THIS LEASE is made the   day of   1998
- ----------                            

BETWEEN the Landlord (hereinafter called "the Landlord") specified in Schedule 1
- -------                                                                         
of the one part and the Tenant (hereinafter called "the Tenant") specified in
Schedule 2 of the other part

WITNESSETH as follows:
- ----------            
1.  In this Lease except as otherwise provided or where the context otherwise
requires:

     "Accessways"                   all unadopted roads driveways service areas
                                    forecourts paths entrances exits lifts
                                    corridors lobbies landings stairways and
                                    other accessways which form part of the
                                    Centre at any time during the Term
     "Advance Payments"             the quarterly advance payments of Service
                                    Charge payable by the Tenant under clause
                                    7.4.1
     "Authorised Person"            anyone deriving title from the Tenant and
                                    anyone at the Premises with the express or
                                    implied authority of the Tenant or of such
                                    person so deriving title
     "Buyer's Works"                the works carried out by the Tenant prior to
                                    completion of the Lease and more
                                    particularly described in the Agreement for
                                    Lease between the Landlord (1) and the
                                    Tenant (2)
     "Cattle Market Car Park"       the car parking area neighbouring the Centre
                                    and known as the Cattle Market Car Park
     "Cattle Market Parking Fee"    ten thousand pounds ((Pounds)10,000.00) per
                                    annum
     "Centre"                       means the property known as the Bio Science
                                    Centre forming part of the International
                                    Centre for Life Newcastle upon Tyne
     "Centre Parking Fee"           the fee for parking two (2) cars or light
                                    vehicles in the basement of the Centre to be
                                    notified by the Landlord to the Tenant not
                                    less than six (6) months before the fifth
                                    anniversary of the commencement of the Term
     "Common Parts"                 means those parts of the Centre not
                                    comprised in any lease tenancy or licence of
                                    the Centre and provided for common use of
                                    the users of the Centre

 
     "Expenditure"                  (1) the aggregate of all costs fees expenses
                                    and outgoings incurred by the Landlord in
                                    providing the Landlord's Services including
                                    bank charges interest and VAT
                                    (2) such sums as the Landlord in its
                                    reasonable discretion considers reasonably
                                    desirable to set aside from time to time for
                                    the purpose of providing for periodically
                                    recurring items of expenditure in connection
                                    with the Landlord's Services whether
                                    recurring at regular or irregular intervals
                                    and
                                    (3) such provisions for anticipated
                                    expenditure in connection with the
                                    Landlord's Services as the Landlord in its
                                    reasonable discretion considers fair and
                                    reasonable in the circumstances
     "Financial Year"               the annual accounting period beginning on 1
                                    January in each year or on such alternative
                                    date as the Landlord may at any time
                                    stipulate
     "Independent Surveyor"         an independent chartered surveyor who has
                                    practised in the United Kingdom for at least
                                    the previous five years and who has recent
                                    substantial experience of the letting and
                                    valuation of premises of similar character
                                    quality and general location to the Premises
                                    and who is appointed as prescribed in clause
                                    8.5.2
     "Insurance Rent"               the amount attributable to the Premises
                                    (conclusively determined by the Landlord
                                    acting reasonably) which the Landlord from
                                    time to time incurs or expends in insuring
                                    the Centre in accordance with its covenants
                                    at clause 4.2
     "Insured Risks"                The insurance risks referred to at clause
                                    4.3
     "Landlord"                     includes the person from time to time
                                    entitled to the reversion immediately
                                    expectant on the determination of the term
                                    hereby granted
     "Landlord's Services"          the services which the Landlord covenants to
                                    provide in clause 7 and the services listed
                                    in Schedule 2 which the Landlord may provide
                                    in its absolute discretion
     "Landlord's Surveyor"          means such surveyor appointed by the
                                    Landlord from time to time

                                      -2-

 
     "Perpetuity Period"            shall be the period of eighty years from the
                                    date hereof and shall be the perpetuity
                                    period applicable in this Lease
     "Pipes"                        means pipes sewers drains mains ducts
                                    conduits gutters watercourses wires cables
                                    channels flues and other conducting media
                                    and includes any fixings louvres cowls and
                                    any other ancillary apparatus
     "Planning Acts"                means the Town and Country Planning Act 1990
                                    the Planning (Listed Building and
                                    Conservation Areas) Act 1990 the Planning
                                    (Hazardous Substances) Act 1990 the Planning
                                    (Consequential Provisions) Act 1990 and the
                                    Planning and Compensation Act 1991 and any
                                    Act or Acts for the time being, in force
                                    amending or replacing the same and any
                                    directions regulations plans permissions
                                    consents licences or orders made thereunder
                                    or under any enactment repealed thereby
     "Permitted Part"               such part or parts of the Premises as the
                                    Landlord acting reasonably shall specify in
                                    writing as being capable of being underlet
     "Premises"                     means the premises hereby demised and
                                    includes (without prejudice to the
                                    generality of the foregoing) all additions
                                    and improvements which during the Term may
                                    be made to the Premises hereby demised and
                                    all equipment plant machinery materials and
                                    items (including the Landlord's fixtures and
                                    fittings) which may at any time during the
                                    Term be therein
     "Permitted Hours"              means between the hours of 8 .a.m. and 6
                                    p.m. and such other times as shall be agreed
                                    by the parties (acting reasonably) PROVIDED
                                    THAT the Tenant shall reimburse the Landlord
                                    its reasonable costs in respect of services
                                    provided at such other times
     "Prescribed Rate"              means the rate of interest which is from
                                    time to time 3% above the base rate for the
                                    time being of Royal Bank of Scotland Plc or
                                    in the event of the said base rate ceasing
                                    to exist such other reasonable rate of
                                    interest as the Landlord may from time to
                                    time specify in writing
     "Rent Commencement Date"       means

                                      -3-

 
     "Review Date"                  means
     "Rent"                         means the rents reserved by Clause 2 hereof
                                    or any sum substituted for the rent on Rent
                                    Review
     "Service Charge"               the Service Charge Proportion of the
                                    Expenditure or such other proportion of the
                                    Expenditure as the Landlord or the
                                    Landlord's Surveyor may from time to time
                                    acting reasonably determine to be fair and
                                    reasonable in all circumstances Provided
                                    That for the first five years of the Term
                                    the annual Service Charge payable in respect
                                    of the Premises shall not exceed
                                    (Pounds)2.50 per square foot of the Premises
     "Service Charge Proportion"    means    %
     "Tenant"                       includes the persons deriving, title under
                                    the Tenant hereinbefore named
     "Term"                          means the term hereby created
     "the 1954 Act"                  means the Landlord and Tenant Act 1954 (as
                                     amended)
     "the 1995 Act"                  means the Landlord and Tenant (Covenants)
                                     Act 1995
     "Title Matters"                 means the matters affecting or relating to
                                     the Landlord's reversionary interest
                                     specified in Schedule 1
     "VAT"                           means value added tax as defined by the
                                     Value Added Tax Act 1994 and any new tax of
                                     a similar nature

    1.1   Where the expression "the Tenant" at any time comprises two or more
          persons firms or companies the obligations of the Tenant shall be
          construed as joint and several and the Landlord shall not be
          prejudiced by any agreement bankruptcy composition dealing death
          dissolution indulgence liquidation or security in relation to some one
          or more of such persons firms or companies

    1.2   Any reference to an Act of Parliament shall include any modification
          extension or re-enactment thereof for the time being in force and
          shall also include all instruments orders plans regulations
          permissions and directions for the time being made issued or given
          thereunder or deriving validity therefrom

    1.3   Any reference to the masculine gender only shall include the feminine
          and neuter genders and vice versa and any reference to the similar
          shall include the plural and vice versa and any reference to persons
          shall include corporations and vice versa

                                      -4-

 
2.  In consideration of the rent and of the Tenant's covenants hereinafter
    contained the Landlord hereby demises unto the Tenant ALL THAT the Premises
    described in Schedule 1 TO HOLD the same unto the Tenant for the Term
    specified in Schedule 1 YIELDING AND PAYING therefor yearly during the Term
    on and with effect from the Rent Commencement Date to the Landlord:

    2.1  the rent specified in Schedule 1 by equal quarterly payments in advance
         on the usual quarter days in every year the first such payments or a
         due proportion thereof being made on the Rent Commencement Date

    2.2  Charge in accordance with the provisions of clause 7

    2.3  on demand those costs which the Landlord incurs in insuring the
         Premises in accordance with the provisions of clause 4

    2.4  the Centre Parking Fee and the Cattle Market Parking Fee by equal
         quarterly payments in advance on the usual quarter days in every year
         the Centre Parking Fee only to be payable from the fifth anniversary
         of the date hereof and the Cattle Market Parking Fee only to be
         payable from the third anniversary of the date hereof

    2.5  VAT at the standard rate for the time being in force upon such sums

3.  The Tenant hereby covenants with the Landlord throughout the Term as
    follows:-

    3.1  To pay to the Landlord without any deduction or set-off:

         3.1.1  the Rent Service Charge Centre Parking Fee Cattle Market Parking
                Fee and Insurance Rent reserved in clause 2 at the times and in
                the manner stated and

         3.1.2  on demand all VAT properly chargeable on every VAT supply made
                by the Landlord to the Tenant under this Lease

         3.1.3  all other sums due from the Tenant under this Lease

    3.2  Without prejudice to any other right remedy or power herein contained
         or otherwise available to the Landlord if any rent or any other sum of
         money payable to the Landlord or by the Tenant under these presents
         shall have become due but remain unpaid for fourteen days after demand
         to pay on demand to the Landlord (if the Landlord shall so require)
         interest thereon at the Prescribed Rate from the date when the same
         became due and until payment thereof (as well after as before any
         judgement)

    3.3  At the expense of the Tenant to insure forthwith and throughout the
         term with an insurance office of repute against public liability claims
         arising out of or as a result of

                                      -5-

 
         its occupation of the Premises in the sum of at least
         (Pounds)2,000,000.00 (two hundred thousand pounds) for any one incident
         in any one year and the produce to the Landlord on demand such
         insurance policy receipt proving payment of the premium for the
         relevant period

    3.4  From time to time and at all times during the Term to keep the Premises
         in good and substantial repair condition and decoration and to decorate
         the Premises in colours approved by the Landlord in every third year of
         the Term and in the last year of the Term (whenever it ends) in a good
         and workmanlike manner using good quality materials (damage by Insured
         Risks excepted unless the insurance is vitiated by the Tenant) PROVIDED
         THAT this Clause 3.4 shall be null and void to the extent that any want
         of repair relates to a matter which would otherwise have given rise to
         an actionable claim by the Tenant under the warranties described below)
         in the event that the Tenant has not by the date hereof received from
         Building Design Partnership Limited and John Laing Construction Limited
         in each case an enforceable deed of collateral warranty in favour of
         the Tenant in terms no less onerous than the latest edition of the
         British Property Federation standard form warranty for purchasers and
         tenants (CoWa/P&T)

    3.5  At the expiration or sooner determination of the Term quietly to yield
         up the Premises in a good and tenantable repair and in a clean and tidy
         condition in accordance in all respects with the covenants herein
         contained

    3.6  To indemnify and keep indemnified the Landlord from and against its
         liability (if any) for injury (whether fatal or not) to persons
         (including officers and employees of the Landlord) the infringement
         disturbance or destruction by the Tenant or his agents or licensees of
         any right easement or privilege and for damage to property (movable or
         immovable) caused by or in any way arising out of the condition of the
         Premises (other than the structure thereof) or any fixtures fittings
         equipment machinery or chattels therein or the use and occupation of
         the Premises during the Term or any fixtures fittings equipment
         machinery and chattels therein or the act or default of the Tenant its
         employees or visitors and from all proceedings costs claims and demands
         of whatsoever nature in respect of any such liability or alleged
         liability

    3.7  Not to do anything or suffer anything to be done on the Premises which
         would remove support from any adjoining land buildings or structures or
         endanger such land buildings or structures in any way whatsoever

    3.8  Not at any time during the Term without the consent in writing of the
         Landlord

         3.8.1  to make any alterations or additions whatsoever in or to the
                Premises or any part thereof or cut maim injure or remove any of
                the walls beams, columns or other structural parts thereof
                provided that the Tenant may without the Landlord's prior
                consent install internal demountable

                                      -6-

 
                partitioning at the Premises provided that the Premises are re-
                instated at the end or sooner determination of the Term to the
                Landlord's reasonable satisfaction or

         3.8.2  to make any alteration or addition to the electrical
                installation or mechanical installation in the Premises save in
                accordance with the regulations of the electricity supply or gas
                supply authorities

    3.9  To permit the Landlord or its agents with or without workmen and others
         authorised by the Landlord at all reasonable times during the Term at
         convenient hours in the day time upon reasonable prior written notice
         (or at any time in an emergency without notice) as often as occasion
         shall require to enter into and upon the Premises or any part thereof
         for the purpose of carrying out any work to adjoining property of the
         Landlord or for the purpose of connecting services necessary therefor
         into the services in the Premises provided that the same shall not be
         overloaded and also for the purpose of carrying, out any work required
         in relation to the provisions of Schedule 2 the person or persons so
         entering causing as little damage and inconvenience to the Tenant's
         business and use as possible and making good all damage caused by the
         exercise of such rights

   3.10  To permit the Landlord or its agents with or without workmen and others
         authorised by the Landlord at all reasonable times during the Term at
         convenient hours in the day time upon reasonable prior written notice
         (or at any time in an emergency without notice) as often as occasion
         shall require to enter into and upon the Premises or any part thereof
         for the purpose of taking inventories of the Landlord's fixtures and
         fittings therein or of viewing and examining the state and condition of
         the Premises and equipment and on notice in writing of any want of
         cleansing or repair or decoration or defect in the order or condition
         of the Premises or equipment for which the Tenant is liable hereunder
         being given to the Tenant or left at or upon the Premises for the
         Tenant by or on behalf of the Landlord to repair, cleanse, decorate,
         amend, maintain and (where necessary) renew the same accordingly within
         two months after the date of such notice and so that in case of default
         by the Tenant the Landlord may carry out all necessary or proper
         cleansing reparation decoration amendment maintenance and renewal
         thereof and any money expended by the Landlord for that purpose shall
         be repayable by the Tenant on demand and if not so repaid shall be
         recoverable by the Landlord as rent in arrear

   3.11  3.11.1  Not at anytime either to use or permit or suffer the Premises
                 nor any part thereof to be used for any illegal nor immoral
                 purpose nor the sale of ale, beer, wine or spiritous liquors
                 nor any noisy or offensive or dangerous trade or business nor
                 any sale by auction nor to do or permit or suffer to be done in
                 the Premises or any part thereof any act or thing, which may be
                 or grow to be in any way an annoyance disturbance or nuisance
                 or

                                      -7-

 
                 detrimental to the neighbourhood or to the adjoining or
                 neighbouring property or to the Landlord

         3.11.2  Not at any time either to use or permit or suffer the Premises
                 nor any part thereof to be used for any testing or
                 experimentation on or involving animals and not to bring onto
                 or suffer or allow or permit to be kept on the Premises any
                 animal or animals

   3.12  3.12.1  Subject to the Tenant obtaining all requisite consents under
                 the Planning Acts to use the Premises at all times for the
                 purpose specified in Schedule 1 and not at any time to use or
                 permit or suffer the Premises or any part thereof to be used
                 for any other purpose

         3.12.2  To ensure that all waste and refuse of a specialist or toxic
                 nature is stored and disposed of safely and in accordance with
                 the reasonable requirements of the Landlord and with any
                 requirements of the local authority or other relevant authority
                 as to the storage collection and disposal of all such waste or
                 refuse

    3.13  Not without the consent in writing of the Landlord to bring on to the
          Premises any safe or other heavy object and not to take any goods upon
          the Premises so as to cause any undue stress or strain to the floors
          main girders or structure of the Centre in any manner whatsoever

    3.14  Not to store any explosive or inflammable materials at the Premises
          nor to allow any grit, noxious or offensive effluvia to be emitted
          from the Premises or any part thereof nor to allow any oil grease or
          other deleterious materials or substances to enter the Pipes

   3.15  3.15.1  Not at any time during the Term to do or omit or permit or
                 suffer to be done or omitted anything on the Premises or any
                 part thereof the doing or omission of which shall be a
                 contravention of the Planning Acts and to indemnify the
                 Landlord against all actions proceedings, damages, penalties,
                 costs, charges, claims and demands in respect of such acts or
                 omissions or any of them

        3.15.2   To give notice as soon as practicable to the Landlord of any
                 notice order or proposal for a notice or order served on the
                 Tenant under the Planning Acts and if so required by the
                 Landlord to produce the same and at the request and cost of the
                 Landlord to make or join in making, such objections or
                 representations in respect of any proposal as the Landlord may
                 require

                                      -8-

 
         3.15.3  To comply at the cost of the Tenant with any notice or order
                 served on the Tenant under the provisions of the Planning Acts
                 which relates to the Tenant's use of the Premises and to keep
                 the Landlord effectually indemnified against all actions,
                 proceedings, damages, penalties, costs charges and demands in
                 respect thereof

   3.16  Not to place or affix any aerial signboard, fascia, placard, bill,
         notice or other notification whatsoever to or upon the outside of the
         Premises or in or upon the windows thereof without the prior written
         consent of the Landlord (such consent not to be unreasonably withheld
         or delayed)

   3.17  Not to use the Common Parts except in accordance with any reasonable
         rules or regulations which the Landlord shall impose in relation
         thereto and without prejudice to the generality of the foregoing not to
         obstruct any part or parts of the Common Parts nor store any materials
         or refuse thereon nor allow any vehicles or machinery to be repaired or
         maintained thereon

   3.18  At all times during, the Term at the expense of the Tenant to do and
         execute or cause to be done and executed all such works and to do all
         such things as under or by virtue of any Act or Acts of Parliament now
         or hereafter to be passed and orders by-laws rules and regulations
         thereunder are or shall be directed or necessary to be done or executed
         upon or in respect of the Premises or any part thereof by the owner
         lessee tenant or occupier thereof and at all times to save harmless and
         to keep indemnified the Landlord against all actions costs claims
         demand costs expenses and liabilities in respect thereof and to pay all
         costs charges and expenses properly incurred by the Landlord in abating
         a nuisance or for remedying any other matter in connection with the
         Premises in obedience to a notice served by a local or any other
         authority

   3.19  To inform the Landlord immediately of the receipt by the Tenant of any
         bankruptcy notice or order or (as the case may be) any winding-up
         petition in connection with any insolvency proceedings in which the
         Tenant is involved

   3.20  Within fourteen days of the receipt of notice of the same to give full
         particulars to the Landlord of any permission notice order or proposal
         for a notice or order made given or issued to the Tenant by any
         government department local or public authority under or by virtue of
         any statutory powers and if so required by the Landlord to produce such
         permission notice order or proposal for a notice or order to the
         Landlord and also without delay to take all reasonable or necessary
         steps to comply with any such notice or order and at all times to save
         harmless and to keep indemnified the Landlord and the Landlord's estate
         and effects against all actions claims demands costs expenses and
         liability in respect thereof and also at the request and cost of the
         Landlord to make or join with the Landlord in making such objections or
         representations against

                                      -9-

 
         or in respect of any such notice order or proposal as aforesaid as the
         Landlord shall deem expedient

   3.21  To pay to the Landlord all reasonable and proper costs charges and
         expenses including legal costs and charges payable to a surveyor
         (together with (in any such case) any value added tax or similar tax
         which may be chargeable thereon) which may be incurred by the Landlord
         in or in contemplation of any application to the Landlord for any
         consent pursuant to the covenants herein contained or relating to or in
         contemplation of any proceedings relating to the Premises or any part
         thereof under Section 146 or 147 of the Law of Property Act 1925
         notwithstanding forfeiture is avoided otherwise than by relief granted
         by the Court

   3.22  Not to stop or darken or obstruct any windows or lights belonging to
         the premises without the prior written consent of the Landlord provided
         that the Tenant shall be entitled to darken 2 (two) windows in respect
         of room in the east wing

   3.23  By way of indemnity only to observe and perform the Title matters so
         far as the same relate to or affect the Premises

   3.24  3.24.1  not in relation to either the whole or to any part of the
                 Premises to hold the tenancy on trust to assign underlet part
                 with or share possession or occupation or to grant licences or
                 franchises to use and occupy except as expressly contemplated
                 in the following provisions of Clause 3.21

         3.24.2  not to assign the whole of the Premises without having obtained
                 the Landlord's prior consent and for the purposes of s.19(1A)
                 of the Landlord and Tenant Act 1927 and subject to the proviso
                 in Clause 3.24.3 the Landlord is entitled to refuse consent in
                 any of the circumstances specified in Clauses 3.24.4 and 3.24.5
                 and to impose any of the conditions specified in Clause 3.24.6

         3.24.3  whether or not any of the specified circumstances have arisen
                 or any of the imposed conditions have been complied with the
                 Landlord shall be entitled to refuse consent or to impose any
                 further condition or conditions where it would be reasonable to
                 do so

         3.24.4  the Landlord is entitled to refuse consent where the proposed
                 assignee or its proposed guarantor

                 (a)  is a member of the same group of companies (within the
                      meaning of s.42(l) of the 1954 Act) as the person who is
                      the Tenant at the time of the application or

                                      -10-

 
                 (b)  is a limited company which is not registered in the United
                      Kingdom or

                 (c)  has or will have immunity from suit or legal process in
                      relation to any breach of any covenant or condition of
                      this Lease

         3.24.5  the Landlord is entitled to refuse consent where in the
                 Landlords reasonable opinion

                 (a)  the effect of the proposed assignment would be to diminish
                      the value of the Landlords reversionary interest in the
                      Premises or his interest in any Landlord's property

                 (b)  either the use to which the assignee intends to put the
                      Premises or the trading profile of the assignee is either
                      unsuitable on grounds of good estate management or does
                      not comply with the Landlords policy of tenant mix

         3.24.6  the Landlord is entitled as a condition of granting consent to
                 assign to require:

                 (a)  that whether or not any further surety is required the
                      Tenant enters into an authorised guarantee of the
                      assignees liability under this Lease pursuant to s.16 of
                      the 1995 Act in such reasonable form as the Landlord shall
                      require including provisions requiring the former tenant
                      to take up a new lease in the event of disclaimer

                 (b)  in addition to any authorised guarantee agreement for the
                      purposes of s.16 of the 1995 Act but only if this further
                      requirement is reasonable that one or more third party
                      guarantor approved by the Landlord (acting reasonably)
                      covenants with the Landlord

         3.24.7  not to underlet the whole or a Permitted Part of the Premises,
                 without having, obtained the Landlord's prior consent which
                 consent will not be unreasonably withheld where the provisions
                 of Clauses 3.24.8 to 3.24.10 (inclusive) are first either
                 actually complied with or agreed to be complied with (as
                 appropriate)

         3.24.8  in relation to every underlease:

                 (a)  to procure that the undertenant covenants directly with
                      the Landlord to perform and observe the covenants and
                      conditions in this Lease (other than the covenant to pay
                      the Yearly Rent) so far as they relate to the underlet
                      premises

                                      -11-

 
                 (b)  to obtain a guarantor or guarantors of the undertenant to
                      be approved by the Landlord who must covenant by deed with
                      the Landlord in such reasonable form as the Landlord shall
                      require including provisions requiring the former tenant
                      to take up a new Lease in the event of disclaimer

                 (c)  to enforce observance of the provisions of the underlease
                      by every undertenant and not at any time to waive any
                      breach of the covenants or conditions on the part of the
                      undertenant

                 (d)  to grant the underlease without any premium or other
                      consideration and at a rent which is approved by the
                      Landlord and which is no lower than the then open market
                      rent of the underlet premises or in the case of an
                      underletting of the whole at a rent equal to the higher of
                      the Rent then payable under this Lease and the then open
                      market rent of the Premises

         3.24.9  any permitted underlease must be in a form approved by the
                 Landlord and must in addition provide that the undertenant
                 enters into an authorised guarantee agreement pursuant to s.16
                 of the 1995 Act on assignment of the underlease

        3.24.10  in the case of the grant of an underlease of a Permitted Part
                 the Landlord may require the following as a pre-condition of
                 giving its consent

                 (a)  that the underlease is excluded from the provisions of
                      ss.24 28 (inclusive) of the 1954 Act and that the Tenant
                      covenants to take all requisite steps to ensure that the
                      undertenant does not acquire protection of Part II of the
                      1954 Act

                 (b)  that the underlease provides that the undertenant will pay
                      a fair proportion of the Insurance Rent and of the costs
                      and expenses incurred by the Tenant in maintaining
                      repairing and decorating and renewing the Premises such
                      proportion in each case to be determined by the
                      underlandlord (acting reasonably)

        3.24.11  notwithstanding Clause 3.24.1, where the Tenant is a company
                 incorporated under the Companies Acts 1948 to 1985 the Tenant
                 may share occupation of the Premises with any other company
                 which is a member of the same group of companies as the Tenant
                 (within the meaning of s.42(l) of the 1954 Act) PROVIDED that
                 no tenancy is created or allowed to arise that the Tenant gives
                 the Landlord at least one months prior notice of such proposed
                 occupation and notifies the Landlord when the occupation ends
                 and that any such occupation ends immediately if the

                                      -12-

 
                 company ceases to be a member of the same group of companies as
                 the Tenant

4.  The Landlord hereby covenants with the Tenant that

    4.1  The Tenant paving the Rent and observing and performing the Tenant's
         covenants herein contained shall and may peaceably hold and enjoy the
         Premises during the Term without any interruption or disturbance from
         or by the Landlord or any person lawfully claiming through under or in
         trust for the Landlord

    4.2  The Landlord will keep the Centre (including the Premises) (except any
         plate glass and except any fixtures fittings and contents belonging to
         the Tenant) insured with reputable insurers against the risks and for
         the cover stated in clause 43 so far as cover is available at normal
         insurance rates for the locality and subject to reasonable excesses and
         exclusions

    4.3  The Landlord's insurance will cover full rebuilding site clearance
         professional fees, VAT and three years, loss of rent against the risks
         of fire, lightning, explosion, earthquake, landslip, subsidence, riot,
         civil commotion, aircraft, aerial devices, storm, flood water, theft,
         impact by vehicles, malicious damage and third party liability and any
         other risks reasonably required by the Landlord

    4.4  On request (but not more than once in any 12 month period) the Landlord
         will give to the Tenant particulars of the policy and evidence from the
         insurer that it is in force

    4.5  The Landlord will make good damage to the Premises and their means of
         access caused by any Insured Risk as soon as possible after the
         insurance money is paid to the Landlord

    4.6  The Tenant will not do or omit anything, which would have the effect of
         causing the insurance of the Centre to become void and the Tenant will
         comply with all the insurer's reasonable requirements

    4.7  The Landlord is not liable to reinstate any part of the Centre if the
         insurance money is wholly or partly unpaid owing to the act or default
         of the Tenant or persons under its control

    4.8  If the Premises become unusable owing to damage caused by an Insured
         Risk then unless the insurance money is wholly or partly unpaid owing
         to the act or default of the Tenant or persons under its control the
         Rent and Service Charge or a fair proportion of them are to be
         suspended until the expiry of a period three years from the date of the
         damage or until the Premises are fully restored (whichever is the
         earlier)

                                      -13-

 
    4.9  If because of the act or default of the Tenant or persons under its
         control the insurance money is wholly or partly unpaid or if it appears
         impractical or uneconomical to reinstate the Centre within the three
         year period then the Landlord is entitled to terminate this Lease by
         notice to the Tenant at any time before the end of that period and is
         entitled to keep any insurance money

   4.10  The Landlord shall ensure that the goods lift security access system
         incorporates a mechanism which prevents unauthorised access to the
         Premises

   4.11  The Landlord shall affix to the Common Parts direction signage for the
         benefit of the Tenant and any other users of the Premises

5.  IT IS HEREBY AGREED AND DECLARED as follows:-

    5.1  Nothing herein contained shall by implication of law or otherwise
         operate to confer on the Tenant any easement rig t or privilege
         whatsoever over or against the Premises or any adjoining or other
         property belonging, to the Landlord which might restrict or
         prejudicially affect the future rebuilding, alteration or development
         of the Premises or such adjoining or other property nor shall the
         Tenant be entitled to compensation for any damage or disturbance caused
         by or suffered through any such rebuilding alteration or development

    5.2  The Tenant may not less than six (6) months before the expiry of the
         fifth anniversary of the Term or (if later) within one (1) month of the
         Landlord advising the Tenant in writing of the Landlord's proposal for
         the Rent to apply from the Review Date give notice to the Landlord of
         its intention to determine this Lease on the later of the Review Date
         and the date six (6) months after the giving of such notice on expiry
         of which notice if the Tenant shall have throughout the Term up until
         such date have reasonably observed and performed the covenants terms
         and obligations on its part contained in this Lease the Term shall
         thereupon determine but without prejudice to the rights of either party
         against the other in respect of any antecedent breach of the terms
         hereof

    5.3  In the event of the Premises being damaged or destroyed for any reason
         whatsoever the Landlord as an alternative to reinstatement shall be
         entitled to determine this tenancy by one months written notice to the
         Tenant

    5.4  Except as herein expressly provided to the contrary all disputes or
         differences which may arise touching the provisions hereof or the
         operation or construction hereof or the rights or liabilities of the
         Landlord and the Tenant shall be referred to arbitration by a single
         arbitrator under the provisions of the Arbitration Act 1996 or any Act
         amending or replacing the same

                                      -14-

 
    5.5  No receipt of rents or other payments paid by standing order or
         otherwise inadvertently accepted by the Landlord or the Landlord's
         personnel of any breach of any of the Tenant's covenants shall operate
         as a waiver wholly or partially of such breach and the Tenant shall not
         be entitled to set up such demand or receipt as a defence in any act or
         proceeding by the Landlord

    5.6  All rents and sums due from the Tenant hereunder shall be deemed to be
         exclusive of Value Added Tax and the Landlord or other the person to
         whom the Tenant is making payment shall be entitled to charge such
         Value Added Tax on such rents and sums as may be required or be
         permitted by law to be charged from time to time on production of a
         valid VAT invoice addressed to the Tenant

    5.7  Nothing contained in this Lease or done thereunder and no consents
         given by the Landlord or any other person acting on behalf of the
         Landlord hereunder shall affect the power of the Landlord in any other
         capacity whatsoever (other than as a landowner) under or by virtue of
         any public private or local act, order, instrument, regulation or bye-
         law in operation from time to time nor relieve the Tenant from the
         necessity of obtaining all such approvals or consents (in respect of
         plans or otherwise) as may from time to time be requisite from the
         Landlord in any such capacity as aforesaid under or by virtue of any
         such act order instrument, regulation or bye-law in operation from time
         to time notwithstanding that consent may have been given by the
         Landlord hereunder

6.  FORFEITURE

    6.1  The Landlord is entitled to forfeit this Lease by entering any part of
         the Premises whenever full payment of any of the sums reserved as rent
         is overdue more than 14 days (whether or not formally demanded) and in
         any of the circumstances specified in clause 6.2 but re-entry does not
         prejudice any rights of the Landlord in respect of previous breaches of
         covenant by the Tenant

    6.2  The circumstances referred to in clause 6.1 are whenever the Tenant

         6.2.1  is in breach of a material covenant or

         6.2.2  ceases to carry on its business or suffers distress or execution
                to be levied on its goods or

         6.2.3  becomes insolvent or unable to pay its debts as they fall due or

         6.2.4  enters into any deed or scheme of arrangement or composition
                with its creditors or any application or proposal is made for a
                voluntary arrangement in respect of it under the Insolvency Act
                1986 or the Insolvent Partnerships Order 1994 or

                                      -15-

 
         6.2.5  (if an individual and if more than one any of them) is
                adjudicated bankrupt or an interim receiver of his property is
                appointed or he dies or

         6.2.6  (if a company and if more than one any of them) has a receiver
                or manager appointed (including an administrative receiver) or
                goes into liquidation (unless the liquidation has the Landlord's
                approval and is solely for the purpose of amalgamation or
                reconstruction when solvent) or has an administration order made
                in respect of it

7.  SERVICE CHARGE

    7.1  Landlord's covenant

         The Landlord covenants with the Tenant that subject to the Tenant
         paying the Service Charge the Landlord will keep the Common Parts and
         the roof foundations structural parts and exterior of the Centre in
         good and substantial repair and condition throughout the Term provided
         that:

         7.1.1  this covenant does not apply to any works or repairs which the
                Tenant is liable to carry out under the provisions of this Lease
                or which are necessary as a result of the default or neglect of
                the Tenant

         7.1.2  in supplying the Landlord's Services the Landlord may employ
                managing, agents contractors or such other suitably qualified
                persons as the Landlord may from time to time think fit and
                whose proper and reasonable fees salaries charges and expenses
                (including VAT) will form part of the Expenditure

    7.2  Breakdown in Landlord's Services

         7.2.1  The Landlord will not be liable for any injury to or loss or
                damage suffered by the Tenant caused by:

                7.2.1.1  any breakdown, absence, failure or insufficiency of any
                         of the Landlord's Services or

                7.2.1.2  any defect in any of the Conduits or any boiler lift
                         machinery appliance or apparatus used in connection
                         with the provision of the Landlord's Services or

                7.2.1.3  any defect in any part of the Centre unless either:-

                7.2.1.4  the injury loss or damage is covered by and the
                         Landlord receives payment under a policy of insurance
                         effected by it in respect of that risk or

                                      -16-

 
                7.2.1.5  such injury loss or damage arises out of the wilful
                         neglect or refusal of the Landlord to comply with the
                         provisions of clause 7.2.2

                         provided to the extent that any such failure or
                         interruption could not readily have been prevented or
                         shortened by the exercise of proper care, attention,
                         diligence and skill by the Landlord or those
                         undertaking the services on behalf of the Landlord or
                         the Landlord uses and continues to use its reasonable
                         endeavours to restore the services in question

         7.2.2  The Landlord will use all reasonable endeavours to remedy or
                make good any breakdown absence failure insufficiency or defect
                in the provision of the Landlord's services for which the
                Landlord is responsible under this Lease within a reasonable
                time after the Tenant notifies the Landlord in writing of such
                matter but the Landlord will not be liable under this covenant:

                7.2.2.1  for anything, which the Tenant covenants to repair or
                         make good under this Lease or

                7.2.2.2  if the policy money due to the Landlord under any
                         relevant insurance policy effected by the Landlord in
                         respect of that matter has been wholly or partly
                         refused or withheld in consequence of some act, neglect
                         or default of the Tenant

    7.3  Service Charge Accounts

          As soon as convenient after the end of each Financial Year the
          Landlord will prepare accounts certified by a properly qualified
          accountant showing the Expenditure for that Financial Year and
          containing a fair summary of the various items comprising the
          Expenditure and a copy of such accounts will be supplied to the Tenant

    7.4   Payment of Service Charge

          7.4.1  The Tenant covenants with the Landlord that on each of the
                 usual quarter days in every year during, the Term the Tenant
                 will pay the Landlord such a sum in advance and on account of
                 the Service Charge for the Financial Year then current as the
                 Landlord may from time to time specify as being in its
                 reasonable discretion a fair and reasonable assessment of one
                 quarter of the likely Service Charge for that particular
                 Financial Year the first advance payment of which (apportioned
                 if necessary on a daily basis) will be made on the date of this
                 Lease

                                      -17-

 
          7.4.2  If the Service Charge for any Financial Year:

                 7.4.2.1  exceeds the Advance Payments for that Financial Year
                          the excess will be paid by the Tenant to the Landlord
                          on demand or

                 7.4.2.2  is less than the Advance Payments for that Financial
                          Year the overpayment will be credited to the Tenant
                          against the next quarterly payment of the Service
                          Charge
 
    7.5   Omission of item of Expenditure in any Financial Year

          If the Landlord does not seek to recover any sum expended or liability
          incurred by it in connection with the Landlord's Services in any
          Financial Year the Landlord may nevertheless in its reasonable
          discretion recover such sum or liability in any subsequent Financial
          Year

    7.6   Variation of Landlord's Services

          The Landlord may at its reasonable discretion withhold add to extend,
          vary or make any alterations to any of the Landlord's Services from
          time to time if the Landlord reasonably deems it desirable to do so
          for the more efficient management security and operation of the Centre
          or for the comfort of the tenants in the Centre

     7.7  Variation of the Centre

          If at any time during the Term the total property vested in the
          Landlord which enjoys or is capable of enjoying the benefit of any of
          the Landlord's Services is extended to Adjoining Premises or is
          increased or decreased on a permanent basis the Service Charge
          Proportion will be varied with immediate effect and the variation will
          be determined reasonably by the Landlord's Surveyor (acting as an
          expert and not as an arbitrator) and his decision will be final and
          binding on the parties

     7.8  End of the Term

          The provisions of this clause will continue to apply notwithstanding
          the end of the Term but only in respect of the period to the end of
          the Term and the Service Charge for that Financial Year will be
          apportioned for such period on a daily basis

     7.9  Sinking Fund

          7.9.1  in accordance with paragraph 14 of Schedule 2 a reasonable
                 provision (to be determined by the Landlord) may be made
                 towards the Landlord's anticipated expenditure during the Term
                 in respect of periodically recurring items whether recurring,
                 at regular or irregular intervals and such of the Landlord's
                 services as relate to the renewal or replacement of the

                                      -18-

 
                 items referred to provided that such reasonable provision in
                 relation to this sub-clause and paragraph 14 of Schedule 2
                 shall be determined on the assumption that the cost of
                 replacement of such items is calculated on such life expectancy
                 as the Landlord may reasonably determine and that each year the
                 Tenant will be required to pay a reasonable proportion toward
                 the anticipated costs of renewal or replacement to the intent
                 that a fund or funds be accumulated sufficient to cover the
                 cost of renewal or replacement by the end of the anticipated
                 life of each such item

          7.9.2  any expenditure by the Landlord in respect of a recurring item
                 referred to in this sub-clause or pursuant to paragraph 14 of
                 Schedule 2 in connection with the renewal or replacement of an
                 item referred to where either

                 (a)  a fund has been established in connection with such
                      recurring item or the renewal or replacement of that item
                      ("the Specific Fund")

                 (b)  a part of a fund ("the General Fund") has been allocated
                      by the Landlord for such recurring, item or the renewal or
                      replacement of that item shall first be met out of the
                      Specific Fund or as appropriate out of the General Fund to
                      the extent of the credit allocated for that item by the
                      Landlord in the General Fund

         7.9.3  the General Fund statement shall indicate whether or not the
                Landlord has established and is monitoring any fund or funds
                pursuant to this paragraph and shall provide full details of any
                such fund or funds

         7.9.4  all sums received by the Landlord pursuant to this sub-clause
                shall be credited to an account separate from the Landlord's own
                money and shall be held by the Landlord upon trust during the
                Term for the persons who from time to time shall be tenants of
                the Centre to apply the same and any interest accruing, for the
                purposes set out in this sub-clause and at the expiry of such
                period any such sums unexpended shall be paid to the Tenant in
                proportion to the area of the property occupied by them

8.  RENT REVIEW

    8.1   Requirement for Review

          The amount of the Rent is to be reviewed on the Review Date and the
          sum payable as the Rent on and following the Review Date will be the
          greater of

          8.1.1  the amount of the Rent immediately before such Review Date and

                                      -19-

 
          8.1.2  the best annual rent at which the Premises might reasonably be
                 expected to be let in the open market at the Review Date
                 ascertained as if to be let on the terms of the hypothetical
                 lease described in clause 8.2 and on the assumptions set out in
                 clause 8.3 but disregarding the matters set out in clause 8.4
                 ("the open market rent")

     8.2  The Hypothetical Lease

          The hypothetical lease by reference to which each review of the Rent
          is to take place is a lease

          8.2.1  on the same terms as this Lease (including but not limited to
                 the review provisions and with review of rent on the same dates
                 as are specified in this Lease) except for the amount of the
                 Rent and for anything which is inconsistent with the express
                 assumptions and disregards set out in clauses 8.3 and 8.4 and

          8.2.2  granted without any premium by a willing lessor to a willing
                 lessee with vacant possession and for whichever is longer of a
                 term equal to the residue of the Term unexpired at the Review
                 Date and a term of 10 years starting on the Review Date

     8.3  Assumptions

          The assumptions to be made in ascertaining the open market rent are

          8.3.1  that no work has been carried out to the Premises which has
                 diminished their rental value

          8.3.2  that the Premises are fit for immediate occupation and use with
                 all requisite services connected and available and that if the
                 Premises have been damaged or destroyed they have been fully
                 restored

          8.3.3  that at the Review Date the Tenant has already had the benefit
                 of a rent free period for fitting out

          8.3.4  that the covenants in this Lease have been fully performed and
                 observed
     
          8.3.5  that the Premises are let as a whole or if the aggregate of
                 rents for such sublettings would produce a higher rental value
                 of the Premises that each separately lettable part of the
                 Premises is separately let

    8.4  Matters to be disregarded

         In assessing the open market rent the following are to be disregarded

                                      -20-

 
         8.4.1  any effect on rent of the fact that the Tenant or any
                predecessors of the Tenant or any authorised underlessee of
                either of them have been in occupation of the Premises

         8.4.2  any goodwill attached to the Premises by reason of the carrying
                on there of the Tenants business or that of any predecessors of
                the Tenant or of any authorised underlessee of either of them

         8.4.3  any increase in value attributable to tenant's fixtures and
                fittings

         8.4.4  subject to the assumptions at clause 8.3.2 arid 8.3.3 any
                increase in rental value attributable to any improvement to the
                Premises carried out with the Landlord's written permission by
                the Tenant or any predecessors of the Tenant or any authorised
                underlessee during the Term and the Buyer's Works except for any
                improvement which has been carried out pursuant to an obligation
                to the Landlord or its predecessors or which has been carried
                out wholly or partly at the Landlords expense

    8.5  Settlement of open market rent

         8.5.1  the Landlord and the Tenant will endeavour to agree the open
                market rent prior to the Review Date but if agreement has not
                then been reached either party may at any time thereafter refer
                the determination of the open market rent to the Independent
                Surveyor

         8.5.2  the appointment of the Independent Surveyor is to be made by
                agreement between the parties but in default of agreement then
                either party may request the President of the Royal Institution
                of Chartered Surveyors to nominate or arrange the nomination of
                the Independent Surveyor and the person so nominated is to be
                appointed by the parties jointly but if for any reason notice of
                his determination is not given within a reasonable period the
                parties may appoint a replacement Independent Surveyor using the
                procedures in this sub-clause

         8.5.3  the Independent Surveyor is at the Landlords option to act as an
                expert and the parties may make representations to him but he is
                not bound to take them into account in reaching his decision
                which (including his decision as to the payment of his costs) is
                to be final and binding on the parties but if he fails to make a
                decision as to payment of his costs they are to be shared
                equally between the parties

                                      -21-

 
    8.6  Arrears of increased rent and interest

         8.6.1  where and for so long, as settlement of any Rent Review remains
                uncompleted the Rent will continue to be payable on and
                following the Review Date at the rate applying immediately
                before such Review Date

         8.6.2  immediately after the parties have agreed the amount of the open
                market rent or where the determination was referred to the
                Independent Surveyor immediately after he has notified the
                parties of his decision the Tenant will forthwith pay to the
                Landlord the full amount of the difference (if any) between:

                (a)  the total of the sums in respect of the Rent actually paid
                     by the Tenant to the Landlord for the period starting on
                     the Review Date and ending, on the day before the quarter
                     day which immediately follows the date of such agreement or
                     notification and

                (b)  the total of the sums in respect of the Rent which would
                     have been payable in respect of that period had the
                     agreement or notification been made on or prior to such
                     Review Date

         8.6.3  where any payment falls to be made by the Tenant to the Landlord
                pursuant to clause 8.622 the Tenant will at the same time pay to
                the Landlord interest at 3% below the Prescribed Rate on that
                payment in respect of the period beginning on the day on which
                each instalment was due and ending on the date of the payment
                made by the Tenant under clause 8.6.2

    8.7   Time not of the essence

          Time is not to be of the essence of any of the Review Provisions

    8.8   Memorandum

          After the open market rent has been ascertained in respect of a Review
          Date a memorandum signed by the Landlord and the Tenant recording the
          amount of the Rent so ascertained is to be endorsed on or annexed to
          this Lease and its counterpart (each party bearing its own costs)]

9.  Having been authorised to do so by an Order of the Newcastle upon Tyne
    County Court made on the day of        , 199   under the provisions of
    Section 38(4) of the Landlord and Tenant Act 19-54 (as amended by Section 5
    of the Law of Property Act 1969) the parties hereto agree that the
    provisions of Section 24-28 (inclusive) of that Act shall be excluded in
    relation to the Lease hereby created

                                      -22-

 
10.  The parties hereto certify that this is a new tenancy under the 1995 Act

     This document is executed as a deed on the date at the beginning of the
     document

                                      -23-

 
                                   SCHEDULE 1
                                   ----------

The Landlord
- ------------

Name                   :   International Centre for Life (Property) Limited

Company Number         :   3261320

Registered Office      :   Scotswood House Newcastle Business Park Newcastle
                           upon Tyne NE4 7YL
The Tenant
- ----------

Name                   :   Applied Imaging International Limited

Company Number         :   1984637

Registered Office      :   Hylton Park Wessington Way Sunderland SR5 3HD

The Term
- --------

10 years from              1998 subject to clause 5

The Rent
- --------

(Pounds)119,372.56 per annum exclusive of VAT and of all rates and all other
outgoings whatsoever

Rent Commencement Date
- ----------------------


Permitted User
- --------------

The manufacture of medical devices related equipment and test services together
with office use ancillary thereto

Title Matters
- -------------

All rights easements covenants agreements and declarations exceptions
reservations and other matters contained or referred to in the Property and
Charges Registers of title number TY239836 so far as they subsist and are
capable of being enforced and relate to the Premises or the Centre

The Premises
- ------------

ALL THAT property being, part of the Centre and shown for the purposes of
identification only

                                      -24-

 
8.  The right to use any lifts in the Centre PROVIDED THAT the Tenant shall only
    have the right to use the goods lift to access the first floor and the
    basement

9.  The right to use the meeting conference rooms at the Centre at a rent or
    licence fee and on terms to be agreed between the Landlord and the Tenant
    from time to time during the Term in the Centre and such other communal
    facilities as are provided by the Landlord in the Centre for the common use
    of the tenants of the International Centre for Life

10. The right to use the dedicated loading bays at the Centre

11. The right until the date immediately preceding the third anniversary of the
    date hereof to park without charge twenty five (25) cars or light vehicles
    in the spaces in the Cattle Market Car Park from time to time designated by
    the Landlord and a right thereafter to park such vehicles in such spaces
    until the date immediately preceding the fifth anniversary of the date
    hereof subject to payment of the Cattle Market Parking Fee Provided That
    such right to park in the Cattle Market Car Park shall be extended for a
    period ending at the expiry or sooner determination of the Term (howsoever
    determined) subject to prior agreement between the Landlord and the Tenant
    of the fee payable for such right which shall be not less than the Cattle
    Market Parking Fee

     EXCEPT AND RESERVING to the Landlord and all persons authorised by the
Landlord or otherwise entitled the following rights:-

1.  Full and free right to enter the Premises at all reasonable times after
    reasonable notice (or at any tune in an emergency) with or without surveyors
    agents workmen materials and appliances to exercise any of the rights
    excepted reserved or contained in this Lease or to comply with any
    obligation of the Landlord under this Lease or to carry out the Landlord's
    Services the person or persons exercising such rights causing as little
    inconvenience as reasonably practicable and making good all damage to the
    Premises caused in the exercise of the rights but the Landlord will not be
    liable to the Tenant in respect of any loss damage or claim arising from
    noise, dust, vibration, noxious fumes, odours, loss of trade, nuisance or
    annoyance caused to the Tenant or any other person in connection with the
    exercise of those rights

2.  Full right and liberty to build on alter add to redevelop or extend in
    height or otherwise the Centre or any adjoining premises notwithstanding
    that the access of light and air to the Premises and its lights windows and
    openings may be affected

3.  The free and uninterrupted use of the Conduits and the right to enter the
    Premises at all reasonable times after reasonable notice (or at any time in
    an emergency) to install make connection with clean alter renew remove
    replace or inspect the Conduits or any of them as

                                      -25-

 
    the Landlord may require and during the Perpetuity Period to build
    additional Conduits or relay any existing Conduits the person or persons
    exercising such rights causing as little inconvenience as reasonably
    practicable and making good all damage to the Premises caused in the
    exercise of the rights but the Landlord will not be liable to the Tenant in
    respect of any loss damage or claim arising from noise, dust, vibration,
    noxious fumes, odours, loss of trade, nuisance or annoyance caused to the
    Tenant or any other person in connection with the exercise of these rights

4.  Full right and liberty to enter the Premises at all reasonable times after
    reasonable notice as often as may be necessary to inspect repair maintain
    cleanse decorate or renew the Centre or any adjoining premises (including
    the right if necessary to erect and maintain scaffolding for the purpose of
    repairing or cleaning the exterior of the Centre or any adjoining premises
    notwithstanding that such scaffolding may temporarily interfere with the
    access to or enjoyment and use of the Premises) the person or persons
    exercising such rights causing, as little inconvenience as reasonably
    practicable and making good all damage to the Premises caused in the
    exercise of the rights but the Landlord will not be liable to the Tenant in
    respect of any loss damage or claim arising from noise dust vibration
    noxious fumes odours loss of trade nuisance or annoyance caused to the
    Tenant or any other person in connection with the exercise of those rights

5.  Full rights of lateral and subjacent support and protection from the
    Premises for the remainder of the Centre and any adjoining premises

6.  The right in emergency only to pass on foot through the Premises via any
    fire escape door or Corridor leading through the Premises

7.  Full rights of light and air and all other easements and rights now or at
    any time during the Term belonging to or enjoyed by the Centre and any
    adjoining premises

                                   SCHEDULE 2
                                   ----------
                              Landlord's Services
                              -------------------

1.  Maintenance of the Centre
    -------------------------

    The maintenance repair rebuilding replacement and renewal of:

    1.1  the main structure and exterior of the Centre including (without
         limitation) all structural or load-bearing walls and columns the
         structural parts of the floors and columns and the timbers stanchions
         girders roof and foundations of the Centre

    1.2  the boundary walls fences and other structures of the Centre

    1.3  the party walls within the Centre

                                      -26-

 
    1.4  the Conduits

    1.5  the Common Parts

    1.6  any rooms occupied and used by any staff employed by the Landlord

    1.7  all other parts of the Centre not included in the above paragraphs but
         excluding, in each case any such which are included in this Lease or
         the Lease tenancy or licence of any other part of the Centre or the
         repair of which are the responsibility of the Tenant or any other
         tenant licensee or occupier of the Centre

2.  Decoration
    ----------

    2.1  The painting cleaning and decorating of:

    2.2  the exterior of the Centre

    2.3  the Common Parts

    2.4  any rooms occupied or used by any staff employed by the Landlord

         such painting cleaning and decorating to be carried out by the
         Landlord at such intervals as it may decide

3.   Plant and Machinery
     -------------------

     Operating, inspecting, servicing, overhauling, repairing, maintaining,
     cleaning, lighting and renewing or replacing all landlord's fixtures
     fittings plant machinery apparatus and equipment in the Centre from time to
     time during the Term including (without limitation) the lifts, lift shafts
     and lift motor room and the boilers and all items relating to the heating,
     air conditioning and the natural and carbon gas supply, the compressed air
     supply and the vacuum system and any fibre optic cabling ventilation and
     hot and cold and de-ionised water systems serving the Centre including the
     provision of all fuel and electricity for them and maintenance contracts
     and insurance in respect of them (but excluding all landlord's fixtures,
     fittings, plant machinery apparatus and equipment which are included in
     this Lease or the lease tenancy or licence of any other part of the Centre
     or the repair of which are the responsibility of the Tenant or any other
     tenant licensee or occupier of the Centre)

4.   Common Parts
     ------------

     4.1  The furnishing, alteration and reinstatement of the Common Parts

     4.2  The purchase or hire (as appropriate) maintenance and renewal of
          plants and any planters and any other landscaping features in the
          Common Parts and the cultivation of all landscaped areas within the
          Common Parts

                                      -27-

 
     4.3  The operation repair maintenance renewal replacement and cleaning of
          all signs and notices and lighting systems in the Common Parts

     4.4  The provision of fire extinguishers and other fire fighting equipment
          in the Common Parts and the payment of all charges in connection with
          their rental installation and maintenance

5.  Heating and hot water
    ---------------------

     The provision of:-

     5.1  an adequate supply of hot water during the Permitted Hours for
          domestic use to the basins which are in the Centre at any time during
          the Term and

     5.2  reasonably adequate heat to the radiators which are in the Centre at
          any time during the Term during the Permitted Hours and during the
          period from 1 October to the following 1 May (or such other period as
          the Landlord may determine from time to time having regard to weather
          conditions)

     5.3  a hot and cold water shower facility in the Common. Parts for domestic
          use during the Permitted Hours

6.   Staff
     -----

     The provision of cleaning and other staff for the day to day running of the
     Centre and for the provision of cleaning security and other services and
     for the general management, operation and security of the Centre (including
     such direct or indirect labour as the Landlord deems appropriate) and all
     other related expenditure including but not limited to:

6.1  the payment of wages salaries and expenses together with such statutory and
     other insurance health pension and welfare severance and other payments
     contributions and premiums as the Landlord may deem reasonably necessary in
     relation to such staff

6.2  the provision of uniforms working clothes tools appliances materials and
     equipment including telephones for the proper performance of the duties of
     any such staff

7.   Refuse
     ------

     The provision repair maintenance and renewal of any litter bins, bin
     liners, paladin units, refuse trolleys or other receptacles for the storing
     or packaging of refuse for the Centre and the cost of storing collecting
     and disposing of all refuse from the Centre

                                      -28-

 
8.   Window Cleaning
     ---------------

     The cleaning of the outside of all the windows in the Centre (including
     those of the Premises) and the cleaning of the inside of all the windows in
     the Common Parts

9.   Staff accommodation
     -------------------

     The payment of rent for any accommodation occupied or used by any staff
     employed by the Landlord within other property belonging to the Landlord (a
     notional rent equivalent to the rent at which the Landlord's Surveyor
     considers such accommodation might be let from time to time in the open
     market with vacant possession)

10.  Management Costs
     ----------------

     10.1  The employment of managing agents, contractors, surveyors, valuers,
           architects, engineers accountants, solicitors and other professional
           persons in connection with the management and/or maintenance of the
           Centre and the payment of all proper fees, charges, salaries,
           expenses and commissions payable to them including the payment of the
           fees and expenses incurred by the Landlord in preparing accounts of
           the Expenditure for each Financial Year and having such accounts
           certified by the Accountant in accordance with clause 7

     10.2  The payment of a proper management charge in respect of the provision
           of Services for the Centre during each Financial Year

     10.3  The payment of all proper costs and expenses including bank charges
           interest and VAT incurred by the Landlord incidental to the provision
           of services for the Centre

11.  Statutory Requirements
     ----------------------

     The costs to the Landlord of carrying out any works to the Centre required
     to comply with any statute (other than works for which any tenant or
     occupier is responsible) and the cost to the Landlord of taking any steps
     deemed desirable or expedient by the Landlord for complying with making
     representations against or otherwise contesting the incidence of the
     provisions of any statute including those concerning town planning, public
     health, fire precautions, highways, streets, drainage or other matters
     which may affect the Centre (other than such matters which relate only to
     one tenant or occupier of the Centre)

12.  Outgoings
     ---------

     The payment of all existing and future rates (including water rates) taxes
     assessments charges and outgoings whether parliamentary local or otherwise
     whether of the nature of capital or revenue and even though of a wholly
     novel character which may now or at any time be rated taxed assessed
     charged or imposed upon the Common Parts or any part of them or upon the

                                      -29-

 
     Centre as a whole or upon any accommodation occupied or used by any staff
     employed by the Landlord

13.  General
     -------

     The provision of such other services and works as the Landlord may
     reasonably deem desirable or necessary for the benefit of the Centre or the
     tenants or occupiers of it or in the interests of good estate management

14.  Sinking Fund
     ------------

     Such provision of anticipated future expenditure in relation to the Common
     Parts as may in the Landlord's reasonable opinion be appropriate in
     accordance with the provisions outlined in clause 7 of this Lease

                                      -30-

 
EXECUTED AS A DEED by
affixing the Common Seal of                                   [SEAL]
APPLIED IMAGING INTERNATIONAL
LIMITED in the presence of:-

                         Director  /s/  L.G. Grant

                         Secretary  /s/ ILLEGIBLE

                                      -31-

EX-23.1

                                                                  Exhibit 23.1

                       Consent of Independent Auditors 

The Board of Directors
Applied Imaging Corp.:

We consent to incorporation by reference in the registration statements (Nos. 
333-26127 and 333-57835) on Form S-8 and registration statement (No. 333-60345) 
on form S-3 of Applied Imaging Corp. of our report dated February 5, 1999, 
relating to the consolidated balance sheets of Applied Imaging Corp. and 
subsidiaries as of December 31, 1998 and 1997, and the related consolidated 
statements of operations, stockholders' equity, and cash flows for each of the 
years in the three-year period ended December 31, 1998, and the related 
consolidated financial statement schedule, which report appears in the December 
31, 1998, annual report on Form 10-K of Applied Imaging Corp.


/s/ KPMG LLP


Mountain View, California
March 29, 1999

EX-27.1

 


<ARTICLE> 5
       
                                                  
<PERIOD-TYPE>                   YEAR                   YEAR
<FISCAL-YEAR-END>                          DEC-31-1997             DEC-31-1998
<PERIOD-START>                             JAN-01-1997             JAN-31-1998
<PERIOD-END>                               DEC-31-1997             DEC-31-1998
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