PART I

Item 1.    Business.

(a)            Introduction

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

(b)            Financial Information About Industry Segments

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

   (c)            Description of Business

        (i)            Principal Products

                          Hair Removal/Vascular Lasers

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

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

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

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

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

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

                          Tattoo Removal/Pigmented Lesion Laser

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

                          Distribution and Service

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

       (ii)            Products Under Development

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

       (iii)            Production and Sources and Availability of Materials

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

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

       (iv)            Patents and Licenses

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

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

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

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

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

        (v) Seasonal Influences

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

        (vi) Working Capital

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

         (vii) Dependence on a Single Sales Agent

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

         (viii) Backlog

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

         (ix) Government Contracts

        Not applicable.

         (x) Competition

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

   (xi) Research and Development

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

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

   (xii) Environmental Protection Regulations

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

   (xiii) Number of Employees

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

   (d) Financial Information About Exports by Domestic Operations

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

Item 2.   Properties.

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

Item 3.   Legal Proceedings.

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

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

               (See Item 7. "Risk Factors.")

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

                Not applicable.

PART II

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

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

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

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

Item 6.   Selected Financial Data.

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

Selected Financial Data

(in thousands, except per share data)

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

(a) Overview

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

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

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

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

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

(b) Results

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(c)   Liquidity and Capital Resources

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

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

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

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

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

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

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

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

d)     Year 2000 Impact

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

(e)     Recently Issued Accounting Standard

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

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

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