FORM 10-K

U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For fiscal year ended December 31, 2001

Commission file number:  0-22340

PALOMAR MEDICAL TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)

82 Cambridge Street, Burlington, Massachusetts 01803
(Address of principal executive offices)

(781) 993-2300
(Issuer’s telephone number, including area code)

Securities registered pursuant to Section 12 (b) of the Act:

Securities registered pursuant to Section 12 (g) of the Act:
Common Stock, $.01 par value

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

     Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-K contained in this form, and no disclosure will be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  _____

     As of February 28, 2002, 10,514,979 shares of common stock were outstanding. The aggregate market value of the voting shares (based upon the closing price reported by Nasdaq on February 28, 2002) of Palomar Medical Technologies, Inc., held by nonaffiliates was $5,675,513. For purposes of this disclosure, shares of common stock held by entities and individuals who own 5% or more of the outstanding common stock and shares of common stock held by each officer and director have been excluded in that such persons may be deemed to be “affiliates” as that term is defined under the Rules and Regulations of the Securities Exchange Act of 1934. This determination of affiliate status is not necessarily conclusive.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the definitive proxy statement to be filed prior to April 30, 2002, pursuant to Regulation 14A of the Securities Exchange Act of 1934 are incorporated by reference into Part III of this Form 10-K

Transitional Small Business Disclosure Format:               Yes         X          No

INDEX

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PART I

Item 1. Business.

     Palomar Medical Technologies, Inc. (the “Company”) 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 filed its initial public offering. Subsequently, the Company pursued an 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. 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 a 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 and light based products in dermatology and cosmetic procedures, with an emphasis on laser / light based hair removal and research and development relating to that and other cosmetic laser / light based products. On December 7, 1998, the Company entered into an Agreement and Plan of Reorganization (the “Agreement”) with Coherent, Inc. 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 (Coherent Medical Group was subsequently sold to ESC Medical, now known as “Lumenis, Inc.” and hereinafter “Lumenis”). Currently, the Company has two operating subsidiaries, Palomar Medical Products, Inc. (“PMP”) and Esthetica Partners, Inc. (formerly Cosmetic Technology International, Inc. and hereinafter “Esthetica”). PMP, located at the Company’s headquarters in Burlington, Massachusetts, oversees the manufacture and sale of the Company’s laser / light systems currently on the market. Esthetica is also based in Burlington, Massachusetts. (See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Overview.”)

     The Company conducts business in one industry segment, medical products and services.

Hair Removal/Vascular Lasers and Light Based Systems

     During 2001, Palomar received FDA clearance to market and sell the Palomar EsteLux™ light-based system. The Palomar EsteLux™ light-based system has the fastest coverage rate, a long pulsewidth and SpectruMax™ filtering. It combines the latest flashlamp technology with simple, streamlined engineering and is both effective and economical. The system features a large spot size that makes the system effective when treating large areas such as legs and backs. Users can treat more customers in less time, maximizing their return on investment. The system is smaller and lighter than current systems, which is especially desirable for mobile and/or small physician offices. The system’s simple operation opens its applications to a wider band of worldwide users. Palomar intends on introducing, complimentary handpieces, pending 510(k) approval, for the Palomar EsteLux™ light-based system.

     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 less costly to produce than current systems on the market.

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     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 patented technology licensed exclusively to Palomar. In turn, Palomar has sublicensed this patented technology to several competitors at a royalty rate of 7.5%. 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 was superior to hair removal lasers then available in a number of respects, including speed and efficacy. The Palomar E2000™ has also received FDA clearance for hair removal.

     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.

     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.

     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 / light based hair removal is in its early stages. Benefits of Palomar’s laser / light based 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 than that of other laser / light based hair removal devices, a procedure that is relatively painless and non-invasive, reduced risk of scarring and cross-contamination, and better efficacy rates.

Tattoo Removal/Pigmented Lesion Laser

     During 2001, Palomar received FDA clearance to market and sell the Palomar Q-YAG 5™ laser system for tattoo and pigmented lesion removal. The Palomar Q-YAG 5™ is a state-of-the-art, Q-switched, frequency-doubled Neodymium laser. This laser system allows users to switch between a 1064-nm single-wavelength beam and a 1064/532-nm mixed-wavelength beam. The combination of wavelengths allows users to treat a full spectrum of colors and inks, and the system’s design lowers costs and allows broader use of the instrument. The single 1064-nm wavelength is ideal for treating darker tattoo inks and dermal-pigmented lesions, such as Nevi of Ota. The mixed 1064/532-nm wavelength is better suited for brighter colors and epidermal-pigmented lesions, such as solar lentigines. In addition, the mixed wavelength permits brighter/more superficial and deeper/darker target areas to be treated simultaneously. The Palomar Q-YAG 5™ incorporates the laser into the hand piece making it smaller and lighter than current systems, which is especially desirable for mobile and/or small physician offices. These attributes reduce the cost of the system and eliminate costly optics and service problems that are common with other high power Q-Switched lasers.

     The Company 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 2002 at a low volume to foreign countries where the advantages of the ruby laser for treatment of pigmented lesions is especially important.

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Distribution and Service

     Palomar has changed its distribution method over the past few years to address changes in market conditions and composition of its product line. The Company has continued to hire a number of direct sales representatives to support products introduced in 2001 and additional products to be introduced in 2002. 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 and in certain other countries, Palomar provides service through its own service organization.

     The Company is engaged in developing products for the dermatology and cosmetic market. Products under development include lasers and light based products in hair removal, tattoo and pigmented lesion removal, leg vein and other vascular lesion removal, acne treatment and fat reduction, skin rejuvenation and wrinkle removal. Palomar performs its own research as well as research with other partners, including Massachusetts General Hospital (“MGH”). Product development is performed by scientists and engineers at the Company’s headquarters. The Company splits its efforts between new products for existing markets such as hair, vascular and pigmented lesion and tattoo removal, and new products for markets, such as acne treatment, fat reduction and wrinkle removal.

     Palomar’s manufacturing operations are currently located in Burlington, Massachusetts. Palomar maintains control of and manufactures most key components in-house. Manufacturing consists of the assembly and testing of components purchased from outside suppliers and contract manufacturers. 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, ISO 13485 and EN 46001 registration.

     The Company’s success and ability to compete are dependent on its ability to develop and maintain the proprietary aspects of its technology and operate without infringing on the proprietary rights of others. The Company relies on a combination of patents, trademarks, trade secret and copyright laws and contractual restrictions to protect the proprietary aspects of its technology. These legal protections afford only limited protection for its technology. The Company presently has numerous patent applications pending in the United States and in foreign countries. Furthermore, the Company cannot be certain that patents will be granted based on these or any other applications.

     The Company seeks to limit disclosure of its intellectual property by requiring employees, consultants and any third party with access to the Company’s proprietary information to execute confidentiality agreements with the Company. Due to rapid technological change, the Company believes that factors such as the technological and creative skills of its personnel, new product developments and enhancements to existing products are as important as the various legal protections of the Company’s technology to establishing and maintaining a technology leadership position.

     Despite the Company’s efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the products or to obtain and use information that the Company regards as proprietary. Policing unauthorized use of the Company’s products is difficult. Litigation may be necessary to enforce intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement or invalidity. Any such resulting litigation could result in substantial costs and diversion of resources and could have a material adverse effect on the business, operating results and financial condition. There can be no assurance that the Company’s means of protecting proprietary rights will be adequate or that the Company’s competitors will not independently develop similar technology. Any failure by the Company to meaningfully protect the Company’s proprietary rights could have a material adverse effect on the business, operating results and financial condition.

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     Management believes that none of the Company’s current products infringe upon valid claims of patents owned by third parties. However, there have been claims and there can be no assurance that third parties will not make further claims of infringement with respect to our current or future products. Any such claims, with or without merit, could be time-consuming to defend, result in costly litigation, divert management’s attention and resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all. A successful claim of intellectual property infringement against us and our failure or inability to license the infringed technology or develop or license technology with comparable functionality could have a material adverse effect on our business, financial condition and operating results. (See Item 7A. “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 except when externally applied chromophores are used (hereinafter referred to, respectively, as “hair removal,” “fat removal,” “acne treatment,” and “skin rejuvenation” for simplicity).

     Palomar has licensed two United States patents (and corresponding, foreign patent applications) involving laser / light based hair removal that expire on February 1^st, 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 patents in the fields of hair removal, fat removal, and acne treatment 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 these two MGH patents to several competitors. Palomar also has rights to patents arising out of MGH’s Palomar funded, clinical trials in other fields and to patents jointly invented by Palomar and MGH.

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

     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.

     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. The Sales Agency Agreement terminated upon the closing of the sale of Star in April 1999.

     The Company’s backlog of firm orders for its continuing operations at December  31, 2001 and December 31, 2000, was approximately $275,000 and $606,000 respectively.

     Not applicable.

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     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 then to Lumenis and 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 2002, 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.”)

     Palomar’s research and development goals in the field of laser / light based hair removal are to design systems that (1) permit more effective treatment and 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 dermatological and cosmetic procedure markets other than hair, including the fields of acne treatment, fat removal, skin rejuvenation and wrinkle removal.

     During fiscal 2001, 2000 and 1999, the Company incurred approximately $6,045,000, $7,851,000, $8,022,000, 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 7A. “Risk Factors” and Note 4 to Financial Statements.)

     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.

     As of December 31, 2001, the Company employed 89 persons. The Company is not subject to any collective bargaining agreements, has never experienced a work stoppage and considers its relations with its employees to be good.

     Aggregate export sales for the Company’s continuing operations were approximately $8.4 million for 1999, $3.9 million for 2000 and $6.0 million for 2001. (See Notes 2(i) and 3 to Consolidated 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 believes that this facility is in good condition and is suitable and adequate for its current operations.

     In the fourth quarter of 2001, the Company announced a workforce reduction and closed its 4,000 square foot research space in Livermore, California. The lease at the Livermore facility had expired in December 2001.

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. The court entered a final judgement of dismissal with prejudice 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 upon receipt of instruction from plaintiff’s counsel.

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     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 7A. “Risk Factors.”)

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

     Not applicable.

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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 February 28, 2002, the Company had 1,684 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.

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Item 6. Selected Financial Data.

     The following table sets forth selected consolidated financial and other information on a 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, 2001. 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)

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

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

     On April 27, 1999, the Company sold all of the issued and outstanding common stock of Palomar’s Star Medical Technologies, Inc. (“Star”) subsidiary to Coherent, Inc. (“Coherent”) for $65 million, paid in cash and an on-going 7.5% royalty on the LightSheer product line. 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. The Company believes the successful introduction and marketing of new products will become critical to the Company’s long-term success. Broad market acceptance of laser / light based hair removal and specific acceptance of the Palomar SLP1000™ diode laser system, Palomar EsteLux™ light based system and the Palomar Q-Yag 5™ Q-Switched ND: Yag laser system is critical to the Company’s success. The three systems, all of which have FDA clearance, cover a wide spectrum of cosmetic applications; the Palomar SLP1000® is the first diode laser system in the marketplace cleared for use on all skin types and has different hand pieces to be used in a variety of cosmetic applications including hair and vascular lesion removal; the Palomar EsteLux™ system is a fast, more compact and efficient light based system for hair removal and pigmented lesion removal and the Palomar Q-Yag 5™ is a laser system for tattoo and pigmented lesion removal. The Company has traditionally spent a significant amount of its resources in developing new technologies and products.

     During the fourth quarter of 2001, substantial cost reductions were implemented; the Company expects these cost-cutting measures to reduce payroll costs by more than 20 percent in 2002, as well as decrease expenses throughout the organization. Included in these cost reduction measures was the closing of the Company’s 4,000 square foot research space in Livermore, California. The lease had expired in December 2001. In addition, the Company plans to focus its efforts on expanding its distribution network, both domestically and internationally.

The Company believes the following represent its critical accounting policies:

Revenue Recognition

     The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB 101), as amended by SAB 101A and 101B. SAB 101 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the fee charged for services rendered and products delivered and the collectibility of those fees. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.

     Products sold are generally covered by a warranty for a period of one year. The Company accrues a warranty reserve for estimated costs to provide warranty services. The Company’s estimate of costs to service its warranty obligations is based on historical experience and expectation of future conditions. To the extent the Company experiences increased warranty claim activity or increased costs associated with servicing those claims, its warranty accrual will increase resulting in decreased gross profit.

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     For the year ended December 31, 2001, the Company’s revenues increased to $16.7 million, as compared to $13.2 million for the year ended December 31, 2000. This increase in the Company’s revenues of $3.5 million, or 26% from the year ended December 31, 2000, was mainly due to an increase in product sales of SLP1000® of $1.6 million, the newly introduced EsteLux™ pulsed light hair removal system of $1.4 million, shipments associated with the Q-Yag 5™ of $1.1 million, offset by a decrease in service revenue of $200,000 a decrease in product sales associated with the RD1200™ of $1.0 million and a decrease in shipments associated with the E2000™ of $500,000. Additionally, royalty revenues received by the Company increased by $1.1 million. Included in this increase was a back-owed payment of $1.2 million paid by one of the Company’s licensees, resulting from a royalty audit performed through the period ending December 31, 1999.

     Gross profit for the year ended December 31, 2001 was $5.3 million, 32% of revenues, as compared $2.6 million, or 20% of revenues for the year ended December 31, 2000. The increase in gross profit and gross profit percentage was mainly due to an increase in product sales of the SLP1000, the newly introduced EsteLux, shipments associated with the Q-Yag 5 as well as the increased royalty payments received during the twelve-month period.

     Research and development costs decreased to $6.0 million for the year ended December 30, 2001, from $7.9 million for the year ended December 31, 2000. Research and development expenses as a percentage of revenue totaled 36% for the year ended December 31, 2001 and 60% for the year ended December 31, 2000. The continued spending on research and development reflects the Company’s commitment to research and development for devices and delivery systems for cosmetic and medical applications using a variety of lasers and light-based systems, while continuing dermatology research utilizing the Company’s platforms. The research and development goals in the fields of laser and light-based 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, the Company is aiming to address dermatology and cosmetic procedure markets other than hair, including the fields of fat reduction, acne treatment and skin rejuvenation.

     Sales and marketing expenses increased to $3.5 million (21% of revenues) for the year ended December 31, 2001, from $3.2 million (24% of revenues) for the year ended December 31, 2000. The increase in selling and marketing expenses is directly associated with the increased shipments of the SLP1000 and launch of the EsteLux and Q-Yag 5 products.

     General and administrative expenses decreased to $2.5 million (15% of revenues) for the year ended December 31, 2001, as compared to $3.9 million (29% of revenues) for the year ended December 31, 2000. This decrease of $1.4 million or 36% for the year ended December 31, 2001 is attributable to the reduction in legal expenses of $123,000, the reduction in the legal accrual of $250,000, the reduction in the incentive compensation accrual of $513,000, the reduction of Directors and Officers’ insurance expense of approximately $200,000 and other cost cutting measures taken by management.

     During the year ended December 31, 2000, the Company made a determination that goodwill and equipment related to certain past generation products being phased out had been impaired and, accordingly, wrote-off $522,000 of goodwill and $224,000 of equipment.

     Gain from the sale of a subsidiary, Star, was $2.4 million, net of certain commitments and contingencies related to the sale, in the year ended December 31, 2000 as the one-year escrow period had lapsed.

     Interest expense decreased to $98,000 for year ended December 31, 2001, from $155,000 for the year ended December 31, 2000.

     Interest income decreased to $759,000 for the year ended December 31, 2001 as compared to $1.2 million for the year ended December 31, 2000. This decrease in interest income is attributable to the reduction in cash available for investment.

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     Other income, net decreased to $186,000 for the year ended December 31, 2001, as compared to $380,000 for the year ended December 31, 2000.

     The Company recognized an income tax benefit of $422,000 for the year ended December 31, 2001 as compared to $226,000 for the year ended December 31, 2000.

     During the year ended December 31, 2000, the Company adopted Securities and Exchange Commission (SEC) Staff Accounting Bulletin (“SAB”) No. 101, Revenue Recognition. As a result of adopting SAB 101, the Company now records royalty income when cash is 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, totaling $712,000, in the year ended December 31, 2000 statement of operations, effective January 1, 2000.

     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^TM, offset by an increase of $3.7 million from the Palomar SLP 1000^TM 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.

     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 18, 2004. The funding will be in the fields of photo thermal removal or reduction of hair, non-invasive electromagnetic targeting of subcutaneous fat, treatment of sebaceous glands and related skin disorders (e.g., acne) using infrared light except when externally applied chromophores are used and other fields agreed to by the Company and Massachusetts General Hospital. 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.

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     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.

     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 as the one-year escrow period had lapsed in connection with the sale of Star.

     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. 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, totaling $712,000, in the year ended December 31, 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.

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     As of December 31, 2001, the Company had $5.8 million in cash and cash equivalents. The successful sales and marketing of new products and an on-going royalty stream will be critical to future liquidity.

     The Company’s operating activities used cash of $9.2 million and $11.8 million for the years ended December 31, 2001 and 2000, respectively. Net cash provided during the year ended December 31, 2001 consisted primarily of a net loss from operations, offset by depreciation and amortization, an increase in accounts receivable, an increase in inventories, a decrease in other current assets, a decrease in accounts payable, accrued liabilities and accrued income taxes and an increase in deferred revenue. Net cash used for operating activities during the year ended December 31, 2000 consisted primarily of a net loss from operations, offset by depreciation and amortization, an increase in gain from subsidiary, goodwill, asset and inventory write-offs, warrants issued for investment banking services, a decrease in accounts receivable, an increase in inventories, a decrease in receivable from sale of subsidiary, a decrease in other current assets, an increase in accounts payable and accrued liabilities, a decrease in accrued income taxes, deferred gain from subsidiary and deferred revenue.

     Investing activities provided cash of $5.6 million and $19.7 million during the year ended December 31, 2001 and 2000, respectively. During the year ended December 31, 2001, the principal uses were purchases of available-for-sale investments, increases in other assets and purchases of property and equipment, offset by proceeds from the sale of available-for-sale investments. During the year ended December 31, 2000, the principal uses were purchases of available-for-sale investments, purchases of property and equipment, offset by proceeds from the sale of available-for-sale investments, proceeds from the sale of subsidiary and a decrease in other assets.

     Financing activities used cash of $118,000 and $1.1 million during the year ended December 31, 2001 and 2000, respectively. During the year ended December 31, 2001, the principal uses of cash used in financing activities consisted of proceeds from the exercise of warrants, stock options and employee stock purchase plan, proceeds from the issuance of notes payable to related party, offset by costs incurred to issuance of common stock and payments on Swiss Franc convertible debentures. During the year ended December 31, 2000, the principal uses of cash used in financing activities consisted of proceeds from the exercise of warrants, stock options and employee stock purchase plan, offset by costs incurred to issuance of common stock and payments on Swiss Franc convertible debentures.

     The Company anticipates that capital expenditures for 2002 will total $200,000, consisting primarily of machinery, equipment, computers and peripherals. The Company expects to finance these expenditures with cash on hand and equipment leasing.

     In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This statement supercedes FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations, Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. Under this statement it is required that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and it broadens the presentation of discontinued operations to include more disposal transactions. The provisions of this statement are effective for financial statements issued for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years, with early adoption permitted. The Company does not expect the adoption of this statement to have a material impact on its results of operations or financial position.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

     SFAS No. 107 requires disclosure about fair value of financial instruments. Financial instruments consist of cash equivalents, accounts receivable, accounts payable and short-term debt obligations. The fair value of these financial instruments approximates their carrying amount as of December 31, 2001 due to their short-term nature. All of the Company’s investments are considered cash equivalent money market accounts and debt securities which are considered available-for-sale investments and are carried at market value, with the difference between cost and market value, net of related tax effects, recorded as a separate component of stockholders’ (deficit) equity. Accordingly, the Company has no quantitative information concerning the market risk of participating in such investments.

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

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Statement under the Private Securities Litigation Reform Act

     In addition to the other information in this Form 10-K, the following cautionary statements should be considered carefully in evaluating the Company and its business. Statements contained in this Form 10-K that are not historical facts and other information provided by the Company and its employees from time to time may contain certain forward-looking information, as defined by (i) the Private Securities Litigation Reform Act of 1995 (the “Reform Act”) and (ii) releases by the SEC. Our actual results could differ materially from those suggested in such forward-looking statements due to the risk factors identified below and other factors including, without limitation, risks concerning the timing of new product introductions, financing of future operations, the Company’s research partnership with MGH, manufacturing risks, variations in our quarterly results, enforcement of intellectual property rights by us and our competitors, the occurrence of unanticipated events and circumstances, ability to maintain the NASDAQ minimum continued listing requirements and general economic conditions, including stock market volatility. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to release publicly the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. The cautionary statements below are being made pursuant to the provisions of the Reform Act and with the intention of obtaining the benefits of safe harbor provisions of the Reform Act. Forward looking statements include statements regarding our expectations, beliefs, intentions or strategies regarding the future and can be identified by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” and “would” or similar words.

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RISK FACTORS

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

     We face rapidly changing technology and continuing improvements in cosmetic laser / light-based technology. In order to be successful, we must continue to make significant investments in research and development in order to develop in a timely and cost-effective manner new products that meet changing market demands, to enhance existing products, and to achieve market acceptance for such products. We have in the past experienced delays in developing and marketing new products and enhancing existing products. Furthermore, some of our new products under development are based on unproven technology and/or technology with which the Company has no previous experience. Since the sale of Star to Coherent, our revenues have almost entirely depended on sales of newly introduced products. In addition, the market for hair removal laser / light-based devices may already be saturated. At present, broad market acceptance of laser / light-based hair removal is critical to our success. We intend to continue to diversify our product line by developing cosmetic laser / light-based products for uses other than hair and tattoo removal and treatment of pigmented and vascular lesions, but there can be no assurance that we will be able to successfully implement such strategy in a timely fashion or at all.

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

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

We may need to secure additional financing, and our auditors have expressed doubt about our ability to continue as a going concern.

     We have a history of losses. As a result, the report of our independent public accountants in connection with our Consolidated Balance Sheets as of December 31, 2000 and 2001, and the related Consolidated Statements of Operations, Stockholders’ Equity (Deficit) and Cash Flows for the three years ended December 31, 2001 includes an explanatory paragraph stating that our recurring losses, and cash flow from operations raises substantial doubts about our ability to continue as a going concern. We may have to secure additional financing to complete our research and development activities, commercialize our current and proposed cosmetic laser / light-based products, and fund ongoing operations. However, there can be no assurance that such financing will be obtained. We may also determine, depending upon the opportunities available, to seek additional debt or equity financing to fund the costs of operations or expansion. Additionally, if we incur indebtedness to fund increased levels of accounts receivable, finance the acquisition of capital equipment, or if we issue debt securities in connection with any acquisition we will be subject to risks associated with incurring substantial additional indebtedness.

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

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

We could be delisted from NASDAQ.

     For continued listing on The NASDAQ SmallCap Market, a company must maintain a minimum bid price of $1.00 per share. A company must also maintain a minimum requirement of net tangible assets of $2.5 million or market capitalization of $35 million or net income (in latest fiscal year or 2 of the last 3 fiscal years) of $500,000. In March 1999, NASDAQ held a hearing regarding our continued listing on The NASDAQ SmallCap Market in light of the fact that our common stock had traded below the $1.00 minimum bid price requirement for longer than 30 trading days. As a result of our reverse stock split, we regained compliance with the minimum bid price requirement before that date, and are now in compliance with all of NASDAQ’s requirements for continued listing on The NASDAQ SmallCap Market. However, there can be no assurance that we will remain in compliance with NASDAQ’s criteria for continued listing or that we will remain listed on NASDAQ. The delisting of our common stock would likely reduce the liquidity of our common stock and our ability to raise capital. If our common stock is delisted from The NASDAQ SmallCap Market, it will likely be quoted on the “pink sheets” maintained by the National Quotation Bureau, Inc. or NASDAQ’s OTC Bulletin Board. These listings can make trading more difficult for stockholders.

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

     We develop laser / light-based systems that incorporate third-party components. Some of these items are custom made or otherwise not readily available on the market. We purchase some of these components from small, specialized vendors that are not well capitalized. A disruption in the delivery of these key components could have an adverse effect on our business.

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

     All of our current products are laser / light-based medical devices which are subject to FDA regulations for clinical testing, manufacturing, labeling, sale, distribution and promotion. Before a new product or a new use of or claim for an existing product can be introduced into the market, we must obtain clearance from the FDA. Our products may also be subject to state regulations, which are, in many instances, in a state of flux. Changes in state regulations may enhance or impede sales. Our products are subject to similar regulations in our major international markets. Complying with these regulations is necessary for our strategy of expanding the markets for and sales of our products into these countries. Compliance with the regulatory clearance process in any country is expensive and time-consuming, and we may not be able to obtain such clearances in a timely fashion or at all. Regulatory clearances may necessitate clinical testing, limitations on the number of sales and limitations on the type of end user, among other things. In certain instances, these constraints can delay planned shipment schedules as design and engineering modifications are made in response to regulatory concerns and requests.

We are dependent on third-party researchers.

     We are substantially dependent upon third-party researchers over whom we do not have absolute control to satisfactorily conduct and complete research on our behalf. We are also substantially dependent upon 3^rd party researchers to grant us licensing terms, which may or may not be favorable for products and technology, which they may develop. At present, our principal research partner is the Wellman Laboratories of Photomedicine at Massachusetts General Hospital. We provide research funding, laser technology and optics know-how in return for licensing rights with respect to specific medical applications and patents. Our success will be highly dependent upon the results of this research. We cannot be sure that such research agreements will provide us with marketable products in the future or that any of the products developed under these agreements will be profitable for us.

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

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

Our proprietary technology has only limited protections.

     Our business could be materially and adversely affected if we are not able to adequately protect our intellectual property rights. We rely on a combination of patent, copyright, trademark and trade secret laws, license and confidentiality agreements to protect our proprietary rights. We generally enter into non-disclosure agreements with our employees and third parties with which we work, including but not limited to consultants and vendors, to restrict access to, and distribution of, our proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our technology. Monitoring unauthorized use of our technology is difficult and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. If competitors are able to use our technology, our ability to compete effectively could be harmed. Costly and time consuming lawsuits may be necessary to enforce patents issued or licensed exclusively to us, to protect our trade secrets and/or know-how or to determine the enforceability, scope and validity of others’ intellectual property rights. Our competitors also may independently develop technologies that are substantially equivalent or superior to our technology.

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We could become subject to claims by third parties regarding intellectual property rights.

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

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

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

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

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

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

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We may not be able to successfully collect licensing royalties.

     At present, material portions of our revenues consist of royalties from licensing patents licensed to us on an exclusive basis by Massachusetts General Hospital. However, there can be no assurance that these royalty amounts will not decrease or that we will be able to collect all licensing royalties owed by current licensees or increase royalties by licensing additional third parties.

We face risks associated with pending litigation.

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

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

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

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

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

We face risks associated with revenues.

     There can be no certainty as to the severity or duration of the current economic downturn and its impact on our future revenues.

We face risks associated with liquidity and capital resources.

     There can be no assurance that we will not require additional financing to fund our operations or that such additional funding, if needed, will be available on terms acceptable to us or at all.

We may be unable to generate sufficient revenues to achieve profitability.

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     There can be no assurance that our revenues will increase or that we will generate sufficient revenues to achieve or sustain profitability. While we strive to minimize the Company’s business expenses, we will continue to have large fixed expenses and we expect to continue to incur significant sales and marketing, product development, customer support and service, administrative and other expenses. As a result, we need to generate significantly higher revenue to achieve and maintain profitability.

Terrorist acts and acts of war may seriously harm our business and revenues, costs and expenses and financial condition.

     Terrorist acts or acts of war (wherever located around the world) may cause damage or disruption to Palomar, our employees, facilities, partners, suppliers, distributors, resellers, or customers, which could significantly impact our revenues, costs and expenses and financial condition. The terrorist attacks that took place in the United States on September 11, 2001 were unprecedented events that have created many economic and political uncertainties, some of which may materially harm our business and results of operations. The long-term effects on our business of the September 11, 2001 attacks are unknown. The potential for future terrorist attacks, the national and international responses to terrorist attacks, and other acts of war or hostility have created many economic and political uncertainties, which could adversely affect our business and results of operations in ways that cannot presently be predicted.

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Item 8. Financial Statements.

PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Palomar Medical Technologies, Inc:

     We have audited the accompanying consolidated balance sheets of Palomar Medical Technologies, Inc. (a Delaware corporation) and subsidiaries as of December 31, 2000 and 2001 and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

     In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Palomar Medical Technologies, Inc. and subsidiaries as of December 31, 2000 and 2001 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States.

     The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered recurring losses from operations that raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1 to the consolidated financial statements. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

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

                          /s/ ARTHUR ANDERSEN LLP

Boston, Massachusetts
January 29, 2002

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PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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

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PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

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

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PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

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

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PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1) Organization and Operations

     Palomar Medical Technologies, Inc. and subsidiaries (“Palomar” or “the Company”) are engaged in the commercial sale and development of cosmetic and medical laser / light-based systems and services. The Company’s medical laser products are in various stages of development; accordingly, the success of future operations is subject to a number of risks similar to companies in similar stages of development. Principal among these risks are the need for successful development and marketing of the Company’s products, the need for regulatory approval, the need to achieve profitable operations, competition from substitute products and larger companies, the need for successful funding of future operations, and dependence on key individuals.

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

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

     Under the terms of the Agreement, the Company will receive an ongoing royalty of 7.5% from Coherent on the sale of any products by Coherent that incorporate certain patented technology or use certain patented methods currently licensed by the Company on an exclusive basis from Massachusetts General Hospital (“MGH”). Portions of these royalty proceeds are remitted to MGH. For the years ended December 31, 1999, 2000, the Company recognized royalty revenue from Coherent of $1,837,250, $3,836,875, respectively, and for the year ended December 31, 2001, the Company recognized royalty revenue from Coherent of $3,398,253 (of which $1,221,859 was from back owed royalties) and $1,533,315 from ESC Medical who acquired Coherent Medical Group and formed Lumenis, Inc. The Company recognized a cost of royalty to MGH of $734,900, $1,534,750 and $1,972,627, respectively. The Company will receive an on-going royalty rate of 7.5% from Lumenis for the sale of the LightSheer™.

     The Company has incurred significant losses since inception. The Company continues to seek additional financing from issuances of common stock and / or other potential sources in order to fund its operations over the next twelve months. The Company has financed current operations primarily through the private sale of debt and equity securities of the Company. Net cash used in financing activities totaled $9.6 million, $1.1 million and $118,000 for the years ended December 31, 1999, 2000 and 2001, respectively. Net cash used in operating activities totaled $14.2 million, $11.8 million and $9.2 million for the years ended December 31, 1999, 2000 and 2001, respectively. The Company believes that it will require additional financing during the next twelve-month period to continue to fund operations and growth. This additional financing could be in the form of sales of securities to private investors, which are generally sold at a discount to the publicly quoted market price for similar securities. It has been the Company’s experience that private investors require that the Company make its best effort to register these securities for re-sale to the public at some future time.

(2) Summary of Significant Accounting Policies

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

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PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

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

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

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

     Available-for-sale investments in the accompanying balance sheet at December 31, 2000 include debt securities of $5,868,213. Actual maturities may differ from contractual maturities as a result of the Company’s intent to sell these securities prior to maturity and as a result of call features of the securities that enable either the Company, the issuer, or both to redeem these securities at an earlier date. Unrealized holding gains totaling $65,107 and $2,836 on such debt securities were recorded in stockholders’ equity during the twelve months ended December 31, 2000 and 2001, respectively.

     Inventories are stated at the lower of cost (first-in, first-out) or market. At December 31, 2000 and 2001, inventories consist of the following:

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PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

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

     At December 31, 2000 and 2001, property and equipment consist of the following:

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

     The costs in excess of net assets for acquired businesses were being amortized on a straight-line basis over five to seven years. Amortization expense for the years ended December 31, 1999, 2000 and 2001 amounted to approximately $252,000, $0 and $0 respectively, and is included in general and administrative expenses in the consolidated statements of operations.

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

     The Company incurred financing costs related to several issuances of convertible debentures. Deferred financing costs are amortized by a charge to interest expense over the period that the debt is outstanding. Any remaining unamortized deferred financing costs are charged to additional paid-in-capital upon conversion (see Note 10(a)).

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PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

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

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

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

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

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

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

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PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)