UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Commission file number 0-21982

DIAMETRICS MEDICAL, INC.

Registrant’s telephone number, including area code: (651) 639-8035

     Securities registered pursuant to Section 12(b) of the Act: None

     Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ       No o

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

     Indicate by check mark whether the Registrant is an accelerated filer (as defined by Rule 12b-2 of the Act).

Yes o       No þ

     The aggregate market value of voting stock held by non-affiliates of the Registrant as of June 30, 2004, (the last business day of the Registrant’s second fiscal quarter) was approximately $8,400,000 (based upon the last sale price of such stock as quoted on the OTCBB ($0.24).

     As of May 2, 2005, the Registrant had 35,121,835 shares of Common Stock outstanding.

DIAMETRICS MEDICAL, INC.

Annual Report on Form 10-K
For the year ended December 31, 2004

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PART I

Item 1. Business

Overview

     Unless the context otherwise indicates, all references to the “Registrant,” the “Company,” or “Diametrics” in this Annual Report on Form 10-K are to Diametrics Medical, Inc., a Minnesota corporation, incorporated in January 1990, and where the context requires, its former subsidiary, Diametrics Medical, Ltd. (“DML”), or its subsidiary TGC Research Limited (“TGC”).

     From its inception in 1990 until September 2003, the Company developed, manufactured and distributed intermittent blood testing products based on electrochemical sensor technology. That business was located in Roseville, Minnesota. The Company had also acquired a continuous monitoring business in 1996. That business, known as Diametrics Medical, Ltd, operated as a wholly owned subsidiary of the Company until November 1, 2004, with operations located in High Wycombe, England. The Company’s continuous monitoring systems were based on fiber optic sensor technology which measured color changes optically via light transmitted through plastic fibers embedded with fluorescent dyes sensitive to chemicals in blood and tissue.

     Significant changes occurred in the business of Diametrics Medical, Inc. during the years ended December 31, 2003 and 2004. On September 29, 2003, the Company sold its intermittent blood testing business to International Technidyne Corporation (“ITC”). In October 2004, the Company discontinued its only other line of business, the manufacture and distribution of continuous blood and tissue monitoring products. At December 31, 2004, the only employees of the Company were its three officers and its only activities related to the planned start-up of a new product research project focused on the development of products aimed at continuous glucose monitoring and control in critically ill patients, based in part on information obtained during its previous business activities.

     The Company’s historical operations never produced net income or positive cash flow necessary to continue product and market development activities in either the intermittent and continuous blood testing lines of business. External fund raising efforts became increasingly more difficult, and the Board of Directors decided in early 2003 to dispose of one of its lines of business in order to focus all resources on the other line of business. The sale of the intermittent testing business, however, did not generate sufficient cash to meet all the product and market development requirements of the continuous monitoring business. Although those products represented the only continuous blood and tissue monitoring systems in the market, the medical procedures that utilized them had not become the standard of care and market growth was slow. The Company did succeed in raising additional capital for those efforts in January 2004 and May 2004, but its efforts to raise another round in late 2004 were unsuccessful and the lack of funds left the Board of Directors no choice other than ceasing operations at DML. On November 1, 2004, the Company terminated all of its employees in the United Kingdom and all but four of its employees in the United States. On November 22, 2004, a Meeting of Creditors was held in London, England for the purposes of liquidating the assets of DML.

     In December 2004, the Company was able to raise additional funds through the issuance of $1.8 million of convertible debt and arranged an additional $1.2 million as part of the same financing agreements, if it met certain requirements for increasing its authorized shares and registering for resale shares of its common stock with the Securities and Exchange Commission. The funds raised in the first tranche are being used in preparation for a new product development project for continuous glucose monitoring started in early 2005.

     The Company did not meet all of the requirements for the second tranche, but has arranged an additional loan of $150,000 under the same terms as the first tranche to continue the new product planning process. Waivers of all events have been obtained with the understanding that certain filings with the Securities and Exchange Commission would be complete by May 31, 2005.

     The Company has created a new wholly-owned subsidiary in the U.K., TGC Research Limited, for the purpose of new product research and development, and a portion of the funds from the December 2004 financing were used to purchase certain equipment and intellectual property from the liquidator of DML in early 2005. TGC will focus initially on the development of new products aimed at continuous glucose monitoring and control in critically ill patients in a hospital setting. The Company is aware that clinical practices in this area have changed dramatically in recent years. The Company believes that clinical evidence has conclusively demonstrated that maintaining patients within strict glycemic limits can dramatically reduce mortality, risk of infection and other complications, and represents a significant business opportunity. The Company believes its experience with in-vivo measurement systems positions it well to develop products that continuously monitor glucose in intensive care units.

     The Company will have to raise substantial additional funds to complete its product development activities, obtain regulatory clearance and implement a manufacturing and distribution plan.

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     The results of operations for the intermittent testing business have been reported as discontinued operations for all periods presented in this report. Revenues of the intermittent testing business totaled $4.8 million for the year ended December 31, 2003, and $12.3 million for the year ended December 31, 2002. Net losses attributable to the intermittent testing business during the same periods totaled $2.1 million and $1.9 million, respectively. The carrying value of assets sold to ITC approximated $3 million and ITC assumed liabilities of the intermittent testing business totaling $669,000.

     The results of operations for the continuous monitoring business have also been reported as discontinued operations for all periods presented in this report. Revenues of the continuous monitoring business totaled $2.4 million, $3.1 million and $5.5 million, respectively for the three years ended December 31, 2004, 2003 and 2002. Net losses attributable to that business during those periods were $4.1 million, $6.2 million and $2.4 million, respectively.

     The Company’s principal executive office is located at 3050 Centre Pointe Drive, Suite 150, Roseville, Minnesota 55113, and its telephone number is (651) 639-8035. The Company’s website is located at www.diametrics.com. Its Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports are made available to the public free of charge as soon as reasonably practicable after such material is filed with the SEC.

RISK FACTORS

We may not be able to develop our new products successfully.

     Under our current business plan, our Company’s future success initially will be dependent upon our ability to successfully identify, develop, produce and market a new product line to continuously monitor blood glucose levels in critically ill hospitalized patients. However, the relevant technology is currently unproven and we may not be able to develop it through the necessary clinical trial phases.

     In developing these new product(s) we will be incurring all costs of development, market research, manufacturing, market development and sales and marketing expenses. Our success will be dependent on our ability to successfully accomplish these goals in a timely fashion. There can be no assurance that revenues, if any, from these new product(s) will be sufficient to recoup our expenses in developing and marketing any new product offerings. Moreover, there is no assurance that we can manufacture these new product(s) at a cost, or sell these product(s) at a price, that will result in an acceptable rate of return for the Company. Market acceptance of these new products may be slow or customers may not accept the new products at all. If we cannot successfully develop and market new product(s), our financial performance and results of operations will be adversely affected.

We may not be able to establish market acceptance for our new products.

     Market acceptance of our product(s) will depend, in part, on the capabilities and operating features of our product(s) compared to other alternatives available to critical care clinicians, our ability to convince the medical community of the clinical efficiency of our products, the timeliness of our product introductions and our ability to manufacture quality products profitability and in sufficient quantities. Failure of our products to gain market acceptance would have a material adverse effect on our business, financial condition and results of operations. Furthermore, even if there is growth in the markets for our products, there can be no assurance that we will participate in such growth.

We have received a qualified opinion from our independent auditors, have a history of operating losses, and may not achieve profitability sufficient to generate a positive return on your investment.

     We have incurred net operating losses since our inception. We have prepared our consolidated financial statements for the year ended December 31, 2004 on a going-concern basis, which contemplates the realization of assets and satisfaction of liabilities and other commitments in the normal course of business. The report of our independent registered public accounting firm covering the December 31, 2004 consolidated financial statements contains an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern as a result of recurring losses and negative cash flows. We incurred a consolidated net loss of $11,868,578 for the year ended December 31, 2004 and consolidated net losses of $8,479,145 and $7,531,016 for the years ended December 31, 2003 and 2002, respectively. For our discontinuing operations, we incurred net losses of $6,007,660, $6,409,951 and $4,232,424 for the years ended December 31, 2004, 2003 and 2002, respectively. Our accumulated deficit as of December 31, 2004 was $167,882,627. We expect to incur net operating losses at least through 2008.

     We do not have a history of operations with our proposed new product line and are, in many respects, subject to all the risks inherent in the establishment of a new business enterprise. You should view us as a start-up company with all the associated risks and uncertainties. Start-up companies frequently incur losses before achieving any degree of profitability and many of them never become profitable. Thus, our likelihood of success must be considered in light of the problems, delays, expenses and difficulties frequently

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encountered in connection with the launch of a new business, the utilization of new and developing technologies and the competitive and regulatory environment in which we intend to operate. We cannot assure you that we will ever generate substantial revenues or achieve profitability at a level sufficient to generate a positive return on your investment. If we are unable to raise an adequate level of additional capital or generate sufficient cash flows from operations, we may be unable to execute our business plan and remain a going concern.

     We may be unable to raise additional funds or generate sufficient cash from operations to meet our future capital requirements and execute our business plan.

     Our long-term capital requirements for the development of our continuous glucose monitoring business will depend upon numerous factors, including the rate of market acceptance of our products; the level of resources devoted to expanding our business and manufacturing capabilities; and the level of research and development activities. Cash including restricted cash increased by $204,000 during the year ended December 31, 2004 to $1.1 million. Cash on hand at December 31, 2004 was expected to provide five to six months of funding as we developed plans for our new product development activities. An additional $150,000 was borrowed in May 2005 and additional amounts will likely be required to complete the planning process. We are monitoring our cash position carefully and evaluating our future operating cash requirements in the context of our strategy, business plan and expected operating performance. As part of this, we have delayed certain project spending and capital expenditures, and implemented other cost-cutting measures across all areas of our operations.

     We will be required to raise additional capital in order to sustain and fund our operations over the long term. Our initial projections indicated a need for $10 million to $15 million, which may be adjusted as we develop our business plan and evaluate further the need for costs of product enhancements and sales and marketing programs. We do not currently have any available lines of credit or other credit facilities and we are not certain that we can obtain financing or, if it is available, whether it will be on acceptable terms. We may pursue the issuance of additional equity or debt securities to the extent funding raised from other business alternatives is not sufficient to meet our funding requirements. If we raise additional funds through the issuance of equity or equity-related securities, our shareowners may experience dilution of their ownership interests and the newly issued securities may have rights superior to those of common stock. If we raise additional funds by issuing debt, we may be subject to restrictive covenants that could limit our operating flexibility. While we believe that we will be able to raise adequate funding to meet our operational requirements, there can be no assurance that adequate funds will be available when needed and on acceptable terms. If we are unable to obtain additional financing when needed, we would be required to significantly scale back development plans and, depending upon cash flow from our business, reduce the scope of our operations or cease operations entirely.

     We may make additional strategic changes to our product portfolio but our strategic changes and restructuring programs may not yield the benefits that we expect.

     Since September 2003, we have divested or closed our two original product lines and businesses because they were not profitable and embarked on our new strategic plan of developing a new product line focused on continuous glucose monitoring. As necessary, we may make further changes to product lines and business plans. We also may make strategic acquisitions.

     The impact of potential changes to our product portfolio and the effect of such changes on our business, operating results and financial condition are unknown at this time. If we acquire other businesses in our areas of strategic focus, we may have difficulty assimilating these businesses and their products, services, technologies and personnel into our operations. These difficulties could disrupt our ongoing business, distract our management and workforce, increase our expenses and adversely affect our operating results and financial condition. In addition to these integration risks, if we acquire new businesses we may not realize all of the anticipated benefits of these acquisitions and we may not be able to retain key management, technical and sales personnel after an acquisition.

We face significant competition in the medical device industry that may have a negative impact on our potential market share.

     Our industry is characterized by rapidly evolving technology and intense competition. Many of our competitors have substantially greater capital resources, research and development staff and facilities than we do and many of these companies also have greater experience in research and development, obtaining regulatory approvals, manufacturing, and sales and marketing. We cannot assure you that our competitors will not succeed in developing or marketing technologies and products that are more effective or less expensive than ours and therefore make our products obsolete or noncompetitive. Although we anticipate that our new products may offer certain technological advantages over our competitors’ current products, earlier entrants in the market often obtain and maintain significant market share.

Our financial success will depend upon our ability to manage any growth in our business with limited resources.

     If we are successful in developing and marketing a continuous glucose monitoring product or other products, we may be required to expand our operations. Such expansion could result in new and increased responsibilities for our management personnel and place significant strain on our management, operating and financial systems and other resources. To accommodate any such growth and compete effectively,

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we may be required to implement improved information systems, procedures and controls, and to expand, train, motivate and manage our work force. Our future success will depend to a significant extent on the ability of our current and future management personnel to operate effectively both independently and as a group. We cannot assure you that our personnel, systems, procedures and controls will be adequate to support our future operations.

We depend on patents and proprietary technology, that we may not be able to protect in a manner that will provide us any competitive advantage.

     Our success will depend in part on our ability to obtain patent protection for our products and processes, to preserve our trade secrets and to operate without infringing the intellectual property rights of others. The patent positions of medical device companies are uncertain and involve complex and evolving legal and factual questions. We cannot assure you that any of our future patent applications will result in issued patents; that any current or future patents will not be challenged, invalidated or circumvented; that the scope of any of our patents will exclude competitors; or that the patent rights granted to us will provide us any competitive advantage. In addition, we cannot assure you that our competitors will not seek to apply for and obtain patents that will prevent, limit or interfere with our ability to make, use or sell our products either in the United States or in international markets. Further, the laws of certain foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States.

     In addition to patents, we rely on trade secrets and proprietary knowledge that we seek to protect, in part through confidentiality agreements with employees, consultants and others. We cannot assure you that our proprietary information or confidentiality agreements will not be breached; that we will have adequate remedies for any breach; or that our trade secrets will not otherwise become known to or independently developed by competitors.

We may face intellectual property infringement claims, which would be costly to resolve and may exceed our financial resources to assert or defend our claim.

     There has been substantial litigation regarding patent and other intellectual property rights in the medical device industry and our competitors may resort to intellectual property litigation as a means of competition. Intellectual property litigation is complex and expensive and the outcome is difficult to predict. We cannot assure you that we will not become subject to patent infringement claims or litigation. Litigation or regulatory proceedings may also be necessary to enforce our patents or other intellectual property rights. We may not always have the financial resources to assert patent infringement suits or to defend ourselves from claims. An adverse result in any litigation could subject us to significant liabilities to, or require us to seek licenses from or pay royalties to, others. Furthermore, we cannot assure you that the necessary licenses would be available to us on satisfactory terms, if at all.

The demand for and price of our products may depend in part on uncertain government health care policies and reimbursement by third parties, and which could decline as a result of future health care reform.

     The willingness of hospitals or others to purchase our products may depend on the extent to which they limit their own capital expenditures due to existing or future cost reimbursement regulations. In addition, sales volumes and prices of our products in certain markets will depend in part on the level of reimbursement to hospitals for blood analysis from third-party payers, such as government and private insurance plans, health maintenance organizations and preferred provider organizations. Third-party payers are increasingly challenging the pricing of medical procedures they consider unnecessary, inappropriate or not cost-effective. We cannot assure you that current reimbursement amounts, if any, will not be decreased in the future, and that any decrease will not reduce the demand for or the price of our products. Any federal or state health care reform measures could adversely affect the price of medical devices in the United States, including our products, or the amount of reimbursement available. We cannot predict whether any reform measures will be adopted or what impact they may have on us.

We must obtain and maintain regulatory approval in order to sell our products.

     Our business is regulated by the Food and Drug Administration. We will need to obtain pre-market notification clearances under Section 510(k) to market a continuous glucose monitoring system or other medical device products we develop. Obtaining FDA clearance can be a lengthy and expensive process with an uncertain outcome. A Section 510(k) clearance is subject to continual review and later discovery of previously unknown problems may result in restrictions on marketing or withdrawal of the product from the market. We will also market our products in several foreign markets. Requirements vary widely from country to country, ranging from simple product registrations to detailed submissions such as those required by the FDA. Our manufacturing facilities will also be subject to FDA inspection on a periodic basis and we and our contract manufacturers will need to demonstrate compliance with current Quality System Regulations promulgated by the FDA. Violations of the applicable regulations at our manufacturing facilities or the manufacturing facilities of our contract manufacturers could prevent us from marketing our products.

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International operations will expose us to additional risks that could have an adverse effect on our ability to market our products abroad.

     We expect that distributors would sell our products globally, including international markets, subject to receipt of required foreign regulatory approvals. We cannot assure you that such distributors would devote adequate resources to selling our products internationally. Doing business outside of the United States also exposes us to various risks that could have a material and adverse effect on our ability to market our products internationally, including:

	•	changes in overseas economic and political conditions,
	•	currency exchange rate fluctuations,
	•	foreign tax laws, or
	•	tariffs or other trade regulations.

     Our business is also expected to subject us and our representatives, agents and distributors to laws and regulations of the foreign jurisdictions in which they operate or our products are sold. We may depend on foreign distributors and agents for compliance and adherence to foreign laws and regulations. We have no control over most of these risks and may be unable to anticipate changes in international economic and political conditions, and may be unable to alter our business practices in time to avoid any adverse effects.

     Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses.

     Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and stock market rules are creating uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases due to their lack of specificity and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. In particular, our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding our required assessment of our internal controls over financial reporting and our external auditors’ audit of that assessment will require the commitment of significant resources. We expect these efforts to require the continued commitment of significant resources, both financial and managerial. Further, our board members, chief executive officer and chief financial officer could face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficulty attracting and retaining qualified board members and executive officers, which could harm our business.

     Failure to achieve and maintain effective internal controls could have a material adverse effect on our business, operating results and stock price.

     Although we currently qualify as a “non-accelerated filer” for purposes of filing required reports under the Securities Exchange Act of 1934, prior to December 31, 2004 we were deemed to be an “accelerated filer.” As a result, pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our Annual Report on Form 10-K for the fiscal year ending December 31, 2004 we are required to furnish a report by our management on our internal control over financial reporting. Such report will contain, among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. Such report will also contain a statement that our auditors have issued an attestation report on management’s assessment of such internal controls.

     In late November 2004, the Securities and Exchange Commission issued an exemptive order providing a 45 day extension for the filing of these reports and attestations by eligible companies. We intended to utilize this 45 day extension. Because of the change in our independent auditors and the significant change in our business operations during 2004 and the resulting delay in the completion of our audit for the fiscal year ended December 31, 2004, we have not yet been able to complete the process of documenting and testing our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act and have not been able to meet the deadline currently imposed on us, potentially subjecting us to regulatory sanctions. We intend to provide the required management and auditor attestation reports in an amendment to our Form 10-K as soon as practicable. During the course of our testing, we may identify deficiencies which we may not be able to remediate adequately for compliance with the requirements of Section 404. In addition, if we fail to achieve and maintain the adequacy

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of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002. Moreover, effective internal controls are necessary for us to produce reliable financial reports and are important to helping prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information and the trading price of our stock could drop.

     Our common stock is traded on the Over-the-Counter Bulletin Board which may result in reduced liquidity for our common stock.

     On July 1, 2003, we announced that we received a notice from The Nasdaq Stock Market indicating that the Nasdaq Listing Qualifications Panel determined to delist our common stock from The Nasdaq SmallCap Market effective July 2, 2003. Our common stock became immediately eligible to trade on the OTC Bulletin Board, an NASD-sponsored and operated inter-dealer automated quotation system for equity securities not included on The Nasdaq Stock Market, under the symbol “DMED.” Trading our common stock through the OTC Bulletin Board may be more difficult because of lower trading volumes, transaction delays and reduced security analyst and news media coverage. These factors could contribute to lower share prices and larger spreads in the bid and ask prices for our common stock. Trading of our common stock in an over-the-counter market may also attract a different type of investor in our common stock which may limit further our future equity funding options. Failure on our part to maintain our eligibility for trading on the OTCBB, such as for failure to timely file required reports under the Securities Exchange Act, may further reduce the liquidity of our common stock as well as result in an event of default under the terms of our outstanding convertible debt.

     Our stock price is volatile.

     As a result of the decline in our operations and the change in our business strategy, our stock price is highly volatile. For example, in the fifty-two weeks prior to December 31, 2004, the trading price of our common stock has ranged from a high of $0.54 per share to a low of $0.02 per share. Our stock price may be affected by a number of factors, such as:

	•	our ability to develop a marketable product;
	•	our cash liquidity and ability to raise additional funding;
	•	adverse developments regarding the safety and efficacy of our products;
	•	changes in reimbursement policies or medical practices;
	•	clinical trial results;
	•	product development announcements by us or our competitors;
	•	regulatory matters;
	•	intellectual property and legal matters; and
	•	broader economic, industry and market trends unrelated to our performance.

     Our outstanding convertible debt, convertible preferred stock and warrants may have an adverse effect on the market price of common stock and make it more difficult to effect a business combination.

     We currently have approximately 600,000,000 shares of common stock reserved for issuance upon exercise or conversion of outstanding convertible notes, convertible preferred stock and warrants that were issued in conjunction with previous rounds of financing. The sale, or even the possibility of sale, of the shares underlying the convertible securities could have an adverse effect on the market price for our common stock or on our ability to obtain future public financing. Additionally, the potential for the issuance of substantial numbers of additional shares upon exercise of these convertible securities could make us a less attractive acquisition vehicle in the eyes of a target business as such securities, when exercised, will increase the number of issued and outstanding shares of our common stock and reduce the value of the shares issued to complete the business combination. Accordingly, our convertible securities may make it more difficult to effectuate a business combination or increase the cost of the target business. Additionally, if and to the extent these warrants and options are exercised, you may experience dilution to your holdings.

     We have not in the past and do not intend in the foreseeable future to pay cash dividends on our common stock.

     We currently do not pay any cash dividends on our common stock and do not anticipate paying any cash dividends on our common stock in the foreseeable future. We intend to retain future earnings, if any, to finance our operations and for general corporate purposes.

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Item 2. Properties

     The Company’s principal executive offices are located in Roseville, Minnesota, and consists of approximately 3,500 square feet of office space leased through November 2008. During the year ended December 31, 2004, the Company’s other principal properties were as follows:

     The Company is evaluating facilities required for its projected future needs.

Item 3. Legal Proceedings

     The Company is currently not subject to any material pending or threatened legal proceedings.

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

     No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2004.

PART II

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

     On January 9, 2003, the Company received a NASDAQ Staff Determination indicating that the Company did not comply with the minimum stockholders’ equity requirement for continued listing on the NASDAQ National Market set forth in Marketplace Rule 4450(a)(3), and that its securities were subject to delisting from that market. The Company subsequently applied and received approval to transfer the listing of its securities to the NASDAQ SmallCap Market effective February 26, 2003. On April 25, 2003, the Company received a NASDAQ Staff Determination indicating that it failed to comply with the minimum common stock market value requirement for continued listing on the NASDAQ SmallCap Market set forth in Marketplace Rule 4310(c)(2)(B)(ii), and that its securities were subject to delisting. On July 1, 2003, the Company received a notice from the NASDAQ Stock Market indicating that, following a review of an appeal the Company presented on

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June 5, 2003, the NASDAQ Listing Qualifications Panel determined to delist the Company’s common stock from the NASDAQ SmallCap Market effective with the open of business on Wednesday, July 2, 2003. The Company’s common stock became immediately eligible to trade on the Over-the-Counter Bulletin Board effective with the open of business on July 2, 2003 under the symbol “DMED.” The following table sets forth, for the periods indicated, the high and low quarterly closing prices for the Common Stock as quoted on The NASDAQ National Market, The NASDAQ SmallCap Market or the Over-the-Counter Bulletin Board, as applicable.

     There were approximately 340 common shareholders of record and an estimated 4,800 shareholders holding stock in “street name” accounts as of December 31, 2004. The Company has not paid any stock dividends on its common stock since its inception and management does not anticipate paying cash dividends in the foreseeable future.

Item 6. Selected Financial Data

     The table below provides selected historical consolidated financial data for the Company as of and for the periods indicated, as derived from our audited historical consolidated financial statements. The data should be read in conjunction with the Company’s consolidated financial statements and related notes and “Management Discussion and Analysis of Results of Operations and Financial Condition” in this report. All amounts have been restated to reflect discontinued operations, as discussed in note 3 to the consolidated financial statements.

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SELECTED THREE-YEAR FINANCIAL DATA

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

FORWARD-LOOKING STATEMENTS

     This annual report on Form 10-K of Diametrics Medical, Inc. for the year ended December 31, 2004 contains forward-looking statements, principally in the sections entitled “Management’s Discussion and Analysis of Results of Operations and Financial Condition” and “Business.” Generally, you can identify these statements because they use words like “anticipates,” “believes,” “expects,” “future,” “intends,” “plans,” and similar terms. These statements reflect only our current expectations. Although we do not make forward-looking statements unless we believe we have a reasonable basis for doing so, we cannot guarantee their accuracy and actual results may differ materially from those we anticipated due to a number of uncertainties, many of which are unforeseen, including, among others, the risks we face as described in this filing. You should not place undue reliance on these forward-looking statements which apply only as of the date of this annual report. These forward-looking statements are within the meaning of Section 27A of the Securities Act of 1933, as amended, and section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbors created thereby. To the extent that such statements are not recitations of historical fact, such statements constitute forward-looking statements that, by definition, involve risks and uncertainties. In any forward-looking statement where we express an expectation or belief as to future results or events, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the statement of expectation of belief will be accomplished.

     We believe it is important to communicate our expectations to our investors. There may be events in the future, however, that we are unable to predict accurately or over which we have no control. The risk factors listed in this filing, as well as any cautionary language in this annual report, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. Factors that could cause actual results or events to differ materially from those anticipated, include, but are not limited to: our ability to successfully develop new products; the ability to obtain financing for product development; changes in product strategies; general economic, financial and business conditions; changes in and compliance with governmental healthcare and other regulations; changes in tax laws; and the availability of key management and other personnel.

OVERVIEW

     The focus of the Company has changed significantly over the past 18 months. On November 1, 2004, we terminated all of our employees in the United Kingdom and all but four of our employees in the United States. On November 22, 2004, a Meeting of Creditors was held in London, England for the purposes of liquidating the assets of the Company’s wholly-owned subsidiary in the United Kingdom, Diametrics Medical Limited (“DML”). The Company subsequently created a new, wholly-owned subsidiary in the United Kingdom, TGC Research Limited (“TGC”), which acquired certain equipment and intellectual property from the liquidator of DML in early 2005.

     TGC will become a research and development organization which will focus initially on the development of a line of new products aimed at continuous glucose monitoring and control in critically ill patients in a hospital setting at the point-of-patient care. During the past three years, clinical practice patterns in intensive care units around the world have changed dramatically. Clinical evidence, we believe, has conclusively demonstrated that maintaining patients within strict glycemic limits (a clinical practice known as tight glycemic control) can dramatically reduce mortality, risk of infection and other complications. We believe that optimal glycemic control can only be achieved by the continuous monitoring of glucose, a measurement modality that is not currently available in intensive care units. We believe that clinically accurate glucose measurements can only be achieved by in-vivo measurement. Our new focus will be to develop a product system that will effectively and accurately measure, on a continuous basis, glucose in the critically ill patient. We expect this product offering will allow clinicians around the world to maintain tight glycemic control in this patient population, which we believe, represents a significant business opportunity.

     From October 2003 to November 1, 2004, we developed, manufactured and distributed blood and tissue monitoring systems that provided continuous diagnostic information at the point-of-patient care. That business, known as Diametrics Medical, Ltd., was acquired in late 1996 and operated as a wholly-owned subsidiary of the Company, with manufacturing, research and development and marketing operations located in High Wycombe, England. Blood and tissue analysis is an integral part of patient diagnosis and treatment and timely access to certain measurements is critical to effective patient care. We believed that use of our systems would result in more timely decisions by providing accurate and continuous test results at the patient’s bedside, thereby reducing the time spent in critical care settings. Our monitoring systems had also recently been used in several biotech applications to provide continuous measurement of environments surrounding cell research and growth. Most of those utilizations had been on a trial basis, although others had generated revenue from systems and sensor sales.

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     We marketed and distributed our TrendCare products through a direct sales force in the United States, the United Kingdom and Germany and through nonexclusive third-party distributors in various other countries. We distributed our Neurotrend cerebral tissue monitoring system through Codman & Shurtleff, Inc., a Johnson & Johnson Company (“Codman”), under an exclusive worldwide distribution agreement.

     Our primary line of business from our inception in 1990 through September 2003 was the development, manufacture and distribution of intermittent blood testing products. That line of business, which comprised 66% and 57% of consolidated revenues for the years ended December 31, 2003 and 2002, respectively, was sold in late September 2003 to International Technidyne Corporation (“ITC”), a wholly owned subsidiary of Thoratec Corporation, for approximately $5.2 million in cash and the assumption of certain liabilities, including $583,000 in trade payables. Of the cash payment, $758,000 was placed in escrow by ITC for 180 days to cover any shortfall in collected receivables or any indemnification claims. In late March 2004, sales proceeds of $713,000 remaining in escrow were released to the Company.

     The results of operations for the intermittent testing business have been reported as discontinued operations for all periods presented in this report. Revenues of the intermittent testing business totaled $4.8 million for the year ended December 31, 2003, and $12.3 million for the year ended December 31, 2002. Net losses attributable to the intermittent testing business during the same periods totaled $2.1 million and $1.9 million, respectively. The carrying value of assets sold to ITC approximated $3 million and ITC assumed liabilities of the intermittent testing business totaling $669,000.

     The results of operation for the continuous monitoring business have also been reported as discontinued operation for all periods presented in this report. Revenues of the continuous monitoring business totaled $2.4 million, $3.1 million and $5.5 million, respectively for the three years ended December 31, 2004. Net losses attributable to that business during those periods were $4.1 million, $6.2 million and $2.4 million, respectively.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

     The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the U.S., which require the Company to make estimates and assumptions in certain circumstances that affect amounts reported. In preparing these financial statements, management has made its best estimates and judgments of certain amounts, giving due consideration to materiality. The Company believes that of its significant accounting policies (more fully described in notes to the consolidated financial statements), the following are particularly important to the portrayal of the Company’s results of operations and financial position and may require the application of a higher level of judgment by the Company’s management, and as a result are subject to an inherent degree of uncertainty.

     Debt and Equity Instruments. On December 15, 2004, the Company borrowed $1,800,000 under Convertible Senior Secured Notes due December 15, 2007 (the Convertible Senior Notes). Principal and interest are payable in cash or registered shares over a 32-month period beginning 120 days after closing. The subscribers also received warrants to purchase up to 45,000,000 shares of the Company’s common stock at an exercise price of $0.025. The warrants expire on December 15, 2009.

     The Company determined the relative fair value of the debt was $2,627,588 and $1,549,818 for the warrants. The Company allocated $1,018,980 and $601,020 of the net proceeds totaling $1,620,000 to the debt and warrants, respectively. The application of the provisions of EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments” resulted in the calculation of an embedded beneficial conversion feature in the Convertible Senior Notes, which is required to be treated as an additional discount to the debt. The value of the beneficial conversion feature of $1,018,980 was limited to the amount allocated to the debt. $16,010 of the beneficial conversion feature was amortized into interest expense for the year ended December 31, 2004.

     The relative fair value of the warrants issued were determined using the Black-Scholes option-pricing model based on the following assumptions: volatility of 116%, expected life of 5 years, risk free interest rate of 3.53% and no dividends.

     The subscribers received a first lien on all of the assets of the Company. The holders of the Company’s previously issued convertible senior secured fixed rate notes due August 4, 2005 (the Convertible Subordinated Notes), consented to the new financing and the subordination of their secured position to a second lien on all of the assets of the Company in consideration for an amendment of the conversion price of the Convertible Subordinated Notes to $0.02 per share and the amendment of the exercise price of their outstanding warrants to purchase up to 4,255,837 shares of the Company’s common stock to $0.025 per share. See below for the recording of the amendment to the Convertible Subordinated Notes.

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     Stock warrants outstanding to purchase up to 17,555,589 shares of the Company’s common stock, issued in connection with the Company’s Series E, F and G preferred stock financing, were also amended to reduce the exercise price thereof to $0.025 per share, of which certain warrants outstanding to purchase up to 12,000,000 shares of the Company’s common stock were further amended to reduce the exercise price thereof to $0.01 per share. See note 6 for discussion related to the accounting for the modification of these warrants. The reductions in the exercise price or ceiling exercise price, as applicable, of the warrants previously issued to these investors and the issuance of new warrants to purchase 12,000,000 additional shares of common stock resulted in a deemed dividend on the Series E, F and G preferred stock, requiring a charge to retained earnings and an offsetting credit to additional paid-in capital aggregating $1,211,247. Similar to the beneficial conversion features, this amount was charged to retained earnings, with an offsetting credit to additional paid-in-capital, and was treated as a reconciling item on the statement of operations to adjust the reported net loss to “net loss available to common shareholders,” which is used in the numerator in the loss per share calculation for the year ended December 31, 2004.

     The Company classified the warrants issued in connection with the Series E, F and G preferred stock financing as equity rather than debt based upon an assessment of the Company’s contractual obligations for registration of the related common shares issuable upon exercise of the warrants as provided under EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”

     During the second quarter 2003, the Company completed the renegotiation of the terms of its Convertible Subordinated Notes and completed a $1.5 million financing through the sale of 15,000 shares of Series E convertible preferred stock. Both transactions also included the issuance of warrants for the purchase of the Company’s common stock. The accounting for these debt and equity related transactions was complex and required the Company to make certain judgements regarding their accounting treatment. The Company’s significant conclusions related to these transactions included: 1) the accounting applicable to the modification of the convertible notes falls primarily under the treatment prescribed by EITF 96-19, “Debtors Accounting for a Modification or Exchange of Debt Instruments,” 2) the determination of the respective fair values to use as a basis for recording the carrying values of the convertible notes, Series E preferred stock and warrants issued in connection with each transaction and 3) the classification of the warrants as equity versus debt based upon an assessment under EITF 00-19 of the Company’s contractual obligations for registration of the related common shares issuable upon exercise of the warrants.

     On January 16, 2004, the Company completed the sale of 15,000 shares of Series F convertible preferred stock at a price of $100 per share, resulting in aggregate gross proceeds to the Company of $1.5 million. Each share of preferred stock is convertible at any time into common stock at 75% of the volume weighted average trading price of the lowest three inter-day trading prices of the common stock for the five consecutive trading days preceding the conversion date, but at an exercise price of no more than $.25 per share and no less than $.20 per share. In accordance with the terms of the Series F preferred stock agreement, the floor conversion price was reduced to $.15 per share effective June 30, 2004, due to the Company’s inability to achieve a six-month cash flow projection through that date. Five-year warrants were also issued to purchase an aggregate of 6,000,000 shares of the Company’s common stock at the lower of $.35 per share or the average of the lowest ten inter-day closing prices of the Company’s common stock on the Over-the-Counter Bulletin Board during the 10 trading days immediately preceding the exercise date. The ceiling exercise price on the Series F warrants was reduced from $.35 to $.11 per share in connection with the Series G preferred stock financing transaction completed in May 2004.

     Accounting for this transaction falls primarily under EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments.” The Company allocated the net investor proceeds of $1,350,000 from the issuance of the Series F convertible preferred stock to the preferred stock and associated warrants based upon their estimated relative fair values. The resulting fair value allocations of $665,994 and $684,006 for the preferred stock and warrants, respectively, were recorded as equity in the first quarter 2004. The beneficial conversion feature embedded in the preferred stock was calculated at $665,994 and was limited to the fair value allocated to the preferred stock. The beneficial conversion feature of $665,994 was treated as a deemed dividend to preferred shareholders, and was charged to retained earnings, with the offsetting credit to additional paid-in-capital. Additionally, the Company treated the beneficial conversion feature of $665,994 as a reconciling item on the statement of operations to adjust its reported net loss to “net loss available to common shareholders,” which is used in the calculation for the year ended December 31, 2004.

     On May 28, 2004, the Company completed a $1.5 million financing through the sale of 15,000 shares of Series G convertible preferred stock at $100 per share. Each share of the Series G preferred stock is convertible at any time into common stock at 75% of the volume weighted average trading price of the lowest three inter-day trading prices of the common stock during the five consecutive trading days preceding the conversion date, with a maximum exercise price of $.14 per share and a minimum price of $.06 per share. The minimum exercise price was decreased automatically to $.03 per share after the shareholders of the Company authorized an increase in common stock from 100 million shares to 200 million shares on September 7, 2004.

     As part of this financing, the Company issued three-year warrants (“Series G warrants”) to the purchasers of the Series G preferred stock. Those warrants entitle the holders to purchase an aggregate of 1,250,000 shares of the Company’s common stock at the lower of $.11 per share or the average of the lowest ten inter-day closing prices of the Company’s common stock during the ten trading days preceding the

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exercise date. The Company also issued three-year warrants to investors in the Company’s Series E and Series F preferred stock to purchase an aggregate of 12,241,608 shares of common stock at $.05 per share.

     In connection with the Series G financing, the holders of the Company’s Convertible Subordinated Debt agreed to defer until December 31, 2004 the Company’s obligation to make interest payments previously due on June 30, 2004 (including interest payments originally due on December 31, 2003 and March 31, 2004, payment of which was deferred until June 30, 2004) and September 30, 2004. In exchange for the deferral of interest payments, the exercise price on the note holders’ common stock warrants was reduced from $.34 per share to $.09 per share. Accounting for these transactions required a review of several criteria, including assessment of the treatment of the beneficial conversion feature associated with the Series G preferred stock, an assessment of the classification as debt or equity of the warrants issued in connection with the Series G preferred stock financing, an assessment of the impact of the changes in the exercise and ceiling exercise prices, as applicable, of the common stock warrants previously issued to the note holders and the Series E and Series F preferred stock investors and an assessment of the treatment of the fair value associated with the new warrants issued to the Series E and Series F preferred stock investors.

     Additionally, in connection with the Series G financing, the exercise price of the outstanding common stock warrants issued as part of the Series E preferred stock financing was reduced from $.35 per share to $.11 per share, and the ceiling price for the exercise of the common stock warrants issued as part of the Series F preferred stock financing was reduced from $.35 per share to $.11 per share.

     The application of the provisions of EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments” resulted in the calculation of an embedded beneficial conversion feature in the Series G preferred stock, which is required to be treated as a deemed dividend to preferred shareholders. The Company allocated the net investor proceeds of $1,445,000 from the issuance of the Series G convertible preferred stock to the preferred stock and Series G warrants based upon their relative fair values. The fair value allocated to the Series G warrants of $68,205 was recorded as equity. The fair value allocated to the preferred stock of $1,376,795 and the original conversion terms were used to calculate the value of the beneficial conversion feature of $1,067,650 at the date of issuance of the Series G preferred stock. The $1,067,650 was charged to retained earnings with the offsetting credit to additional paid-in-capital. The Company treated the beneficial conversion feature of $1,067,650 as a reconciling item on the statement of operations to adjust its reported net loss to “net loss available to common shareholders”. As a result of the decrease in the conversions rate to $.03 per share, the Company increased the value of beneficial conversion feature to $1,280,216 which was limited to the amount of proceeds allocated to the Series G preferred stock. Additionally, the Company treated the beneficial conversion feature of $1,280,216 as a reconciling item on the statement of operations to adjust its reported net loss to “net loss available to common shareholders,” which is used in the numerator in the loss per share calculation for the year ended December 31, 2004.

     Revenue Recognition and Accounts Receivable. Effective July 1, 2003, the Company adopted the provisions of EITF Issue 00-21, “Revenue Arrangements with Multiple Deliverables,” which provides guidance on the measurement and allocation of revenue from sales undertakings to deliver more than one product or service. Sales of the Company’s hardware and disposable sensors were priced and sold separately and had readily determined fair market values based upon sales histories of these products. As such, the hardware and disposable sensors have stand-alone value to the customer. Sales to distributors and existing end-user customers were specifically priced for each product and had no right of return, except for standard warranty provisions. Revenue was recognized upon shipment of products to distributors and direct customers or, in the case of trial monitors placed directly with end-user customers, upon the customer’s acceptance of the product. Sales to new direct end-user customers requires training on the products during a product evaluation period completed prior to the customer making the purchase. Revenue for these sales transactions was recognized when the purchase was made at the end of the evaluation period.

     Many of the Company’s distribution agreements governing the terms of sales transactions with its European and Asian distributors provided for retention of title to products delivered to such distributors until the distributor made payment to allow the Company to recover the products in the event of distributor defaulted on payment. The agreements provided for this protection because the laws of the countries in which the distributors conducted business did not provide for a seller’s retention of a security interest in goods in the same manner as established in the U.S. Uniform Commercial Code. The Company recognized revenue on sales transactions governed by such distributor agreements upon delivery of the products, which may occur prior to receipt of payment and the transfer of title. This treatment is permitted under SEC Staff Accounting Bulletin (“SAB”) No. 104 – “Revenue Recognition,” as all other revenue recognition criteria outlined in SAB No. 104 had been met and the only rights the Company retained with the title in such transactions were those enabling recovery of the products in the event of distributor payment default. The Company did not retain any other rights of ownership, such as the ability to direct the disposition of the products sold, rescind the transaction or prohibit the distributor from moving, selling or otherwise using the goods in the normal course of business.

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RESULTS OF OPERATIONS

2004 Compared to 2003

     Revenue and Cost of Revenue. As a result of discontinued operations, the Company has no revenue or cost of sales related to continuing operations.

     Operating Expenses. Total operating expenses for the year ended December 31, 2004 totaled $1,665,794, a decrease of $721,288 or 30% relative to 2003. The decrease in expense reflects the Company’s reduction in expenditures as operations declined. All operating expenses were related to corporate level activities as all selling and research and development expenditures were reclassified to discontinued operations.

     Other Income (Expense). The significant changes between periods in net other income and expense occurred primarily as a result of the accounting treatment for the issuance of additional debt and the modification of debt. The expensing of the beneficial conversion feature related to the Convertible Senior Secured Notes resulted in the recognition of $16,010 of interest expense and the modification of the Convertible Subordinated Debt resulted in a loss $1,670,683 in 2004. Total accretion on notes payable in 2004 was $1,206,884 compared to $632,143 in 2003. Modification of the Company’s Convertible Subordinated Debt in April 2003, resulted in recognition of a $1,500,000 gain during the second quarter 2003.

     Discontinued Operations. On October 4, 2004, the Company concluded that it was no longer able to fund the operations of DML. The Directors of DML then ceased all operations in the U.K. and, effective November 1, 2004 terminated all of our employees there. On November 22, 2004, a Meeting of Creditors was held in London, England for the purposes of liquidating the assets of DML. Based upon a review of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” the Company assessed the measurement date for the sale transaction as the date of Director approval, which occurred on October 4, 2004. As prescribed by SFAS No. 144, the Company began reporting the results of operations of DML as discontinued operations effective as of the year ended December 31, 2004 for all periods presented. Upon DML entering liquidation in November, the Company recorded a loss of $2.4 million.

     The operations of the Company’s continuous monitoring business, reflected in discontinued operations, reported a net loss of $4,127,982, $6,170,974, and $2,368,005 for the years ended December 31, 2004, 2003 and 2002 respectively. The decrease in net loss from 2003 to 2004 is primarily the result of restructuring that took place in 2003. The increase in net loss from 2002 to 2003 is primarily the result of a reduction in revenues and an increase in sales and marketing expenses as the Company expended its distribution channels after the termination of the exclusive agreement with Philips Medical Systems.

     Net Loss / Net Loss Available to Common Shareholders. The Company’s reported consolidated net loss in 2004 of $10,978,828 was further adjusted by a $1,946,210 charge for a beneficial conversion feature and $1,211,247 for deemed dividend on preferred stock to arrive at “net loss available to common shareholders” of $14,136,285, which is used in the numerator in the loss per share calculation. This occurred as a result of the application of the provisions of EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments” resulted in the calculation of an embedded beneficial conversion feature in the Series F and G preferred stock. The beneficial conversion feature – preferred stock dividend for Series F and G was $665,994 and $1,280,216, respectively.

     Subsequent to the preferred stock financings described above, the exercise price of the warrants issued with the preferred stock were adjusted downward during 2004 as a result of the issuance of the Series G financing and the new Convertible Senior Notes. In addition new warrants to purchase 12,241,608 shares of common stock were issued to the Series E and Series F investors as a result of the Series G financing. The new Convertible Senior Note financing reduce the exercise price of warrants to purchase 5,555,589 shares of common stock to $.025 per share and warrants to purchase 12,000,000 shares of common stock to $.01 per share. The reductions in the exercise price or ceiling exercise price, as applicable, of the warrants previously issued to these investors and the issuance of new warrants to purchase additional shares of common stock resulted in a deemed dividend on the Series E, F and G preferred stock, requiring a charge to retained earnings and an offsetting credit to additional paid-in capital aggregating $1,211,247. Similar to the beneficial conversion features discussed above, this amount was charged to retained earnings, with an offsetting credit to additional paid-in-capital, and was treated as a reconciling item on the statement of operations to adjust the reported net loss to “net loss available to common shareholders,” which is used in the numerator in the loss per share calculation for the year ended December 31, 2004.

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2003 Compared to 2002

     Revenue and Cost of Revenue. As a result of discontinued operations, the Company has no revenue or cost of sales related to continuing operations.

     Operating Expenses. Total operating expenses from continuing operations decreased by $601,831 or 20% from 2002 to 2003. The decrease in expense reflects the Company’s reduction in expenditures as operations declined. All operating expenses were related to corporate level activities as all selling and research and development expenditures were reclassified to discontinued operations.

     Interest and Other Income / Expense. The Company realized interest income of $15,878 in 2003 compared to $86,441 in 2002. The year-to-year declines reflect the impact of lower average cash and investment balances and lower average interest rates.

     The gain on modification of convertible notes in 2003 occurred as a result of the accounting treatment for the modification of the Company’s Convertible Subordinated Notes, which resulted in the recognition as other income in the second quarter 2003 of a $1,500,000 gain. The modified notes and associated warrants were recorded at their individual estimated fair values of $5,000,000 and $800,000, respectively. The $7,300,000 carrying value of the original notes was retired, and the residual amount of $1,500,000 was reflected as a gain on the transaction. Prior to the additional modification to the Convertible Subordinated Notes, the Company was accreting the initial $5,000,000 carrying value of the modified notes to their redemption value of $7,300,000 using the effective interest method over the remaining term of the modified notes, which would have resulted in the recording of $2,300,000 of additional interest expense over this period. Accordingly, the accretion of the convertible notes balance resulted in an additional charge to interest expense of $632,143 in 2003, partially offsetting the gain.

     Interest expense totaled $1,262,307 in 2003, compared to $545,976 in 2002. The significant increase in interest expense in 2003 primarily reflects the recognition of additional interest expense of $632,143 for the accretion of the convertible notes discussed above, the amortization of extension costs associated with the Company’s convertible notes and the impact of higher average interest rates on capital lease obligations entered into in late 2002 and early 2003.

     Discontinued Operations. On October 4, 2004 the Company concluded that it was no longer able to fund the operations of DML. The Directors of DML then ceased all operations in the U.K. and, effective November 1, 2004, terminated all of its employees there. On November 22, 2004, a Meeting of Creditors was held in London, England for the purposes of liquidating the assets of DML. Based upon a review of SFAS No. 144, “Accounting for the Impairment of Disposal of Long-lived Assets,” the Company assessed the measurement date for the sale transaction as the date of Director approval, October 4, 2004. As prescribed by SFAS No. 144, the Company began reporting the results of operations of DML as discontinued operations effective as of the year ended December 31, 2004 for all periods presented. Upon DML entering liquidation in November, the Company recorded a loss of $2.4 million.

     On September 29, 2003, the Company completed the sale of substantially all of the assets used in the Company’s intermittent testing business to ITC. Based upon a review of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” the Company assessed the measurement date for the sale transaction as the date of shareholder approval, which occurred on September 19, 2003. As prescribed by SFAS No. 144, the Company began reporting the results of operations of the intermittent testing business as discontinued operations effective with the quarter ended September 30, 2003, for all periods presented. Upon completion of the sale transaction in September, the Company recorded a gain on the sale of the intermittent testing business of $1.8 million.

     The operations of the Company’s intermittent testing business, reflected in discontinued operations, reported a net loss of $2,071,036 and $1,864,469 for the years ended December 31, 2003 and 2002 respectively. The increase in net loss is primarily the result of a reduction in revenues and an increase in sales and marketing expenses, both stemming from the termination of the exclusive agreement with Philips and the resulting transition to expanded distribution channels.

     Net Loss / Net Loss Available to Common Shareholders. The Company’s reported consolidated net loss in 2003 of $8,479,145 was further adjusted by a $958,962 charge for a beneficial conversion feature to arrive at “net loss available to common shareholders” of $9,438,107, which is used in the numerator in the loss per share calculation. This occurred as a result of the required accounting treatment of the Company’s issuance of $1.5 million of Series E convertible preferred stock and associated warrants in May 2003. As further discussed in note 6 to the consolidated financial statements, the Company allocated the net investor proceeds of $1,350,000 from the issuance of the Series E convertible preferred stock to the preferred stock and associated warrants based upon their estimated relative fair values. The resulting fair value allocations of $958,962 and $391,038 for the preferred stock and warrants, respectively, were recorded as equity. The beneficial conversion feature embedded in the preferred stock was calculated at $958,962 and was limited to the fair value allocated to the preferred stock. The beneficial conversion feature of $958,962 was treated as a deemed dividend to preferred shareholders, and was charged to retained earnings, with the offsetting credit to additional paid-in-capital.

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     LIQUIDITY AND CAPITAL RESOURCES

     The accompanying financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and satisfaction of liabilities and other commitments in the normal course of business. The report of the Company’s independent auditors contains an explanatory paragraph expressing substantial doubt about the Company’s ability to continue as a going concern as a result of recurring losses and negative cash flows. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that may be necessary if the Company is unable to continue as a going concern.

     At December 31, 2004, the Company had negative working capital of approximately $331,000, compared with negative working capital of approximately $417,000 at December 31, 2003, after restatement of the balance sheet for the impact of discontinued operations. Cash of $1,096,000 represented 87% of total current assets at December 31, 2004. Current liabilities of $1,477,000 at that date consisted primarily of $1,355,000 in accounts payable and accrued expenses and $28,000 in current maturities of long-term debt. The Company used the net proceeds from $1,800,000 of Convertible Senior Notes funded on December 15, 2004, after banking, legal and accounting fees related to that financing, to pay certain critical liabilities. Others have been negotiated or are being paid over several months.

     Net losses for the years ended December 31, 2004 and 2003 were $10,979,000 and $8,479,000 respectively, after losses related to discontinued operations of $6,008,000 and $6,410,000. In addition, charges were recorded for a deemed preferred stock dividend related to beneficial conversion features of $1,946,000 in 2004 and $959,000 in 2003 and a deemed dividend of $1,211,000 on preferred stock in 2004.

     During 2004, the Company received net proceeds of $1,620,000 from borrowings and $2,611,000 from sales of preferred stock. These proceeds were used primarily to fund net requirements for continuing operating activities in the amount of $1,351,000 and requirements for discontinued operations in the amount of $1,947,000. The net increase in cash compared with net decreases of $3,736,000 in 2003 and $3,233,000 in 2002. The most significant sources of funds in 2003 were $4,153,000 net proceeds, including gain from the sale of discontinued operations and $596,000 from sales of preferred and common stock, less mandatory redemptions. Continuing operations used $3,648,000 in 2003 and provided $618,000 in 2002.

     The Company is monitoring its cash position carefully and is evaluating its future operating cash requirements in the context of its strategy, business objectives and expected business performance. Cash on hand at December 31, 2004 was expected to provide five to six months of funding as the Company developed plans for its new product development activities. An additional $150,000 was borrowed on May 2, 2005 and additional amounts will likely be required to complete that planning. After receipt of the $150,000 in May 2005, the Company had available funds of $250,000. Operations used about $100,000 in April 2005 and it is expected that requirements will be similar in future months, excluding incremental accounting, auditing and legal fees related to filings with the Securities and Exchange Commission and any initial new product development costs.

     The Company’s long-term capital requirements for the development of its new products will depend upon numerous factors, including the rate of market acceptance of the Company’s products and the level of research and development activities. It is presently anticipated that such activities will require from $10 to $15 million. While there can be no assurance that adequate funds will be available when needed, or on acceptable terms, management believes that the Company will be able to raise adequate funding to meet its operational requirements. If the Company is unable to raise an adequate level of additional capital or generate sufficient cash flows from operations, the Company’s ability to execute its business plan and remain a going concern will be significantly impaired.

     Net cash provided by financing activities totaled $4,246,000 in 2004, an increase over the $514,000 of net cash provided financing activities in 2003. Financing activities in 2004 related to the issuance of $1,620,000 net of cash discounts for the Convertible Senior Notes in December 2004 and two rounds of preferred stock offerings which totaled $2,611,000 after offering costs which occurred in January 2004 and May 2004.

     Income Tax Carryforwards. At December 31, 2004, the Company had U.S. tax net operating loss and research and development tax credit carryforwards for income tax purposes of approximately $139,500,000 and $1,493,000, respectively. Pursuant to the Tax Reform Act of 1986, use of a portion of the Company’s net operating loss carryforwards are limited due to a “change in ownership.” If not used, these net operating loss carryforwards begin to expire in 2005 ($500,000) and at increasing amounts between 2006 and 2023 ($31.6 million between 2006 and 2009, and $100 million thereafter).

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Disclosure of Contractual Obligations

     In late 1996 the Company entered into a long-term debt obligation consisting of a $7.3 million senior secured fixed rate loan note issued to Pfizer Inc. in connection with the Company’s acquisition of DML. Proceeds from the issuance in August 1998 of $7.3 million of Convertible Subordinated Notes, issued in conjunction with a private equity placement, were simultaneously used to retire the $7.3 million Pfizer note. Payments on the Company’s contractual obligations, consisting of debt, capital leases and operating leases are summarized below:

     NEW ACCOUNTING PRONOUNCEMENTS

     EITF Issue No. 03-01, “Meaning of Other-Than Temporary Impairment and Its Application to Certain Investments,” addresses both qualitative and quantitative disclosures required for marketable equity and debt securities accounted for under FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The disclosure requirements are effective for fiscal years ending after December 15, 2003. EITF Issue No. 03-01 did not have a material impact on the Company’s financial statements.

     In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” which established standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both debt and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. For example, the Statement requires liability classification for a financial instrument issued in the form of shares that are mandatorily redeemable, e.g., includes an unconditional obligation requiring the issuer to redeem it by transferring at a specified or determinable date or dates or upon an event certain to occur. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company has adopted SFAS No. 150 and applied its provisions to the classification at September 30, 2003 of the $750,000 of Series E convertible preferred stock that was put back to the Company effective with the sale of the Company’s intermittent testing business.

     In December 2003, the FASB issued a revision to FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” which replaces the original issuance of FASB Interpretation No. 46 in January 2003 and clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” This interpretation addresses consolidation by business enterprises of variable interest entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. The adoption of this standard did not have a significant impact on the consolidated financial statements.

Item 7.a. Quantitative and Qualitative Disclosures About Market Risk

     The Company is exposed to market risk from foreign exchange rate fluctuations of the British pound sterling to the U.S. dollar as the financial position and operating results of the Company’s U.K. subsidiary, TGC, are translated into U.S. dollars for consolidation. The Company is presently considering certain product development contracts with European based businesses. Such contracts would likely be denominated in Euros which would also create market risk as funds were transferred from the U.S. The Company’s exposure to foreign exchange rate fluctuations also arises from transferring funds to its U.K. subsidiary in British pounds sterling.

     As a result of fluctuations of the British pound sterling to the U.S. dollar in 2003, the Company’s reported consolidated net loss for 2003 increased in excess of $400,000 relative to 2002. The effect of foreign exchange rate fluctuations on the Company’s financial results for 2002 was not material. The Company does not currently use derivative financial instruments to hedge against exchange rate risk or

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interest rate risk. The Company’s debt obligations as of December 31, 2004 bear interest at fixed rates, and are therefore not subject to exposure from fluctuating interest rates.

Item 8. Financial Statements and Supplementary Data

     All other schedules have been omitted because they are not applicable or not required, or because the required information is included in the consolidated financial statements or the notes thereto.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders, Audit Committee and Board of Directors
Diametrics Medical, Inc.
Roseville, Minnesota

We have audited the accompanying consolidated balance sheet of Diametrics Medical, Inc. as of December 31, 2004, and the related consolidated statements of operations, shareholders’ deficit and comprehensive loss and cash flows for the year then ended. These consolidated financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Diametrics Medical, Inc. as of December 31, 2004 and the results of their operations and their cash flows for the year then ended, in conformity with U.S. generally accepted accounting principles.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has recurring operating losses, negative cash flows from operations, a working capital deficit, and a shareholders’ deficit that raise substantial doubt about its ability to continue as a going concern. Management’s plans in regards to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ Virchow, Krause & Company, LLP

Minneapolis, Minnesota
April 28, 2005 (except as to Note 17, as to which the date is May 2, 2005)

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Consolidated Statements of Operations

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

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Consolidated Balance Sheets

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

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Consolidated Statements of Shareholders’ Equity (Deficit) and Comprehensive Loss

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

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Consolidated Statements of Cash Flows

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

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(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Description of the Business. Diametrics Medical, Inc., along with its subsidiary (“the Company”), is a medical device company whose focus has changed significantly over the past 18 months. On November 1, 2004, the Company terminated all of its employees in the United Kingdom and all but four of its employees in the United States. On November 22, 2004, a meeting of creditors was held in London, England for the purposes of liquidating the assets of its wholly owned subsidiary in the United Kingdom, Diametrics Medical Limited (“DML”). The Company has created a new, wholly owned subsidiary called TGC Research Limited (“TGC”), which has acquired certain assets, including equipment and intellectual property, from the liquidator of DML in January 2005. TGC will become an R&D organization which will focus initially on the development of a line of new products aimed at continuous glucose monitoring and control in critically ill patients in a hospital setting at the point-of-patient care.

     On September 29, 2003, the Company completed the sale of substantially all of the assets used in the Company’s intermittent testing business to International Technidyne Corporation (“ITC”), a wholly owned subsidiary of Thoratec Corporation, for approximately $5.2 million in cash and the assumption of certain liabilities, including $583,000 in trade payables. The results of operations for the intermittent testing business have been reported as discontinued operations for all periods presented in this Annual Report on Form 10-K.

     With the termination effective November 1, 2002 of the Company’s agreement with Philips Medical Systems for exclusive worldwide distribution of the Company’s TrendCare continuous blood gas monitoring systems, the Company began reestablishing a direct sales force in the United States, the United Kingdom and Germany, as well as nonexclusive third-party distributors in various other countries. The Company continued to sell disposable sensors and related accessories to Philips for Philips’ nonexclusive distribution to its customer base through October 31, 2003. Until November 1, 2004, the Company continued to distribute its Neurotrend cerebral tissue monitoring system through Codman & Shurtleff, Inc. a Johnson & Johnson Company (“Codman”), under an exclusive distribution agreement entered into October 1, 1998.

     Principles of Consolidation. The accompanying consolidated financial statements include the accounts of Diametrics Medical, Inc. and its wholly owned subsidiaries TGC Research Medical Limited, and Diametrics Medical, Ltd. All material intercompany accounts and transactions have been eliminated.

     Foreign Currency Translation/Transactions. The financial statements of the Company’s foreign subsidiary are translated into U.S. dollars for consolidation. All assets and liabilities are translated using period-end exchange rates and statements of operations items are translated using average exchange rates for the period. The resulting translation adjustments are recorded as a separate component of shareholders’ equity (deficit). Also recorded as translation adjustments in shareholders’ equity (deficit) are transaction gains and losses on intercompany balances for which settlement is not planned or anticipated in the foreseeable future. Other foreign currency transaction gains and losses are included in determining net loss, but have not been material in any of the years presented.

     Cash Equivalents. The Company considers highly liquid debt instruments purchased with an original maturity of 90-days or less to be cash equivalents. The Company maintains its cash in high quality financial institutions. The balances, at times, may exceed the insured limits.

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     Inventories. Inventories were stated at the lower of cost or market using the first in, first out method. Reserves for slow moving and obsolete inventories were provided based upon current and expected future product sales, the expected impact of changes in production levels and product transitions or modifications.

     Property and Equipment. Property and equipment are recorded at cost. Depreciation and amortization are computed using the straight-line method over estimated useful lives of 2 to 10 years for equipment and furniture and the term of the underlying lease for leasehold improvements. Maintenance and repairs are expensed as incurred.

     Impairment of Long-lived Assets. The Company reviews its long-lived asset groups for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of asset groups to be held and used is measured by a comparison of the carrying amount of an asset group to future net cash flows expected to be generated by the asset group. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset group exceeds the fair value of the assets in the group. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

     Revenue Recognition. The Company recognizes revenue upon its shipment of product to its distributors and direct customers or, in the case of trial monitors placed directly with customers, upon the customer’s acceptance of the product. The Company’s sales terms to its distributors and direct customers provide no right of return outside of the Company’s standard warranty policy and payment terms consistent with industry standards apply. Sales terms and pricing extended to the Company’s distributors and direct customers are governed by the respective distribution agreements and contracts, together with binding purchase orders for each transaction. The transition to expanded distribution channels and the resulting increase in sales to direct end-user customers is expected to increase the diversity of the Company’s sales transactions and customer base, which may result in some transactions with nonstandard terms and conditions, such as acceptance criteria. In these cases, revenue will be recognized upon the fulfillment of the obligation specific to the terms of the customer’s contract. In cases where an end-user customer requires more than an insignificant amount of post-sales training, the Company will defer the greater of the relative fair value of that training or any contingent payments until the training is completed in accordance with EITF 00-21 “Revenue Arrangements with Multiple Deliverables.”

     Research and Development. Research and development costs relate to hardware and software development and enhancements to existing products. All such costs are expensed as incurred. Research and development funds earned by the Company under the Philips exclusive agreement (which ceased with the termination of that agreement effective November 1, 2002), were recorded as a reduction of the development costs incurred, and approximated $467,000 in 2002.

     Net Loss Per Common Share. Basic earnings per share (“EPS”) is calculated by dividing net loss by the weighted average common shares outstanding during the period. Diluted EPS reflects the potential dilution to basic EPS that could occur upon conversion or exercise of securities, options, or other such items, to common shares using the treasury stock method based upon the weighted average fair value of the Company’s common shares during the period. For each period presented, basic and diluted loss per share amounts are identical, as the effect of potential common shares is antidilutive.

     The following is a summary of outstanding securities which have been excluded from the calculation of diluted EPS because the effect on net loss per common share would have been antidilutive:

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     Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Due to historical net losses of the Company, a valuation allowance is established to offset the deferred tax asset.

     Use of Estimates. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses during the reporting period. The Company’s significant estimates primarily relate to the assessment of required accounts receivable and inventory valuation allowances, the fair value of long-lived assets, accounting for debt and equity transactions, accounting for foreign currency translation and transactions and defined benefit retirement plan funding and accounting. Actual results could differ from those estimates.

     Fair value of financial instruments. The Company’s financial instruments are recorded on its consolidated balance sheet. The carrying amount for cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximates fair value due to the immediate or short-term maturity of these financial instruments. The fair value of long-term debt approximates the carrying amounts based upon the Company’s expected borrowing rate for debt with similar remaining maturities and comparable risk.

     Stock Based Compensation. As permitted by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” the Company applies the intrinsic-value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for the issuance of stock incentives to employees and directors. As a result, no compensation expense related to employees’ and directors’ stock incentives has been recognized in the financial statements as all options granted under stock incentive plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Had compensation costs for the Company’s stock incentive plans been determined based on the fair value of the awards on the date of grant, consistent with the provisions of SFAS No. 123, the Company’s net loss per share would have increased to the pro forma amounts indicated below:

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For each period presented, basic and diluted loss per share amounts are identical, as the effect of potential common shares is antidilutive.

     An option to purchase 25,000 shares was granted to a new Director in 2004. The per share weighted-average fair value of options granted under the Company’s stock option plans was $.14, $.75 and $2.41 for the years ended December 31, 2004, 2003 and 2002, respectively. These per share values were determined using the Black Scholes option-pricing model with the following assumptions: annualized volatility of 115.77%, 100.92% and 91.53% for 2003 and 2002, respectively; risk-free interest rate of 3.5% in 2004, 3.25% in 2003 and 3.76%; and an expected life of five years and no dividends for each year.

     Comprehensive Loss. Comprehensive loss is presented as a component of Shareholders’ Equity (Deficit) and consists of net loss, foreign currency translation adjustments and changes in the Company’s minimum pension liability. The accumulated balances for each component of accumulated other comprehensive loss are as follows:

The foreign currency translation adjustment and minimum pension liability were related to the Company’s discontinued DML subsidiary. These amounts were realized in the statement of operations as part of the loss on liquidation of the DML subsidiary.

     Defined Benefit Retirement Plan Funding. The Company’s U.K. subsidiary sponsored a contributory defined benefit retirement plan (“Retirement Plan”) covering all eligible employees. The Company’s funding policy was to contribute into a trust fund at an annual rate that was intended to remain at a level percentage of total pensionable payroll. Annual contribution amounts were determined by a qualified actuary and were intended to adequately fund the Company’s projected pension liability payable upon employees’ retirement, given actuarial assumed rates of average market and trust fund investment performance.

     Reclassifications. Certain amounts included in the prior year consolidated financial statements, including the impact of the Company’s discontinued operations, have been reclassified in prior years to conform to the current year presentation. Such reclassifications had no effect on the Company’s previously reported consolidated financial position, net loss or cash flows.

     New Accounting Pronouncements. In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes APB 25 “Accounting for Stock Issued to Employees”. SFAS 123(R) requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, in the financial statements. The effective date of SFAS No. 123(R) for the Company is January 1, 2006. SFAS No. 123(R) permits companies to adopt its requirements using either a “modified prospective” method, or a “modified retrospective” method. Under the “modified prospective” method, compensation cost is recognized in the financial statements beginning with the effective date, based

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on the requirements of SFAS No. 123® for all share-based payments granted after that date, and based on the requirements of SFAS No. 123 for all unvested awards granted prior to the effective date of SFAS 123®. Under the “modified retrospective” method, the requirements are the same as under the “modified prospective” method, but also permits entities to restate financial statements of previous periods based on proforma disclosures made in accordance with SFAS No. 123. The Company expects to adopt the “modified prospective” method under SFAS No. 123®. The Company is currently determining the impact on the Company’s financial statements.

     In December 2003, the FASB issued a revision to FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” which replaces the original issuance of FASB Interpretation No. 46 in January 2003 and clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” This interpretation addresses consolidation by business enterprises of variable interest entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. The adoption of FIN 46 did not have a material effect on our results of operations, cash flows or financial position.

(2) GOING CONCERN

     Although the Company discontinued all its operations in October 2004, it did obtain additional funding in December 2004 and again in May 2005 for a new product research project started in early 2005. The accompanying financial statements have therefore been prepared on a going-concern basis after adjusting all assets and liabilities to amounts expected to be realized or paid, respectively, in the normal course of business. The report of the Company’s independent auditors contains an explanatory paragraph expressing substantial doubt about the Company’s ability to continue as a going concern as a result of recurring losses, negative cash flows and uncertainties regarding the Company’s ability to successfully develop, produce and market a new product or products. The financial statements would require additional adjustments relating to the recoverability and classification of recorded asset amounts and the amounts and classification of liabilities and would be necessary if the Company is unable to continue as a going concern.

     The Company is planning to use available funds to develop new products aimed at continuous glucose monitoring in critically ill patients. It believes its experience with in-vivo measurement systems positions it well to develop such products. Planning efforts are projected to continue through summer 2005.

     We will be required to raise additional capital in order to sustain and fund our operations over the long term. Our initial projections indicated a need for $10 million to $15 million, which may be adjusted as we develop our business plan and evaluate further the need for costs of product enhancements and sales and marketing programs. We do not currently have any available lines of credit or other credit facilities and we are not certain that we can obtain financing or, if it is available, whether it will be on acceptable terms. We may pursue the issuance of additional equity or debt securities to the extent funding raised from other business alternatives is not sufficient to meet our funding requirements. If we raise additional funds through the issuance of equity or equity-related securities, our shareowners may experience dilution of their ownership interests and the newly issued securities may have rights superior to those of common stock. If we raise additional funds by issuing debt, we may be subject to restrictive covenants that could limit our operating flexibility. While we believe that we will be able to raise adequate funding to meet our operational requirements, there can be no assurance that adequate funds will be available when needed and on acceptable terms. If we are unable to obtain additional financing when needed, we would be required to significantly scale back development plans and, depending upon cash flow from our business, reduce the scope of our operations or cease operations entirely.

(3) DISCONTINUED OPERATIONS

     On October 4, 2004, the Company determined it would longer fund the operations of DML. On that same day, DML’s board of directors decided to shut-down DML. On November 1, 2004, the Company terminated all of our employees in the United Kingdom and all but three of our employees in the United States. On November 22, 2004, a Meeting of Creditors was held in London, England for the purposes of liquidating the assets of DML. Based upon a review of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” the Company assessed the measurement date for the sale transaction as the date of board of director approval, which occurred on October 4, 2004. As prescribed by SFAS No. 144, the Company began reporting the results of operations of DML as discontinued operations effective as of the year ended December 31, 2004 and for all periods presented. Upon DML entering liquidation in November, the Company recorded a loss of $2.4 million.

     Following are summary operating results of the continuous monitoring business, included in discontinued operations in the Company’s Consolidated Statements of Operations for the respective periods:

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     On September 29, 2003, the Company completed the sale of substantially all of the assets used in the Company’s intermittent testing business to ITC, for approximately $5.2 million in cash and the assumption of certain liabilities, including trade payables of approximately $583,000, certain capital lease obligations of $56,000 and product warranty obligations estimated at $30,000. Of the cash payment, $758,000 was placed in escrow by ITC and was restricted from the Company’s use for 180 days to cover any shortfall in collected receivables or any indemnification claims. Amounts remaining in escrow at December 31, 2003, after deducting escrow account fees and $33,000 in trade payables assumed by ITC in excess of an established $550,000 ceiling, approximated $720,000 and were recorded as restricted cash and a deferred credit in current liabilities. Based upon a review of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” the Company assessed the measurement date for the sale transaction as the date of shareholder approval, which occurred on September 19, 2003. As prescribed by SFAS No. 144, the Company began reporting the results of operations of the intermittent testing business as discontinued operations effective with the quarter ended September 30, 2003, for all periods presented. Upon completion of the sale transaction in September, the Company recorded a gain on the sale of the intermittent testing business of $1.8 million. In late March 2004, sale proceeds remaining in escrow and deferred for recognition were released to the Company, amounting to approximately $713,000. After deducting transaction costs of $156,000, an additional gain on the sale of discontinued operations was recognized in the first quarter 2004 of approximately $557,000.

     Following are summary operating results of the intermittent testing business, included in discontinued operations in the Company’s Consolidated Statements of Operations for the respective periods:

     The carrying value of assets sold to ITC, consisting primarily of accounts receivable, inventory and property and equipment, approximated $3.0 million, and liabilities assumed by ITC totaled approximately $669,000.

     The assets and liabilities of the discontinued operations at December 31, 2004 are as follows:

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(4) COMPONENTS OF SELECTED BALANCE SHEET ACCOUNTS

     Approximately $720,000 of the proceeds from the sale of the Company’s intermittent testing business remained in escrow at December 31, 2003 and were restricted from the Company’s use for 180 days after the closing date to fund indemnification obligations. In late March 2004, sale proceeds remaining in escrow and deferred for recognition were released to the Company, amounting to approximately $713,000. After deducting transaction costs of $156,000, an additional gain on the sale of discontinued operations was recognized in the first quarter 2004 of approximately $557,000.

(5) BORROWINGS

     Long-term debt at December 31, 2004 and 2003 consisted of the following:

The following is a schedule of principal payments for long-term debt:

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CONVERTIBLE SENIOR SECURED NOTES

     On December 14, 2004, the Company entered into a subscription agreement with certain institutional investors (the “Subscribers”) for a new round of financing for the Company of up to $3,000,000. On December 15, 2004, the Company received the first tranche of $1,800,000 in gross proceeds. The notes, Convertible Senior Notes are due December 15, 2007, with principal and interest payable in cash or registered shares over a 32-month period beginning 120 days after closing. The Subscribers also received a due diligence fee of $180,000. Interest on the notes is at prime plus 4% with a floor of 8% (9.25% at December 31, 2004). The conversion price of the notes is fixed at $0.02 per share, subject to adjustment depending upon the market price of the Company’s common stock. Of the total 90,000,000 shares that the debt is convertible into, 80,000,000 shares had been reserved at December 31, 2004, with the remaining 10,000,000 being allocated when additional shares of stock are authorized by the Company shareholders (see subsequent events note).

     The Subscribers also received warrants (the “Warrants”) to purchase up to 45,000,000 shares of the Company’s common stock at an exercise price of $0.025 per share in the first tranche, and will receive additional warrants to purchase up to 30,000,000 shares if the second tranche is funded. The Warrants expire on December 15, 2009.

     The Company determined the relative fair value of the debt was $2,627,588 and $1,549,318 for the warrants. The Company allocated $1,018,980 and $601,020 of the net proceeds totaling $1,620,000 to the debt and warrants, respectively. The application of the provisions of EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments” resulted in the calculation of an embedded beneficial conversion feature in the Convertible Senior Notes, which is required to be treated as an additional discount to the debt. The value of the beneficial conversion feature of $1,018,980 was limited to the amount allocated to the debt. $16,010 of the beneficial conversion feature was amortized into interest expense for the year ended December 31, 2004.

     The relative fair value of the warrants issued were determined using the Black-Scholes option-pricing model based on the following assumptions: volatility of 116%, expected life of 5 years, risk free interest rate of 3.53% and no dividends. The effective interest rate on the notes is approximately 193%.

     The Subscribers received a first lien on all of the assets of the Company. The holders of the Company’s previously issued convertible senior secured fixed rate notes due August 4, 2005 (the Convertible Subordinated Notes), consented to the new financing and the subordination of their secured position to a second lien on all of the assets of the Company in consideration for an amendment of the conversion price of the Convertible Subordinated Notes to $0.02 per share and the amendment of the exercise price of their outstanding warrants to purchase up to 4,255,837 shares of the Company’s common stock to $0.025 per share. See below for the recording of the amendment to the Convertible Subordinated Notes. Preferred stock warrants outstanding to purchase up to 17,555,589 shares of the Company’s common stock were also amended to reduce the exercise price thereof to $0.025 per share, of which certain warrants outstanding to purchase up to 12,000,000 shares of the Company’s common stock were further amended to reduce the exercise price thereof to $0.01 per share. See note 6 for discussion related to the accounting for the modification of these warrants.

CONVERIBLE SUBORDINATED NOTES

     On August 4, 1998, the Company issued Convertible Subordinated Notes with proceeds aggregating $7,300,000. Subsequent to the date of issuance the terms of the Convertible Subordinated Notes have been renegotiated. With the issuance of the Convertible Senior Notes on

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December 15, 2004, the Convertible Subordinated Note holders agreed to subordination of their senior position. In addition, they agreed to defer all principal and interest payments until after the Convertible Senior Notes were repaid. For these concessions, the Convertible Subordinated Note holders received a reduction in the conversion rate of their debt from $3.51 to $0.02 and a reduction in the exercise price of previously issued warrants from $0.09 to $0.025. Of the 360,000,000 shares of common stock the Convertible Subordinated Notes are convertible into, only 2,013,431 shares were allocated for potential conversion at December 31, 2004. Additional shares were to be allocated when additional shares of the Company stock was authorized by the Company (see the subsequent events note). This transaction required accounting treatment prescribed under EITF 96-19, “Debtors Accounting for a Modification or Exchange of Debt Instruments.” As such, the modified notes were recorded at its fair value of $8,295,112. The increase of $1,670,683 was recorded in other income as a loss on modification of the notes.

     With the decrease in the conversion price of the debt, the Company applied the provisions of EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments”. This resulted in the calculation of an embedded beneficial conversion feature in the Convertible Subordinated Notes, which is required to be treated as an additional discount to the debt. The value of the beneficial conversion feature of $7,300,000 was recorded as a discount to the debt. $40,269 of the beneficial conversion feature was amortized into interest expense for the year ended December 31, 2004. The remaining balance will be amortized into interest expense in the first quarter of 2005.

     The reduction in the exercise price increased the value of the warrant by $32,131. The increased value in warrants was recorded as a discount to the debt with an offsetting amount recorded to accumulated paid-in capital.

     The notes have a stated interest rate of 7% for principal balances that are not past due and 9% on the principal balances that have been deferred and accrued interest.

     Effective April 7, 2003, the Company completed the renegotiation of the terms of the Convertible Subordinated Notes, to extend repayment of the notes to August 4, 2005. In exchange for the extension of repayment, the Company agreed to reduce the conversion price for $6.9 million principal value of the notes from $8.40 to $3.51 per share, and to use 50% of the net proceeds in excess of $10 million received prior to August 4, 2005 from the issuance of any equity securities to pay down the principal value of the notes. In addition, the Company issued the note holders five-year warrants for 4,255,837 shares of its common stock at an exercise price of $.94 per share. This transaction required accounting treatment prescribed under EITF 96-19, “Debtors Accounting for a Modification or Exchange of Debt Instruments.” As such, the modified notes and associated warrants were recorded in debt and equity, respectively, at their respective fair values of $5 million and $800,000. The $7.3 million carrying value of the original notes was retired, and the residual amount of $1.5 million was recorded in the second quarter 2003 in other income as a gain on modification of the notes. The Company is accreting the initial $5 million carrying value of the modified notes to their redemption value of $7.3 million over the remaining term of the notes using the effective interest method at an effective interest rate of approximately 17%. This will result in the recording of $2.3 million of additional interest expense over the remaining term of the notes, of which $632,142 was recorded during 2003.

     In August 2003, the Convertible Subordinated Note holders agreed to further amend the Note Purchase Agreement to defer the timing of interest payments on the notes for the first and second quarters of 2003, amounting to approximately $254,000, as well as increase their security position to include all unencumbered assets of the Company. The deferred interest was fully paid to the note holders in September 2003. In January 2004, the note holders agreed to further amend the Note Purchase Agreement effective December 30, 2003 to defer the timing of interest payments due for the fourth quarter 2003 and the first quarter 2004, amounting to approximately $256,000, to June 30, 2004, and to reduce the exercise price on the warrants from $.94 per share to $.34 per share.

     In connection with the Series G preferred stock financing completed in May 2004, the Convertible Subordinated Note holders agreed to again amend the Note Purchase Agreement to defer until December 31, 2004 the Company’s obligation to make interest payments previously

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due on June 30, 2004 (including the deferred interest payments described above) and September 30, 2004, amounting to approximately $640,000. In exchange for the deferral of interest payments, the exercise price on the note holders’ common stock warrants was further reduced from $.34 per share to $.09 per share. The first and second quarter reductions in the exercise price of the warrants resulted in an increase in the fair value of the warrants of $90,674 and $70,517, respectively. These amounts were recorded as a charge to interest expense with an offsetting credit to additional paid-in capital in the respective quarter. The Company evaluated the appropriate accounting treatment for the modification of the terms of the convertible notes and associated warrants and determined that the provisions of SFAS No. 15, “Accounting for Debtors and Creditors for Troubled Debt Restructurings,” and EITF 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments,” were not applicable.

(6) CONVERTIBLE PREFERRED STOCK

     The following is a summary the status of the Company’s preferred stock as of December 31, 2004 and 2003:

SERIES G CONVERTIBLE PREFERRED STOCK

     On May 28, 2004, the Company completed a $1.5 million financing through the sale of 15,000 shares of Series G convertible preferred stock at $100 per share. The financing was completed in a private placement with the Mercator Advisory Group and its related funds and BCC Acquisition II, LLC. The Mercator Advisory Group and its related funds were also the investors in the Company’s Series E and Series F convertible preferred stock issued in May 2003 and January 2004, respectively. Each share of the Series G preferred stock is convertible at any time into common stock at 75% of the volume weighted average trading price of the lowest three inter-day trading prices of the common stock during the five consecutive trading days preceding the conversion date, with a maximum exercise price of $.14 per share and a minimum price of $.06 per share. The minimum exercise price was decreased automatically to $.03 per share after the shareholders of the Company authorized an increase in common stock from 100 million shares to 200 million shares on September 7, 2004.

     The Series G financing effectively replaced the unfunded second tranche of the Series F preferred stock financing arranged in January 2004. As expected, the first $1.5 million tranche of financing generated in January 2004 under the Series F preferred stock agreement and other available funds had been substantially consumed by operations by the time the Series G financing was completed. This additional financing was necessary to help meet near-term funding requirements for support of the Company’s operations as the Company continued to

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pursue longer-term financing in order to sustain the development of its continuous monitoring business and explore additional applications of its technology.

     As part of this financing, the Company issued three-year warrants (“Series G warrants”) to the purchasers of the Series G preferred stock. Those warrants entitle the holders to purchase an aggregate of 1,250,000 shares of the Company’s common stock at the lower of $.11 per share or the average of the lowest ten inter-day closing prices of the Company’s common stock during the ten trading days preceding the exercise date. The Company also issued three-year warrants to the Mercator Advisory Group and its related funds that invested in the Company’s Series E and Series F preferred stock to purchase an aggregate of 12,241,608 shares of common stock at $.05 per share.

     In connection with the Series G financing, the holders of the Company’s Convertible Subordinated Notes agreed to defer until December 31, 2004 the Company’s obligation to make interest payments previously due on June 30, 2004 (including interest payments originally due on December 31, 2003 and March 31, 2004, payment of which was deferred until June 30, 2004) and September 30, 2004. In exchange for the deferral of interest payments, the exercise price on the note holders’ common stock warrants was reduced from $.34 per share to $.09 per share (see note 5). Additionally, in connection with the Series G financing, the exercise price of the outstanding common stock warrants issued as part of the Series E preferred stock financing was reduced from $.35 per share to $.11 per share, and the ceiling price for the exercise of the common stock warrants issued as part of the Series F preferred stock financing was reduced from $.35 per share to $.11 per share (see below for additional discussion).

     Accounting for these transactions required a review of several criteria, including assessment of the treatment of the beneficial conversion feature associated with the Series G preferred stock, an assessment of the classification as debt or equity of the warrants issued in connection with the Series G preferred stock financing, an assessment of the impact of the changes in the exercise and ceiling exercise prices, as applicable, of the common stock warrants previously issued to the note holders and the Series E and Series F preferred stock investors and an assessment of the treatment of the fair value associated with the new warrants issued to the Series E and Series F preferred stock investors.

     The application of the provisions of EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments” resulted in the calculation of an embedded beneficial conversion feature in the Series G preferred stock, which is required to be treated as increase in the net loss available to common shareholders. The Company allocated the net investor proceeds of $1,445,000 from the issuance of the Series G convertible preferred stock to the preferred stock and Series G warrants based upon their relative fair values. The fair value allocated to the Series G warrants of $68,205 was recorded as equity. The fair value allocated to the preferred stock of $1,376,795 and the original conversion terms were used to calculate the value of the beneficial conversion feature of $1,067,650 at the date of issuance of the Series G preferred stock. The $1,067,650 was charged to retained earnings with the offsetting credit to additional paid-in-capital. The Company treated the beneficial conversion feature of $1,067,650 as a reconciling item on the statement of operations to adjust its reported net loss to “net loss available to common shareholders”. As a result of the decrease in the conversions rate to $.03 per share, the Company increased the value of beneficial conversion feature to $1,280,216 which was limited to the amount of proceeds allocated to the Series G preferred stock. Additionally, the Company treated the beneficial conversion feature of $1,280,216 as a reconciling item on the statement of operations to adjust its reported net loss to “net loss available to common shareholders,” which is used in the numerator in the loss per share calculation for the year ended December 31, 2004.

SERIES F CONVERTIBLE PREFERRED STOCK

     On January 16, 2004, the Company completed the sale in a private placement of 15,000 shares of Series F convertible preferred stock at a price of $100 per share, resulting in aggregate gross proceeds to the Company of $1.5 million. Each share of preferred stock is convertible at any time into common stock at 75% of the volume weighted average trading price of the lowest three inter-day trading prices of the common stock for the five consecutive trading days preceding the conversion date, but at an exercise price of no more than $.25 per share and

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no less than $.20 per share. In accordance with the terms of the Series F preferred stock agreement, the floor conversion price was reduced to $.15 per share effective June 30, 2004, due to the Company’s inability to achieve a six-month cash flow projection through that date. Five-year warrants were also issued to purchase an aggregate of 6,000,000 shares of the Company’s common stock at the lower of $.35 per share or the average of the lowest ten inter-day closing prices of the Company’s common stock on the Over-the-Counter Bulletin Board during the 10 trading days immediately preceding the exercise date. As discussed in note 2, the ceiling exercise price on the Series F warrants was reduced from $.35 to $.11 per share in connection with the Series G preferred stock financing transaction completed in May 2004. Proceeds from the Series F interim financing were used to help meet the Company’s short-term funding requirements for support of its operations.

     Accounting for this transaction falls primarily under EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments.” The Company allocated the net investor proceeds of $1,350,000 from the issuance of the Series F convertible preferred stock to the preferred stock and associated warrants based upon their estimated relative fair values. The resulting fair value allocations of $665,994 and $684,006 for the preferred stock and warrants, respectively, were recorded as equity in the first quarter 2004. The beneficial conversion feature embedded in the preferred stock was calculated at $665,994 and was limited to the fair value allocated to the preferred stock. The beneficial conversion feature of $665,994 was treated as a deemed dividend to preferred shareholders, and was charged to retained earnings, with the offsetting credit to additional paid-in-capital. Additionally, the Company treated the beneficial conversion feature of $665,994 as a reconciling item on the statement of operations to adjust its reported net loss to “net loss available to common shareholders,” which is used in the numerator in the loss per share calculation for the year ended December 31, 2004.

SERIES E CONVERTIBLE PREFERRED STOCK

     On May 12, 2003, the Company completed a $1.5 million financing through the sale of 15,000 shares of Series E convertible preferred stock at a price of $100 per share. The preferred stock is convertible at any time into the Company’s common stock at 88% of the volume weighted average trading price of the common stock for the five consecutive trading days before the conversion date, subject to a maximum and minimum conversion price of $.75 per share and $.35 per share, respectively. The preferred stock is callable by the Company during the first 12 months at the original purchase price plus a return of 2% per month from the date of investment, and 50% could be put back to the Company in the event of the Company’s completion of the sale of its intermittent testing business, at the original purchase price plus a return of 1% per month. Effective upon the sale of the Company’s intermittent testing business, the holders of the Series E preferred stock elected to exercise their option to put back to the Company 50% of their original $1.5 million investment plus a return of 1% per month.

     Five-year warrants to purchase 735,000 shares of the Company’s common stock at $.35 per share were also issued in conjunction with the financing. The warrants are exercisable after the conversion of the preferred stock. Accounting for this transaction falls primarily under EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments.” The Company allocated the net investor proceeds of $1,350,000 from the issuance of the Series E convertible preferred stock to the preferred stock and associated warrants based upon their estimated relative fair values. The resulting fair value allocations of $958,962 and $391,038 for the preferred stock and warrants, respectively, were recorded as equity in the second quarter 2003.

     The beneficial conversion feature embedded in the preferred stock was calculated at $958,962 and was limited to the fair value allocated to the preferred stock. The beneficial conversion feature of $958,962 was treated as a deemed dividend to preferred shareholders, and was charged to retained earnings, with the offsetting credit to additional paid-in-capital. Additionally, the Company treated the beneficial conversion feature of $958,962 as a reconciling item on the statement of operations to adjust its reported net loss to “net loss available to common shareholders,” which is used in the numerator in the loss per share calculation for the year ended December 31, 2003.

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PREFERRED STOCK WARRANTS

     Subsequent to the preferred stock financings described above, the exercise price of the warrants to purchase common stock issued with the preferred stock were adjusted downward during 2004 as a result of the issuance of the Series G financing and the new Convertible Senior Notes. In addition new warrants to purchase 12,241,608 shares of common stock were issued to the Series E and Series F investors as a result of the Series G financing. The new financing reduced the exercise price of warrants to purchase 5,555,589 shares of common stock to $.025 per share and warrants to purchase 12,000,000 shares of common stock to $.01 per share The reductions in the exercise price or ceiling exercise price, as applicable, of the warrants previously issued to these investors and the issuance of new warrants to purchase additional shares of common stock resulted in a deemed dividend on the Series E, F and G preferred stock, requiring a charge to retained earnings and an offsetting credit to additional paid-in capital aggregating $1,211,247. Similar to the beneficial conversion features discussed above, this amount was charged to retained earnings, with an offsetting credit to additional paid-in-capital, and was treated as a reconciling item on the statement of operations to adjust the reported net loss to “net loss available to common shareholders,” which is used in the numerator in the loss per share calculation for the year ended December 31, 2004.

     The Company classified the warrants issued in connection with the Series E, F and G preferred stock financing as equity rather than debt based upon an assessment of the Company’s contractual obligations for registration of the related common shares issuable upon exercise of the warrants as provided under EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”

(7) STOCK OPTIONS, WARRANTS AND RESTRICTED STOCK

     The Company’s 1990 Stock Option Plan provides for the grant of incentive stock options, non-qualified stock options, stock appreciation rights, restricted stock awards and performance awards for the purchase or issuance of up to 5,200,000 shares of common stock to Company employees, directors and consultants.

     In July 2002, the Compensation Committee of the Company’s Board of Directors approved retention agreements for certain of the Company’s key employees. The agreements became effective August 1, 2002 and provided for the grant under the 1990 Stock Option Plan of 329,885 restricted shares of the Company’s Common Stock as an incentive to the employees to remain in the employ of the Company and put forth maximum efforts for the success of the Company. The agreements provide for vesting of 50% of the shares on August 1, 2003, and vesting of the remaining 50% on August 1, 2004, provided the employee remains employed by the Company. The fair value of the restricted shares on the date of grant, August 1, 2002, was $824,711, which was recognized as restricted stock with a corresponding charge to deferred compensation, a contra equity account. The Company is recognizing the deferred compensation as expense ratably over the two-year vesting period. Compensation expense related to these shares was $340,496 in 2003 and $171,815 in 2002.

     Under the terms of the retention agreements, in the event of involuntary termination, including transfer of employees to ITC, 50% of a participant’s restricted shares vest if termination occurs prior to August 1, 2003 and a pro rata portion of shares vest for each full month of employment if termination occurs on or after August 1, 2003. The retention agreements require cancellation of remaining unvested shares. As a result of the sale of the Company’s intermittent testing business to ITC, and also due to involuntary employee terminations in the Company’s continuing operations, 87,483 restricted shares previously granted to participating employees were cancelled as of September 30, 2003. This resulted in the retirement of approximately $219,000 of common stock and additional paid-in capital and a corresponding reduction in deferred compensation as of September 30, 2003.

     The Company’s 1993 Directors’ Stock Option Plan, which provided for annual and discretionary grants to non-employee directors of the Company of non-qualified stock options, expired during 2003 in accordance with its terms. The Company’s shareholders approved an amendment to the 1990 Stock Option Plan in May 2003 to modify the eligibility requirements for participation in that plan in order to allow nonemployee directors to participate and become eligible to receive awards or options under the 1990 Stock Option Plan. While no grants were

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made from the 1993 Directors’ Plan during 2004 and 2003, outstanding options under that plan remain exercisable under their original terms.

     Under the plans, the option price is equal to the fair value on the date of grant. Under the 1990 Stock Option Plan, options become exercisable over varying periods and terminate up to ten years from the date of grant. Under the 1993 Directors’ Stock Option Plan, initial grants of options to new directors became exercisable over a three-year period and terminate ten years from the date of grant. Annual grants to directors vested six months after the date of grant. At December 31, 2004, 578,490 shares were available for grant under the 1990 Stock Option Plan.

     Summarized below is the status of the Company’s stock option plans as of December 31, 2004, 2003 and 2002 and changes during those years: