FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

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

For the quarterly period ended June 30, 2003

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

For the transition period from to

Commission file number 1010397

PHYSIOMETRIX, INC.

(Exact name of registrant as specified in its charter)

Delaware		77-0248588
(State or other jurisdiction of incorporation or organization)		(IRS Employer identification No.)

Five Billerica Park, N. Billerica, MA		01862-1256
(Address of principal executive offices)		(Zip code)

(978) 670-2422
(Registrant’s telephone number, including area code)

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.

ITEM 1 - Yes ý No o

ITEM 2 - Yes ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yeso No ý

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.

Class		Outstanding at July 31, 2003
Common Stock, $.001 par value		8,422,994

PHYSIOMETRIX, INC.

TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION

Item 1			Unaudited Condensed Financial Statements

			Unaudited Condensed Balance Sheets as of December 31, 2002 and June 30, 2003

			Unaudited Condensed Statements of Operations for the Three and Six Months Ended June 30, 2002 and 2003

			Unaudited Condensed Statements of Cash Flows for the Six Months Ended June 30, 2002 and 2003

			Notes to Unaudited Condensed Financial Statements

Item 2			Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3			Quantitative and Qualitative Disclosures about Market Risk
Item 4			Controls and Procedures

PART II	OTHER INFORMATION

Item 1		Legal Proceedings
Item 2		Changes in Securities
Item 3		Defaults upon Senior Securities
Item 4		Submission of Matters to a Vote of Security Holders
Item 5		Other Information
Item 6		Exhibits and Reports on Form 8-K

SIGNATURES

EXHIBIT INDEX

PHYSIOMETRIX, INC.
UNAUDITED CONDENSED BALANCE SHEETS

	December 31 2002			June 30 2003
ASSETS
Current assets:
Cash and cash equivalents	$	2,690,042		$	1,405,668
Short-term investments	1,243,875			—
Accounts receivable, net	61,206			100,052
Inventories	1,331,435			1,388,717
Prepaid expenses	114,002			215,652
Total current assets	5,440,560			3,110,089

Property, plant and equipment	1,326,979			1,334,907
Less allowances for depreciation	(959,528		)	(1,078,678		)
	367,451			256,229

Total assets	$	5,808,011		$	3,366,318

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	58,332		$	122,709
Accrued expenses	401,394			352,332
Total current liabilities	459,726			475,041

Stockholders’ equity
Preferred stock: $.001 par value; 10,000,000 shares authorized; none issued and outstanding	—			—
Common stock: $.001 par value; 50,000,000 shares authorized; 8,422,994 shares issued and outstanding	8,423			8,423
Additional paid-in capital	56,945,035			56,975,910
Deferred compensation	(4,469		)	(6,094		)
Accumulated other comprehensive income	2,360			—
Accumulated deficit	(51,603,064		)	(54,086,962		)
Total stockholders’ equity	5,348,285			2,891,277

Total liabilities and stockholders’ equity	$	5,808,011		$	3,366,318

See accompanying notes

PHYSIOMETRIX, INC.
UNAUDITED CONDENSED STATEMENTS OF OPERATIONS

	Three Months Ended June 30						Six Months Ended June 30
	2002			2003			2002			2003

Revenues	$	91,293		$	200,524		$	183,600		$	439,268

Costs and expenses:
Cost of products sold	310,320			331,130			537,480			671,246
Research and development	682,998			426,615			1,502,215			797,424
Selling, general and administrative	791,178			743,042			1,582,881			1,470,573
	1,784,496			1,500,787			3,622,576			2,939,243

Operating loss	(1,693,203		)	(1,300,263		)	(3,438,976		)	(2,499,975		)

Interest income	31,072			5,834			76,057			16,077

Net loss	$	(1,662,131	)	$	(1,294,429	)	$	(3,362,919	)	$	(2,483,898	)

Basic and diluted net loss per common share	$	(0.20	)	$	(0.15	)	$	(0.40	)	$	(0.29	)

Shares used in computing basic and diluted net loss per common share	8,422,299			8,422,994			8,422,126			8,422,994

See accompanying notes.

PHYSIOMETRIX, INC.
UNAUDITED CONDENSED STATEMENTS OF CASH FLOWS

	Six Months Ended June 30
	2002			2003
Operating activities:
Net loss	$	(3,362,919	)	$	(2,483,898	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	117,416			119,150
Stock-based compensation in connection with issuance of stock options to consultants	(18,729		)	29,250
Changes in operating assets and liabilities:
Accounts receivable	(1,451		)	(38,846		)
Inventories	16,953			(57,282		)
Prepaid expenses	(136,987		)	(101,650		)
Accounts payable and accrued expenses	(966,069		)	15,315
Net cash used in operating activities	(4,351,786		)	(2,517,961		)

Investing activities:
Purchase of equipment	(30,593		)	(7,928		)
Purchase of short-term investments	(2,034,888		)	—
Proceeds from maturity of short-term investments	7,980,621			1,241,515
Net cash provided by investing activities	5,915,140			1,233,587

Financing activities:
Proceeds from issuance of common stock	651			—
Net cash provided by financing activities	651			—

Net increase (decrease) in cash and cash equivalents	1,564,005			(1,284,374		)
Cash and cash equivalents at beginning of period	2,730,460			2,690,042

Cash and cash equivalents at end of period	$	4,294,465		$	1,405,668

See accompanying notes.

PHYSIOMETRIX, INC.
Notes to Unaudited Condensed Financial Statements

Note 1 - Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and in accordance with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.

Operating results for the interim periods presented are not necessarily indicative of the results that may be expected for the year ending December 31, 2003 or any other interim period. The accompanying financial statements should be read in conjunction with the audited financial statements for the period ended December 31, 2002 included in our form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 28, 2003.

Note 2 – Going Concern

Physiometrix, Inc. (the “Company) is subject to numerous risks and uncertainties, including the need to raise additional capital to fund operations, research and development efforts and commercialization of its products. Since its inception, the Company has incurred cumulative losses of approximately $54.1 million, including losses of approximately $ 2.5 million during the six months ended June 30, 2003, $5.5 million during the year ended December 31, 2002 and $12.0 million during the year ended December 31, 2001. The Company’s principal source of liquidity at June 30, 2003 consists of cash, cash equivalents and short-term investments, which aggregate $1.4 million. The Company believes that cash on hand coupled with anticipated cash flows from operations, which are dependent on sales of inventory to its distributor, Baxter, will be sufficient to conduct operations until February 2004, however, there is a risk management may not meet its plan and may need sources of liquidity prior to February 2004. The Company is significantly dependent on Baxter for sale of its inventories and has not provided any additional inventory valuation reserves based upon Baxter's current intention to purchase such inventories, although Baxter is not under any obligation to do so. In the event such sales do not materialize, the Company will assess the need to write down its inventories to net realizable value during such periods, and additionally, the Company's cash flows will be negatively impacted. These factors raise substantial doubt about the Company’s ability to continue as a going concern. Management is actively pursuing several sources of additional financing, including debt or equity financings, to address this uncertainty. There can be no assurances that management can secure additional financing under terms that are acceptable to the Company or at all. These financial statements do not include any adjustments that might result from the outcome of this uncertainty.

The Company believes that the success of the PSA 4000 is the most critical component to the Company’s ability to continue as a going concern. The Company’s plan for 2003 is to support the activities of its partner, Baxter Healthcare Corporation (“Baxter”), in the commercialization of the PSA 4000 with the new PSArray2. The PSArray2 is a new frontal-only array sensor that received FDA 510(k) approval in October of 2002. The Company will also continue development of the next generation monitor for sale beyond the PSA 4000. The Company will be prepared to sell product to Baxter to support its operations and will attempt to complete a debt or equity financing prior to depleting its cash resources. The Company will make every attempt to conserve its cash resources and continue as a business. Although management and the current investors of the Company do not have any intention of liquidating the business, the Company

would consider a sale of the technology if its cash constraints do not allow it to execute its plan. The Company is aware of one other company with similar products to the PSA 4000. The Company does not believe it will be at a significant disadvantage in marketing its products against that company.

Note 3 - Stock Based Compensation

The Company has adopted the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of Financial Accounting Standards Board (FASB) Statement No. 123”. The Statement requires prominent disclosures in both annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company applies the principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its Plans. Under APB No. 25, compensation expense is measured as the difference, if any, between the option exercise price and the fair value of the Company’s common stock at the date of grant. The Company has historically granted options to employees and directors at exercise prices equal to the fair value of the Company’s common stock. Accordingly, no compensation expense has been recognized for its employee stock-based compensation plans.

SFAS No. 123, “Accounting for Stock-Based Compensation,” establishes a fair value based approach for valuing stock options. The Company follows the disclosure-only alternative afforded by SFAS No. 123. Had compensation costs for stock options issued to employees and directors been determined based on the estimated fair value at the grant dates as calculated in accordance with SFAS No. 123, the Company’s reported net loss and basic and diluted net loss per common share for the three and six months ended June 30, 2002, and 2003 would have been adjusted to the pro forma amounts indicated below:

	Three Months Ended June 30,						Six Months Ended June 30,
	2002			2003			2002			2003
Net loss as reported	$	(1,662,131	)	$	(1,294,429	)	$	(3,362,919	)	$	(2,483,898	)
Pro forma compensation expense	(146,545		)	(155,173		)	(345,381		)	(311,776		)
Pro forma net loss	$	(1,808,676	)	$	(1,449,602	)	$	(3,708,300	)	$	(2,795,674	)

Basic and diluted loss per share:
As reported	$	(0.20	)	$	(0.15	)	$	(0.40	)	$	(0.29	)
Pro forma	$	(0.21	)	$	(0.17	)	$	(0.44	)	$	(0.33	)

The average estimated fair value of options granted during the three month period ended June 30, 2002, was $1.16, and there were no options granted during the three month period ended June 30, 2003. The average estimated fair value of options granted during the six month periods ended June 30, 2002, and 2003 were $1.20 and $0.48, respectively, and was estimated using the Black-Scholes option-pricing model using the following weighted-average assumptions:

	2002	2003
Dividend yield	0%	0%
Volatility	122%	127%
Risk-free interest rate	4.10%	3.21%
Expected life (years)	5.5	5.5

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the use of highly subjective assumptions, including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective assumptions can materially affect the fair value estimates, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock-based compensation.

Note 4 – Recent Accounting Pronouncements

In April 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 145, Recission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13 and Technical Corrections. This statement eliminates extraordinary accounting for a gain or loss reported on the extinguishment of debt and amends other existing authoritative pronouncements to make technical corrections, clarify meanings or describe their applicability under changed conditions. The provisions of this standard were effective for the Company with the beginning of fiscal 2003 and the adoption of this standard has not had a material impact on the Company’s overall financial position or results of operations.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and rescinds EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). This Statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of SFAS No. 146 are effective for exit and disposal activities that are initiated after December 31, 2002. The adoption of this standard has not had a material impact on the Company’s overall financial position or results of operations.

In January, 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, (FIN 46) to clarify the conditions under which assets, liabilities and activities of another entity should be consolidated into the financial statements of a company. FIN 46 requires the consolidation of a variable interest entity by a company that bears the majority of the risk of loss from the variable-interest entity’s activities, is entitled to receive a majority of the variable-interest entity’s residual returns or both. The provisions of FIN 46 are required to be adopted by the Company in fiscal 2003. The Company does not believe the adoption of FIN 46 will have a material impact on its overall financial position or results of operations.

Note 5 – Significant Accounting Policies

Inventories

Inventory is recorded at the lower of cost (first-in, first-out) or market, and consists of the following:

	December 31, 2002		June 30, 2003
Purchased components	$	961,444	$	545,681
Work in process	39,685		24,550
Finished units	330,306		818,486
	$	1,331,435	$	1,388,717

We review our inventories for excess and obsolete inventory on a periodic basis and provide a reserve to write down inventory to its net realizable value.

Revenue Recognition

We recognize revenue for product sales upon shipment, net of allowances for discounts and estimated returns which are also provided for at the time of shipment in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements.

Net Loss Per Common Share

Basic net loss per common share is computed based on the weighted average common shares outstanding for the three and six months ended June 30, 2002 and 2003. Diluted net loss per common share is the same as basic net loss per common share since the inclusion of common stock equivalents (the effect of stock options) would be anti-dilutive on the net loss.

Comprehensive Loss

SFAS No. 130, Reporting Comprehensive Income, establishes standards for the reporting and display of comprehensive loss and its components in financial statements. The Company’s accumulated other comprehensive income is comprised primarily of net unrealized gains or losses on available-for-sale securities. Comprehensive loss is computed as follows:

	Three Months Ended June 30,						Six Months Ended June 30,
	2002			2003			2002			2003
Net loss	$	(1,662,131	)	$	(1,294,429	)	$	(3,362,919	)	$	(2,483,898	)
Net unrealized holding losses on investments	1,455			(985		)	(5,227		)	(2,360		)
Total comprehensive loss	$	(1,660,676	)	$	(1,295,414	)	$	(3,368,146	)	$	(2,486,258	)

Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of the financial condition and results of operations of Physiometrix should be read in conjunction with the Financial Statements and related Notes thereto included elsewhere in this Form 10-Q. This Report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual events or results may differ materially from those projected in the forward-looking statements as a result of the factors described herein in the Risk Factors section of this Report on Form 10-Q and in the documents incorporated herein by reference. Such forward-looking statements include, but are not limited to, statements concerning (i) business strategy; (ii) products under development; (iii) other products; (iv) marketing and distribution; (v) research and development; (vi) manufacturing; (vii) competition; (viii) government regulation especially as it relates to Food and Drug Administration (“FDA”) approvals; (ix) third-party reimbursement; (x) operating and capital requirements; (xi) clinical trials; and (xii) other factors that might be described from time to time in periodic filings with the Securities and Exchange Commission and include those set forth in this Quarterly Report on Form 10-Q as “Risk Factors”.

Overview

Since our inception in January 1990, we have been engaged primarily in the design and development and more recently the manufacture and sale of noninvasive, advanced medical products. Our products, which incorporate proprietary materials and electronics technology, are used in neurological monitoring applications. Our initial products were our e-Net headpiece and disposable HydroDot biosensors and custom electronics, which are packaged as the HydroDot NeuroMonitoring System. We also have an additional neurological monitoring product, the Patient State Analyzer (“PSA 4000”) which received FDA 510(k) approval on June 30, 2000. We received FDA 510(k) clearance on October 7, 2002, for the PSArray2, which is a new frontal-only disposable array sensor which attaches to and is used with our PSA 4000 consciousness-monitoring system. The introduction and successful commercialization of this product is critical to our success and near-term liquidity. We introduced this product at the annual American Society of Anesthesiologists meeting in October 2002.

We have a limited history of operations and have experienced significant operating losses since our inception. As of June 30, 2003, we had an accumulated deficit of approximately $54.1 million. The PSA 4000, PSArray2 and the HydroDot NeuroMonitoring System are currently our principal commercial products. We anticipate that our operating results will fluctuate on a quarterly basis for the foreseeable future due to several factors, including actions relating to regulatory and reimbursement matters, the extent to which our products gain market acceptance, introduction of alternative means for neurophysiological monitoring and competition. Results of operations will also be affected by the progress of clinical trials and in-house development activities, and the extent to which we establish distribution channels for our products domestically and internationally. Since the third quarter of 2000, substantially all of our sales were to Baxter Healthcare Corporation (“Baxter”). There can be no assurance we will achieve significant commercial revenues or profitability.

In May 2000, we entered into a distribution arrangement with Baxter for the exclusive distribution of our PSA 4000 in the United States. In February 2003, we entered into an amendment to our U.S distribution agreement with Baxter for the PSA 4000 consciousness monitoring system. The highlights of the enhanced agreement include:

• Targeted sales, marketing and product development milestones;

• Segmentation of the Operating Room (“OR”), Intensive Care Unit (“ICU”) and Interventional Sedation Unit (“ISU”) markets to enable us and Baxter to focus on the particular requirements of each market segment;

• Minimum-purchase requirements in the OR segment;

• Innovative marketing programs to promote our technology; and

• Expansion of the territory to include Canada

Under the amended agreement, if Baxter fails to meet minimum purchase commitments, we have the option to convert their distribution agreement into a non-exclusive relationship for the OR market segment. The term of the Baxter distribution agreement extends through March 2005, but is cancelable by either party upon specified notice after December 31, 2003. If Baxter does not meet minimum purchase requirements for the first milestone by September 15, 2003, which includes a sixty-day grace period, we will be able to revoke Baxter’s exclusivity if we choose to do so.

Critical Accounting Policies

In December 2001, the Securities and Exchange Commission requested that all registrants discuss their most “critical accounting policies” in Management’s Discussion and Analysis of Financial Condition and Operations. The Commission indicated that a “critical accounting policy” is one which is both important to the portrayal of the company’s financial condition and results, and requires management’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We believe the following accounting policies to be critical:

Use of Estimates

We prepare our financial statements in accordance with generally accepted accounting principles. These principles require that we make estimates and use assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates are made in connection with determining the market value of inventory, if lower than cost, establishing allowances for bad debts and warranty costs, and other accruals. Actual results could differ from those estimates.

Revenue Recognition

We recognize revenue for product sales upon shipment, net of allowances for discounts and estimated returns which are also provided for at the time of shipment in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements.

Inventories

Inventories are recorded at the lower of cost (first-in, first-out) or market. We review our inventories for excess and obsolete inventory on a periodic basis and provide a reserve to write down inventory to its net realizable value. We are significantly dependent on Baxter for sale of our inventories and have not provided any additional inventory valuation reserves based upon Baxter's current intention to purchase such inventories, although Baxter is not under any obligation to do so. In the event such sales do not materialize, we will assess the need to write down our inventories to net realizable value during such periods.

Results of Operations

Three Months Ended June 30, 2003 and 2002

Revenues

Revenues increased 120% to $201,000 for the three months ended June 30, 2003 from $91,000 for the three months ended June 30, 2002. This increase was primarily due to shipments to Baxter of the PSArray2 during the quarter ended June 30, 2003, which accounted for revenues of $96,000. The PSArray2, a new frontal-only disposable array sensor that attaches to and used with our PSA 4000 system, received FDA 510(k) clearance in October 2002, and therefore, there were no revenues related to the PSArray2 during the quarter ended June 30, 2002. The PSArray2 was developed in an effort to improve market acceptance of the PSA 4000. The introduction and successful commercialization of this product is critical to our future success. Because of our U.S. distribution agreement with Baxter for this product, we are significantly dependent upon Baxter for successful commercialization of this product. Sales of our HydroDot NeuroMonitoring products were relatively unchanged compared with the same period last year.

Cost of Products Sold

Cost of products sold increased 7% to $331,000 for the three months ended June 30, 2003 from $310,000 for the three months ended June 30, 2002. This increase was primarily due to costs associated with the shipments of the PSArray2 to Baxter during the second quarter of 2003. The PSArray2 received FDA 510(k) clearance in October 2002, and therefore, there were not any shipments of this product during the second quarter of 2002. This increase was partially offset by a reduction in direct headcount related expenses as a result of staff reductions undertaken during the period ended June 30, 2002. We have not provided any additional inventory reserve during the quarter based upon Baxter's intention to purchase the inventory. In the event that Baxter does not purchase the inventory, we will provide for the write-down of such inventory to its net realizable value as a consequence of not selling the inventory.

Gross Margin

The negative gross profit margin incurred during the three months ended June 30, 2003 and June 30, 2002 resulted from costs of the product incurred together with headcount and overhead costs required in our manufacturing department exceeding the reported revenues. The negative gross margin improved during 2003 due to the shipments of PSArray2 units during the three months ended June 30, 2003 along with a reduction in costs resulting from staff reductions undertaken during the second quarter of 2002. The PSArray2 units shipped were at a volume less than what was needed to cover fixed and variable costs in our manufacturing department. We expect costs of products sold to increase consistent with increases in revenues of the PSA 4000 in the remainder of 2003 based upon sales to Baxter in the third quarter of 2003.

Research and Development Expenses

Research and development expenses, consisting principally of headcount related expenses, clinical study costs and consulting fees, decreased 38% to $427,000 for the three months ended June 30, 2003 from $683,000 for the three months ended June 30, 2002. This decrease was primarily due to a decrease in outside consulting costs associated with development of the PSA 4000, as well as staff reductions and other discretionary expense reductions undertaken in the second quarter of 2002.

Selling, General and Administrative Expenses

Selling, general and administrative expenses decreased 6% to $743,000 for the three months ended June 30, 2003 from $791,000 for the three months ended June 30, 2002. This decrease was due to decreased headcount related expenses and outside consulting related to the commercialization of the PSA 4000.

Interest Income

Interest income decreased to $6,000 for the three months ended June 30, 2003 from $31,000 for the three months ended June 30, 2002. This decrease was due to lower average cash balances available for investment in 2003 along with lower interest rates.

Income Taxes

We have not provided for income taxes in any of the periods reported due to losses incurred during each of periods presented. At December 31, 2002, we had federal net operating loss carryforwards of approximately $40.5 million and research and development tax credit carryforwards of approximately $1.4 million that will expire in varying amounts through 2022, if not utilized. Utilization of net operating loss and tax credit carryforwards will be subject to substantial annual limitations provided by the Internal Revenue Code of 1986, as amended. The annual limitation may result in the expiration of net operating loss and tax credit carryforwards before full utilization.

Six Months Ended June 30, 2003 and 2002

Revenues

Revenues increased 139% to $439,000 for the six months ended June 30, 2003 from $184,000 for the six months ended June 30, 2002. This increase was primarily due to shipments to Baxter of the PSArray2 during the six-month period ended June 30, 2003, which accounted for revenues of $231,000. The PSArray2, a new frontal-only disposable array sensor that attaches to and used with our PSA 4000 system, received FDA 510(k) clearance in October 2002, and therefore, were no revenues related to the PSArray2 during the six months ended June 30, 2002. The PSArray2 was developed in an effort to improve market acceptance of the PSA 4000. The introduction and successful commercialization of this product is critical to our future success. Because of our U.S. distribution agreement with Baxter for this product, we are significantly

dependent upon Baxter for successful commercialization of this product. Sales of our HydroDot NeuroMonitoring products were relatively unchanged compared with the same period last year.

Cost of Products Sold

Cost of products sold increased 25% to $671,000 for the six months ended June 30, 2003 from $537,000 for the six months ended June 30, 2002. This increase was primarily due to the shipments of the PSArray2 to Baxter during the six months ended June 30, 2003. The PSArray2 received FDA 510(k) clearance in October 2002, and therefore, there were not any shipments of this product during the first six months of 2002. This increase was partially offset by a reduction in direct headcount related expenses as a result of staff reductions undertaken during the period ended June 30, 2002. We have not provided any additional inventory reserve during the quarter based upon Baxter's intention to purchase the inventory. In the event that Baxter does not purchase the inventory, we will provide for the write-down of such inventory to its net realizable value as a consequence of not selling the inventory.

Gross Margin

The negative gross profit margin incurred during the six months ended June 30, 2003 and June 30, 2002 resulted from costs of the product incurred together with headcount and overhead costs required in our manufacturing department exceeding the reported revenues. The negative gross margin improved during 2003 due to the shipments of PSArray2 units during the six months ended June 30, 2003 along with cost reductions associated with staff reductions undertaken during the second quarter of 2002. The PSArray2 units shipped were at a volume less than what was needed to cover fixed and variable costs in our manufacturing department. We expect costs of products sold to increase consistent with increases in revenues of the PSA 4000 in 2003 based upon sales to Baxter in the third quarter of 2003.

Research and Development Expenses

Research and development expenses, consisting principally of headcount related expenses, clinical study costs and consulting fees, decreased 47% to $797,000 for the six months ended June 30, 2003 from $1,502,000 for the six months ended June 30, 2002. This decrease was primarily due to a decrease in outside consulting costs associated with development of the PSA 4000, as well as staff reductions and other discretionary expense reductions undertaken in the second quarter of 2002.

Selling, General and Administrative Expenses

Selling, general and administrative expenses decreased 7% to $1,471,000 for the six months ended June 30, 2003 from $1,583,000 for the six months ended June 30, 2002. This decrease was due to decreased headcount related expenses and outside consulting related to the commercialization of the PSA 4000.

Interest Income

Interest income decreased to $16,000 for the six months ended June 30, 2003 from $76,000 for the six months ended June 30, 2002. This decrease was due to lower average cash balances available for investment in 2003 along with lower interest rates.

Income Taxes

Liquidity and Capital Resources

At June 30, 2003, our cash, cash equivalents and short-term investments were $1,406,000 as compared to $3,934,000 at December 31, 2002.

Our operating activities used cash of $2,518,000 in the six months ended June 30, 2003 as compared to $4,352,000 in the six months ended June 30, 2002. The decrease in net cash used in 2003 compared to 2002 was due to the reduced net loss coupled with a large decrease in accounts payable and accrued expenses that occurred during 2002.

Net cash provided by investing activities in the six months ended June 30, 2003 was $1,234,000 as compared with $5,915,000 provided in the six months ended June 30, 2002. The decrease was due to a decrease in the net proceeds from the sale of short-term investments of $4,704,218, partially offset by a decrease in equipment purchases in the amount of $22,665.

Our financing activities did not provide or use cash in the six months ended June 30, 2003, as compared to $651 of cash provided in the six months ended June 30, 2002.

Our principal source of liquidity at June 30, 2003 consists of cash, cash equivalents and short-term investments, which aggregate $1.4 million. We believe that cash on hand coupled with anticipated cash flows from operations, which are dependent on sales of inventory to our distributor, Baxter, will be sufficient to conduct operations until February 2004, however, there is a risk that we may not meet our plan and may need sources of liquidity prior to February 2004. We are significantly dependent on Baxter for sale of our inventories and have not provided any additional inventory valuation reserves based upon Baxter's current intention to purchase such inventories, although Baxter is not under any obligation to do so. In the event such sales do not materialize, we will assess the need to write down our inventories to net realizable value during such periods, and additionally, our cash flows would be negatively impacted. As a result, there is substantial doubt about our ability to continue as a going concern. We plan to raise capital through equity and/or debt issuance when, and if, such capital is available to us. There is no assurance that we will be able to raise additional capital on acceptable terms, or at all. Future equity financings may result in dilution to the holders of our common stock. Future debt financings may require us to pledge assets and to comply with financial and operational covenants. If additional amounts can not be raised and we are unable to substantially reduce our expenses, we would suffer material adverse consequences to our business, financial condition and results of operations and would likely be required to seek other alternatives up to and including protection under the United States bankruptcy laws or cessation of operations.

We believe that the success of the PSA 4000 is the most critical component to our ability to continue as a going concern. We intend to sell the PSA 4000 through our existing distributor, Baxter, in North America and pursue a distributor for rest of the world rights. Therefore, our

ability to generate additional revenues and commercialize the PSA 4000 is dependent upon our relationship with Baxter. Although management and our current investors do not have any intention of liquidating the business, we would consider a sale of our technology if, in 2003, our cash constraints would not allow us to execute our plan. We are aware of one other company with products similar to the PSA 4000. Such competitor has an FDA-cleared frontal array for its consciousness-monitoring system. We believe that we are not at a significant disadvantage in marketing our products against this company.

We have a $1.3 million investment in inventory related to the PSA 4000 system. The sale of this inventory will be subject to conditions that are generally outside our control. We are highly dependent upon the ability of Baxter, our exclusive distributor of the PSA 4000 in North America, to successfully market and sell our products. Market acceptance of the PSArray2, a new frontal-only disposable array sensor that attaches to and is used with our PSA 4000 system, is critical to the sale of the finished units that are currently in inventory. We submitted a 510(k) application for the commercial clearance of the PSArray2 on February 28, 2002 and received FDA 510(k) clearance for the PSArray2 on October 7, 2002. Based on our recent experience with units placements to our U.S. distributor, we believe that inventory units on hand included in our Balance Sheet at June 30, 2003 are fully realizable and are expected to be sold within the next twelve months. We have not provided any additional inventory reserve during the quarter based upon Baxter's intention to purchase the inventory. In the event that Baxter does not purchase the inventory, we will provide for the write-down of such inventory to its net realizable value as a consequence of not selling the inventory.

At December 31, 2002, we had available net operating loss carry forwards (NOL’s) of approximately $40.5 million available to offset future federal taxable income, if any. These NOL’s expire in varying amounts through 2022. At December 31, 2002, we also had research and development tax credit carry forwards of approximately $1.4 million available to offset future income taxes, if any, which expire in varying amounts through 2022. Since we have incurred only losses since our inception, and due to the degree of uncertainty related to the use of the loss and credit carry forwards, we have provided a full valuation allowance against these future tax benefits.

Risk Factors

You should carefully consider the risks described below before making an investment decision. We believe that the risks and uncertainties described below are the principal material risks facing us as of the date of this Form 10-Q. In the future, we may become subject to additional risks that are not currently known to us. If any of the following risks actually occur, our business, financial condition and operating results could be seriously harmed. As a result, the trading price of our common stock could decline, and you could lose all or part of the value of your investment.

We will need additional funds, and such funds may not be available on commercially reasonable terms when we need them.

We anticipate that our current cash, cash equivalents and short-term investments are adequate to maintain our current and planned operations until October 2003. As a result, there is substantial doubt about our ability to continue as a going concern. We believe if we can achieve revenues in the amount of $2.0 million during the remainder of 2003, we will have funds to conduct planned operations until February 2004. There can be no assurance, however, that these

revenues will be achieved. We plan to raise capital through equity and/or debt issuance when, and if, such capital is available to us. There is no assurance, however, that we will be able to raise additional capital on acceptable terms, or at all. If we cannot raise additional capital, we would suffer material adverse consequences to our business, financial condition and results of operations and would likely be required to seek other strategic alternatives up to and including the sale of our technology, filing for protection under the United States bankruptcy laws or ceasing operations.

We plan to continue to expend substantial funds for obtaining regulatory approvals, continuing sales and marketing activities and research and development. We may be required to expend greater than anticipated funds if unforeseen difficulties arise in the course of obtaining necessary regulatory approvals or in other aspects of our business. Our future liquidity and capital requirements will depend upon numerous factors, including actions relating to regulatory matters, and the extent to which the PSA 4000 gains market acceptance. Any additional financing, if required, may not be available on satisfactory terms or at all. Future equity financings may result in dilution to the holders of our common stock. Future debt financings may require us to pledge assets and to comply with financial and operational covenants.

We are dependent upon the PSA 4000, and if we are unable to introduce and successfully commercialize this product, our business will be seriously harmed.

Our business is completely dependent upon the PSA 4000. If we are unable to achieve widespread market acceptance for the PSA 4000, we will not be able to sustain or grow our business. In this event, our business and operating results would be seriously harmed and our stock price would likely decline.

During 2001, we began development of the PSArray2, which is a new frontal-only disposable array sensor that attaches to and is used with our PSA 4000 consciousness-monitoring system. The PSArray2 was developed in an effort to improve market acceptance of the PSA 4000. We submitted our FDA 510(k) application for the commercial clearance of the PSArray2 on February 28, 2002 and received FDA 510(k) clearance for the PSArray2 on October 7, 2002. The introduction and successful commercialization of this product is critical to our future success. We commercially introduced this product in October 2002 at the annual American Society of Anesthesiologists meeting and began shipments of this product to Baxter during the fourth quarter of 2002. Initial commercialization efforts for this product have only recently begun, and we are not currently able to predict as to when or whether this product will achieve commercial acceptance.

We will not be able to achieve revenue growth or profitability if hospitals and anesthesia service providers do not buy and use the PSA 4000 in sufficient quantities.

Our revenue growth and prospects will depend on customer acceptance and usage of the PSA 4000. Customers may determine that the cost of the PSA 4000 exceeds cost savings in drugs, personnel and post-anesthesia care recovery resulting from use of the PSA 4000. In addition, hospitals and anesthesia providers may not accept the PSA 4000 as an accurate means of assessing a patient’s level of consciousness during surgery if patients regain consciousness during surgery while being monitored with the PSA 4000 or if they do not consider the PSA 4000 to be a clinically reliable measuring system for other reasons. If extensive or frequent

malfunctions occur, these providers may also conclude that the PSA 4000 is unreliable. If hospitals and anesthesia providers do not accept the PSA 4000 as cost-effective, accurate or reliable, they will not buy and use the PSA 4000 in sufficient quantities to enable us to be profitable. In this event, our business, operating results and long-term prospects would be seriously harmed. Our stock price would also likely decline.

Since the second quarter of 2001, we experienced a sharp downturn in orders and in end-user demand for the PSA 4000. We believe that this downturn is due in part to economic conditions generally and in the healthcare sector in particular. In addition, marketing programs instituted by one of our competitors have adversely affected our ability to sell PSA 4000 products. More specifically, however, as a result of market feedback, we concluded that we needed to introduce a simpler headpiece for use with the PSA 4000. Therefore, the PSArray2 was developed, and we received FDA 510(k) clearance for the PSArray2 on October 7, 2002. Even with FDA clearance for this headpiece, we cannot assure that introduction of the PSArray2 will improve market acceptance of the PSA 4000 or our results of operations. At this point, we are currently unable to accurately predict future demand for the PSA 4000, and we cannot assure you that the current economic environment and current product market environment will not continue.

We expect to continue to incur losses in the future, and we cannot assure you that we will ever become profitable.

We have incurred net losses in each year since inception. We expect to continue to incur substantial research and development, sales and marketing and general and administrative expenses in future periods. We will spend these amounts before we receive any incremental revenue from these efforts. Therefore, our losses will be greater than the losses we would incur if we developed our business more slowly. In addition, we may find that these efforts are more expensive than we currently anticipate, which would further increase our losses. Failure to become and remain profitable may depress the market price of our common stock and our ability to raise capital and continue our operations.

We have a limited operating history that you may use to assess our prospects, and we have no operating experience or history related to the PSA 4000, our current principal product.

We have a limited history of operations. Since our inception in January 1990, we have been primarily engaged in research and development of neurophysiological monitoring products. To date, we have sold only a relatively small number of units of our HydroDot NeuroMonitoring System and these sales have generated only limited revenues. Furthermore, these products are not central to our core business, which relates to the development and commercialization of the PSA 4000. We have had limited revenues from commercial sales of the PSA 4000. Accordingly, our historical results of operations may be of limited utility in evaluating our future prospects. In addition, we do not have experience in manufacturing, marketing or selling our products in quantities necessary for achieving profitability. Whether we can successfully manage the transition to a larger scale commercial enterprise will depend upon the successful development of our manufacturing capability, the development of our marketing and distribution network, obtaining U.S. FDA and foreign regulatory approvals for future products and other

potential products and strengthening our financial and management systems, procedures and controls. With respect to our PSA 4000, we will need to develop in collaboration with third parties, a sales and marketing effort targeted towards anesthesiologists, rather than neurologists to whom we have previously marketed our products. Accordingly, due to the significant change in our business associated with the PSA 4000, our historical financial information is of limited utility in evaluating our future prospects, and we cannot assure that we will be able to achieve or sustain revenue growth or profitability.

We face intense competition and may not be able to compete effectively, which could harm the market for our products and our operating results.

We expect to face substantial competition from larger medical device companies that have greater financial, technical, marketing and other resources than we do. As our resources in these areas are extremely limited, any current or potential competitor of ours is likely to have greater resources in these areas. In particular, Aspect Medical markets an anesthesia monitoring system that competes with the PSA 4000. Aspect has received FDA clearance for this system and is marketing it in the U.S and internationally. We may not be able to compete effectively with Aspect or other potential competitors. Other companies may develop anesthesia-monitoring systems that perform better than the PSA 4000 and/or sell for less. Competition in the sale of anesthesia-monitoring systems could result in the inability of the PSA 4000 to achieve market acceptance, price reductions, fewer orders, reduced gross margins and inability to establish or erosion of market share. Any of these events would harm our business and operating results and cause our stock price to decline.

We may not be able to keep up with new products or alternative techniques developed by competitors, which could impair our future growth and our ability to compete.

The medical industry in which we market our products is characterized by rapid product development and technological advances. Our current or planned products are at risk of obsolescence from:

• new monitoring products, based on new or improved technologies,

• new products or technologies used on patients or in the operating room during surgery in lieu of monitoring devices,

• electrical or mechanical interference from new or existing products or technologies,

• alternative techniques for evaluating the effects of anesthesia,

• significant changes in the methods of delivering anesthesia, and

• the development of new anesthetic agents.

We may not be able to improve our products or develop new products or technologies quickly enough to maintain a competitive position in our markets and continue to grow our business.

If we do not successfully develop and introduce new or enhanced products, we could lose revenue opportunities and customers.

As the market for anesthesia monitoring equipment matures, we need to develop and introduce new products for anesthesia monitoring or other applications. In particular, we are

developing versions of the PSA 4000 for use in areas outside the traditional hospital operating room setting and the success of these efforts and acceptance of our products and technology in these additional settings will be critical to our future success. We face at least the following risks:

• we may not successfully adapt the PSA 4000 to function properly in the intensive care unit, for procedural sedation, when used with anesthetics we have not tested or with patient populations we have not studied, such as infants and young children, and

• our technology is complex, and we may not be able to develop it further for applications outside anesthesia monitoring.

If we do not successfully adapt the PSA 4000 for new products and applications both within and outside the field of anesthesia monitoring, then we could lose revenue opportunities and customers. In this event, our business and results of operations would be harmed.

We have experienced significant operating losses to date, and our future operating results could fluctuate significantly.

We have experienced significant operating losses since inception and, as of June 30, 2003 had an accumulated deficit of approximately $54.1 million. The development and commercialization of the PSA 4000 and other new products, if any, will require substantial development, clinical, regulatory and other expenditures. We expect our operating losses to continue for at least the next two years as we continue to expend substantial resources to maintain marketing and sales activities, scale up manufacturing capabilities, continue research and development and support regulatory and reimbursement approvals. Results of operations may fluctuate significantly from quarter to quarter and will depend upon numerous factors, including actions relating to regulatory and reimbursement matters, and market acceptance of the PSA 4000. In addition, competition, availability of third party reimbursement and other factors may affect our future results of operations.

Our reliance on sole and limited source suppliers could harm our ability to meet customer requirements in a timely manner or within budget.

Some of the components that are necessary for the assembly of our PSA 4000 are currently provided to us by separate sole suppliers or a limited group of suppliers. We purchase components through purchase orders rather than long-term supply agreements and generally do not maintain large volumes of inventory. We have experienced shortages and delays in obtaining some of the components of our PSA 4000 in the past, and we may experience similar delays or shortages in the future. The disruption or termination of the supply of components could cause a significant increase in the costs of these components, which could affect our profitability. A disruption or termination in the supply of components could also result in our inability to meet demand for our products, which could lead to customer dissatisfaction and damage our reputation. Furthermore, if we are required to change the manufacturer of a key component of the PSA 4000, we may be required to verify that the new manufacturer maintains facilities and procedures that comply with quality standards and with all applicable regulations and guidelines. The delays associated with the verification of a new manufacturer could delay our ability to manufacture the PSA 4000 in a timely manner or within budget.

Our business depends on our intellectual property rights, and measures we take to protect those rights may not be sufficient.

The success of our business depends, in part, on our ability to obtain patents and maintain adequate protection of our intellectual property for our technologies and products in the U.S. and other countries. The laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the U.S., and many companies have encountered significant problems in protecting their proprietary rights in these foreign countries. These problems can be caused by, for example, a lack of rules and processes allowing for a meaningful defense of intellectual property rights. If we do not adequately protect our intellectual property, competitors may be able to practice our technologies and erode our competitive advantage, and our business and operating results could be harmed.

The patent positions of technology companies, including our patent positions, are often uncertain and involve complex legal and factual questions. We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary technologies are covered by valid and enforceable patents or are effectively maintained as trade secrets. We apply for patents covering our technologies and products as we deem appropriate. However, we may not obtain patents on all inventions for which we seek patents, and any patents we obtain may be challenged and may be narrowed in scope or extinguished as a result of such challenges. Our existing patents and any future patents we obtain may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products. Others may independently develop similar or alternative technologies or design around our patented technologies or products. These companies would then be able to offer research services and develop, manufacture and sell products, which compete directly with our research services and products. In that case, our revenues and operating results would decline.

In addition to patents, we rely on trade secrets and proprietary know how, which we seek to protect, in part, through appropriate confidentiality and proprietary information agreements. These agreements generally provide that all confidential information developed or made known to the individual by us during the course of the individual’s relationship with us, is to be kept confidential and not disclosed to third parties, except in specific circumstances. The agreements generally provide that all inventions conceived by the individual in the course of rendering services to us are our exclusive property. However, some of our agreements with consultants, who typically are employed on a full time basis by academic institutions or hospitals, do not contain assignment of invention provisions. We cannot assure you that proprietary information or confidentiality agreements with employees, consultants and others will not be breached, that we would have adequate remedies for any breach, or that our trade secrets will not otherwise become known to or independently developed by competitors. Disclosure or misuse of our confidential information would harm our competitive position and could cause our revenues and operating results to decline.

We could become involved in litigation relating to intellectual property rights, and any such litigation, even if resolved favorably to us, will result in significant cost and diversion of management’s time and effort.

The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. We cannot assure you that we will not in the future become subject to patent infringement claims and litigation or interference proceedings declared by the United States Patent and Trademark Office (“US PTO”) to determine the priority of inventions. The defense and prosecution of intellectual property suits, US PTO interference proceedings and related legal and administrative proceedings are both costly and time consuming. Litigation may be necessary to enforce patents issued to us, to protect trade secrets or know how owned by us or to determine the enforceability, scope and validity of the proprietary rights of others.

Any litigation or interference proceedings will result in substantial expense to us and significant diversion of effort by our technical and management personnel. An adverse determination in litigation or interference proceedings to which we may become a party could subject us to significant liabilities to third parties or require us to seek licenses from third parties. Costs associated with licensing or similar arrangements that may be involved in statement of intellectual property disputes, including patent disputes, may be substantial and could include ongoing royalties. Furthermore, there can be no assurance that necessary licenses would be available to us on satisfactory terms if at all. Adverse determinations in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing, marketing and selling our products, which would seriously harm our business and operating results and would likely cause our stock price to decline.

Our business entails the risk of product liability claims, and these claims could harm our financial condition and our ability to maintain insurance coverage.

The manufacture and sale of our products expose us to product liability claims and product recalls, including those which may arise from misuse or malfunction of, or design flaws in, our products or use of our products with components or systems not manufactured or sold by us. Product liability claims or product recalls, regardless of their ultimate outcome, could require us to spend significant time and money in litigation or to pay significant damages. We currently maintain insurance; however, it might not cover the costs of any product liability claims made against us. Furthermore, we may not be able to obtain insurance in the future at satisfactory rates or in adequate amounts.

If we do not attract and retain skilled personnel, we will not be able to expand our business.

Our products are based on complex technology. Accordingly, we require skilled personnel to develop, manufacture, sell and support our products. In addition, as we move to continue commercialization of our products, we may require additional personnel skilled in the sales and marketing of medical device products. Our future success will depend largely on our ability to continue to hire, train, retain and motivate additional skilled personnel, particularly sales representatives and clinical specialists who are responsible for customer education and training and post-installation customer support. We continue to experience difficulty in recruiting and retaining skilled personnel because the pool of experienced persons is small and we compete for personnel with other companies, many of which have greater resources than we do.

Consequently, if we are not able to attract and retain skilled personnel, we will not be able to expand our business.

Failure of users of the PSA 4000 to obtain adequate reimbursement from third party payers could limit market of the system, which could prevent us from growing our business.

Anesthesia providers are generally not reimbursed separately for patient monitoring activities, including any such activities that would involve use of the PSA 4000. Accordingly, potential users of the PSA 4000 would have to justify its use based on the clinical and cost benefits they believe use of the system provides. For hospitals and outpatient surgical centers, when reimbursement is based on charges or costs, patient monitoring with the PSA 4000 may reduce reimbursements for surgical procedures, because charges or costs may decline as a result of monitoring with the PSA 4000. Failure by hospitals and other users of the PSA 4000 to obtain adequate reimbursement from third-party payers, or any reduction in the reimbursement by third-party payers to hospitals and other users as a result of using the PSA 4000 could limit market acceptance of the PSA 4000, which could prevent us from growing our revenues and our business.

Our stock price may fluctuate, which may cause your investment in our stock to suffer a decline in value.

The market price of our common stock has fluctuated significantly in the past and may fluctuate significantly in the future in response to factors which are beyond our control. In addition, the stock market in general has recently experienced extreme price and volume fluctuations. In addition, the market prices of securities of technology and medical device companies have been extremely volatile, and have experienced fluctuations that often have been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations could result in extreme fluctuations in the price of our common stock, which could cause a decline in the value of your shares.

We may incur significant costs from securities class litigation due to our stock price volatility.

Our stock price may fluctuate for many reasons, including timing of regulatory actions relating to the PSA 4000, variations in our quarterly operating results and changes in market valuations of medical device companies. Recently, when the market price of a stock has been volatile as our stock price may be, holders of that stock have occasionally instituted securities class action litigation against the company that issued the stock. If any of our stockholders were to bring a lawsuit of this type against us, even if the lawsuit is without merit, we could incur substantial costs defending the lawsuit. The lawsuit could also divert the time and attention of our management.

Our investments could lose market value and consequently harm our ability to fund continuing operations.

The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we

maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including government and corporate obligations and money market funds. These securities are generally classified as available for sale and consequently are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income (loss). The market values of these investments may fluctuate due to market conditions and other conditions over which we have no control. Fluctuations in the market price and valuations of these securities may require us to record losses due to an impairment in the value of the securities underlying our investment. This could result in future charges on our earnings. All securities are held in U.S. currency.

Investments in both fixed rate and floating rate interest earning instruments carry varying degrees of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates. In general, securities with longer maturities are subject to greater interest rate risk than those with shorter maturities. While floating rate securities generally are subject to less interest rate risk than fixed rate securities, floating rate securities may produce less income than expected if interest rates decrease. Due in part to these factors, our investment income may fall short of expectations or we may suffer losses in principal if securities are sold that have declined in market value due to changes in interest rates.

Anti-takeover provisions in our charter documents and under Delaware law could prevent or delay transactions that stockholders may favor.

Provisions of our restated certificate of incorporation and amended and restated by-laws may discourage, delay or prevent a merger or acquisition that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions include:

• authorizing the issuance of “blank check” preferred stock without any need for action by stockholders,

• requiring supermajority stockholder voting to effect certain amendments to our restated certificate of incorporation and amended and restated by-laws,

• eliminating the ability of stockholders to call special meetings of stockholders,

• prohibiting stockholder action by written consent, and

• establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings.

Item 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that an increase in prevailing interest rates may cause the principal amount of the investment to decrease. To minimize this risk in the future, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds and government and non-government debt securities. Due to the conservative nature of our investments and relatively short duration, interest rate risk is mitigated. As of June 30, 2003, 100% of our total portfolio will mature in one year or less.

Item 4.

CONTROLS AND PROCEDURES

Within the 90 days prior to the date of filing this Quarterly Report on Form 10-Q, we carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14 and 15d-14. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us required to be included in our periodic SEC filings. Subsequent to the date of that evaluation, there have been no significant changes in our internal controls or in other factors that could significantly affect internal controls, nor were any corrective actions required with regard to significant deficiencies and material weaknesses.

PART II OTHER INFORMATION

Item 1 Legal Proceedings:

Not applicable.

Item 2 Changes in Securities:

Not applicable.

Item 3 Defaults upon Senior Securities:

Not applicable.

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

On May 29, 2003, the Company held its annual meeting of shareholders. The following items were submitted for a vote of the shareholders.

Election of Christopher D. Mitchell as a Class I director.

For:		7,322,102
Against:		0
Abstain:		0

Ratification of Ernst & Young as independent auditors for the year ending December 31, 2003.

For:		7,341,753
Against:		3,120
Abstain:		0

Item 5 Other Information:

None.

Item 6 Exhibits and Reports on Form 8-K:

(a) Exhibits

31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.

31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.

32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K.

We filed a Current Report on Form 8-K dated July 30, 2003, attaching our second quarter ended June 30, 2003 earnings release dated July 30, 2003.

June 30, 2003

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

		PHYSIOMETRIX, INC.


DATE:	August 7, 2003	BY:	/s/John A. Williams
			John A. Williams
			President, Chief Executive Officer

		BY:	/s/Daniel W. Muehl
			Daniel W. Muehl
			Vice President, Chief Financial Officer
			(Principal Financial and Accounting Officer)

Exhibit Index

Exhibit No.		Description
31.1		Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.
31.2		Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.
32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Note 5 – Significant Accounting Policies

Revenue Recognition

We recognize revenue for product sales upon shipment, net of allowances for discounts and estimated returns which are also provided for at the time of shipment in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements.

Net Loss Per Common Share

Use of Estimates

Revenue Recognition

Inventories

Results of Operations

Three Months Ended June 30, 2003 and 2002

Revenues

Six Months Ended June 30, 2003 and 2002

Item 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Item 4.

CONTROLS AND PROCEDURES

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK