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 September 30, 2004

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	(IRS Employer
incorporation or organization)	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 Rule 12b-2 of Exchange Act). Yes o 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 October 29, 2004
Common Stock, $.001 par value		13,654,266

PHYSIOMETRIX, INC.

UNAUDITED CONDENSED BALANCE SHEETS

	December 31				September 30
	2003				2004
ASSETS
Current assets:
Cash and cash equivalents	$	4,099,155			$		1,258,565
Short-term investments	3,526,894				2,511,923
Accounts receivable, net	304,392				187,650
Inventories	560,294				142,079
Prepaid expenses	101,798				137,113
Total current assets	8,592,533				4,237,330

Property, plant and equipment	1,360,960				1,397,687
Less allowances for depreciation	(1,181,292			)	(1,270,117			)
	179,668				127,570

Total assets	$		8,772,201		$	4,364,900

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts payable	$		147,762		$	163,273
Accrued expenses	823,519				611,496
Warrant derivative contract	11,342,730				—
Total current liabilities	12,314,011				774,769

Stockholders’ equity (deficit)
Preferred stock: $.001 par value; 10,000,000 shares authorized; none issued and outstanding	—				—
Common stock: $.001 par value; 50,000,000 shares authorized; 13,380,481 shares in 2003 and 13,654,266 shares in 2004 issued and outstanding	13,380				13,654
Additional paid-in capital	56,098,127				68,405,645
Unrealized loss on available-for-sale securities	—				(2,489			)
Accumulated deficit	(59,653,317			)	(64,826,679			)
Total stockholders’ equity (deficit)	(3,541,810			)	3,590,131
Total liabilities and stockholders’ equity (deficit)	$		8,772,201		$	4,364,900

See accompanying notes

PHYSIOMETRIX, INC.

UNAUDITED CONDENSED STATEMENTS OF OPERATIONS

	Three Months Ended							Nine Months Ended
	September 30							September 30
	2003			2004				2003				2004
Revenues	$	609,095		$	437,791			$	1,048,363			$	1,466,108
Cost of products sold	657,332			510,085				1,328,578				1,549,176
Gross deficit	(48,237		)	(72,294			)	(280,215			)	(83,068			)

Costs and expenses:
Research and development	391,822			542,933				1,189,246				1,329,305
Selling, general and administrative	685,731			908,430				2,156,304				2,761,836
	1,077,553			1,451,363				3,345,550				4,091,141
Operating loss	(1,125,790		)	(1,523,657			)	(3,625,765			)	(4,174,209			)
Other income (expense):
Change in fair value of warrant derivative	—			—				—				(1,046,080			)
Interest income	1,537			12,829				17,614				46,927

Net loss	$	(1,124,253	)	$	(1,510,828		)	$	(3,608,151		)	$	(5,173,362		)

Basic and diluted net loss per common share	$	(0.13	)	$		(0.11	)	$		(0.43	)	$		(0.38	)

Shares used in computing basic and diluted net loss per common share	8,422,994			13,654,266				8,422,994				13,569,233

See accompanying notes.

PHYSIOMETRIX, INC.

UNAUDITED CONDENSED STATEMENTS OF CASH FLOWS

	Nine Months Ended
	September 30
	2003			2004
Operating activities:
Net loss	$	(3,608,151	)	$	(5,173,362	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	174,672			88,825
Change in fair value of warrant derivative	—			1,046,080
Stock-based compensation in connection with issuance of stock options to consultants	62,766			—
Changes in operating assets and liabilities:
Accounts receivable	(80,737		)	116,742
Inventories	301,796			418,215
Prepaid expenses	(39,211		)	(35,315		)
Accounts payable and accrued expenses	(99,390		)	(196,512		)
Net cash used in operating activities	(3,288,255		)	(3,735,327		)

Investing activities:
Purchase of equipment	(8,647		)	(36,727		)
Purchase of short-term investments	—			(669,231		)
Proceeds from maturity of short-term investments	1,241,515			1,681,713
Net cash provided by investing activities	1,232,868			975,755

Financing activities:
Private placement cash offering costs	—			(110,256		)
Proceeds from issuance of common stock	—			29,238
Net cash used in financing activities	—			(81,018		)

Net decrease in cash and cash equivalents	(2,055,387		)	(2,840,590		)
Cash and cash equivalents at beginning of period	2,690,042			4,099,155

Cash and cash equivalents at end of period	$	634,655		$	1,258,565

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, 2004 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, 2003 included in our form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 30, 2004.

Note 2 — Going Concern

Physiometrix, Inc. (the “Company,” “Physiometrix,” “we,” “us,” and “our”) 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 $64.8 million, including losses of approximately $5.2 million during the nine months ended September 30, 2004, $8.1 million during the year ended December 31, 2003 and $5.5 million during the year ended December 31, 2002.

The Company’s principal source of liquidity at September 30, 2004 consisted of cash, cash equivalents and short-term investments, which aggregated $3.8 million. The Company’s net working capital at September 30, 2004 was $3.5 million. The Company had a net working capital deficit of $3.7 million at December 31, 2003, which was due primarily to a warrant derivative issued in connection with its common stock financing completed in December 2003, which raised net proceeds of approximately $7.5 million. The warrants were classified as derivatives due to the possibility of the Company having to make a cash settlement, including penalties, in the event the Company failed to complete the registration of the shares underlying the warrants under the Securities Act of 1933, as amended, within 90 days after the closing of the private placement transaction. A registration statement covering the shares sold in the private placement, along with the shares underlying the warrants, was filed with the Securities and Exchange Commission on Form S-3 on December 11, 2003 and declared effective on February 5, 2004. Therefore, the value of the warrants was reclassified as equity in the first quarter of 2004 and there is no future cash settlement requirement on behalf of the Company. Consequently, the Company has stockholders’ equity of $3.6 million at September 30, 2004.

The Company believes it has the necessary cash, cash equivalents and short-term investments, and other currents assets on hand at September 30, 2004, to fund its operations and execute its operating plan into the third quarter of 2005.

The Company believes that the success of the PSA 4000, the signing of a distribution partner for the PSA 5000 and raising additional working capital are the most critical components to the Company’s ability to continue as a going concern. The Company’s plan for the remainder of 2004 is to support the activities of its partner, Baxter Healthcare Corporation (“Baxter”), in the commercialization of the PSA 4000 with the PSArray2 and to seek a distribution partner for the PSA 5000. 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 will 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 this company.

Note 3 — Stock Based Compensation

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 stock 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, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of Financial Accounting Standards Board (“FASB”) Statement No. 123”. Had compensation costs for stock options issued to employees and directors been determined based on the estimated fair value of such stock options 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 nine months ended September 30, 2003, and September 30, 2004 would have been adjusted to the pro forma amounts indicated below:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2003			2004			2003			2004
Net loss as reported	$	(1,124,253	)	$	(1,510,828	)	$	(3,608,151	)	$	(5,173,362	)
Pro forma compensation expense	(156,660		)	(130,004		)	(468,436		)	(453,400		)
Pro forma net loss	$	(1,280,913	)	$	(1,640,832	)	$	(4,076,587	)	$	(5,626,762	)

Basic and diluted loss per share:
As reported	$	(0.13	)	$	(0.11	)	$	(0.43	)	$	(0.38	)
Pro forma	$	(0.15	)	$	(0.12	)	$	(0.48	)	$	(0.41	)

There were no options granted during the three month periods ended September 30, 2003 and September 30, 2004. The average estimated fair value of options granted during the nine month periods ended September 30, 2003 and September 30, 2004 were $0.48 and $2.17, respectively, and was estimated using the Black-Scholes option-pricing model using the following weighted-average assumptions:

	2003		2004
Dividend yield	0	%	0	%
Volatility	127	%	134	%
Risk-free interest rate	3.21	%	3.16	%
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 January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (“ARB”) No. 51 (“FIN 46”). FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity 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 from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. However, in December 2003, the FASB deferred the effective date of FIN 46 to the end of the first interim or annual period ending after December 15, 2003 for those arrangements involving special purpose entities entered into prior to February 1, 2003. All other arrangements within the scope of FIN 46 are subject to its provisions beginning in 2004. The Company adopted FIN 46, as required, with no impact to its consolidated financial position or results of operations.

Note 5 — Significant Accounting Policies

Inventories

Inventories are recorded at the lower of cost (first-in, first-out) or market, and consist of the following:

	December 31,			September 30,
	2003			2004
Purchased components	$		512,179	$	101,967
Work in process	19,752			29,086
Finished units	28,363			11,026
	$	560,294		$		142,079

The Company reviews its inventories for excess and obsolete inventory on a periodic basis and provides a reserve for its estimate of excess and obsolete inventory. The Company had inventory reserves of $2.0 million and $1.9 million for the periods ended December 31, 2003 and September 30, 2004, respectively, which included reserves for 450 PSA 4000 units at December 31, 2003 and 375 PSA 4000 units at September 30, 2004.

Revenue Recognition

The Company recognizes revenue for product sales upon shipment, net of allowances for discounts, and estimates returns which are also provided for at the time of shipment in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 104, 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 nine months ended September 30, 2003 and September 30, 2004. 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						Nine Months Ended
	September 30,						September 30,
	2003			2004			2003			2004
Net loss	$	(1,124,253	)	$	(1,510,828	)	$	(3,608,151	)	$	(5,173,362	)
Net unrealized holding gains (losses) on investments	—			1,254			(2,360		)	(2,489		)
Total comprehensive loss	$	(1,124,253	)	$	(1,509,574	)	$	(3,610,511	)	$	(5,175,851	)

Warrant Derivative

The Company had a derivative liability associated with warrants issued in connection with its private placement transaction completed in December 2003 due to the possibility of the Company having to make a cash settlement, including penalties, in the event the Company failed to register the shares underlying the warrants under the Securities Act of 1933, as amended within 90 days after the closing of the private placement transaction. The Company accounted for this warrant derivative in accordance with EITF 00-19 Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock. The warrants were included as a liability and valued at fair market value until the Company met the criteria under EITF 00-19 for permanent equity. The Company valued the derivative warrant using the Black-Scholes model. A registration statement covering the shares sold in the private placement, along with the shares underlying the warrants, was filed with the Securities and Exchange Commission on Form S-3 on December 11, 2003 and was declared effective on February 5, 2004. Therefore, the value of the warrants was reclassified as equity in the first quarter of 2004 and there is no future cash settlement requirement on behalf of the Company. Consequently, the Company has stockholders’ equity of $3.6 million at September 30, 2004.

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 that involve risks and uncertainties. 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. These statements typically may be identified by the use of forward-looking words or phrases such as “believe,” expect,” “intend,” “anticipate,” “should,” “planned,” “estimated,” and “potential,” among others. All forward-looking statements included in this Report on Form 10-Q are based on current expectations, and we assume no obligation to update any of these forward-looking statements. The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for these forward-looking statements. In order to comply with the terms of the safe harbor, we note that a variety of factors could cause actual results and experiences to differ materially from the anticipated results or

other expectations expressed in these forward-looking statements. The risks and uncertainties that may affect the operations, performance, development and results of our business 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 principal product is the Patient State Analyzer (“PSA 4000”), a consciousness monitoring system. The PSA 4000 is used with the PSArray2, a frontal-only disposable array sensor which attaches to the PSA 4000. We received 510(k) clearance from the FDA for the PSArray2 in October 2002. The PSArray2 was developed in an effort to improve market acceptance of the PSA 4000.

We have a limited history of operations and have experienced significant operating losses since our inception. As of September 30, 2004, we had an accumulated deficit of approximately $64.8 million. 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, the introduction of our new product, the PSA 5000, the 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 under a distribution agreement, which provides Baxter with exclusive distribution rights to our PSA 4000 in the United States and Canada. The agreement extends through September 30, 2005, but is cancelable by either party upon six months notice after December 31, 2003.

Under the terms of the agreement, as amended in February 2003, if Baxter fails to meet minimum purchase commitments, we have the option to convert their distribution agreement into a non-exclusive relationship for the operating room market segment. In 2003, Baxter failed to meet minimum purchase requirements, however, we have not enforced our right to change the terms of the agreement, including Baxter’s exclusivity rights. We may enter into additional distribution arrangements with other parties, enter into negotiations with Baxter to amend or modify our agreement or elect to enforce this right to change the terms of the existing agreement with Baxter.

On February 10, 2004, we received clearance from the FDA for commercial distribution of our PSA 5000 next generation monitor. The PSA 5000 is a new state of the art monitor that is more powerful, cost effective and ergonomic than its predecessor the PSA 4000. We anticipate

launch of the product in mid 2005. We do not believe that the PSA 5000 will result in the obsolescence of the PSA 4000.

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. 104, 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 an inventory reserve. On February 10, 2004, we received clearance from the FDA for commercial distribution of our PSA 5000 next generation monitor. The PSA 5000 is a new state of the art monitor that is more powerful, cost effective and ergonomic than its predecessor the PSA 4000. We anticipate launch of the product through a new distribution partner in mid 2005.

At September 30, 2004, we had 375 PSA 4000 units on hand with all 375 units on hand fully reserved for. We shipped 25 units during the quarter ended September 30, 2004. In the event we obtain firm purchase orders for up to 375 PSA units, we would expect to reverse the related amount of inventory reserves in such period.

Warrant Derivative

We had a derivative liability as of December 31, 2003, which resulted from a potential cash settlement, which was required in the event we could not successfully register the shares underlying the warrants, issued in connection with our common stock financing completed in December 2003. We account for this warrant derivative in accordance with EITF 00-19 Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock. The warrants were included as a liability and valued at fair market value until we met the criteria under EITF 00-19 for equity. A registration statement covering the shares sold in the private placement, along with the shares underlying the warrants was filed with the Securities and Exchange Commission on Form S-3 on December 11, 2003, and declared effective on February 5, 2004. Therefore, the value of the warrants was reclassified as stockholders’ equity in the first quarter of 2004 and there is no future cash requirement with respect to this liability on behalf of the Company.

Stock - - Based Compensation

We apply the principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for our employee stock-based compensation plans. Under APB No. 25, compensation expense is measured as the difference, if any, between the option exercise price and the fair value of our common stock at the date of grant. We have historically granted options to employees and directors at exercise prices equal to the fair value of our common stock. Accordingly, no compensation expense has been recognized for our employee stock-based compensation plans.

We follow the disclosure-only provisions under SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure.

Results of Operations

Three Months Ended September 30, 2004 and September 30, 2003

Revenues

Revenues decreased 28% to $438,000 for the three months ended September 30, 2004 from $609,000 for the three months ended September 30, 2003. This decrease was primarily due to a reduction in shipments of PSA 4000 units to 25 units during the three months ended September 30, 2004 compared to 100 PSA 4000 units shipped during the three months ended September 30, 2003. The decrease in revenues of the PSA 4000 was slightly offset by an increase in shipments of the PSArray2. The decrease in revenues of the PSA 4000 for the quarter ended September 30, 2004 resulted from Baxter’s decision to focus on converting the approximately 165 hospitals, that are currently in clinical evaluations, to purchases or leases. As a result, Baxter’s requirements for new PSA 4000 monitors declined.

Future PSA 4000 revenues are entirely dependent on the acceptance of the new PSArray2 by anesthesiologists, which was developed in 2002 in an effort to improve market acceptance of

the PSA 4000. Our current agreement with Baxter provides Baxter with exclusive distribution rights for the PSA 4000 in the U.S. and Canada, making us significantly dependent upon Baxter for successful commercialization of this product. There is no assurance that this will occur. Under the terms of the agreement, as amended in February 2003, if Baxter fails to meet minimum purchase commitments, we have the option to convert their distribution agreement into a non-exclusive relationship for the operating room market segment. In 2003, Baxter failed to meet minimum purchase requirements, however, we have not enforced our right to change the terms of the agreement, including Baxter’s exclusivity rights. We may enter into additional distribution arrangements with other parties including our current search for a PSA5000 distribution partner, enter into negotiations with Baxter to amend or modify our agreement or elect to enforce this right to change the terms of the existing agreement with Baxter. Sales of our HydroDot NeuroMonitoring products were relatively unchanged compared with the same period last year.

Cost of Products Sold

Cost of products sold decreased 22% to $510,000 for the three months ended September 30, 2004 from $657,000 for the three months ended September 30, 2003. This decrease was primarily due to a reduction in shipments of PSA 4000 units to Baxter, from 100 during the quarter ended September 30, 2003 to 25 units during the quarter ended September 30, 2004 offset by an increase in PSArray2 shipments.

Gross Deficit

The gross deficit incurred during the three months ended September 30, 2004 was $72,000 compared to a gross deficit of $48,000 incurred during the three months ended September 30, 2003. The increase in the gross deficit was primarily the result of the reduction in shipments of the PSA 4000 to Baxter, from 100 units shipped during the quarter ended September 30, 2003 to 25 units during the quarter ended September 30, 2004 offset by an increase in PSArray2 shipments. The gross deficit incurred during the three months ended September 30, 2004 and September 30, 2003 resulted from costs of the product incurred together with headcount and overhead costs required in our manufacturing group exceeding the reported revenues. At September 30, 2004, we had 375 PSA 4000 units on hand fully reserved for. In the event we obtain firm purchase orders for PSA 4000 units, we would expect to reverse the related amount of inventory reserves in the applicable period.

Research and Development Expenses

Research and development expenses, consisting principally of headcount related expenses, clinical study costs and consulting fees, increased 39% to $543,000 for the three months ended September 30, 2004 from $392,000 for the three months ended September 30, 2003. This increase was primarily the result of an increase in costs associated with the development of the PSA 5000. The PSA 5000 is a new state of the art monitor that is more powerful, cost effective and ergonomic than its predecessor the PSA 4000.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 32% to $908,000 for the three months ended September 30, 2004 from $686,000 for the three months ended September 30, 2003. This increase was primarily due to an increase in headcount related expenses, including bonus accruals, coupled with an increase in advertising costs and auditing fees.

Interest Income

Interest income increased to $12,829 for the three months ended September 30, 2004 from $1,537 for the three months ended September 30, 2003. This increase resulted from higher average cash balances available for investment in 2004 due to the private equity financing completed in December 2003, which raised net proceeds of approximately $7.5 million.

Income Taxes

We have not provided for income taxes in any of the periods reported due to losses incurred during each of the periods presented and uncertainty regarding future taxable income. At December 31, 2003, we had federal net operating loss carryforwards of approximately $46.2 million and research and development tax credit carryforwards of approximately $1.5 million that will expire in varying amounts through 2023, 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 (“Internal Revenue Code”). The annual limitation may result in the expiration of net operating loss and tax credit carryforwards before full utilization.

Nine Months Ended September 30, 2004 and 2003

Revenues

Revenues increased 40% to $1,466,000 for the nine months ended September 30, 2004 from $1,048,000 for the nine months ended September 30, 2003. This increase was primarily due to the shipment of 200 PSA 4000 units during the nine months ended September 30, 2004 compared to 100 PSA 4000 units shipped for the nine months ended September 30, 2003, coupled with an increase in PSArray2 sales. Future PSA 4000 revenues are entirely dependent on the acceptance of the new PSArray2 by anesthesiologists, which was developed in 2002 in an effort to improve market acceptance of the PSA 4000. Our current agreement with Baxter provides Baxter with exclusive distribution rights for the PSA 4000 in the U.S. and Canada, making us significantly dependent upon Baxter for successful commercialization of this product. There is no assurance that this will occur. Under the terms of the agreement, as amended in February 2003, if Baxter fails to meet minimum purchase commitments, we have the option to convert their distribution agreement into a non-exclusive relationship for the operating room market segment. In 2003, Baxter failed to meet minimum purchase requirements, however, we have not enforced our right to change the terms of the agreement, including Baxter’s exclusivity rights. We may enter into additional distribution arrangements with other parties, enter into negotiations with Baxter to amend or modify our agreement or elect to enforce this right to change the terms of the existing agreement with Baxter. 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 17% to $1,549,000 for the nine months ended September 30, 2004 from $1,329,000 for the nine months ended September 30, 2003. This increase was primarily due to costs associated with the shipments of 200 PSA 4000 units to Baxter during the nine months ended September 30, 2004 compared to 100 PSA 4000 units shipped during the same period of 2003 combined with an increase in PSArray2 shipments. Of the 200 PSA 4000 units shipped in 2004, 75 units had been reserved for in a prior year based on uncertainty as to the saleability of the units, and therefore no cost was recognized on the shipment of these 75 units during the nine months ended September 30, 2004.

Gross Deficit

The gross deficit incurred during the nine months ended September 30, 2004 and September 30, 2003 of $83,000 and $280,000, respectively, resulted from costs of the product incurred together with headcount and overhead costs required in our manufacturing group exceeding the reported revenues. The gross deficit decreased by $197,000 during the nine months ended September 30, 2004 compared to the same period in the prior year primarily due to the shipment of 200 PSA 4000 units during the nine months ended September 30, 2004 compared to 100 PSA 4000 units shipped during the same period of 2003 combined with an increase in PSArray2 shipments. Of the 200 PSA 4000 units shipped during 2004, 75 units had been reserved for in a prior year and therefore a 100% gross margin was realized on these 75 units. At September 30, 2004, we had 375 PSA 4000 units on hand fully reserved for. In the event we obtain firm purchase orders for PSA 4000 units, we would expect to reverse the related amount of inventory reserves in the applicable period.

Research and Development Expenses

Research and development expenses, consisting principally of headcount related expenses, clinical study costs and consulting fees, increased 12% to $1,329,000 for the nine months ended September 30, 2004 from $1,189,000 for the nine months ended September 30, 2003. The increase is primarily due to an increase in costs associated with the development of the PSA 5000. The PSA 5000 is a new state of the art monitor that is more powerful, cost effective and ergonomic than its predecessor the PSA 4000.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 28% to $2,762,000 for the nine months ended September 30, 2004 from $2,156,000 for the nine months ended September 30, 2003. This increase was primarily due to an increase in headcount related expenses, including bonus accruals, coupled with an increase in advertising costs as well as various consulting expenses, including equity research analyst fees, auditing fees and Nasdaq listing fees.

Change in Fair Value of Warrant Derivative

During the first quarter of 2004, we recorded a non-cash expense of $1,046,080 related to warrants issued in connection with our common stock financing completed in December 2003. In accordance with EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, warrants are included as a liability and valued at fair market value until the criteria under EITF 00-19 for equity are met. The warrants issued by the Company in the private placement transaction were classified as a derivative and recorded as a liability due to the possibility of the Company having to make a cash settlement, including penalties, in the event we failed to register the shares underlying the warrants under the Securities Act of 1933, as amended, within 90 days after the closing of the private placement transaction. We valued the warrant derivative using the Black-Scholes model using the following assumptions: risk-free interest rate of 3.16%, expected life of warrants of 4.83 years, expected stock volatility of 157% and no expected dividend yield. A registration statement covering the shares sold in the private placement, along with the shares underlying the warrants, was filed with the Securities and Exchange Commission on Form S-3 on December 11, 2003 and declared effective on February 5, 2004. Therefore, the value of the warrants was reclassified as equity in the first quarter of 2004.

Interest Income

Interest income increased to $47,000 for the nine months ended September 30, 2004 from $18,000 for the nine months ended September 30, 2003. This increase was due to higher average cash balances available for investment in 2004 due to the private equity financing completed in December 2003, which raised net proceeds of approximately $7.5 million.

Income Taxes

We have not provided for income taxes in any of the periods reported due to losses incurred during each of the periods presented and uncertainty regarding future taxable income. At December 31, 2003, we had federal net operating loss carryforwards of approximately $46.2 million and research and development tax credit carryforwards of approximately $1.5 million that will expire in varying amounts through 2023, 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. The annual limitation may result in the expiration of net operating loss and tax credit carryforwards before full utilization.

Liquidity and Capital Resources

At September 30, 2004, our cash, cash equivalents and short-term investments were $3,770,000 as compared to $7,626,000 at December 31, 2003.

Our operating activities used cash of $3,735,000 in the nine months ended September 30, 2004 as compared to $3,288,000 in the nine months ended September 30, 2003. The operating activities for 2004 included a non-cash expense of $1,046,080 related to the derivative accounting treatment of warrants issued in connection with our private placement completed in

December 2003. The increase in net cash used in the nine month period ended September 30, 2004 compared to the same period in the prior year was due to the increased net loss combined with a decrease in accounts payable and accrued expenses, partially offset by a decrease in accounts receivable (due to payments on shipments to Baxter) and a decrease in inventories in 2004. Accounts payable and accrued expenses decreased significantly during the first nine months of 2004 due to the payment of accrued placement agent fees and other accrued costs associated with the private financing that was completed in December 2003.

Net cash provided by investing activities in the nine months ended September 30, 2004 was $976,000 as compared with $1,233,000 provided in the nine months ended September 30, 2003. The decrease resulted from an increase in the purchase of short-term investments in 2004 (approximately $669,231 in the nine months ended September 30, 2004 compared to none in the nine months ended September 30, 2003) due to additional cash available to invest as a result of the private equity financing completed in December 2003 which raised net proceeds of approximately $7.5 million.

Our financing activities used cash of $81,000 in the nine months ended September 30, 2004 as compared to no financing activities during the nine months ended September 30, 2003. The cash used during the nine months ended September 30, 2004 was due to costs associated with the private equity financing that was completed in December 2003, slightly offset by proceeds from the exercise of stock options.

Our principal source of liquidity at September 30, 2004 consisted of cash, cash equivalents and short-term investments, which aggregated approximately $3.8 million. Our net working capital at September 30, 2004 was approximately $3.5 million. We had a net working capital deficit of approximately $3.7 million at December 31, 2003, which was due primarily to warrant derivatives issued in connection with our common stock financing completed in December 2003, which raised net proceeds of approximately $7.5 million. The warrants were classified as derivatives due to the possibility of the Company having to make a cash settlement, including penalties, in the event we failed to complete the registration of the shares underlying the warrants under the Securities Act of 1933, as amended, within 90 days after the closing of the private placement transaction. A registration statement covering the shares sold in the private placement, along with the shares underlying the warrants, was filed with the Securities and Exchange Commission on Form S-3 on December 11, 2003 and declared effective on February 5, 2004. Therefore, the value of the warrants was reclassified as equity in the first quarter of 2004 and there is no future cash requirement with respect to this liability on behalf of the Company. Consequently, the Company has equity of $3.6 million at September 30, 2004. We believe that our existing cash, cash equivalents and short-term investments, and other current assets on hand at September 30, 2004 will be sufficient to conduct operations as planned into the third quarter of 2005.

We are significantly dependent on our distributor, Baxter, for sale of inventories of our principal product, the PSA 4000, 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.

We may need 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 at acceptable terms and we were 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.

The Company believes that the success of the PSA 4000, and when introduced, the PSA 5000, as well as raising additional working capital are the most critical components to the Company’s ability to continue as a going concern. The Company’s plan for the remainder of 2004 is to support the activities of its partner, Baxter, in the commercialization of the PSA 4000 with the PSArray2. 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 will 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 this company.

At December 31, 2003, we had tax net operating loss carryforwards of approximately $46.2 million available to offset federal taxable income, which expire in varying amounts through 2023, and $29.0 million to offset state taxable income, which expire in varying amounts through 2008. We also have research and development tax credit carryforwards of approximately $1.5 million available to offset income taxes, which expire in varying amounts through 2023. In accordance with Section 382 of the Internal Revenue Code, the use of the above carryforwards may be subject to annual limitations based upon ownership changes of our stock, which have occurred. The annual limitation may result in the expiration of net operating loss and tax credit carryforwards before full utilization.

Off-Balance Sheet Financing

We have not entered into any off-balance sheet financing arrangements and have not established any special purpose entities as of September 30, 2004.

Overview Of Contractual Obligations

There have been no material changes in the composition, magnitude or other key characteristics of the Company’s contractual obligations or other commitments as disclosed in the Company’s Form 10-K for the year ended December 31, 2003.

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 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 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 received FDA 510(k) clearance for the PSArray2 in October 2002. The introduction and successful commercialization of this product is critical to our future success. We began shipments of this product to Baxter, our exclusive distribution partner in the U.S. and Canada, 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.

Our current agreement with Baxter provides Baxter with exclusive distribution rights for the PSA 4000 in the U.S. and Canada, making us significantly dependent upon Baxter for successful commercialization of this product. There is no assurance that this will occur. Under the terms of the agreement, as amended in February 2003, if Baxter fails to meet minimum purchase commitments, we have the option to convert their distribution agreement into a non-exclusive relationship for the operating room market segment. In 2003, Baxter failed to meet minimum purchase requirements, however, we have not enforced our right to change the terms of the agreement, including Baxter’s exclusivity rights. We may enter into additional distribution arrangements with other parties, enter into negotiations with Baxter to amend or modify our agreement or elect to enforce this right to change the terms of the existing agreement with Baxter. There can be no assurance that we will obtain a new distribution partner for the PSA 4000 on terms that are mutually acceptable or that Baxter will continue to support the PSA 4000 at current levels, which would cause our business and results of operations to be materially and adversely affected.

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, our current principal product, 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 the PSA 4000 is determined not to be a clinically reliable measuring system for other reasons. 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.

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 in October 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 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.

Our ability to achieve future revenue growth or profitability will be dependent on the successful introduction of our newly developed product, the PSA 5000, and if we are unable to introduce and successfully commercialize this product, our business will be seriously harmed.

In February 2004, we received clearance from the FDA for commercial distribution of our PSA 5000 next generation monitor. The PSA 5000 is a new state of the art monitor that is more powerful, cost effective and ergonomic than it’s predecessor, the PSA 4000. We are currently developing our marketing, sales and distribution strategy for the PSA 5000, and anticipate launch of the product in the middle of 2005. There can be no assurance that we will obtain a suitable distribution partner for the PSA 5000 on terms that are mutually acceptable. Further, we cannot assure that the introduction of the PSA 5000 will be accepted by customers, perform as anticipated or improve our results of operations or competitive position. As the PSA 5000 has not been released for commercial sale, there is no way to predict commercial viability or future demand of this product.

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

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, which would affect our future liquidity and capital requirements. There can be no assurance, however, that sufficient revenues to meet these expenses will be achieved.

We completed a private placement transaction in December 2003, through which we raised net proceeds of approximately $7.5 million. We expect that the proceeds from this private placement will allow us to have funds to conduct planned operations into the third quarter of 2005. We may seek to raise capital through equity and/or debt issuance when such capital is available to us. There is no assurance, however, that we will be able to raise additional capital on acceptable terms. 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 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, and in the future, the PSA 5000. We have had limited revenues from commercial sales of the PSA 4000 and have not yet released the PSA 5000 for commercial sale. 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, and in the future with respect to the PSA 5000, we will need to develop 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. In addition, the PSA 5000 has not been released for commercial sale and by the time it is released, competition and new or enhanced technologies could result in the inability of the PSA 5000 to achieve market acceptance. 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.

In addition, we recently received FDA clearance for our new product, the PSA 5000. The PSA 5000 has not yet been released for commercial sale. Prior to its release new or enhanced technologies could emerge, resulting in the inability of the PSA 5000 to achieve market acceptance. In addition, there is no assurance the PSA 5000 will perform as anticipated or that customers will accept or demand this technology. Further, we may not be able to successfully adapt the PSA 5000 to other applications.

If we do not successfully adapt the PSA 4000 and PSA 5000 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 September 30, 2004, had an accumulated deficit of approximately $64.8 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, market acceptance of the PSA 4000, and the future market acceptance of the PSA 5000. In addition, competition, availability of third party reimbursement, implementing a distribution strategy for the PSA 5000 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 acceptance 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 may 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 particular, 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 and PSA 5000, 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.

28

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 September 30, 2004, 100% of our total portfolio will mature in one year or less. All securities are held in U.S. currency.

Item 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in internal control over financial reporting. There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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:
	None.

Item 5	Other Information:
	None.

Item 6	Exhibits and Reports on Form 8-K:

	(a)	Exhibits

		31.1	Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15(d)-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.
		31.2	Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15(d)-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.
		32.1	Certification of Chief Executive Officer and 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 furnished a Current Report on Form 8-K dated November 4, 2004, attaching our third quarter ended September 30, 2004 earnings release dated November 4, 2004.

		We furnished a Current Report on Form 8-K dated July 28, 2004, attaching our second quarter ended June 30, 2004 earnings release dated July 28, 2004.

September 30, 2004

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: November 15, 2004	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)

PART I	FINANCIAL INFORMATION

	Item 1		Unaudited Condensed Financial Statements

			Unaudited Condensed Balance Sheets as of December 31, 2003 and September 30, 2004

			Unaudited Condensed Statements of Operations for the Three and Nine Months Ended September 30, 2003 and 2004

			Unaudited Condensed Statements of Cash Flows for the Nine Months Ended September 30, 2003 and 2004

			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

Exhibit No.		Description
31.1		Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15(d)-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15(d)-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302(a) Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.1		Press Release dated November 04, 2004 (This is incorporated by reference to Exhibit 99.1 to the Company’s Form 8-K filed November 04, 2004).