PART I - FINANCIAL INFORMATION

Item 1.

CLARIENT, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in thousands, except share and per share amounts)

	March 31, 2005			December 31, 2004
	(Unaudited)
Assets
Current assets:

Cash and cash equivalents	$	4,825		$	10,045
Accounts receivable, net of allowance for doubtful accounts (Instrument Systems and Other)	1,232			1,387
Accounts receivable, net of allowance for doubtful accounts (Diagnostic Services)	2,210			1,273
Net investment in sales type leases	115			—
Other receivable	107			90
Other	386			438
Total current assets	8,875			13,233
Property and equipment, net of accumulated depreciation	5,609			6,084
Patents, net of accumulated amortization	707			743
Net investment in sales type leases	500			—
Other	109			97
Total assets	$	15,800		$	20,157

Liabilities and Stockholders’ Equity

Current liabilities:

Accounts payable	$	940		$	1,566
Accrued payroll	1,379			1,148
Accrued liabilities	917			1,138
Current maturities of long-term debt, including capital lease obligation	2,201			2,031
Total current liabilities	5,437			5,883
Long-term debt, including capital lease obligation	2,163			2,386
Commitments and contingencies
Stockholders’ equity:
Series C convertible preferred stock, $0.01 par value, authorized 200,000 shares, none issued and outstanding	—			—
Common stock $0.01 par value, authorized 100,000,000 shares, issued and outstanding 51,634,268 shares in 2005 and 51,590,448 in 2004	516			516
Additional paid-in capital	117,541			117,481
Accumulated deficit	(109,357		)	(105,483		)
Deferred compensation	(455		)	(576		)
Accumulated other comprehensive loss	(45		)	(50		)
Total stockholders’ equity	8,200			11,888
Total liabilities and stockholders’ equity	$	15,800		$	20,157

See accompanying notes to condensed consolidated financial statements.

CLARIENT, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

(in thousands, except share and per share amounts)

(Unaudited)

	Three Months Ended March 31,
	2005			2004
Revenue:
Diagnostic services	$	1,887		$	—
Instrument systems and other	2,120			1,931
Total revenue	4,007			1,931
Cost of revenue:
Diagnostic services	1,833			—
Instrument systems and other	641			926
Total cost of revenue	2,474			926
Gross profit	1,533			1,005
Operating expenses:
Selling, general and administrative	3,029			2,847
Diagnostic services administration	1,423			414
Research and development	928			1,029
Total operating expenses	5,380			4,290
Loss from operations	(3,847		)	(3,285		)
Other expense	27			61
Loss before income taxes	(3,874		)	(3,346		)
Income taxes.	—			—
Net loss	$	(3,874	)	$	(3,346	)
Basic and diluted net loss per common share	$	(0.08	)	$	(0.08	)
Weighted average number of common shares outstanding	51,616,369			39,917,232

See accompanying notes to condensed consolidated financial statements.

CLARIENT, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(in thousands, except share and per share amounts)

(Unaudited)

	Three Months Ended March 31,
	2005			2004

Cash flows from operating activities:
Net loss	$	(3,874	)	$	(3,346	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	786			717
Non-cash compensation charges	121			228
Reserve for bad debt	25			—

Changes in operating assets and liabilities:
Accounts receivable, net (Instrument Systems & Other)	155			443
Accounts receivable, net (Diagnostic Services)	(962		)	—
Other receivable	(17		)	399
Net investment in sales type leases	(615		)	—
Other assets	40			(80		)
Accounts payable	(626		)	370
Accrued payroll	231			103
Accrued liabilities	(209		)	(29		)
Net cash used in operating activities	(4,945		)	(1,195		)

Cash flows from investing activities:
Additions to patents	(6		)	(81		)
Purchase of property and equipment	(281		)	(1,108		)
Net cash used in investing activities	(287		)	(1,189		)

Cash flows from financing activities:
Proceeds from exercise of stock options	60			55
Repayments on long-term debt, including capital lease obligation	(495		)	(249		)
Borrowings on long-term debt, including capital lease obligation	442			—
Issuance of common stock	—			13,400
Offering costs	—			(541		)
Net cash provided by financing activities	7			12,665

Effect of exchange rate changes on cash and cash equivalents	5			54

Net increase (decrease) in cash and cash equivalents	(5,220		)	10,335

Cash and cash equivalents at beginning of period	10,045			1,699

Cash and cash equivalents at end of period	$	4,825		$	12,034

See accompanying notes to condensed consolidated financial statements.

CLARIENT, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(1) Interim Financial Statements

These interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our annual report on Form 10-K for the fiscal year ended December 31, 2004 filed with the Securities and Exchange Commission.

The accompanying unaudited condensed consolidated financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the financial position and the results of operations for the interim periods presented. All such adjustments are of a normal, recurring nature. Certain amounts have been reclassified to conform to the current period presentation. The results of operations for any interim period are not necessarily indicative of the results to be obtained for a full fiscal year.

Stock Options

Pro forma information, which assumes the Company had accounted for stock options granted under the fair value method prescribed by SFAS No. 123, “Accounting for Stock-based Compensation,” is presented below. The per share weighted-average fair value of stock options granted was $1.08 for the three-month period ended March 31, 2005, and $1.87 for the three-month period ended March 31, 2004, respectively, as estimated using the Black-Scholes option-pricing model.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting periods. The Company’s historical and pro forma net loss per share for the three-month periods ended March 31, 2005 and 2004 are as follows (in thousands, except per share data):

	Three Months Ended March 31,
	2005			2004
Consolidated net loss attributable to common stock:
As reported	$	(3,874	)	$	(3,346	)

Add: Stock-based employee compensation expense included in net loss	121			228
Deduct: Total stock-based employee compensation expense determined under fair-value based method for all awards	$	(465	)	$	(572	)
Pro forma net loss	$	(4,218	)	$	(3,690	)

Net loss per share — Basic and Diluted:
As reported	$	(0.08	)	$	(0.08	)
Pro forma	$	(0.08	)	$	(0.09	)

The following assumptions were used to determine the fair value of stock options granted using the Black-Scholes option-pricing model:

	2005		2004
Dividend yield	0.0	%	0.0	%
Volatility	103	%	109	%
Average expected option life	4 years		4 years
Risk-free interest rate	4.10	%	2.74	%

(2) Net Loss Per Share

Basic and diluted loss per common share is calculated by dividing net loss by the weighted average common shares outstanding during the period. Stock options and warrants to purchase an aggregate of 10,493,261 and 8,925,687 shares of common stock were outstanding at March 31, 2005 and 2004, respectively. These stock options and warrants outstanding were not included in the computation of diluted earnings per share because the Company incurred a net loss in all periods presented and hence, the impact would be anti-dilutive.

(3) Patents

Patents with estimated useful lives are amortized over their respective estimated useful lives to their estimated residual values. The following table provides a summary of the Company’s patents with definite useful lives recorded as of March 31, 2005 (in thousands):

	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Amortization Period in Years
Technology related	$	1,183	$	(476	)	$	707	10

The following table summarizes the future estimated annual pretax amortization expense for these assets (in thousands):

Fiscal Year
2005	$	90
2006	120
2007	120
2008	120
2009 & thereafter	257
Total	$	707

(4) Net Investment in Sales-Type Leases

The Company derives a portion of its revenues under leasing arrangements. Such arrangements provide for monthly payments covering the system sale, maintenance and interest. These arrangements meet the criteria to be accounted for as sales-type leases pursuant to Statement of Financial Accounting Standards No. 13, “Accounting for Leases”. Accordingly, the system sale is recognized upon delivery of the system, provided all other revenue recognition criteria are met as described above. Upon the recognition of revenue, an asset is established for the “investment in sales-type leases”. Maintenance revenue and interest income are recognized monthly over the lease term.

The following lists the components of the net investment in direct financing and sales-type leases as of March 31 (in thousands):

	2005
Total minimum lease payments to be received	$	854
Less: Amounts representing estimated maintenance costs including profit thereon, included in total minimum lease payments	(116		)
Net minimum lease payments receivable	738
Less: Unearned income & interest	(123		)
Net investment in sales-type leases	$	615

(5) Currency Translation

The financial position and results of operations of the Company’s foreign subsidiaries are determined using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate in effect at each quarter-end. Income statement accounts are translated at the average rate of exchange prevailing during the period. The effects of currency translations are included in comprehensive loss.

(6) Comprehensive Loss

The total comprehensive loss is summarized as follows (in thousands):

	Three Months Ended March 31,
	2005			2004
Net loss	$	(3,874	)	$	(3,346	)
Foreign currency translation adjustment	5			54
Comprehensive loss	$	(3,869	)	$	(3,292	)

(7) Business Segments

Although the Company targets three business segments, it currently operates primarily in two of these segments — “instrument systems and other” (which comprises the development, manufacture and marketing of an automated cellular imaging system designed to assist physicians in making critical medical decisions, including services to biopharmaceutical companies and other research organizations) and “diagnostic services” (which consists of the Company’s diagnostic laboratory services business). The segments are determined based on product and or services delivered to customer groups. The Company’s chief operating decision maker is the Chief Executive Officer and President. The chief operating decision maker allocates resources and assesses performance and other activities at the operating segment level.

Cost of revenue and loss from operations for our operating segments are as follows (in thousands):

	Three Months Ended							Three Months Ended
	March 31, 2005							March 31, 2004
	Diagnostic Services		Instrument Systems & Other		Total			Instrument Systems & Other
Total revenues	$	1,887	$	2,120	$	4,007		$	1,931

Cost of revenue	1,833		641		2,474			926
Gross profit	$	54	$	1,479	$	1,533		$	1,005
Selling, general and administrative (including diagnostic services administration)					4,452			3,261
Research & development					928			1,029
Loss from operations					$	(3,847	)	$	(3,285	)

Identifiable assets	$	9,756	$	6,044	$	15,800		$	21,128

The following table represents business segment information by geographic area (in thousands):

	Three Months Ended March 31,
	2005			2004
Net revenue
United States	$	4,003		$	1,724
Europe (a)	4			207
Total net revenue	$	4,007		$	1,931

Operating loss
United States	$	(3,789	)	$	(3,158	)
Europe (a)	(85		)	(127		)
Total operating loss	$	(3,874	)	$	(3,285	)

	March 31, 2005		December 31, 2004
Identifiable assets
United States	$	15,779	$	20,115
Europe (a)	21		42
Total assets	$	15,800	$	20,157

(a) European operations represent business activities conducted primarily in Germany, Great Britain and France.

(8) Recent Accounting Developments

Share-Based Payment

On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) will require companies to measure all employee stock-based compensation awards using a fair value method and record such expense in their consolidated financial statements. The adoption of SFAS No. 123(R) requires additional accounting and disclosure related to the income tax and cash flow effects resulting from share-based payment arrangements.

SFAS No. 123(R) would have been effective beginning as of the first interim or annual reporting period beginning after June 15, 2005. On April 14, 2005, the Securities Exchange Commission changed the effective date of most public companies for annual periods that begin after June 15, 2005. The Company is in the process of determining the impact of the requirements of SFAS No. 123(R) which could have a material impact on its consolidated financial statements.

Exchanges of Nonmonetary Assets

On December 16, 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets”, (“SFAS No. 153”), an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for nonmonetary asset exchanges beginning in the third quarter of 2005. The Company does not believe adoption of SFAS No. 153 will have a material effect on its consolidated financial position, results of operations or cash flows.

Inventory Costs

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs”, (“SFAS No. 151”), an amendment of Accounting Research Bulletin No. 43, Inventory Pricing. SFAS No. 151 requires all companies to recognize a current-period charge for abnormal amounts of idle facility expense, freight, handling costs and wasted materials. The statement also requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. This new standard will be effective for fiscal years beginning after June 15, 2005. The Company is currently evaluating the effect that the accounting change will have on its financial position and results of operations.

(9) Stock Transactions

On February 10, 2004, the Company completed a private placement exempt from registration under Section 4(2) of the Securities Act to issue 2,295,230 shares of common stock and a warrant to purchase shares of common stock to Safeguard for a purchase price of $5.0 million. The warrant issued to Safeguard is exercisable until March 1, 2008 and is currently exercisable to purchase 344,285 shares of common stock for an exercise price of $2.95 per share. As a result of this transaction, Safeguard’s percentage of beneficial ownership of the Company’s common stock increased from approximately 60% immediately preceding the transaction to approximately 63%. The Company also entered into a registration rights agreement giving Safeguard certain rights to have the purchased shares registered under the Securities Act of 1933, as amended.

On March 25, 2004, the Company entered into a securities purchase agreement with a limited number of accredited investors pursuant to which the Company agreed to issue and the investors agreed to purchase 10,500,000 shares of common stock, together with warrants to purchase an additional 1,575,000 shares of common stock at an exercise price of $2.75 per share for an aggregate purchase price of $21.0 million (this financing will be referred to as the “March 2004 financing”). The warrants issued in this transaction are exercisable for a period of four years after the date they were issued. This transaction was structured so that a portion of the common stock and warrants issued (4,200,000 shares of common stock and warrants to purchase 630,000 shares of common stock for aggregate gross proceeds of $8.4 million) were issued at an initial closing that occurred on March 31, 2004. The remaining shares and warrants to be issued in the transaction were issued at a subsequent closing which occurred on April 27, 2004. Safeguard was one of the purchasers in the March 2004 financing and acquired 3,750,000 shares (of which 1,500,000 shares were acquired at the initial closing) of common stock and warrants to purchase 562,500 shares of common stock (of which 225,000 shares were acquired at the initial closing) for an aggregate investment of $7.5 million. Following consummation of the subsequent closing of the financing Safeguard beneficially owned approximately 56.7% of the Company’s outstanding common stock.

Each of the purchasers in the March 2004 financing was granted a preemptive right to purchase its pro-rata share of 49.9% of any new equity securities that may be issued on or prior to March 31, 2005. Safeguard had previously been granted preemptive rights, which it waived in connection with the March 2004 financing (except to the extent that it purchased securities in the March 2004 transaction). In connection with the March 2004 financing, the Company entered into a registration rights agreement with the purchasers in that financing, and the Company has registered the resale of shares issued in the March 2004 financing with the Securities and Exchange Commission.

Due to its beneficial ownership of approximately 56.5% of the Company’s outstanding common stock, Safeguard has the power to elect all of the directors of the Company. The Company has given Safeguard contractual rights enabling it to exercise significant control over the Company.

(10) Line of Credit

In February 2003, the Company entered into a $3.0 million revolving credit agreement with the Technology and Life Sciences Division of Comerica Bank-California. This one year agreement was renewed in January 2005 until January 31, 2006 and the amount of this revolving credit agreement was increased to $5.5 million effective March 11, 2005. The borrowings under the line of credit will be used for working capital purposes and will bear interest at Comerica’s prime rate minus one-half percent. The agreement also includes an annual facility fee of $27,500, a fee of .25% on the unused balance of the line of credit,

various restrictive covenants and requirements to maintain certain financial ratios. Borrowings under the line of credit are guaranteed by Safeguard in exchange for a one-time fee of $27,500 and an amount equal to 4.5% per annum of the daily-weighted average principal balance outstanding under the line of credit. The renewed agreement now has only one financial covenant related to tangible net worth, which must be greater than $1 through June 30, 2004 and greater than ($2,000,000) thereafter.

(11) Equipment and Financing

In August 2003, the Company entered into an agreement for an equipment financing line from General Electric Capital Corporation. The equipment financing line provides for $3.0 million in immediate financing resources and an additional $2.0 million as the Company achieves certain system placement objectives. The loan principal amortizes ratably over the 33 month term. In September 2003, the Company borrowed $3.0 million at an interest rate of 8.16%. These borrowings under the equipment financing agreement are being used for working capital purposes and are secured by substantially all of the assets of the Company. The agreement also provides for various restrictive covenants, maintenance of certain financial ratios and a collateral monitoring fee of $5,000 per year.

The agreement also includes a provision whereby a material adverse change to the Company’s financial condition may be considered an event of default. The Company believes however, based on current operations, committed borrowings and its $4.8 million cash balance as of March 31, 2005, that it will remain in compliance with its debt covenants over the next twelve months and that it is not probable that GE will exercise the material adverse change clause as an event of default. The covenants in the equipment financing agreement incorporate the restrictive covenants and certain other requirements of the Comerica revolving credit agreement described in Note 10, including any subsequent waivers or amendments granted by Comerica. As of March 31, 2005, the debt balance outstanding is $1.5 million of which $1.1 million is classified as current and $0.4 as long-term.

In June 2004, the Company entered into a master lease agreement with GE Capital for capital equipment financings of diagnostic services (laboratory) related equipment. During 2004, the Company financed $2.6 million of capital equipment under this arrangement, which was recorded as a capital lease obligation. Each lease financing has a term of 36 months and provides for an early purchase option by the Company after 30 months at 26.6% of the cost of the equipment. As of March 31, 2005, the Company had financed $2.4 million of capital equipment, which was recorded as a capital lease obligation. Approximately $0.9 million of this balance is classified as current and $1.5 million as long-term.

In January 2005, GE Capital approved additional equipment lease financings of up to $2.3 million under this master lease agreement for equipment leases during 2005, subject to execution of definitive documentation for each separate equipment lease and subject to GE Capital’s ongoing review of the Company’s financial condition at the time of each funding request. These additional equipment lease financings have a term of 36 months for each equipment purchase and provide for an early purchase option by the Company after 24 months for a purchase price equal to 40.5% of the cost of the equipment. As of March 31, 2005, the Company had financed $0.4 million of capital equipment under this line, which was recorded as a capital lease obligation. Approximately $0.1 million of this balance is classified as current and $0.3 million as long-term.

The debt and capital lease obligations as of March 31, 2005 are as follows (in thousands):

Fiscal Year:
2005	$	1,634
2006	1,803
2007	912
2008	15
Total	4,364
Less: current portion	(2,201		)
Debt and capital lease obligation, excluding current portion	$	2,163

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about us, the industries in which we operate and other matters, as well as management’s beliefs and assumptions and other statements regarding matters that are not historical facts. These statements include, in particular, statements about our plans, strategies and prospects. For example, when we use words such as “projects,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “should,” “would,” “could,” “will,” “opportunity,” “potential” or “may,” variations of such words or other words that convey uncertainty of future events or outcomes, we are making 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. Our forward-looking statements are subject to risks and uncertainties. Factors that might cause actual results to differ materially, include, but are not limited to, the Company’s ability to successfully implement its plans to change its name, to successfully organize itself into separate business units and to continue to expand its offerings of cancer diagnostic laboratory services, biopharma services and in-sourcing of the Company’s Access remote pathology program, the Company’s ability to successfully locate an alternative site for its corporate headquarters and diagnostic laboratory upon expiration of the Company’s current leases relating to those sites, the performance and acceptance of the Company’s instrument systems in the market place, the Company’s ability to expand and maintain a successful sales and marketing organization, continuation of favorable third party payer reimbursement for tests performed using the Company’s system and for other diagnostic tests, the ability to obtain additional financing for its business on favorable terms or at all, unanticipated expenses or liabilities or other adverse events affecting cash flow, uncertainty of success in developing any new software applications, failure to obtain FDA clearance or approval for particular applications, the Company’s ability to compete with other technologies and with emerging competitors in cell imaging and dependence on third parties for collaboration in developing new tests and in distributing the Company’s systems and tests performed on the system, and those risks which are discussed in “Risk Factors” below. Many of these factors are beyond our ability to predict or control. In addition, as a result of these and other factors, our past financial performance should not be relied on as an indication of future performance. All forward-looking statements attributable to us, or to persons acting on our behalf, are expressly qualified in their entirety by this cautionary statement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this report might not occur.

Results of Operations

Overview and Outlook

We are an advanced oncology diagnostics technology and services company. Our mission is to combine innovative technologies, meaningful test results and world class expertise to improve outcomes of patients suffering from cancer. Our Automated Cellular Imaging System (ACIS^Ò)is a versatile automated microscope system that greatly improves the accuracy and reproducibility of digital cell imaging through its unique, patented technology. We also provide comprehensive laboratory services ranging from in-house pathology testing using the ACIS^Ò to other cutting-edge diagnostic technologies that assist physicians in managing cancer. In addition, we develop ACIS^®-based tools for academic and biopharmaceutical company researchers, allowing them to perform cellular-level analyses much faster and with improved accuracy. A number of the top clinical laboratories, hospitals, university medical centers and biopharmaceutical companies in the U.S. and Europe have adopted our technology.

The decision to provide in-house laboratory services was made in 2004 to give us an opportunity to capture a significant service-related revenue stream over the much broader and expanding cancer diagnostic testing marketplace while also optimizing the level of service and accuracy provided to remote pathology customers. Our business has historically been focused on the market for breast cancer testing. While this market is not insignificant, based on our market research we believe that the broader advanced cancer diagnostics market is approximately $1.5 billion. Our research indicates that this market will approach $2.5 billion by the end of this decade as a result of the substantial growth that is anticipated for both the incidence of cancer and for the development of new cancer therapies that will require a sophisticated diagnostic test. We believe that we are positioned to participate in this growth because of our proprietary analysis capabilities, depth of experience of the staff in our diagnostic laboratory, relationships with the pharmaceutical companies, and demonstrated ability to develop unique assays to support these new diagnostic tests.

The initial objective of our service strategy has been to support the expansion of the Access remote pathology program for community pathologists, a large customer segment. The focus of the development of the ACIS^Ò technology platformhas been to assist our customers in their diagnosis and treatment of cancer. We are now exploring numerous ways to leverage our relationship with our customers to better serve their needs and expand revenue opportunities in doing so. A logical extension of the remote pathology technical services has been the recent introduction of other esoteric tests and related professional diagnosis that support the oncology services marketplace. In order to perform these expanded services, we underwent a rigorous California state inspection process and obtained a California laboratory license in November 2004. We are now able to

provide a broad spectrum of other laboratory services, which include flow cytometry, molecular diagnostics including PCR (polymerase chain reaction), analysis of tumors of unknown origin, expanded services for immunohistochemistry and cytogenetics. In 2004, we launched our Access technical services and the broad complement of additional cancer diagnostic tests in our dedicated laboratory facility in Irvine, California.

We have placed an increasing level of importance relative to prior years on the sale of the ACIS^Ò system to research accounts, which include biopharmaceutical companies, biotechnology companies, and academic medical centers. We believe that there are more than 1,000 such organizations in the U.S. that are good candidates for the ACIS^Ò. This is a customer group that will be increasingly important for us in the coming years because of the large size of this market and the collaborative development opportunities that these customers provide for the development of new diagnostic tests using ACIS^Ò. Important criteria for these customers include the flexibility and ease of use of the system, the accuracy of the system as a measurement tool in the performance of clinical trials and research studies, and the inclusion of certain key features necessary to researchers such as fluorescence or tissue micro array capabilities. By “seeding” the market with ACIS^Ò devices to these customers and working with them on their development activities, we believe that we can help to foster the next generation of applications for ACIS^Ò.

A very important driver of our success in the future will also be our ability to develop new diagnostic tests on the ACIS^®, duplicating the success and market penetration that has been achieved within the breast cancer markets, where our market research indicates that as many as 30% of new breast cancer cases in the U.S. are tested using ACIS^Ò. Working in collaboration with many of the top-tier pharmaceutical companies, we are developing diagnostic tests and related assays that will target new cancer therapies to those patients most likely to benefit from their use. We believe the increasing shift towards an aging U.S. population, a group in which cancer incidence is greatest, the large pipeline of targeted cancer therapies in various stages of clinical study, and the increasingly high cost of these drugs will result in a large and ripe market for proven diagnostic tests. Our future success will rest on our ability to develop and introduce these tests using our proprietary imaging technology and to expand our installed base of clinical system placements in the marketplace.

An important component of our strategy is to continue to build and, when necessary, defend our intellectual property position. Currently, we have 27 issued or allowed patents that were approved over known prior art. Seven key U.S. patents cover the major features necessary to develop a competitive image analysis system and cover important system features such as autoloading, whole tissue imaging, multiple magnifications, and thresholds in hue, intensity and saturation. Asserting our intellectual property rights could be critical to supporting our strategy and in advancing our leadership position. Our research and development efforts have been further validated in the area of automated immunohistochemistry for which we have obtained five FDA 510(k) clearances over the past several years. These clearances help to validate the efficacy of our technology and to broaden the acceptance of our image analysis. It will be important for us to obtain FDA clearances for our portfolio of new diagnostic tests developed in our bioanalytical Services development efforts.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods presented. Therefore, on an ongoing basis, we evaluate our estimates, including those provisions for bad debts and reserves.

For estimated bad debts, we review on an individual account basis the age of the receivable, all circumstances surrounding the transaction that gave rise to the receivable and whether the customer continues to have the financial resources to pay the receivable as of the balance sheet date and prior to the issuance of the financial statements for the related period. This process is followed for both our instrument and laboratory accounts although, because we have outsourced the direct billing and collection of laboratory related receivables, we work closely with our outsourced billing partner to review the details of each laboratory related account. For ACIS^® in progress assets, the respective reserve is based upon the expected future use of the ACIS^® components and whether there are any lower of cost or market considerations. For other obligations, where judgment is required, we review the circumstances surrounding the obligation and evaluate the facts and circumstances to determine an appropriate level of accrual for each obligation.

We review our long-lived assets, such as fixed assets and intangibles, for impairment whenever events or changes indicate the carrying value may not be recoverable or that the useful lives are no longer appropriate. If we determine that the carrying value of the long-lived assets may not be recoverable, the asset is then written down to its estimated fair value based on a discounted cash flow basis. Included in long-lived assets is our ACIS, which is recorded in property and equipment.

Revenue for Diagnostic Services is recognized at the time of completion of services at amounts equal to those amounts expected for collection from third parties including Medicare, insurance companies and, to a small degree, private patients. These expected amounts are based both on Medicare allowable rates and our collection experience with other third party

payors. Because of the requirements and nuances of billing for laboratory services, we may invoice these parties amounts that are greater than those allowable for payment. These differences are described as contractual discounts. As noted, however, it is only the expected payment from these parties which is net of these contractual discounts that is recorded as revenue.

Revenue for “fee-per-use” agreements is obtained through the billing information via modem, which accesses the ACIS^® database. Revenue is recognized based on the greater of actual usage fees or the minimum monthly rental fee. Under this pricing model, we own most of the ACIS^® instruments that are engaged in service and, accordingly, all related depreciation and maintenance and service costs are expensed as incurred. For those instruments that are sold, we recognize and defer revenue using the residual method pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Arrangements.” At the outset of the arrangement with the customer, we defer revenue for the fair value of its undelivered elements (e.g., maintenance) and recognize revenue for the remainder of the arrangement fee attributable to the elements initially delivered in the arrangement (e.g., software license) when the basic criteria in SOP 97-2 have been met. Maintenance revenue is recognized ratably over the term of the maintenance contract, typically twelve months. Revenue on system sales is recognized upon acceptance by the customer, often subsequent to a testing and evaluation period.

Three Months Ended March 31, 2005 Compared with Three Months Ended March 31, 2004

Revenue

Diagnostic services. Revenue for the quarter ended March 31, 2005 was $1.9 million. There is no comparable figure for the quarter ended March 31, 2004, as we commenced providing these services in the second quarter of 2004. In generating this revenue, we provided services for more than 4,700 patient cases at an average revenue per case of $399 for the quarter ended March 31, 2005. The majority of tests performed in our laboratory were related to breast cancer testing and substantially one primary CPT code although the mix of tests has been increasingly shifting to several new tests that we started providing after receipt of our California laboratory license in November 2004. This shift could change the average revenue per test in the future depending on the complexity of service associated with these new tests. We anticipate that diagnostic services revenues will increase throughout 2005 because we are now able to offer a more comprehensive suite of advanced cancer diagnostic tests.

Instrument systems and other. Revenue for this segment, which includes fee-per-use and system sale revenue, for the quarter ended March 31, 2005 was $2.1 million, an increase of approximately $0.2 million or 10% over the quarter ended March 31, 2004. This was due primarily to an increase in instrument systems revenue, which increased $0.4 million from $0.4 million for the quarter ended March 31, 2004 to $0.8 million for the quarter ended March 31, 2005 due to the sale of six ACIS^Ò systems and four remote viewing stations as compared to two ACIS^Ò systems in the first quarter of 2004. This improvement was offset in part by a decline in fee-per-use revenue of $0.3 million from $1.6 million for the quarter ended March 31, 2004 to $1.3 million for the quarter ended March 31, 2005. This decline was caused by a reduction in the aggregate number of ACIS^Ò placements and a significant decline in the average monthly revenue for ACIS^Ò placements and remote viewing stations. We expect Instrument Systems revenue to increase due to an expanded sales force and marketing efforts which we expect will result in a projected increase in the number of systems that are sold.

Cost of revenue

Diagnostic services. Cost of revenue for the quarter ended March 31, 2005 was $1.8 million. There is no comparable figure for the quarter ended March 31, 2004, as these services commenced in the second quarter of 2004. These costs were relatively high compared to Diagnostic Services revenue because these operations have not yet achieved economies of scale. These costs include the laboratory personnel, equipment, laboratory supplies and other direct costs such as shipping that were required to support the launch and service of this operation. We believe that as the diagnostic services operation increases in size throughout 2005, margins for this business will increase to target levels of approximately 40%. However, depending on the pace of the revenue increase for these services it may take anywhere from two to four quarters or longer for us to begin realizing margins of this magnitude.

Instrument systems and other. Cost of revenue was $0.6 million for the quarter ended March 31, 2005. This amount is $0.3 million or 30% less than the $0.9 million cost in the quarter ended March 31, 2004. The cost of revenue primarily consists of cost for manufacturing the ACIS^Ò, which includes the cost for direct material, labor costs, and manufacturing overhead, and direct customer support costs. For fee-per-use revenue, the cost of the ACIS^® is depreciated over a three-year time period and for a system sale or sales-type lease the entire cost of the ACIS^Ò system is recognized at the time of sale. Gross margins for Instrument Systems were 70% in 2005 as compared to 52% in 2004. The improvement was due primarily to lower costs of sale for sold systems, which in many cases were refurbished older systems, and due to lower costs of field service. We expect that margins for the remainder of 2005 will be similar to those achieved in the most recent quarter.

General and Administrative

Selling, general and administrative expenses. These expenses for the three months ended March 31, 2005 increased approximately $0.2 million, or 6% over the comparable period in 2004. The increase for the three-month period includes salary and payroll related costs for the addition of new sales staff, costs related to hiring a new Vice President of Sales, and costs related to our name change and corporate branding campaign. We anticipate that these costs may increase in the future with the addition of sales resources to support our projected increase in service revenues.

Diagnostic services administration. These costs totaled $1.4 million for the quarter ended March 31, 2005 and included the costs of senior medical staff, senior operations personnel, collection costs, consultants and legal resources to facilitate implementation of this new operation. This amount is $1.0 million or 244% higher than $0.4 million in the quarter ended March 31, 2004 which is when we began to incur these start-up charges. In 2005, these costs are expected to continue to increase relative to the prior year because there will be twelve full months of costs compared to approximately eight in 2004 and because of higher collection costs on an anticipated increase in revenue. Collection costs are incurred from a third party billing and collection company that we have engaged to perform these services because of the high degree of technical complexity and knowledge required to effectively perform these operations. These costs are incurred as a percentage of amounts collected. In the future, we will consider directly providing these services but have no plans to do so in 2005.

Research and development expenses. Expenses for the three months ended March 31, 2005 decreased by approximately $0.1 million or 10%, over the comparable period in 2004. The decrease for the three-month period is due to a reduction in personnel as a result of a fourth quarter 2004 workforce reduction. We believe that sufficient resources exist currently to support the development of new features for the clinical and research markets. These new development activities, which are intended to produce features that could expand the volume of clinical tests supported by ACIS and increase the attractiveness of the ACIS as a tool for researchers, are important to increasing clinical system test volume, expanding the number of clinical system placements, and increasing research system sales.

Other expense. Other expense for the three months ended March 31, 2005 totaled $27,000, compared to $61,000 for the comparable period in 2004, and consisted of approximately $61,000 of interest expense offset by approximately $34,000 of interest income. The interest expense is due to the borrowings under our $3.0 million equipment financing agreement, which began accruing in September 2003. The $34,000 of interest income for the first quarter of 2005 compares to $11,000 of interest income for the comparable period of 2004. The increase in interest income is primarily the result of higher cash balances in the first quarter of 2005 compared to the first quarter of 2004.

Factors that May Affect Future Results of Operations

The year 2000 was our first full year of commercial activity during which we focused primarily on marketing and sales of the ACIS system to large hospitals, academic research centers and pathology groups as our menu of capabilities performed with the ACIS expanded and gained commercial acceptance. While we have made significant progress, we still face significant uncertainties, including those discussed below under “Risk Factors” and “Liquidity and Capital Resources,” which include our ability to achieve market acceptance of the ACIS, our ability to ensure satisfactory reimbursement by Medicare and other third party insurance carriers under new billing codes which have been established for image analysis-based testing effective as of January 1, 2004 and our ability to execute on our business plan to provide additional laboratory and bioanalytical services.

Laboratory services provided for patients with the assistance of ACIS technology are eligible for third party reimbursement using medical billing codes which apply to image analysis-based testing. These billing codes are known as Healthcare Common Procedure Coding System (HCPCS) codes, which include the Common Procedural Terminology, or CPT, codes as the means by which Medicare and private insurers identify medical services that are provided to patients in the United States. CPT codes are established by an independent editorial panel convened by the American Medical Association (AMA). The reimbursement amounts, or relative values, associated with the CPT codes are established by the Centers for Medicare and Medicaid Services (CMS), under a process that involves recommendations from an independent Relative Value Update Committee also convened by the AMA, with advice from professional societies representing the various medical specialties.

A new CPT code appropriate for image analysis went into effect on January 1, 2004. The interim rates established for this code in 2004 were subsequently amended on January 1, 2005. Under the new code, the total Medicare reimbursement for ACIS-based procedures performed in physician offices or independent laboratories is approximately $168 per test, reflecting a technical component of approximately $100 and a professional component of approximately $68. The technical component involves preparation of the patient sample and running the test on the ACIS, while the professional component involves the physician’s reading and evaluation of the test results. The actual amount varies based upon a geographic factor index for each state and may be higher or lower than the amounts indicated above in particular cases based on one’s geographic location. In Southern California, for example, where Clarient’s Access technical services are currently performed, the reimbursement amount for technical services is approximately $118 per slide.

We face risks that our ACIS and remote Access viewing systems may become obsolete or their market value may decline below their manufacturing cost. These risks have increased due to the recent slowdown in system placements and increase in

system returns related to the aforementioned reimbursement reductions. Some of these risks are mitigated by the depreciation of these systems as they become engaged in service and our ability to upgrade these systems, at a relatively low cost, to meet new application demands.

We also face uncertainties with respect to our ability to complete development of additional tests for the ACIS. In order to mitigate the risk that any one test will not be successfully developed, we maintain a pipeline of tests in a prioritized queue so that if any one test is not successfully developed, or market feedback suggests that a test should be given a lower priority, we can align development efforts according to priority. In addition, the ACIS system is dependent upon the laboratory producing a quality stained slide for image analysis. Reagent and or stain quality issues by stain manufacturers may impact the rate at which the ACIS technology is adopted or new applications are added to existing placements.

Other uncertainties affecting our business are discussed below under the caption “Risk Factors.”

Liquidity and Capital Resources

At March 31, 2005, we had approximately $4.8 million of cash and cash equivalents, $1.9 million available under our equipment financing lines (subject to lessor approval of each funding request), and $5.5 million available under our revolving line of credit. Cash used in operating activities was $4.9 million for the quarter ended March 31, 2005 due primarily to our net loss of $3.9 million and increases in working capital requirements. Cash used in investing activities of $0.3 million consisted of capital expenditures related primarily to purchases of new equipment for the diagnostic services laboratory. We believe that we have substantially all of the laboratory equipment that is required to support our operating activities for most of 2005 and that any significant additions to this equipment would be dependent on a substantial increase in diagnostic service activity during the latter half of the year. Any equipment purchases for laboratory equipment are intended to be funded with our $1.9 million equipment financing lease line. The rate of capital expenditures, as it relates to ACIS^Ò equipment purchases, has been lower than prior periods due to the slow pace of system placements. Contract signings and related placements of sales of systems to the research markets are expected to increase during 2005. In addition, because of the return of systems from certain accounts during 2004, we have an increase in the supply of returned equipment that is available for placement with new accounts in the future. We believe that we will be able to place this supply of returned equipment with new customers over the next 12 months.

We anticipate placing ACIS^Ò instruments with users and charging a “fee-per-use” for each time the instrument is used to perform a test or, alternatively, to sell these systems to research customers. The manufacture of these instruments is expected to require a modest outlay of cash because of the near term supply of returned equipment noted above. Revenues will be recognized over the lease term or, in the event of a system sale, upon customer acceptance of the system. We intend to fund expenditures for the lease or sale of systems with our current cash resources. Because these resources may not be adequate to support the entirety of our business expansion needs, we intend to increase the ratio of our system sales to per use leases, and we anticipate that the majority of system placements in 2005 will be for system sales as opposed to fee-per-use leases. The majority of these sales are expected to be to research accounts.

Net cash provided from financing activities during the first three months of 2005 was relatively flat primarily due to borrowings of $0.5 million offset by debt payments of $0.4 and the exercise of stock options of $0.1 million.

On February 10, 2004, we completed a private placement of 2,295,230 shares of common stock and a warrant to purchase shares of common stock to Safeguard for a purchase price of $5.0 million. The warrant issued to Safeguard, which is exercisable until March 1, 2008, is currently exercisable to purchase 344,285 shares of common stock for an exercise price of $2.95 per share. In connection with this private placement transaction, we entered into a registration rights agreement giving Safeguard certain rights to have the purchased shares registered under the Securities Act of 1933, as amended.

On March 25, 2004, we entered into a securities purchase agreement with a limited number of accredited investors pursuant to which we sold 10,500,000 shares of common stock, together with warrants to purchase an additional 1,575,000 shares of common stock at an exercise price of $2.75 per share, for an aggregate purchase price of $21.0 million. The warrants issued in this transaction are exercisable for a period of four years after the date of issuance. Safeguard acquired 3,750,000 shares of common stock and warrants to purchase 562,500 shares of common stock for an aggregate investment of $7.5 million. Each of the purchasers was granted a preemptive right to purchase its pro rata share of 49.9% of any new equity securities that we may issue on or prior to March 31, 2005. Safeguard had previously been granted preemptive rights, which it waived in connection with this financing, except to the extent that it purchased securities in the transaction. In connection with the financing, we entered into a registration rights agreement giving the investors certain rights to have the purchased shares registered under the Securities Act of 1933, as amended, and a registration statement covering resales of these securities is currently in effect.

In February 2003, we entered into a $3.0 million revolving credit agreement with the Technology and Life Sciences Division of Comerica Bank-California. This one year agreement was renewed in January 2005 through January 31, 2006 and the amount of this revolving credit agreement was increased to $5.5 million in March 2005. The borrowings under the line of credit will be used for working capital purposes and will bear interest at Comerica’s prime rate plus one-half percent. The agreement also includes an annual facility fee of $27,500, a fee of .25% on the unused balance of the line of credit, various restrictive covenants and requirements to maintain certain financial ratios. Borrowings under the line of credit are guaranteed by Safeguard in

exchange for a one-time fee of $27,500 and an amount equal to 4.5% per annum of the daily-weighted average principal balance outstanding under the line of credit. The renewed agreement now has only one financial covenant related to tangible net worth, which must be greater than $1 through June 30, 2004 and greater than ($2,000,000) thereafter. As of March 31, 2005, $5.5 million was available under the line of credit.

In August 2003, we entered into a $3.0 million equipment financing agreement with GE Capital. The loan principal amortizes ratably over a 33-month term. The borrowings under the equipment financing agreement were used for working capital purposes and bear interest at an annual rate of interest of 8.16%. The agreement also provides for an incremental $2.0 million of financing availability upon reaching certain system placement objectives, various restrictive covenants, maintenance of certain financial ratios and a collateral monitoring fee of $5,000 per year. In September 2003, the entire $3.0 million available under the financing agreement was borrowed. As of March 31, 2005, $1.5 million of debt remains outstanding under this agreement with approximately $1.1 million of the debt classified as current and $0.4 million as long-term.

Borrowings under the equipment financing agreement with GE Capital are secured by substantially all of our assets. The agreement with GE Capital incorporates some of the restrictive covenants and certain other requirements of the Comerica revolving credit agreement, including any amendments granted by Comerica with respect to the incorporated covenants. The agreement with GE Capital also includes a provision whereby a material adverse change to our financial condition could be considered an event of default. We believe, however, based on current operations, committed borrowings and our $4.8 million cash balance as of March 31, 2005, that we will remain in compliance with our debt covenants over the next twelve months.

In June 2004, we entered into a master lease agreement with GE Capital for capital equipment financings of laboratory services related equipment. During 2004, we financed $2.6 million of capital equipment under this arrangement, which was recorded as a capital lease obligation. Each lease financing has a term of 36 months and provides for an early purchase option after 30 months at 26.6% of the cost of the equipment.

In January 2005, GE Capital approved additional equipment lease financings of up to $2.3 million under this master lease agreement for equipment leases during 2005, subject to execution of definitive documentation for each separate equipment lease and subject to GE Capital’s ongoing review of our financial condition at the time of each funding request. These additional equipment lease financings have a term of 36 months for each equipment purchase and provide for an early purchase option by the Company after 24 months for a purchase price equal to 40.5% of the cost of the equipment. As of March 14, 2005, the Company had financed $0.4 million of capital equipment under this line, which was recorded as a capital lease obligation.

The following table summarizes our contractual obligations and commercial commitments at March 31, 2005. Our purchase obligations represent commitments primarily for the purchase of materials for the manufacture of our ACIS^® units.

	Payment due by period
	(in thousands)
Contractual Obligations	Total		Less than 1 Year		1-3 Years		3-5 Years		After 5 Years
Long-Term Debt Obligations	$	1,538	$	845	$	693	$	—	$	—
Capital Lease Obligations-Lab	2,826		789		2,037		—		—
Facility Obligations	235		235		—		—		—
Total	$	4,599	$	1,869	$	2,730	$	—	$	—

We currently lease our corporate headquarters and manufacturing facility and our laboratory services facility under operating lease arrangements. The lease for the corporate headquarters and manufacturing facility expired in February 2005 and we exercised our option to extend the lease six months. The lease for the diagnostic services facility was entered into in May 2004 for a term of one year. We have extended this lease until the end of August 2005. We are in the process of identifying potential new locations to lease for our corporate headquarters, manufacturing and laboratory operations (including locations in which we could combine our headquarters and manufacturing facility with our laboratory facility and also expand our laboratory service offerings). We expect that relocating our corporate headquarters and manufacturing facility and laboratory operations will require significant capital expenditures.

While we believe that our existing cash resources, the available $5.5 million revolving line of credit with Comerica bank and the $1.9 million of potential availability under our new equipment lease line with GE (which remains subject to GE’s ongoing review of our financial condition at the time of each funding request) would be sufficient to satisfy the cash needs of our existing operations during the next twelve months (including a move of our existing operations to one or more new locations), we will require additional debt or equity financing to fund our planned expansion of our diagnostic service operations. In addition, we may also require additional capital to fund our existing operations if we experience difficulty with locating and moving to new facilities or are not able to fully execute our business plans in 2005. There can be no assurance that we will be able to obtain additional debt or equity financing when needed or on terms that are favorable to us and our stockholders. Furthermore, if additional funds are raised through an equity or convertible debt financing, our stockholders may experience significant dilution.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements that provide financing, liquidity or market or credit risk support or involve leasing, hedging or research and development services for our business or other similar arrangements that may expose us to liability that is not expressly reflected in the financial statements, except for facilities and automobile operating leases.

At March 31, 2005, we did not have any relationships with unconsolidated entities or financial partnerships, often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such we are not subject to any material financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

New Accounting Standards

Several new accounting standards have been issued that were adopted in 2004. None of these standards had a material impact on our financial position, results of operations, or liquidity. See Note 8 of the Notes to Condensed Consolidated Financial Statements.

RISK FACTORS

Before deciding to invest in us or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and other reports we have filed with the Securities and Exchange Commission. The risks and uncertainties described below are not the only ones facing our Company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks are realized, our business, financial condition or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.

Risks Related to Our Business

We have limited experience in providing laboratory and other services, which may cause us to experience difficulties that could delay or prevent the development, introduction and marketing of these services.

We began providing the technical component of reference laboratory services in-house beginning in April 2004 and we began to provide additional, oncology-focused laboratory services that complement our image analysis and certified Access reference laboratory services in December 2004. The success and viability of these initiatives is dependent on a number of factors including:

• our ability to develop and provide services that we have not previously provided;

• adequate reimbursement;

• medical efficacy as demonstrated by clinical studies and governmental clearances;

• governmental clearances, governmental regulations and expansion of the menu of tests performed by ACIS^® to bring greater economies of scale to our accounts operations; and

• our ability to obtain timely approval of and renewal of requisite state and federal regulatory licenses.

We may not be successful in any of these areas, we may experience difficulties that could delay or prevent the successful development, introduction and marketing of these services, and we may not adequately meet the demands of the marketplace or achieve market acceptance. Our inability to accomplish any of these endeavors may have a material adverse effect on our business, operating results, cash flows and financial condition.

Our legacy instrument business is highly dependent on increased market acceptance of the ACIS^®, and it is uncertain whether the ACIS^® will achieve that acceptance.

Increased market acceptance of the ACIS^® depends on a number of variables, including, but not limited to, the following:

• the ability of the ACIS^® to perform as expected;

• acceptance by patients, physicians, third party payors and laboratories of the ACIS^® to run the tests performed using it;

• our ability to develop a significant number of tests performed with the ACIS^®;

• our ability to implement our new diagnostic lab service initiative;

• the amount of reimbursement by third party payors for a test performed using the ACIS^®;

• the effectiveness of marketing, distribution and pricing strategy;

• availability of alternative and competing diagnostic products; and

• scientific studies and other publicity concerning ACIS^® or competitive products.

The future commercial success of our products will depend primarily on convincing research, reference and clinical laboratories to evaluate and offer these products as research tools for scientists and clinical investigators and as diagnostic products to physicians, laboratory professionals and other medical practitioner and convincing physicians, laboratory professionals and other medical practitioners to order tests for their patients involving our technologies. To accomplish this, we will need to convince oncologists, pathologists and other members of the medical and biotechnology communities of the benefits of our products. Additionally, if ongoing or future clinical trials result in unfavorable or inconsistent results, these products may not achieve market acceptance. Even if the efficacy of our future products and services are established, physicians may elect not to use them for a number of reasons. These reasons might include the training required for their use or unfavorable reimbursement from health care payors.

Finally, our instrument systems legacy business may ultimately depend on our ability to enter into successful partnerships with other organizations in the diagnostic services industry, such as a reagent or autostainer producer. Inability to do so may limit the marketability of our products and services and create the risk that our technology could become underfunded and obsolete relative to new, emerging technologies of companies that have greater financial resources.

We have a history of operating losses, and our future profitability is uncertain.

We have incurred operating losses in every year since inception, and our accumulated deficit as of March 31, 2005 was $109 million. Those operating losses are principally associated with the research and development of our ACIS^® technology, the conducting of clinical trials, preparation of regulatory clearance filings, the development of our sales and marketing organization to commercialize the ACIS^®and the capital investments we have made relating to our recently launched diagnostic services business. Although leasing and sales of the ACIS^® have been encouraging since we began the commercial distribution of the ACIS^® in late 1999 and we have recently begun to provide a wide array of laboratory services, we may not be able to achieve profitable operations at any time in the future.

Because our operating expenses are likely to increase significantly in the near term, we will need to generate significant additional revenue to achieve profitability. We expect our losses to continue to increase as a result of the expansion of the laboratory services, ongoing research and development and clinical trial expenses, as well as increased sales and marketing expenses. We are unable to predict when we will become profitable, and we may never become profitable. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. If we are unable to achieve and then maintain profitability, the market value of our common stock will decline.

Our leases of our corporate headquarters and manufacturing facility and of our laboratory facility expire in August 2005 and we will be required to locate new facilities and make significant expenditures in relocating our operations.

We currently lease our corporate headquarters and manufacturing facility and our laboratory services facility under operating lease arrangements. The lease for the corporate headquarters and manufacturing facility expired in February 2005 and we exercised our option to extend the lease six months. The lease for the diagnostic services facility was entered into in May 2004 for a term of one year. We have extended this lease until the end of August 2005. We are currently in discussions with both landlords regarding extending these leases for a limited period of time, although there can be no assurance that we will be able to reach satisfactory arrangements with respect to any such extension. We are also in the process of identifying potential new locations to lease for our corporate headquarters, manufacturing and laboratory operations (including locations in which we could combine our headquarters and manufacturing facility with our laboratory facility and also expand our laboratory service offerings). However, we may not be able to locate a suitable facility or facilities prior to the expiration of our existing leases.

We may require additional financing to fund our existing operations and we will require additional financing for our planned expansion of our laboratory operations, and it is uncertain whether such financing will be available on favorable terms, if at all.

We currently believe that our existing cash resources, the available $5.5 million revolving line of credit with Comerica bank and the $1.9 million of potential availability under our new equipment lease line with GE (which remains subject to GE’s ongoing review of our financial condition at the time of each funding request) will be sufficient to satisfy the cash needs of our existing operations during the next twelve months (including a move of our existing operations to one or more new locations). However, we will require additional debt or equity financing to fund our planned expansion of our diagnostic service operations. In addition, we have expended and will continue to expend substantial funds for research and development, clinical trials and manufacturing and marketing of our system and expanding our offerings of bioanalytical services. We will need capital sooner than currently expected if our new business initiatives are not successful or we fail to achieve the level of revenues from applications and our other services in the time frame contemplated by our business plan. In addition, we may also require additional capital to fund our existing operations if we experience difficulty with locating and moving to new facilities upon expiration of the terms of our existing real property leases.

Our present and future funding requirements will also depend on certain other external factors, including, among other things:

• the level of research and development investment required to maintain and improve our technology position;

• costs of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights;

• our need or decision to acquire or license complementary technologies or acquire complementary businesses;

• competing technological and market developments; and

• changes in regulatory policies or laws that affect our operations.

We do not know whether additional financing will be available on commercially acceptable terms when needed. In addition, our existing financing agreements contain covenants that prevent us from incurring additional debt (subject to limited exceptions) and prevent us from granting certain liens, claims or encumbrances on our assets. As a result, we may need the consent of our existing lenders to obtain additional debt financing. If adequate funds are not available or are not available on commercially acceptable terms, we might be required to delay, scale back or eliminate our planned expansion of our laboratory facilities, some or all of our development activities, new business initiatives, clinical studies or regulatory activities or to license to third parties the right to commercialize products or technologies that we would otherwise seek to commercialize ourselves. If additional funds are raised through an equity or convertible debt financing, our stockholders may experience significant dilution.

Our ability to engage in certain business transactions may be limited by the restrictive covenants of our debt financing agreements.

Our existing financing agreements with Comerica Bank and GE Capital contain financial covenants requiring us to meet financial ratios and financial condition tests, as well as covenants restricting our ability to:

• incur additional debt;

• pay dividends or make other distributions or payments on capital stock;

• make investments;

• incur or permit to exist liens;

• enter into transactions with affiliates;

• change business, legal name or state of incorporation;

• guarantee the debt of other entities, including joint ventures;

• merge or consolidate or otherwise combine with another company; and

• transfer or sell our assets.

These covenants could adversely affect our ability to finance our future operations or capital needs and pursue available business opportunities, including acquisitions. A breach of any of these covenants could result in a default in respect of the related indebtedness. If a default occurs, the relevant lenders could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing that indebtedness. We believe that we are currently in compliance with the covenants in our financing agreements.

We have recently terminated our relationships with reference laboratory partners, including our largest customer, which could have a negative impact on our revenue.

During the past several years, we have had reference laboratory partners service our remote pathology ACIS^® users by performing the technical and professional component of analysis such as staining and image scanning. US Labs, Inc. and Esoterix, Inc. are two national reference laboratory partners that have provided these services in-house. In February 2004, we notified US Labs, Inc. and Esoterix, Inc. that we would end our relationship with them and begin to provide in-house laboratory services to our customers beginning in April 2004. For the year ended December 31, 2003, US Labs was our largest customer and accounted for approximately 7% of our revenues. Although we have been able to successfully convert most of our Access customers that were receiving these laboratory services from our former reference laboratory partners to our own laboratory facility, we may not be able to convert the remaining customers and the customers which have converted to our diagnostic services may elect not to continue to purchase laboratory services from us.

We have limited manufacturing experience and may encounter difficulties as we undertake to manufacture our system in increasing quantities.

We have limited commercial manufacturing experience and capabilities. We may encounter significant delays and incur significant unexpected costs in scaling-up our manufacturing operations. In addition, we may encounter delays and difficulties in hiring and training the workforce necessary to manufacture the ACIS^® in the increasing quantities required for us to achieve profitability. The failure to scale-up manufacturing operations successfully, in a timely and cost-effective manner, could have a material adverse effect on our revenues and income. We believe that we have adequate manufacturing capacity to meet anticipated demand for 2005. However, in order to meet demand thereafter, we will have to expand our manufacturing processes and facilities or rely on third-party manufacturers. We might encounter difficulties in expanding our manufacturing processes and facilities or in developing relationships with third-party manufacturers. If we are unable to overcome these difficulties our ability to meet product demand could be impaired or delayed.

We may not successfully manage our growth, which may result in delays or unanticipated difficulties in implementing our business plan.

Our success will depend upon the expansion of our operations and the effective management of our growth. We expect to experience growth in the scope of our operations and services and the number of our employees. If we grow significantly, such growth will place a significant strain on management and on administrative, operational and financial resources. To manage any growth, we would need to expand our facilities, augment our operational, financial and management systems, internal controls and infrastructure and hire and train additional qualified personnel. Our future success is heavily dependent upon growth and acceptance of our future products and services. If we are unable to scale our business appropriately or otherwise adapt to anticipated growth and new product introduction, our business, operating results, cash flows and financial condition may be harmed.

The medical imaging technology market is characterized by rapid technological change, frequent new product introductions and evolving industry standards, and we may encounter difficulties keeping pace with changes in this market.

The introduction of diagnostic tests embodying new technologies and the emergence of new industry standards can render existing tests obsolete and unmarketable in short periods of time. We expect competitors to introduce new products and services and enhancements to existing products and services. The life cycles of tests using the ACIS^®, and of the ACIS^® itself, are difficult to estimate. Our future success will depend upon our ability to enhance our current tests, to develop new tests, and to enhance and continue to develop the hardware and software included in the ACIS^®, in a manner that keeps pace with emerging industry standards and achieves market acceptance. Our inability to accomplish any of these endeavors will have a material adverse effect on our business, operating results, cash flows and financial condition.

We face substantial existing competition and potential new competition from others pursuing technologies for imaging systems.

We compete in a highly competitive industry. ACIS^® was first released in 1997 for use in research as an imaging system for the detection of rare cellular events. The primary application was for the detection of cells which contained a marker used to distinguish possible cancerous cells in bone marrow. At that time, the most significant competition to the ACIS^® for this application was use of manual microscopes and certain other cell-based techniques. These other techniques include polymerase chain reaction (PCR), a technique used in clinical labs to detect DNA sequences, and flow cytometry, a technique used to analyze biological material through the detection of the light-absorbing or fluorescing properties of cells. A natural progression for Clarient and the ACIS^® was to penetrate the manually intensive slide-based cancer testing market, with an initial focus on the breast cancer market. Companies such as DakoCytomation, Ventana and BioGenex have greater cancer-testing market share and stronger medical laboratory relationships than we do. They also have two of the critical system components needed to drive standardization—reagents and staining automation. Other imaging companies such as TriPath and Applied

Imaging are currently expanding into this market. Advancements in alternative cancer diagnostic tests and the development of new protein-based therapies will bring increased competition to this market segment, and such competition could adversely affect our operating results, cash flows and financial condition.

The clinical laboratory business is intensely competitive both in terms of price and service. This industry is dominated by several national independent laboratories, but includes many smaller niche and regional independent laboratories as well. Large commercial enterprises, including Quest and LabCorp, have substantially greater financial resources and may have larger research and development programs and more sales and marketing channels than we do, enabling them to potentially develop and market competing assays. These enterprises may also be able to achieve greater economies of scale or establish contracts with payor groups on more favorable terms. Smaller niche laboratories compete with us based on their reputation for offering a narrow test menu. Academic and regional institutions generally lack the advantages of the larger commercial laboratories but still compete with us on a limited basis. Pricing of laboratory testing services is one of the significant factors often used by health care providers in selecting a laboratory. As a result of the clinical laboratory industry undergoing significant consolidation, larger clinical laboratory providers are able to increase cost efficiencies afforded by large-scale automated testing. This consolidation results in greater price competition. Once we begin to provide laboratory services, we may be unable to increase cost efficiencies sufficiently, if at all, and as a result, our operating results, cash flows and our financial position could be negatively impacted by such price competition.

Competition in the pharmaceutical and biotechnology industries, and the medical devices and diagnostic products segments in particular, is intense and has been accentuated by the rapid pace of technological development. Our competitors in this area include large diagnostics and life sciences companies. Most of these entities have substantially greater research and development capabilities and financial, scientific, manufacturing, marketing, sales and service resources than we do. Some of them also have more experience than we do in research and development, clinical trials, regulatory matters, manufacturing, marketing and sales.

Because of their experience and greater research and development capabilities, our competitors might succeed in developing and commercializing technologies or products earlier and obtaining regulatory approvals and clearances from the FDA more rapidly than we can. Our competitors also might develop more effective technologies or products that are more predictive, more highly automated or more cost-effective, and that may render our technologies or products obsolete or non-competitive.

We rely significantly on third-party manufacturers who may fail to supply us with components necessary to our products and services on a timely basis.

We rely currently and intend to continue to rely significantly in the future on third-party manufacturers to produce all of the components used in our ACIS^® device and for future instrument systems that we may develop. We are dependent on these third-party manufacturers to perform their obligations in a timely and effective manner and in compliance with FDA and other regulatory requirements.

To date, we have generally not experienced difficulties in obtaining components from our manufacturers and, in cases where a particular manufacturer was unable to provide us with a necessary component, we have been able to locate suitable secondary sources. However, if the suppliers we rely on in the manufacturing of our products were unable to supply us with necessary components and we were unable to locate acceptable secondary sources, we might be unable to satisfy product demand, which would negatively impact our business. In addition, if any of these components are no longer available in the marketplace, we will be forced to further develop our technologies to incorporate alternate components. If we incorporate new components or raw materials into our products we might need to seek and obtain additional approvals or clearances from the FDA or foreign regulatory agencies, which could delay the commercialization of these products.

Our strategy for the development and commercialization of the ACIS^® platform contemplates collaborations with third parties, making us dependent on their success.

We have entered into and intend to continue to enter into corporate collaborations for the development of new applications, clinical collaborations with respect to tests using the ACIS^® and strategic alliances for the distribution of the ACIS^® and our other products, including products we may develop in the future. We, therefore, depend upon the success of third parties in performing their responsibilities. We cannot assure you that we will be able to enter into arrangements that may be necessary in order to develop and commercialize our products, or that we will realize any of the contemplated benefits from these arrangements. Furthermore, we cannot assure you that any revenues or profits will be derived from our collaborative and other arrangements.

We do not have the ability to independently conduct the clinical trials required to obtain regulatory clearances for our applications. We intend to rely on third-party expert clinical investigators and clinical research organizations to perform these functions. If we cannot locate and enter into favorable agreements with acceptable third parties, or if these third parties do not successfully carry out their contractual obligations, meet expected deadlines or follow regulatory requirements, including clinical laboratory, manufacturing and good clinical practice guidelines, then we may be the subject of an enforcement action by the

FDA or some other regulatory body, and may be unable to obtain clearances for our products or to commercialize them on a timely basis, if at all.

Failure in our information technology systems could disrupt our operations.

Our success will depend, in part, on the continued and uninterrupted performance of our information technology systems. Information systems are used extensively in virtually all aspects of our business, including laboratory testing, billing, customer service, logistics and management of medical data. Our success depends, in part, on the continued and uninterrupted performance of our information technology, or IT, systems.

Our computer systems are vulnerable to damage from a variety of sources, including telecommunications failures, malicious human acts and natural disasters. Moreover, despite reasonable security measures we have implemented, some of our information technology systems are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems, in part because we conduct business on the Internet and because some of these systems are located at third party web hosting providers and we cannot control the maintenance and operation of the data centers. Despite the precautions we have taken, unanticipated problems affecting our systems could cause interruptions in our information technology systems, leading to lost revenue, deterioration of customer confidence, or significant business disruption. Our business, financial condition, results of operations, or cash flows could be materially and adversely affected by any problem that interrupts or delays our operations.

If a catastrophe were to strike our facility, we would be unable to operate our business competitively.

We currently assemble, test and release our ACIS^® device at our facility located in San Juan Capistrano, California and we provide diagnostic services from our laboratory facility in Irvine, California. We do not have alternative production plans in place or alternative facilities available at this time. If there are unforeseen shutdowns to our facility, we will be unable to satisfy customer orders on a timely basis.

Our facilities may be affected by catastrophes such as fires, earthquakes or sustained interruptions in electrical service. Earthquakes are of particular significance to us because all of our clinical laboratory facilities are located in Southern California, an earthquake-prone area. In the event our existing facilities or equipment are affected by man-made or natural disasters, we may be unable to process our customers’ samples in a timely manner and unable to operate our business in a commercially competitive manner.

Our ability to maintain our competitive position depends on our ability to attract and retain highly qualified managerial, technical and sales and marketing personnel.

We believe that our continued success depends to a significant extent upon the efforts and abilities of our executive officers and our scientific and technical personnel, including the following individuals:

• Michael Cola, our Chairman;

• Ronald A. Andrews, our President and Chief Executive Officer;

• Stephen T. D. Dixon, our Executive Vice President and Chief Financial Officer;

• Heather Creran, our Executive Vice President and Chief Operating Officer — Diagnostic Services;

• Ken Bloom, M.D., our Chief Medical Director;

• Kenneth Bauer, Ph.D., our Vice President and Chief Science Officer;

• Karen Garza, our Vice President of Marketing and Strategic Initiatives;

• Jose de la Torre-Bueno, Ph.D., our Vice President and Chief Technology Officer; and

• David J. Daly, our Vice President of Sales.

We do not maintain key-person life insurance on any of our officers, scientific and technical personnel or other employees. The loss of any of our executive officers or senior managers could have a material adverse effect on our business, operating results, cash flows and financial condition.

Furthermore, our anticipated growth and expansion will require the addition of highly skilled technical, management, financial, sales and marketing personnel. In particular, we may encounter difficulties in attracting a sufficient number of qualified California licensed laboratory scientists. Competition for personnel is intense, and our failure to hire and retain talented personnel or the loss of one or more key employees could have a material adverse effect on our business. Many members of our current senior management group have been recruited and hired over the past 18 months. These individuals may not be able to fulfill their responsibilities adequately and may not remain with us.

The reimbursement rate for ACIS^®-based services has changed significantly over the past several years and further changes may result in an adverse effect on our revenues and results of operations.

The majority of the sales of our products in the US and other markets will depend, in large part, on the availability of adequate reimbursement to users of these products from government insurance plans, including Medicare and Medicaid in the US, managed care organizations, private insurance plans and other third-party payors. The continued success of the ACIS^® depends upon its ability to replace or augment existing procedures that are covered and otherwise eligible for payments and covered by the medical insurance industry.

The impact of the past years’ reimbursement changes to us was a reduction in our average revenue per system placement due to lower pricing that we began to offer to our customers in response to their reduced reimbursement rates. The net reduction of reimbursement for ACIS^®-based procedures over the past several years has reduced revenue for current ACIS^® customers, may result in sales allowances or cancellations of contracts by current customers and may negatively impact future placements of ACIS^®.

We are not able to fully assess or predict the full impact of the changes in reimbursement levels on our business at this time, nor whether Medicare will review the medical necessity and appropriateness of amounts that have been paid in prior years, although it is likely that these further reductions in reimbursement levels will impact our pricing, profitability and the demand for testing.

Our net revenue will be diminished if payors do not adequately cover or reimburse our services.

There has been and will continue to be significant efforts by both federal and state agencies to reduce costs in government healthcare programs and otherwise implement government control of healthcare costs. In addition, increasing emphasis on managed care in the U.S. may continue to put pressure on the pricing of healthcare services. Uncertainty exists as to the coverage and reimbursement status of new assays. Third party payors, including governmental payors such as Medicare and private payors, are scrutinizing new medical products and services and may not cover or may limit coverage and the level of reimbursement for our services. Third party insurance coverage may not be available to patients for any of our existing assays or assays we discover and develop. However, a substantial portion of the testing for which we bill our hospital and laboratory clients is ultimately paid by third party payors. Any pricing pressure exerted by these third party payors on our customers may, in turn, be exerted by our customers on us. If government and other third party payors do not provide adequate coverage and reimbursement for our assays, our operating results, cash flows or financial condition may decline.

Managed care organizations are using capitated payment contracts in an attempt to shift payment risks which may negatively impact our operating margins.

Managed care providers typically contract with a limited number of clinical laboratories and then designate the laboratory or laboratories to be used for tests ordered by participating physicians. The majority of managed care testing is negotiated on a fee-for-service basis at a discount. Such discounts have historically resulted in price erosion and we expect that they will negatively impact our operating margins once we commence offering laboratory services to managed care organizations.

Third party billing is extremely complicated and will result in significant additional costs to us.

Billing for laboratory services is extremely complicated. We plan to provide testing services to a broad range of healthcare providers. We consider a “payor” as the party that pays for the test and a “customer” as the party who refers tests to us. Depending on the billing arrangement and applicable law, we will need to bill various payors, such as patients, insurance companies, Medicare, Medicaid, doctors and employer groups, all of which have different billing requirements. Additionally, our billing relationships require us to undertake internal audits to evaluate compliance with applicable laws and regulations as well as internal compliance policies and procedures. Insurance companies also impose routine external audits to evaluate payments made. This adds further complexity to the billing process.

Among many other factors complicating billing are:

• pricing differences between our fee schedules and the reimbursement rates of the payors;

• disputes with payors as to which party is responsible for payment; and

• disparity in coverage and information requirements among various carriers.

We expect to incur significant additional costs as a result of our participation in the Medicare and Medicaid programs, as billing and reimbursement for clinical laboratory testing is subject to considerable and complex federal and state regulations. The additional costs we expect to incur include those related to: (1) complexity added to our billing processes; (2) training and education of our employees and customers; (3) implementing compliance procedures and oversight; (4) legal costs; and (5) costs associated with, among other factors, challenging coverage and payment denials and providing patients with information regarding claims processing and services, such as advanced beneficiary notices.

We may acquire other businesses, products or technologies in order to remain competitive in our market and our business could be adversely affected as a result of any of these future acquisitions.

We may make acquisitions of complementary businesses, products or technologies. If we identify any additional appropriate acquisition candidates, we may not be successful in negotiating acceptable terms of the acquisition, financing the acquisition, or integrating the acquired business, products or technologies into our existing business and operations. Further, completing an acquisition and integrating an acquired business will significantly divert management time and resources. The diversion of management attention and any difficulties encountered in the transition and integration process could harm our business. If we consummate any significant acquisitions using stock or other securities as consideration, our shareholders’ equity could be significantly diluted. If we make any significant acquisitions using cash consideration, we may be required to use a substantial portion of our available cash. Acquisition financing may not be available on favorable terms, if at all. In addition, we may be required to amortize significant amounts of other intangible assets in connection with future acquisitions, which would harm our operating results, cash flows and financial condition.

Risks Related to Litigation and Intellectual Property

Product liability claims could subject us to significant monetary damage.

The manufacture and sale of the ACIS^® and similar products entails an inherent risk of product liability arising from an inaccurate, or allegedly inaccurate, test or diagnosis. We currently maintain numerous insurance policies, including a $2,000,000 general liability policy, a $5,000,000 technology based errors and omissions policy and a $10,000,000 umbrella liability policy (which excludes technology based errors and omissions). These policies have deductible ranges from $5,000 to $25,000 and contain customary exclusions (including certain exclusions for medical malpractice and asbestos). Although we have not experienced any material losses to date, we cannot assure you that we will be able to maintain or acquire adequate product liability insurance in the future. Any product liability claim against us could have a material adverse effect on our reputation and operating results, cash flows and financial condition.

Clinicians or patients using our products or services may sue us and our insurance may not sufficiently cover all claims brought against us, which will increase our expenses.

The development, marketing, sale and performance of healthcare services expose us to the risk of litigation, including professional negligence. Damages assessed in connection with, and the costs of defending, any legal action could be substantial. We currently maintain numerous insurance policies, including a $3,000,000 professional liability insurance policy ($2,000,000 per incident). This policy has a deductible of $10,000 and contains customary exclusions (including exclusions relating to asbestos and biological contaminants). However, we may be faced with litigation claims which exceed our insurance coverage or are not covered under any of our insurance policies. In addition, litigation could have a material adverse effect on our business if it impacts our existing and potential customer relationships, creates adverse public relations, diverts management resources from the operation of the business or hampers our ability to perform assays or otherwise conduct our business.

If we use biological and hazardous materials in a manner that causes injury, we could be liable for damages.

Our research and development activities sometimes involve the controlled use of potentially harmful biological materials, hazardous materials, chemicals and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury to third parties from the use, storage, handling or disposal of these materials. We currently maintain numerous insurance policies, including a $2,000,000 general liability policy and a $10,000,000 umbrella liability policy (which excludes technology-based errors and omissions). These policies have deductible ranges from $5,000 to $25,000 and contain customary exclusions (including certain exclusions relating to asbestos and medical malpractice). However, in the event of contamination or injury, we could be held liable for any resulting damages, and any liability could exceed our resources or any applicable insurance coverage we may have. Additionally, we are subject on an ongoing basis to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. The cost of compliance with these laws and regulations is significant and could negatively affect our operations, cash flows and financial condition if these costs increase substantially.

Any breakdown in the protection of our proprietary technology, or any determination that our proprietary technology infringes on the rights of others, could materially affect our business.

Our commercial success will depend in part on our ability to protect and maintain our proprietary technology and to obtain and enforce patents on our technology. We rely primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. However, obtaining, defending and

enforcing our patents and other intellectual property rights involve complex legal and factual questions. We cannot assure you that we will be able to obtain, defend or enforce our patent rights covering our technologies in the US or in foreign countries, or be able to effectively maintain our technologies as unpatented trade secrets or otherwise obtain meaningful protection for our proprietary technology. Moreover, we cannot assure you that third parties will not infringe, design around, or improve upon our proprietary technology or rights.

The healthcare industry has been the subject of extensive litigation regarding patents and other proprietary rights and if we are unable to protect our patents and proprietary rights, through litigation or otherwise, our reputation and competitiveness in the marketplace could be materially damaged.

We may initiate litigation to attempt to stop the infringement of our patent claims or to attempt to force an unauthorized user of our trade secrets to compensate us for the infringement or unauthorized use, patent and trade secret litigation is complex and often difficult and expensive, and would consume the time of our management and other significant resources. If the outcome of litigation is adverse to us, third parties may be able to use our technologies without payments to us. Moreover, some of our competitors may be better able to sustain the costs of litigation because they have substantially greater resources. Because of these factors relating to litigation, we may be unable to prevent misappropriation of our patent and other proprietary rights effectively.

If the use of our technologies conflicts with the intellectual property rights of third-parties, we may incur substantial liabilities and we may be unable to commercialize products based on these technologies in a profitable manner, if at all.

Our competitors or others may have or acquire patent rights that they could enforce against us. If they do so, we may be required to alter our technologies, pay licensing fees or cease activities. If our technologies conflict with patent rights of others, third parties could bring legal action against us or our licensees, suppliers, customers or collaborators, claiming damages and seeking to enjoin manufacturing and marketing of the affected products. If these legal actions are successful, in addition to any potential liability for damages, we might have to obtain a royalty or licensing arrangement in order to continue to manufacture or market the affected products. A required license or royalty under the related patent or other intellectual property may not be available on acceptable terms, if at all.

We may be unaware of issued patents that our technologies infringe. Because patent applications can take many years to issue, there may be currently pending applications, unknown to us, that may later result in issued patents upon which our technologies may infringe. There could also be existing patents of which we are unaware upon which our technologies may infringe. In addition, if third parties file patent applications or obtain patents claiming technology also claimed by us in pending applications, we may have to participate in interference proceedings in the US Patent and Trademark Office to determine priority of invention. If third parties file oppositions in foreign countries, we may also have to participate in opposition proceedings in foreign tribunals to defend the patentability of the filed foreign patent applications. We may have to participate in interference proceedings involving our issued patents or our pending applications.

If a third party claims that we infringe upon its proprietary rights, any of the following may occur:

• we may become involved in time-consuming and expensive litigation, even if the claim is without merit;

• we may become liable for substantial damages for past infringement, including possible treble damages for allegations of willful infringement, if a court decides that our technologies infringe upon a competitor’s patent;

• a court may prohibit us from selling or licensing our product without a license from the patent holder, which may not be available on commercially acceptable terms, if at all, or which may require us to pay substantial royalties or grant cross licenses to our patents; and

• we may have to redesign our product so that it does not infringe upon others’ patent rights, which may not be possible or could require substantial funds or time.

If any of these events occurs, our business, results of operation, cash flows and financial condition will suffer and the market price of our common stock will likely decline.

Risks Related to Regulation of Our Industry

FDA regulations and those of other regulatory agencies can cause significant uncertainty, delay and expense in introducing new applications for the ACIS^® and present a continuing risk to our ability to offer applications.

As a medical device, our ACIS^® product is subject to extensive and frequently changing federal, state and local governmental regulation in the U.S. and in other countries. The U.S. Food and Drug Administration (FDA) as well as various other federal and state statutes and regulations, govern the development, testing, manufacture, labeling, storage, record keeping, distribution,

sale, marketing, advertising and promotion and importing and exporting of medical devices. Failure to comply with applicable governmental requirements can result in fines, recall or seizure of products, total or partial suspension of production, withdrawal of existing product approvals or clearances, refusal to approve or clear new applications or notices and criminal prosecution. In addition, changes in existing laws or regulations, or new laws or regulations, may delay or prevent us from marketing our products or cause us to reduce our pricing.

If we are not able to obtain all of the regulatory approvals and clearances required to commercialize our products, our business would be significantly harmed.

Regulatory clearance or approval of applications for the ACIS^® or other products we may develop, including the related software, may be denied or may include significant limitations on the indicated uses for which it may be marketed. The FDA actively enforces the prohibition on marketing products that have not been approved or cleared and also imposes and enforces strict regulations regarding the validation and quality of manufacturing, which are enforced through periodic inspection of manufacturing facilities. Foreign countries have comparable regulations.

In most cases, the development and commercialization of additional diagnostic applications in the U.S. will require either pre-market notification, or 510(k) clearance, or pre-market approval (PMA) from the FDA prior to marketing. The 510(k) clearance pathway usually takes from two to twelve months from submission, but can take longer. The pre-market approval pathway is much more costly, lengthy, uncertain and generally takes from one to two years or longer from submission. We do not know whether we will be able to obtain the clearances or approvals required to commercialize these products.

Applications submitted for FDA clearance or approval will be subject to substantial restrictions, including, among other things, restrictions on the indications for which we may market these products, which could result in lower revenues. The marketing claims we will be permitted to make in labeling or advertising regarding our cancer diagnostic products, if cleared or approved by the FDA, will be limited to those specified in any clearance or approval. In addition, we are subject to inspection and marketing surveillance by the FDA to determine our compliance with regulatory requirements. If the FDA finds that we have failed to comply with these requirements, it can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions, including:

• fines, injunctions and civil penalties;

• recall or seizure of our products;

• operating restrictions, partial suspension or total shutdown of production;

• denial of requests for 510(k) clearances or pre-market approvals of product candidates;

• withdrawal of 510(k) clearances or pre-market approvals already granted; and

• criminal prosecution.

Any of these enforcement actions could affect our ability to commercially distribute our products in the US and may also harm our ability to conduct the clinical trials necessary to support the marketing, clearance or approval of additional applications.

We cannot predict the extent of future FDA regulation of our in-house diagnostic laboratory services.

Neither the FDA nor any other governmental agency currently fully regulates the new in-house diagnostic laboratory services that we may develop and market to physicians, laboratory professionals and other medical practitioners. These tests are commonly referred to as “home brews.” FDA maintains that it has the authority to regulate “home brews” under the Federal Food, Drug, and Cosmetic Act as medical devices, however, as a matter of enforcement discretion, has decided not to exercise its authority. FDA is currently assessing the feasibility of applying additional regulatory controls over in-house diagnostic laboratory testing. We cannot predict the extent of future FDA regulation and there can be no assurance that the FDA will not require in-house diagnostic laboratory testing to receive premarketing clearance, or premarket approval prior to marketing. Additional FDA regulatory controls over our in-house diagnostic laboratory services could add substantial additional costs to our operations, and may delay or prevent our ability to commercially distribute our products in the U.S.

Our medical devices, facilities and products are subject to significant quality control oversight and regulations, and our failure to comply with these could result in penalties or enforcement proceedings.

Manufacturers of medical devices are subject to federal and state regulation regarding validation and the quality of manufacturing facilities, including FDA’s Quality System Regulation, or QSR, which covers the design, testing production processes, controls, quality assurance, labeling, packaging, storing and shipping of medical devices. Our failure to comply with these quality system regulations could result in civil or criminal penalties or enforcement proceedings, including the recall of a product or a “cease distribution” order requiring us to stop placing our products in service or selling, any one of which could materially adversely affect our business, results of operations and financial condition. Similar results would occur if we were to violate foreign regulations.

Our operations are subject to strict laws prohibiting fraudulent billing and other abuse, and our failure to comply with such laws could result in substantial penalties.

Of particular importance to our operations are federal and state laws prohibiting fraudulent billing and providing for the recovery of non-fraudulent overpayments, as a large number of laboratories have been forced by the federal and state governments, as well as by private payors, to enter into substantial settlements under these laws. In particular, if an entity is determined to have violated the federal False Claims Act, it may be required to pay up to three times the actual damages sustained by the government, plus civil penalties of between $5,500 to $11,000 for each separate false claim. There are many potential bases for liability under the federal False Claims Act. Liability arises, primarily, when an entity knowingly submits, or causes another to submit, a false claim for reimbursement to the federal government. Submitting a claim with reckless disregard or deliberate ignorance of its truth or falsity could result in substantial civil liability. A trend affecting the healthcare industry is the increased use of the federal False Claims Act and, in particular, actions under the False Claims Act’s “whistleblower” or “qui tam” provisions. Those provisions allow a private individual to bring actions on behalf of the government alleging that the defendant has submitted a fraudulent claim for payment to the federal government. The government must decide whether to intervene in the lawsuit and to become the primary prosecutor. If it declines to do so, the individual may choose to pursue the case alone, although the government must be kept apprised of the progress of the lawsuit. Whether or not the federal government intervenes in the case, it will receive the majority of any recovery. In recent years, the number of suits brought against healthcare providers by private individuals has increased dramatically. In addition, various states have enacted laws modeled after the federal False Claims Act.

Government investigations of clinical laboratories have been ongoing for a number of years and are expected to continue in the future. Written “corporate compliance” programs to actively monitor compliance with fraud laws and other regulatory requirements are recommended by the Department of Health and Human Services’ Office of the Inspector General and we have a program following the guidelines in place.

Our laboratory services will be subject to extensive federal and state regulation, and our failure to comply with such regulations could result in penalties or suspension of Medicare payments and/or loss of our licenses, certificates or accreditation.

The clinical laboratory testing industry is subject to extensive regulation, and many of these statutes and regulations have not been interpreted by the courts. The Clinical Laboratory Improvement Amendments of 1988 (“CLIA”) established quality standards for all laboratory testing to ensure the accuracy, reliability and timeliness of patient test results regardless of where the test was performed. Laboratories covered under CLIA are those which perform laboratory testing on specimens derived from humans for the purpose of providing information for the diagnosis, prevention, treatment of disease and other factors. The Centers for Medicare and Medicaid Services is charged with the implementation of CLIA, including registration, surveys, enforcement and approvals of the use of private accreditation agencies. For certification under CLIA, laboratories such as ours must meet various requirements, including requirements relating to quality assurance, quality control and personnel standards. Since we will be performing patient testing from all states, our laboratory will also be subject to strict regulation by California, New York and various other states. State laws may require that laboratory personnel meet certain qualifications, specify certain quality controls or require maintenance of certain records, and we will be required to obtain state regulatory licenses to offer the professional and technical components of laboratory services. If we are unable to secure our state regulatory license in a timely manner, our plans to expand into laboratory services could be compromised. We will also seek to be accredited by the College of American Pathologists, a private accrediting agency, and therefore will be subject to their requirements and evaluation. Our failure to comply with CLIA, state or other applicable requirements could result in various penalties, including restrictions on tests which the laboratory may perform, substantial civil monetary penalties, imposition of specific corrective action plans, suspension of Medicare payments and/or loss of licensure, certification or accreditation. Such penalties could result in our being unable to continue performing laboratory testing. Compliance with such standards is verified by periodic inspections and requires participation in proficiency testing programs.

We are subject to significant environmental, health and safety regulation.

We are subject to licensing and regulation under federal, state and local laws and regulations relating to the protection of the environment and human health and safety, including laws and regulations relating to the handling, transportation and disposal of medical specimens, infectious and hazardous waste and radioactive materials as well as to the safety and health of laboratory employees. In addition, the federal Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for health care employers, including clinical laboratories, whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis B virus. These regulations, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to, and transmission of, blood-borne pathogens. In addition, the federally-enacted Needlestick Safety and Prevention Act requires, among other things, that we include in our safety programs the evaluation and use of engineering controls such as safety needles if found to be effective at reducing the risk of needlestick injuries in the workplace.

We are subject to federal and state laws governing the financial relationship among healthcare providers, including Medicare and Medicaid laws, and our failure to comply with these laws could result in significant penalties and other adverse consequences.

Existing federal laws governing Medicare and Medicaid and other similar state laws impose a variety of broadly described restrictions on financial relationships among healthcare providers, including clinical laboratories. These laws include the federal anti-kickback law which prohibits individuals or entities, including clinical laboratories, from, among other things, making any payments or furnishing other benefits intended to induce or influence the referral of patients for tests billed to Medicare, Medicaid or certain other federally funded programs. Several courts have interpreted the statute’s intent requirement to mean that if any one purpose of an arrangement involving remuneration is to induce referrals of federal healthcare covered business, the statute has been violated. Penalties for violations include criminal penalties and civil sanctions such as fines, imprisonment and possible exclusion from Medicare, Medicaid and other federal healthcare programs. In addition, some kickback allegations have been claimed to violate the Federal False Claims Act (discussed above). In addition, many states have adopted laws similar to the federal anti-kickback law. Some of these state prohibitions apply to referral of patients for healthcare items or services reimbursed by any source, not only the Medicare and Medicaid programs. Many of the federal and state anti-fraud statutes and regulations, including their application to joint ventures and collaborative agreements, are vague or indefinite and have not been interpreted by the courts.

In addition, these laws also include self-referral prohibitions which prevent us from accepting referrals from physicians who have non-exempt ownership or compensation relationships with us as well as anti-markup and direct billing rules that may apply to our relationships with our customers. Specifically, the federal anti-”self-referral” law, commonly known as the “Stark” law, prohibits, with certain exceptions, Medicare payments for laboratory tests referred by physicians who have, personally or through a family member, an investment interest in, or a compensation arrangement with, the testing laboratory. A person who engages in a scheme to circumvent the Stark Law’s prohibitions may be fined up to $100,000 for each such arrangement or scheme. In addition, anyone who presents or causes to be presented a claim to the Medicare program in violation of the Stark Law is subject to monetary penalties of up to $15,000 per claim submitted, an assessment of several times the amount claimed, and possible exclusion from participation in federal healthcare programs. In addition, claims submitted in violation of the Stark Law may be alleged to be subject to liability under the federal False Claims Act and its whistleblower provisions.

Several states in which we operate have enacted legislation that prohibits physician self-referral arrangements and/or requires physicians to disclose any financial interest they may have with a healthcare provider to their patients when referring patients to that provider. Some of these statutes cover all patients and are not limited to Medicare or Medicaid beneficiaries. Possible sanctions for violating state physician self-referral laws vary, but may include loss of license and civil and criminal sanctions. State laws vary from jurisdiction to jurisdiction and, in a few states, are more restrictive than the federal Stark Law. Some states have indicated they will interpret their own self-referral statutes the same way that the U.S. Centers for Medicare and Medicaid Services (“CMS”) interprets the Stark Law, but it is possible the states will interpret their own laws differently in the future. The laws of many states prohibit physicians from sharing professional fees with non-physicians and prohibit non-physician entities, such as us, from practicing medicine and from employing physicians to practice medicine.

If we do not comply with existing or additional regulations, or if we incur penalties, it could increase our expenses, prevent us from increasing net revenue, or hinder our ability to conduct our business. In addition, changes in existing regulations or new regulations may delay or prevent us from marketing our products or cause us to reduce our pricing.

Our business is subject to stringent laws and regulations governing the confidentiality of medical information, and our failure to comply could subject us to criminal penalties and civil sanctions.

The use and disclosure of patient medical information is subject to substantial regulation by federal, state, and foreign governments. For example, the Health Insurance Portability and Accountability Act of 1996, known as HIPAA, was enacted among other things, to establish uniform standards governing the conduct of certain electronic health care transactions and to protect the security and privacy of individually identifiable health information maintained or transmitted by health care providers, health plans and health care clearinghouses. We are currently required to comply with two standards under HIPAA. We must

comply with the Standards for Electronic Transactions, which establish standards for common health care transactions, such as claims information, plan eligibility, payment information and the use of electronic signatures; unique identifiers for providers, employers, health plans and individuals; security; privacy; and enforcement. We were required to comply with these Standards by October 16, 2003. We also must comply with the Standards for Privacy of Individually Identifiable Information, which restrict our use and disclosure of certain individually identifiable health information. We were required to comply with the Privacy Standards by April 14, 2003. We are also required to implement certain security measures to safeguard certain electronic health information. In addition, CMS recently published a final rule, which will require us to adopt a Unique Health Identifier for use in filing and processing health care claims and other transactions by May 23, 2007. While the government intended this legislation to reduce administrative expenses and burdens for the health care industry, our compliance with this law may entail significant and costly changes for us. If we fail to comply with these standards, we could be subject to criminal penalties and civil sanctions.

The Standards for Privacy of Individually Identifiable Information establish a “floor” and do not supersede state laws that are more stringent. Therefore, we are required to comply with both federal privacy regulations and varying state privacy laws. In addition, for health care data transfers from other countries relating to citizens of those countries, we must comply with the laws of those other countries.

Risks Related to Our Common Stock

We have never paid cash dividends on our common stock and do not anticipate paying dividends on our common stock, which may cause investors to rely on capital appreciation for a return on their investment.

We currently intend to retain future earnings for use in our business and do not anticipate paying cash dividends on our common stock in the foreseeable future. Any payment of cash dividends will also depend on our financial condition, results of operations, capital requirements and other factors and will be at the discretion of our board of directors. Accordingly, investors will have to rely on capital appreciation, if any, to earn a return on their investment in our common stock.

If we raise additional funds you may suffer dilution or subordination and we may grant rights in our technology or products to third parties.

If we raise additional funds by issuing equity securities, further dilution to our stockholders could result, and new investors could have rights superior to those of holders of the shares of our common stock. Any equity securities issued also may provide for rights, preferences or privileges senior to those of holders of our common stock. If we raise additional funds by issuing debt securities, these debt securities would have rights, preferences and privileges senior to those of holders of our common stock, and the terms of the debt securities issued could impose significant restrictions on our operations. If we raise additional funds through collaborations and licensing arrangements, we might be required to relinquish significant rights to our technologies or products, or grant licenses on terms that are not favorable to us. If adequate funds are not available, we may have to delay or may be unable to continue to develop our products.

Our stock price is likely to continue to be volatile, which could result in substantial losses for investors.

The market price of our common stock has in the past been, and in the future is likely to be, highly volatile. These fluctuations could result in substantial losses for investors. Our stock price may fluctuate for a number of reasons including:

• media reports and publications and announcements about cancer or diagnostic products or treatments or new innovations;

• developments in or disputes regarding patent or other proprietary rights;

• announcements regarding clinical trials or other technological or competitive developments by us and our competitors

• loss of a significant customer or group purchasing organization contract;

• the hiring and retention of key personnel;

• announcements concerning our competitors or the biotechnology industry in general;

• regulatory developments regarding us or our competitors;

• changes in reimbursement policies concerning our products or competitors’ products;

• changes in the current structure of the healthcare financing and payment systems;

• stock market price and volume fluctuations, which have particularly affected the market prices for medical products and

high technology companies and which have often been unrelated to the operating performance of such companies; and

• general economic, political and market conditions.

In addition, stock markets have from time to time experienced extreme price and volume fluctuations. The market prices for medical device and laboratory service affected by these market fluctuations and such effects have often been unrelated to the operating performance of such companies. These broad market fluctuations may cause a decline in the market price of our common stock.

Securities class action litigation is often brought against a company after a period of volatility in the market price of its stock. This type of litigation could be brought against us in the future, which could result in substantial expense and damage awards and divert management’s attention from running our business.

With the advent of the Internet, new avenues have been created for the dissemination of information. We do not have control over the information that is distributed and discussed on electronic bulletin boards and investment chat rooms. The motives of the people or organizations that distribute such information may not be in our best interest or in the interest of our shareholders. This, in addition to other forms of investment information, including newsletters and research publications, could result in a significant decline in the market price of our common stock.

Future sales of shares by existing stockholders could result in a decline in the market price of the stock.

Some of our current stockholders hold a substantial number of shares which they are currently able to sell in the public market, and our employees hold options to purchase a significant number of shares and/or have been issued shares of restricted stock that are covered by registration statements on Form S-8. If our common stockholders sell substantial amounts of common stock in the public market, or the market perceives that such sales may occur, the market price of our common stock could fall. Safeguard Scientifics, Inc., which owns a majority of our outstanding common stock, has rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or other stockholders. Furthermore, if we were to include in a Company-initiated registration statement shares held by those holders pursuant to the exercise of their registrations rights, the sale of those shares could impair our ability to raise needed capital by depressing the price at which we could sell our common stock.

We are controlled by a single existing stockholder, whose interests may differ from other stockholders’ interests and may adversely affect the trading price of our common stock.

Safeguard Scientifics, Inc. beneficially owns a majority of the outstanding shares of our common stock. Safeguard Scientifics, Inc. currently beneficially owns 56.5% of our common stock. As a result, Safeguard Scientifics, Inc. will have significant influence in determining the outcome of any corporate transaction or other matter submitted to the stockholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets. In addition, Safeguard Scientifics, Inc. will have the ability to elect all of our directors and they could, as a result, dictate the management of our business and affairs. The interests of this stockholder may differ from other stockholders’ interests. In addition, this concentration of ownership may delay, prevent, or deter a change in control and could deprive other stockholders of an opportunity to receive a premium for their common stock as part of a sale of our business. This significant concentration of share ownership may adversely affect the trading price of our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders.

We have adopted a stockholder rights plan and other arrangements which could inhibit a change in control and prevent a stockholder from receiving a favorable price for his or her shares.

Our board of directors has adopted a stockholders’ rights plan providing for discounted purchase rights to its stockholders upon specified acquisitions of our common stock. The exercise of these rights is intended to inhibit specific changes of control of our company.

In addition, Section 203 of the Delaware General Corporation Law limits business combination transactions with 15% stockholders that have not been approved by our board of directors. These provisions and others could make it difficult for a third party to acquire us, or for members of our board of directors to be replaced, even if doing so would be beneficial to our stockholders. Because our board of directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt to replace the current management team. If a change of control or change in management is delayed or prevented, you may lose an opportunity to realize a premium on your shares of common stock or the market price of our common stock could decline.

Our shares of common stock currently trade on the NASDAQ SmallCap Market which results in a number of legal and other consequences that may negatively affect our business and the liquidity and price of our common stock.

Effective August 15, 2003, a Nasdaq Qualifications Panel terminated our Nasdaq National Market Listing and transferred our securities to the Nasdaq SmallCap Market. With our securities listed on the Nasdaq SmallCap Market, we face a variety of legal and other consequences that may negatively affect our business including, without limitation, the following:

• future issuances of our securities may require time-consuming and costly registration statements and qualifications because state securities law exemptions available to us are more limited;

• securities analysts may decrease or cease coverage of Clarient; and

• we may lose current or potential investors.

In addition, we are required to satisfy various listing maintenance standards for our common stock to be quoted on the Nasdaq SmallCap Market. If we fail to meet such standards, our common stock would likely be delisted from the Nasdaq SmallCap Market and trade on the over-the-counter bulletin board, commonly referred to as the “pink sheets.” This alternative is generally considered to be a less efficient market and would seriously impair the liquidity of our common stock and limit our potential to raise future capital through the sale of our common stock, which could materially harm our business, results of operations, cash flows and financial position.

Recently enacted and proposed changes in securities laws and regulations will increase our costs.

The Sarbanes-Oxley Act of 2002 along with other recent and proposed rules from the Securities and Exchange Commission and Nasdaq require changes in our corporate governance, public disclosure and compliance practices. Many of these new requirements will increase our legal and financial compliance costs, and make some corporate actions more difficult, such as proposing new or amendments to stock option plans, which now require shareholder approval. These developments could make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments also could make it more difficult for us to attract and retain qualified executive officers and qualified members of our board of directors, particularly to serve on our audit committee.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Historically, we have invested excess cash in short-term debt securities that are intended to be held to maturity. These short-term investments typically have various maturity dates which do not exceed one year. We had no short-term investments as of March 31, 2005.

Two of the main risks associated with these investments are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of debt securities. Fluctuations in interest rates would not have a material effect on our financial statements because of the short-term nature of the securities in which we invest and our intention to hold the securities to maturity. Credit risk refers to the possibility that the issuer of the debt securities will not be able to make principal and interest payments. We have limited the investments to investment grade or comparable securities and have not experienced any losses on our investments to date due to credit risk.

Changes in foreign exchange rates, and in particular a strengthening of the U.S. dollar, may negatively affect our consolidated sales and gross margins as expressed in U.S. dollars. To date, we have not entered into any foreign exchange contracts to hedge our exposure to foreign exchange rate fluctuations. However, as our international operations grow, we may enter into such arrangements in the future. Effective January 1, 2002, our foreign sales were denominated in Euros. Foreign currency-denominated sales have not been significant.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by SEC Rule 13a-15(b), 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 as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that we would meet our disclosure obligations.

There has been no change in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

In February 2004, we filed suit against Applied Imaging Corporation. The lawsuit, filed in the United States District Court for the Southern District of California, asserted that Applied Imaging’s ARIOL SL-50 system infringes upon three of our patents. In April 2004, we amended our original claim against Applied Imaging Corporation to include infringement upon another patent as well as counts of copyright infringement, trade dress infringement, federal unfair competition/false designation of origin, common law unfair competition, and California unfair competition. Applied Imaging filed a response and a countersuit in the United States District Court for the Southern District of California asserting that Clarient infringed upon one of its patents and asserted that we intentionally interfered with Applied Imaging’s business relationships, misappropriation of valuable trade secrets, and unfair business practices and competition. The parties entered into a settlement agreement in March 2005. Under the terms of the settlement, Clarient and Applied Imaging granted each other non-exclusive, worldwide licenses allowing use of their respective brightfield and fluorescent microscopy patent portfolios for pathology applications. Also, as part of the agreement, Clarient will assume non-exclusive distribution rights to Applied Imaging’s flagship Ariol^Ò pathology workstation for select applications in drug discovery and development.

On April 6, 2005, Psyche Systems Corporation commenced an arbitration against Clarient based on Clarient’s alleged breach of a June 1, 2004 contract for the license and implementation of a software system. Psyche contends that Clarient is liable for approximately $158,000 in outstanding payments allegedly due under the contract and for future maintenance and support payments. Prior to implmentation of the software, Clarient notified Psyche Systems that the software would not work for its intended purposes and that it did not intend to utilize the software. While we believe we have defenses to Psyche System’s claims, the outcome of this arbitration is uncertain, and we may be required to pay contract damages to Psyche Systems if an arbitration award is entered against us.

The Company is not otherwise a party to any other legal proceedings, the adverse outcome of which, individually or in the aggregate, management believes would have a material adverse effect on the business, financial condition or results of operations of the business.

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

No matters were submitted to the Company by a vote of the security holders during the first quarter ended March 31, 2005.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

Exhibit Number		Description
3.1		Certificate of Ownership and Merger dated March 15, 2005 (a)
10.1		Third Amendment to Loan Agreement dated January 31, 2005 between the Company and Comerica Bank (b)
10.2		Employment Letter dated as of February 28, 2005 between the Company and David J. Daly (b)+
10.3		Consulting Agreement dated as of April 8, 2005 between the Company and Dr. Richard Cote (c)+
31.1		Certifications pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a) for Ronald A. Andrews. (*)
31.2		Certifications pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a) for Stephen T. D. Dixon. (*)
32.1		Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for Ronald A. Andrews. (*)
32.2		Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for Stephen T. D. Dixon. (*)

(*)		Filed herewith.

(a)		Filed on March 17, 2005 as an exhibit to the Company’s Current Report on Form 8-K and incorporated by reference.

(b)		Filed on March 15, 2005 as an exhibit to the Company’s Annual Report on Form 10-K and incorporated by reference.

(c)		Filed on April 15, 2005 as an exhibit to the Company’s Current Report on Form 8-K and incorporated by reference.

+		Management contract or compensatory plan or arrangement.

Mark One

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

For The Quarterly Period Ended March 31, 2005

OR

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

		For the Transition Period from to

DELAWARE		75-2649072
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)

33171 PASEO CERVEZA SAN JUAN CAPISTRANO, CA		92675
(Address of principal executive offices)		(Zip code)

(949) 443-3355
(Registrant’s telephone number, including area code)

CHROMAVISION MEDICAL SYSTEMS, INC.
(Former name, former address and former fiscal year, if changed since last report)

	CLARIENT, INC.

DATE: MAY 6, 2005	BY:	/s/ Ronald A. Andrews
		Ronald A. Andrews
		President and Chief Executive Officer

DATE: MAY 6, 2005	BY:	/s/ Stephen T. D. Dixon
		Stephen T.D. Dixon
		Executive Vice President and Chief Financial Officer

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

Mark One

ý

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

For The Quarterly Period Ended March 31, 2005

OR

o

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

For the Transition Period from to

CLARIENT, INC.

(Exact name of registrant as specified in its charter)

DELAWARE

75-2649072

(State or other jurisdiction of incorporation or
organization)

(IRS Employer Identification Number)

33171 PASEO CERVEZA
SAN JUAN CAPISTRANO, CA

92675

(Address of principal executive offices)

(Zip code)

(949) 443-3355

(Registrant’s telephone number, including area code)

CHROMAVISION MEDICAL SYSTEMS, INC.

(Former name, former address and former fiscal year, if changed since last report)

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, and (2) has been subject to such filing requirements for the past 90 days.

Yes ý No o

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

Yes o No ý

As of April 30, 2005 there were 51,634,268 shares outstanding of the Registrant’s Common Stock, $0.01 par value.

SIGNATURES

PART I - FINANCIAL INFORMATION

Item 1.

Condensed Consolidated Statements of Cash Flows

Stock Options

(9) Stock Transactions

Overview and Outlook

Critical Accounting Policies and Estimates

RISK FACTORS

SIGNATURES

PART I	FINANCIAL INFORMATION

Item 1	Financial Statements

	Condensed Consolidated Balance Sheets as of March 31, 2005 (unaudited) and December 31, 2004

	Condensed Consolidated Statements of Operations (unaudited) for the three months ended March 31, 2005 and 2004

	Condensed Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2005 and 2004

	Notes to Condensed Consolidated 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 4	Submission of Matters to a Vote of Security Holders

Item 6	Exhibits

SIGNATURES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

Mark One

ý

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

For The Quarterly Period Ended March 31, 2005

OR

o

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

For the Transition Period from to

CLARIENT, INC.

(Exact name of registrant as specified in its charter)

DELAWARE

75-2649072

(State or other jurisdiction of incorporation or organization)

(IRS Employer Identification Number)

33171 PASEO CERVEZA SAN JUAN CAPISTRANO, CA

92675

(Address of principal executive offices)

(Zip code)

(949) 443-3355

(Registrant’s telephone number, including area code)

CHROMAVISION MEDICAL SYSTEMS, INC.

(Former name, former address and former fiscal year, if changed since last report)

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, and (2) has been subject to such filing requirements for the past 90 days.

Yes ý No o

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

Yes o No ý

As of April 30, 2005 there were 51,634,268 shares outstanding of the Registrant’s Common Stock, $0.01 par value.

SIGNATURES

PART I - FINANCIAL INFORMATION

Item 1.

Condensed Consolidated Statements of Cash Flows

Stock Options

(9) Stock Transactions

Overview and Outlook

Critical Accounting Policies and Estimates

RISK FACTORS

SIGNATURES

(State or other jurisdiction of incorporation or
organization)

33171 PASEO CERVEZA
SAN JUAN CAPISTRANO, CA