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Biolase, Inc – ‘10-K’ for 12/31/04

On:  Tuesday, 7/19/05, at 5:26pm ET   ·   For:  12/31/04   ·   Accession #:  1193125-5-144652   ·   File #:  0-19627

Previous ‘10-K’:  ‘10-K’ on 3/3/04 for 12/31/03   ·   Next:  ‘10-K’ on 3/16/06 for 12/31/05   ·   Latest:  ‘10-K’ on 3/21/24 for 12/31/23   ·   26 References:   By:  Biolase, Inc. – ‘POS AM’ on 4/19/24 By:  Biolase, Inc. – ‘POS AM’ on 4/11/24 By:  Biolase, Inc. – ‘S-1/A’ on 3/27/24 By:  Biolase, Inc. – Latest ‘10-K’ on 3/21/24 for 12/31/23 By:  Biolase, Inc. – ‘S-1/A’ on 2/9/24 By:  Biolase, Inc. – ‘S-1/A’ on 2/7/24 By:  Biolase, Inc. – ‘S-1/A’ on 1/31/24 By:  Biolase, Inc. – ‘S-1’ on 1/19/24 By:  Biolase, Inc. – ‘S-1’ on 12/26/23 By:  Biolase, Inc. – ‘S-1/A’ on 9/11/23 By:  Biolase, Inc. – ‘S-1/A’ on 9/5/23 By:  Biolase, Inc. – ‘S-1/A’ on 8/30/23 By:  Biolase, Inc. – ‘S-1/A’ on 8/18/23 By:  Biolase, Inc. – ‘S-1/A’ on 8/14/23 By:  Biolase, Inc. – ‘S-1’ on 7/21/23 By:  Biolase, Inc. – ‘S-1/A’ on 5/24/23 By:  Biolase, Inc. – ‘S-1/A’ on 5/22/23 By:  Biolase, Inc. – ‘S-1/A’ on 5/18/23 By:  Biolase, Inc. – ‘S-1’ on 5/4/23 By:  Biolase, Inc. – ‘10-K’ on 3/28/23 for 12/31/22 By:  Biolase, Inc. – ‘S-1/A’ on 1/3/23 By:  Biolase, Inc. – ‘S-1/A’ on 12/12/22 By:  Biolase, Inc. – ‘S-1’ on 11/22/22 By:  Biolase, Inc. – ‘10-K’ on 3/17/22 for 12/31/21 By:  Biolase, Inc. – ‘10-K’ on 3/31/21 for 12/31/20 By:  Biolase, Inc. – ‘S-1/A’ on 12/8/20 

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 7/19/05  Biolase, Inc                      10-K       12/31/04   17:2.2M                                   RR Donnelley/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K        Form 10-K for Biolase Technology, Inc.              HTML   1.41M 
 2: EX-10.12    Amendment to Credit Agreement                       HTML     24K 
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                          May 16, 2003                                           
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                          May 20, 2003                                           
 5: EX-10.19    Employment Agreement Dated October 24, 2004         HTML     85K 
 6: EX-10.20    Employment Agreement Dated October 26, 2004         HTML     74K 
 7: EX-10.22    Form of Stock Option Agreement                      HTML     39K 
 8: EX-10.25    Amended and Restated 2002 Option Plan               HTML     96K 
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10: EX-10.27    Standard Industrial/Commercial Single-Tenant Lease  HTML    218K 
11: EX-10.28    Basic Sublease Terms                                HTML     29K 
12: EX-21.1     Subsidiaries of the Registrant                      HTML      7K 
13: EX-23.1     Consent of Independent Registered Public            HTML      9K 
                          Accounting Firm                                        
14: EX-31.1     Certification of Robert E. Grant Pursuant to Rule   HTML     15K 
                          13A-14(A) and Rule 15D-14(A)                           
15: EX-31.2     Certification of John Hohener Pursuant to Rule      HTML     15K 
                          13A-14(A) and Rule 15D-14(A)                           
16: EX-32.1     Certification of Robert E. Grant Pursuant to        HTML     10K 
                          Section 906                                            
17: EX-32.2     Certification of John Hohener Pursuant to Section   HTML     10K 
                          906                                                    

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2004

OR

For the transition period from                     to                    

Commission file number 000-19627

BIOLASE TECHNOLOGY, INC.

(Exact Name of Registrant as Specified in Its Charter)

981 Calle Amanecer

San Clemente, California 92673

(Address of Principal Executive Offices, including zip code)

(949) 361-1200

(Registrant’s Telephone Number, Including Area Code)

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

None.

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

Common Stock, par value $0.001 per share

(Title of class)

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

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

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  x    No  ¨

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the Registrant’s most recently completed second fiscal quarter:

As of June 30, 2004, the aggregate market value of the voting and non-voting common equity held by non-affiliates was $327,150,307 based on the closing price per share of $13.46 for the Registrant’s common stock as reported on the NASDAQ National Market on such date multiplied by 24,305,372 shares of the Registrant’s common stock which were outstanding and held by non-affiliates on such date.

Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of the latest practicable date: As of May 31, 2005, there were 22,975,937 shares of the Registrant’s common stock, par value $0.001 per share, outstanding.

Table of Contents

BIOLASE TECHNOLOGY, INC.

ANNUAL REPORT ON FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2004

TABLE OF CONTENTS

BIOLASE^®, Millennium^®, Pulsemaster^® and WaterLase^® are registered trademarks, and LaserSmile^™, Diolase Plus^™, Comfort Jet^™, HydroPhotonics^™, LaserPal^™, MD Flow^™, YSGG^™, Soft Touch^™, WaterLase MD^™, HydroBeam^™ and SensaTouch^™ are trademarks, of BIOLASE Technology, Inc. All other product and company names are registered trademarks or trademarks of their respective companies.

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EXPLANATORY NOTE

In addition to providing financial statements and other required information for our fiscal year ended December 31, 2004, this Annual Report on Form 10-K also includes restated consolidated financial statements for the fiscal years ended December 31, 2003 and 2002, as discussed in Note 3 to our consolidated financial statements. Our previously issued financial statements for each of these periods should not be relied upon.

As reported in the Form 8-K filed May 20, 2005, we decided to restate our financial statements after reaching the conclusion that we had under accrued sales tax and related penalties and interest for fiscal 2002. The impact of these sales tax and related adjustments that impacted 2002, 2003 and the first three quarters of 2004, as well as other adjustments in the areas of value-added tax (“VAT”), payroll and related accruals, deferred revenue, and other accrued liabilities have led our management to recommend, and our Audit Committee to conclude, that the consolidated financial statements as of and for the years ended December 31, 2003 and 2002, the four quarters of 2003 and the first three quarters of 2004 also need to be restated.

We are restating the consolidated financial statements for the years ended December 31, 2003 and 2002 in this Form 10-K to correct for the following items:

The disclosures in the following items related to the years ended December 31, 2003 and 2002 have likewise been updated as a result of the restatement:

Part II – Item 6 – Selected Consolidated Financial Data

Part II – Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Part II – Item 8 – Financial Statements and Supplementary Data

The restated consolidated financial statements as of December 31, 2003 and for the years ended December 31, 2003 and 2002 are included in this Form 10-K. The restatement of the quarterly and year-to-date periods for 2004 and 2003 are included in Amendments on Form 10-Q/A for the quarters ended March 31, 2004, June 30, 2004, and September 30, 2004.

Refer to “Selected Quarterly Financial Data” on page 39 to see the effect of the noted restatements in the quarters of 2003 and 2004.

Concurrently with the filing of this Form 10-K, we are filing with the SEC the Form 10-Q/A for the first, second, and third quarters of 2004 to reflect the changes required as a result of the restatements described above. No amendments have been made to our previously filed Annual Reports on Form 10-K for fiscal years 2003 or 2002, or the Quarterly Reports on Form 10-Q for the quarters ended March 31, 2003, June 30, 2003 and September 30, 2003, and therefore they should not be relied upon.

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CAUTIONARY STATEMENT

This Annual Report contains forward-looking statements that involve a number of risks and uncertainties, These forward-looking statements include, but are not limited to, statements and predictions regarding our operating expenses, sales and operations, anticipated cash needs, capital requirements and capital expenditures, needs for additional financing, use of working capital, plans for future products and services and for enhancements of existing products and services, anticipated growth strategies, ability to attract customers, sources of net revenue, anticipated trends and challenges in our business and the markets in which we operate, the adequacy of our facilities, the impact of economic and industry conditions on our customers and our business, customer demand, our competitive position, the outcome of any litigation against us, the perceived benefits of any technology acquisitions, critical accounting policies and the impact of recent accounting pronouncements. Additional forward-looking statements include, but are not limited to, statements pertaining to other financial items, plans, strategies or objectives of management for future operations, our financial condition or prospects, and any other statement that is not historical fact, including any statement which is preceded by the word “may,” “might,” “will,” “intend,” “should,” “could,” “can,” “would,” “expect,” “believe,” “estimate,” “predict,” “potential,” “plan,” or similar words. For all of the foregoing forward-looking statements, we claim the protection of the Private Securities Litigation Reform Act of 1995. Actual events or results may differ materially from our expectations. Important factors that could cause actual results to differ materially from those stated or implied by our forward-looking statements include, but are not limited to, the impact of changes in demand for our products, our effectiveness in managing manufacturing costs and expansion of our operations, the impact of competition and of technological advances, and the risks set forth under “Risk Factors” in Item 7. These forward-looking statements represent our judgment as of the date hereof. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

The information contained in this Annual Report is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Annual Report and in our other reports filed with the Securities and Exchange Commission (the “SEC”).

PART I

Item 1.    Business

We are the world’s leading dental laser company. We design, manufacture and market proprietary dental laser systems that allow dentists, periodontists, endodontists, oral surgeons and other specialists to perform a broad range of dental procedures, including cosmetic and complex surgical applications. Our systems are designed to provide clinically superior performance for many types of dental procedures, with less pain and faster recovery times than are generally achieved with drills, scalpels and other dental instruments. We have clearance from the U.S. Food and Drug Administration, or FDA, to market our laser systems in the United States and also have the necessary approvals to sell our laser systems in Canada, the European Union and other international markets. We are currently pursuing regulatory approval to market and sell our Waterlase^® system in Japan. Since 1998, we have sold more than 3,350 Waterlase systems and approximately 4,500 laser systems in over 45 countries.

We offer two categories of laser system products: (i) Waterlase system and (ii) Diode system. Our flagship product category, the Waterlase system, uses a patented combination of water and laser to perform most procedures currently performed using dental drills, scalpels and other traditional dental instruments for cutting soft and hard tissue. We also offer a family of Diode laser system products to perform soft tissue and cosmetic procedures, including tooth whitening.

Waterlase system.    We refer to our patented interaction of water with laser as YSGG^™ Laser HydroPhotonics^™. YSGG is a shortened abbreviation referring to the unique crystal (Er, Cr: YSGG) laser used in

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the Waterlase system, which contains the elements erbium, chromium and yttrium, scandium, gallium and garnet. This unique crystal laser produces energy with specific absorption and tissue interaction characteristics optimized for dental applications. HydroPhotonics refers to the interaction of laser with water to produce energy to cut tissue. Through YSGG Laser HydroPhotonics, the Waterlase system can precisely cut hard tissue, such as bone and teeth, and soft tissue, such as gums, with minimal or no damage to surrounding tissue. The Waterlase system is one of the world’s best selling dental laser systems, and we estimate it currently accounts for a majority of all dental lasers sold worldwide.

Diode system.    We also offer a family of Diode system products, which use a semiconductor diode laser to perform soft tissue and cosmetic procedures, including tooth whitening. Our Diode system serves the growing markets for cosmetic and hygiene procedures.

The Diode system, together with our Waterlase system, offer practitioners a broad product line with a range of features and price points. We also manufacture and sell accessories and disposables for our laser systems, such as hand pieces, laser tips and tooth whitening gel. The Waterlase system comprised 84%, 83% and 77% of our total revenue for the years ended December 31, 2004, 2003 and 2002, respectively. The Diode system comprised 11%, 12% and 18% of our total revenue for the same periods.

We believe there is a large market for our products in the United States and abroad. According to the American Dental Association, there are over 160,000 practicing dentists in the United States. According to the World Federation of Dentistry, an international dental organization, there are at least 700,000 dentists worldwide, and we believe that a substantial percentage of them practice in major international markets outside the United States. The use of lasers in dentistry is growing. However, we believe only a small percentage of dentists currently use laser systems, and that there is a significant opportunity to increase sales of our products worldwide.

Our goal is to establish our laser systems as essential tools in dentistry and to continue our leading position in the dental laser market. Our sales and marketing efforts focus on educating dental professionals and patients on the benefits of our laser systems, particularly our Waterlase system. In 2002, we founded the World Clinical Laser Institute, an association that includes prominent dental industry leaders, to formalize our efforts to educate and train dentists and surgeons in laser dentistry. We participate in numerous other symposia and dental industry events to stimulate demand for our products. We have also developed numerous relationships with dental schools, research facilities and dental institutions, in the United States and abroad, which use our products for education and training. More than 25 institutions use our products, including St. Barnabas Hospital and the dental schools of Columbia University, Loma Linda University, Tufts University, University of California at Los Angeles, University of Southern California and Oklahoma University. We are in the process of adding nine more institutions over the coming months. We believe this will expand awareness of our products among new generations of dental professionals.

Company Background and Recent Events

From inception in 1987 until 1998, we were engaged primarily in the research and development of the use of water and laser technology. We were originally formed as Societe Endo Technic, SA, or SET, in 1984 in Marseilles, France, to develop and market various endodontic and laser products developed by Dr. Guy Levy, then chairman of the Endodontics Department at the University of Marseilles. In 1987, SET was moved to the United States and was merged with a public holding company, Pamplona Capital Corp. In 1994, we changed our name to BIOLASE^® Technology, Inc. Through the end of fiscal 2000, we were financed by approximately $42 million in stockholder investments through a series of private placements of stock and the exercise of warrants and stock options.

Since 1998, our objective has been to become the leading designer, manufacturer and marketer of laser systems for the dental industry. We have focused our efforts on receiving governmental clearances with the

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U.S. Food and Drug Administration as well as furthering the commercial success and viability of our water and laser technology via our direct sales campaign initiatives, intellectual property advancements and strategic acquisitions. In 1998, we began the commercialization of our systems based on water and laser technology.

The selective pursuit of acquisitions represents an important component of our business strategy. We focus primarily on those candidates that will enable us to consolidate positions of leadership in our existing markets, further develop our portfolio of intellectual property, expand our strategic partnerships with leading companies and increase our capability and capacity to derive value for our customers and stockholders.

In December 2001, we formed BIOLASE Europe GmbH, a wholly owned subsidiary based in Germany. In February 2002, BIOLASE Europe acquired a laser manufacturing facility in Germany and commenced manufacturing operations at that location. This acquisition has enabled us to initiate an expansion of our sales in Europe and neighboring regions. We purchased the facility for cash consideration in October 2003 for approximately €986,000 (approximately $845,000) plus applicable taxes.

On May 21, 2003, we acquired the American Dental Laser product line and other dental laser assets of American Medical Technologies, Inc., or AMT, for approximately $5.8 million. The acquired assets included dental laser patents, customer lists, brand names and other intellectual property as well as laser systems, including the DioLase and Pulsemaster^® systems.

In May 2004, we launched the DioLase Plus^™ laser system, which is our first dental laser product that resulted from the integration of the American Dental Laser value proposition and BIOLASE’s cutting-edge technology platform. The DioLase Plus is a fully-featured, entry-level cosmetic, soft tissue and periodontal laser. The DioLase Plus delivers more power and features than competing entry-level diode lasers, with 7 watts of power vs. 3-5 watts found in competing systems. The DioLase Plus has many cosmetic and soft tissue applications; soft tissue curettage; laser removal of diseased, infected, inflamed and necrosed soft tissue within the periodontal pocket; and removal of highly inflamed edematous tissue affected by bacteria penetration of the pocket lining and junctional epithelium.

In May 2004, we opened our new manufacturing facility in San Clemente, California. The new facility is located adjacent to our headquarters. The building brings our U.S. leased facility capacity to approximately 40,000 square feet.

In July 2004, we announced that our Board of Directors authorized a 1.25 million share repurchase program. On August 9, 2004, we announced that our Board of Directors authorized the repurchase of an additional 750,000 shares of our common stock, increasing the total share repurchase program to 2.0 million shares of our common stock. During 2004, we repurchased approximately 1,964,000 shares at an average price of $8.35 per share.

In July 2004, we announced a dividend policy to pay a regular cash dividend of $0.01 per share every other month payable to the stockholders of record at the time when declared by the Board of Directors.

In October 2004, we launched the Waterlase MD^™, a new clinical and technological platform for dentistry. The Waterlase MD, which features exclusive, proprietary technology from BIOLASE, has a very broad range of clinical capabilities both in dentistry and other medical disciplines. The Waterlase MD platform is intended to deliver on the “wish list” of clinical capabilities requested by dentists and comfort sought by patients. Notable features include the HydroBeam^™ LED illumination with a contra-angle 360 degree rotating handpiece as well as a SensaTouch^™ laser control system with easy touch screen functionality. The new system provides powerful cutting action, allowing the dentist to select up to 50 pulses per second. Another key advancement of the new system is two distinct pulse modes. Dual-mode capability gives the dentist the ability to do procedures with more comfort and control. These new features coupled with innovative, ergonomic styling and design are part of BIOLASE’s proprietary MD technology platform upon which the Waterlase MD is based. The Waterlase MD

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all-tissue dental laser is the new premium price-point product of BIOLASE’s dental laser product portfolio, serving to expand our existing dental laser product line.

In January 2005, we acquired the intellectual property portfolio of Diodem LLC (“Diodem”), consisting of certain U.S. and international patents of which four were asserted against us, and settled the existing litigation between us and Diodem for consideration of $3.0 million in cash, 361,664 shares of common stock, and a five-year warrant exercisable into 81,037 shares of common stock at an exercise price of $11.06 per share. In addition, if certain criteria specified in the purchase agreement are satisfied on or before July 2006, 45,208 additional shares we have placed in escrow may be released to Diodem and we will incur an expense equal to the fair market value of those shares at the time of their release. These escrowed shares had a fair market value of $500,000 at the time of the Binding Letter of Intent. The total consideration was estimated to have a value of $7.0 million, excluding the value of the shares held in escrow. As of December 31, 2004, we accrued $6.4 million for the settlement of the existing litigation. In January 2005, we recorded an intangible asset of $530,000 representing the estimated fair value of the intellectual property acquired. As a result of the acquisition, Diodem immediately withdrew its patent infringement claims against us and the case was formally dismissed on May 31, 2005. We did not pay and have no obligation to pay any royalties to Diodem on past or future sales of our products.

More recently, we have embarked on conducting research and development activities outside the field of dentistry. In particular, we have been researching a laser procedure for the permanent reversal of presbyopia, which is the phenomenon of natural aging that results in the loss of near-reading ability over the age of 40 years old. According to the Wall Street Journal article “Reading the Fine Print,” published on February 14, 2005, 110 million Americans suffer from presbyopia. In March 2005, we acquired a fully paid license related to patents owned or licensed by SurgiLight, Inc. As a result of the acquisition, BIOLASE received fully paid license rights in the U.S. and International markets to patents in the field of presbyopia and other patents related to the field of Ophthalmology. BIOLASE acquired the fully paid license for a total consideration of $2.0 million in cash, of which $1.8 million was paid during the first quarter of 2005 and $200,000 remains outstanding.

Industry Background

General

More than 200 million hard tissue procedures are performed annually in the United States, according to a 2001 survey, released in 2003, by the American Dental Association. Hard tissue procedures include cavity preparation, inlays, crowns, root canals and other procedures involving bone or teeth. Based on this survey, more than 1.2 million soft tissue procedures are performed annually in the United States. Soft tissue procedures include gum line alteration, gum grafts and other procedures involving soft dental tissue. According to statistics compiled by the American Dental Association, over 90% of hard tissue procedures and 60% of soft tissue procedures in the United States are performed by general dentists, and the rest are performed by oral surgeons, periodontists and other specialists.

The American Dental Association estimates that the demand for dental services in the United States will continue to grow due to population growth and the increased awareness of the benefits associated with preventive dentistry in reducing the incidence of oral disease. According to the American Dental Association, annual expenditures in the United States in 2002 for dental treatment costs were $70 billion, and are expected to increase to approximately $100 billion by 2010.

Recently, the emergence of popular reality television programming focused on “extreme makeovers” has resulted in a growing awareness among consumers of the value and importance of a healthy smile. As such, the dental industry has entered an era of growth and consideration of advanced technologies that allow dentists to perform simple or complex cosmetic dental procedures with minimal trauma, patient acceptance and clinically superior results. We believe our product mix corresponds with this trend, and we expect incremental growth from these pressures in the marketplace.

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Traditional Dental Instruments

Dental procedures are performed on hard tissue, such as bone and teeth, and soft tissue, such as gum and other oral tissue. Dentists and other specialists choose from a variety of instruments depending on the tissue involved and the type of procedure. Most procedures require the use of multiple instruments to achieve the desired result.

High Speed Drills.    Most dentists use high speed drills for hard tissue procedures, such as preparing cavities for filling and gaining access for performing root canals or shaving and contouring oral bone tissue. Adverse effects associated with drills include thermal heat transfer, vibration, pressure and noise. The cutting and grinding action of high speed drills can cause damage to the patient’s dental structure. Additionally, this grinding action of high speed drills on teeth can potentially provide an entry point for the bacteria that causes tooth decay and weakens the tooth’s underlying structure, which leads to fractures and broken cusps. Crowns and root canals may become necessary as a result of damage caused during previous dental procedures.

Cutting Instruments.    Soft tissue procedures, such as reshaping gum lines and grafting on new gum tissue, are typically performed by oral surgeons or periodontists using scalpels, scissors and other cutting tools. Due to the pain and discomfort associated with procedures performed with these instruments, most soft tissue procedures require the use of local anesthetic which results in numbness and discomfort, and often require stitches. Use of scalpels, scissors and other cutting tools typically cause bleeding, post-operative swelling and discomfort. Bleeding reduces the practitioner’s visibility and efficiency, and generally makes procedures more cumbersome. Bleeding is a particular problem for patients with immune deficiencies or blood disorders, and patients taking blood-thinning medications.

Alternative Dental Instruments

Alternative technologies have been developed over the years to address the problems associated with traditional methods used in dentistry. Most alternatives have addressed either hard or soft tissue applications. The predominant alternative technologies and their limitations are discussed below.

Air Abrasion Systems.    Air abrasion systems were introduced as an alternative to the high speed drill for hard tissue procedures. Air abrasion systems blow a powerful air stream of aluminum oxide particles to erode hard tissue and remove the harder forms of decay. Air abrasion is most commonly used to repair cracks and discolorations, clean out pits and fissures, prepare cavities to be filled with composites and prepare tooth surfaces for bonding. However, air abrasion is not suitable for a variety of hard tissue procedures including bone, and cannot be used on, or very near to, soft tissue. In addition, the use of air abrasion is time consuming and scatters particles that can be inhaled by patients and staff, as well as damage equipment and instruments. Due to these limitations, we believe the popularity of these systems has declined over the last few years.

Electrosurge Systems.    A commonly used technology, known as electro surge, was developed to cut soft tissue. Electro surge systems use an electrical spark that simultaneously cuts and cauterizes tissue, resulting in less bleeding than occurs with scalpels. Traditional electro surge results in deep penetration, which can cause unwanted damage to surrounding tissue, and is generally less precise than lasers. Electro surge is not suitable for hard tissue procedures and, due to the depth of penetration, generally requires use of anesthesia and involves a lengthy healing process. Use of most electro surge units is restricted near metal fillings and dental implants. Additionally, electro surge generally cannot be used with patients with implanted pacemakers and defibrillators.

Traditional Laser Systems.    More recently, lasers have gained acceptance for use in general and cosmetic dentistry. Most lasers used in dentistry have been adapted from other medical applications, such as dermatology, and were not designed to perform a wide range of common dental procedures. Most dental lasers use thermal energy to cut tissue and are used primarily for soft tissue procedures.

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Due to the limitations associated with traditional and alternative dental instruments, we believe there is a large market opportunity for dental laser systems that provide superior clinical results and help reduce the trauma, pain and discomfort associated with dental procedures.

The BIOLASE Solution

We believe the potential for increased patient satisfaction, improved outcomes and enhanced practice profitability that can be achieved through use of our products will position our laser systems as the instruments of choice among practitioners and patients for a broad range of dental procedures. We have developed our laser systems and related products specifically for the dental market to more effectively perform a broad range of dental procedures. The skill level and dexterity necessary to operate our laser systems are similar to those necessary to operate conventional drills and other dental equipment. Our laser systems also have the advantage of being able to perform procedures in narrow spaces where access for conventional instruments often is limited. Our systems are intended to complement traditional tools, such as dental drills, which perform functions that our systems do not address, such as cutting metal fillings and certain polishing and grinding functions.

Our primary product category, the Waterlase system, is one of the best selling dental laser system in the world. The Waterlase system precisely cuts hard tissue, such as bone and teeth, and soft tissue, such as gums, with minimal or no damage to surrounding tissue and dental structure. Our Diode system is designed to complement the Waterlase system, and is used in soft tissue procedures and cosmetic applications, such as tooth whitening. The Diode system, together with our Waterlase system, offers practitioners a broad product line with a range of features and price points.

A small percentage of dental professionals worldwide currently use lasers. Moreover, our laser systems are more expensive than traditional dental tools. However, we believe that the significant performance advantages of our systems, the potential return on investment that our systems offer practitioners and the options available to finance the purchase of our systems will enable us to continue to penetrate the dental market segment.

We believe the demand for our systems will continue to expand as we increase awareness of the benefits to patients and dental professionals.

Benefits to Dental Professionals

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Benefits to Patients

Business Strategy

Our objectives are to increase our leadership position in the dental laser market and to establish our laser systems as essential tools in dentistry. Our business strategy consists of the following key elements:

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Products

We have two principal product lines. Our family of products includes the Waterlase and Diode systems, which we developed through our own research and development.

We currently sell our products in over 45 countries. The U.S. Food and Drug Administration (FDA) has cleared all of our laser systems for the applications listed below, which enables us to market the systems in the United States. Our systems have the CE Mark and may be sold in the European Union. Additionally, we have approval to sell our Waterlase system in Canada, Australia, New Zealand and other Pacific Rim countries.

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Related Accessories and Disposable Products

We also manufacture and sell disposable products and accessories for our laser systems. Our Waterlase system uses disposable laser tips of differing sizes and shapes depending on the procedures being performed. We also market aftercare products, such as flexible fibers and hand pieces. Our Diode system also uses flexible fibers and hand pieces as well as tooth whitening gel kits for our LaserSmile system.

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Warranties and Insurance

Our laser systems sold to end users and distributors are covered by one-year and fourteen-month warranties, respectively, against defects in material and workmanship. Our warranty covers parts and service for direct sales and parts only for distributor sales. We sell service contracts to our end users that cover the period after the expiration of our standard warranty coverage for our laser systems. Extended warranty coverage provided under our service contracts varies by the type of system and the level of service desired by the customer. In addition, we maintain product liability insurance with respect to our products with a general coverage limit of $12 million in the aggregate.

Manufacturing

We manufacture, assemble and test our products at manufacturing facilities located in San Clemente, California and Floss, Germany. We acquired our German manufacturing facility in 2002. We manufacture and install our systems and provide maintenance services for products sold in Europe and other international markets through both our California and German operations. Sales of products manufactured at our German facility accounted for 13% of our revenue in 2004, 12% of our revenue in 2003 and 9% of our revenue in 2002.

We use an integrated approach to manufacturing, including the assembly of laser heads, electronics and cabinetry, which allows us to maintain high quality and control cost. We obtain components and subassemblies for our products from third party suppliers, most of which are located in the United States. We generally purchase components and subassemblies from a limited group of suppliers through purchase orders. We have no written supply contracts with our key suppliers. Three key components used in our Waterlase system, which accounted for approximately 84% of our revenue in 2004, 83% of our revenue in 2003 and approximately 77% of our revenue in 2002, are each supplied by a separate single-source supplier. A leading European supplier of precision hand tools manufactures the Waterlase hand pieces and the laser crystal and fiber components are each made by a separate supplier. We have not experienced material delays from the suppliers of these three key components and we have identified and tested alternative suppliers for each of these components. However, an unexpected interruption in a single source supplier could create manufacturing delays and disrupt sales as we take the necessary steps to replace the supplier, which we estimate could take up to three months.

Our manufacturing facilities are ISO 13485 certified. ISO 13485 certification provides guidelines for quality of company systems associated with the design, manufacturing, installation and servicing of company products. In addition, both the U.S. and German facilities are registered with the U.S. Food and Drug Administration and are compliant with the FDA’s Good Manufacturing Practice guidelines.

Marketing and Sales

Marketing

We currently market our laser systems in the United States, Canada, Australia and various countries throughout Europe and the Pacific Rim. Our marketing efforts are focused on increasing brand and specific product awareness among dental practitioners. We recently began efforts to increase awareness of the benefits of our products by marketing directly to patients.

Dental Practitioners.    We currently market our laser systems directly to dental practitioners through regional, national and international trade publications, events, meetings and seminars. We also use brochures, direct mailers, press releases, posters and other promotional materials, as well as print and electronic media news coverage. In 2002, we founded the World Clinical Laser Institute to formalize our efforts to educate and train dental practitioners in laser dentistry. The Institute conducts and sponsors educational programs domestically and internationally for dental practitioners, researchers and academicians, including two or three-day seminars and training sessions involving in-depth discussions on the use of lasers in dentistry. In addition, we have developed relationships with research institutions, dental schools and clinical laboratories, which use our products in training and demonstrations. We believe these relationships will increase awareness of our products.

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Patients.    We recently began to market the benefits of our laser systems directly to patients through marketing and advertising programs, including print and broadcast media, local television news and radio spots, as well as product placements of our laser systems on popular reality television “makeover” programs. We believe that making patients aware of our laser systems and their benefits will increase demand for our products.

Sales

We currently sell our products primarily to dentists in general practice. The majority of the dentists in the United States, as well as the majority of our customers, are sole practitioners. We also expect our laser systems to gain acceptance among oral surgeons and other dental specialists, as they become better aware of the clinical benefits and new treatment options available through use of our laser systems.

International revenue accounts for a significant portion of our total revenue. International revenue accounted for approximately 19%, 20%, and 23% of our total revenue in 2004, 2003, and 2002, respectively. Revenue in Asia, Latin America, Pacific Rim countries and Australia accounted for approximately 8%, 9%, and 12% of our total revenue in 2004, 2003, and 2002, respectively. Revenue in Europe accounted for approximately 11%, 11%, and 11% of total revenue in 2004, 2003, and 2002, respectively.

Direct Sales.    We sell products in the United States and Canada through our direct sales force, which is organized by region. As of December 31, 2004, we had one regional manager and 30 sales representatives. Each of our direct sales employees receives a base salary and commissions on sales. We plan to expand our direct sales force in territories that represent growing markets.

Distributors.    Except for sales in Canada, Germany, Spain and Italy, we sell products outside the United States primarily through a network of independent distributors located in Europe, Asia and Australia. Generally, our distributors enter into exclusive agreements in which they purchase systems and disposables from us at a wholesale dealer price and resell them to dentists in their sales territories. All sales to distributors are final and we can terminate our arrangements with dealers and distributors for cause or non-performance. We have exclusive arrangements with certain distributors for select territories, under which distributors are generally required to satisfy certain minimum purchase requirements to maintain exclusivity. Typically, sales to new distributors are generally paid in advance or secured with a letter of credit.

Seasonality.    We have experienced a distinct seasonal pattern over the past several years. The fourth quarter, ending December 31, has generally been the strongest quarter, and in 2004 accounted for approximately 32% of our 2004 revenue. By contrast, the first quarter is generally the slowest sales quarter and in 2004 accounted for only 24% of our 2004 revenue. The second quarter is generally stronger than the first quarter however in 2004, it also accounted for approximately 24% of our 2004 revenue. The third quarter has generally been flat to down compared to the second quarter, accounting for approximately 20% of our revenue in 2004. We believe the seasonality demonstrated in the fourth and first quarters is due to the buying patterns of many dentists, including the response to certain tax advantages offered in the United States for capital equipment purchases. During 2004, our third quarter was significantly impacted by two items. We believe that many customers delayed purchasing decisions pending the anticipated launching of our new Waterlase product, the Waterlase MD. In addition, some of our U.S. trade shows and seminars were impacted in the southeast by the region’s major hurricanes. Trade shows and seminars are a significant sales-generating process for us. As a result of this seasonality, our growth metrics compare growth in a quarter to the same quarter in the prior year and are not focused on growth in consecutive quarters which has been and we expect will continue to be skewed by this seasonality effect.

Customer Service.    We provide maintenance and support services through our support hotline, service personnel and network of factory-trained service technicians. We provide maintenance and support services in the United States and Germany through our employee service technicians. We train and maintain a network of service technicians trained at our factory locations, who provide maintenance and support services in all other

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countries where we do business. Our distributors are responsible for providing maintenance and support services for products sold by them. We provide parts to distributors at no additional charge for products covered under warranty.

Financing Options.    Many dentists finance their purchases through third-party leasing companies or banks. In these transactions, the dentist first enters into a purchase order with us. We then enter into a purchase order with the leasing company, which purchases the product from us, and the dentist enters into a lease agreement with the leasing company. We receive payment in full for the product at the time of purchase from the leasing company, and we are not a party to the lease. The dentist pays the leasing company or bank in installments, and we do not bear the credit risk that the dentist might not make payments. The leasing companies and banks do not have recourse to us for a dentist’s failure to make payments, nor do we have any obligation to take back the product at the end of the lease. Approximately 28% of our revenue in 2004 was generated from sales to dentists who financed their purchase through National Technology Leasing Corporation, an equipment leasing broker. National Technology Leasing arranges financing through banks.

We have an agreement with National Technology Leasing under which we agreed to offer National Technology Leasing first right of refusal when dentists desire to use a finance or lease company. Our customers are under no obligation to finance the purchase or lease of any equipment through National Technology Leasing, and we refer only those customers that request a referral from us. In exchange, National Technology Leasing agreed to give us first priority on scheduling personnel in support of our sales functions, and on processing lease or financing transactions for our customers. National Technology Leasing further agreed to sponsor marketing programs from time to time for our benefit and the benefit of our customers. Additionally, National Technology Leasing agreed to accept the terms of our customer purchase order in transactions in which it is a party pursuant to the revised agreement entered into August 5, 2003. The agreement is for one year intervals and automatically renews if no action is taken to terminate. The agreement is now in effect until August 5, 2005. The agreement also may be terminated by either party upon 45 days written notice. If leasing arrangements were no longer available through National Technology Leasing or the banks with which it deals, we believe our customers would be able to obtain financing through a variety of other leasing companies or banks that frequently approach us to provide financing for our products.

Research and Product Development

Research and development activities are essential to maintaining and enhancing our business. We believe our research and development team has demonstrated its ability to develop innovative products that meet evolving market needs. Our research and development group consists of 15 individuals with medical device and laser development experience and other relevant backgrounds, the majority of whom have degrees in physics or engineering, including three Ph.Ds. During the years ended December 31, 2004, 2003 and 2002, our research and development expenses were approximately $3.6 million, $2.5 million and $1.7 million, respectively. We intend to focus our research and development activities on improving our existing products and extending our product range in order to provide dental practitioners and patients with less painful and clinically superior laser systems.

More recently, we have embarked on conducting research and development activities outside the field of dentistry. In particular, we have been researching a laser procedure for the permanent reversal of presbyopia, which is the phenomenon of natural aging that results in the loss of near-reading ability for those over the age of 40. According to the Wall Street Journal article “Reading the Fine Print,” published on February 14, 2005, 110 million Americans suffer from presbyopia.

Intellectual Property and Proprietary Rights

We rely, in part, on a combination of patents, trademarks, trade secrets, copyrights and other intellectual property rights to protect our technology. We have 92 issued patents and numerous pending patent applications. Approximately two-thirds of our patents were granted in the United States, and the rest were granted in Europe

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and other countries around the world. Our patents cover the use of laser technologies and fluids for dental, medical and industrial applications, as well as laser characteristics, accessories, future technological developments, fluid conditioning and other technologies and methods for dental, medical and aesthetic applications. We have numerous patent applications pending worldwide and plan to apply for other patents in the future as we develop new technologies. While we hold a variety of patents that cover a broad range of technologies and methods, approximately 67% of these patents provide market protection for our core technologies incorporated in our laser systems, including the Waterlase system, which accounted for approximately 84% of our revenue in 2004 and approximately 83% of our revenue in 2003. Our patents provide market protection for our core technologies and will end their lifetime given by the granting patent offices as follows: One in 2006, three in 2008, eleven in 2009, and the balance have expiration dates ranging from 2010 to 2022.

In January 2005, we acquired the intellectual property portfolio of Diodem LLC (“Diodem”), consisting of certain U.S. and international patents of which four were asserted against us, and settled the existing litigation between us and Diodem, for consideration of $3.0 million in cash, 361,664 shares of common stock, and a five-year warrant exercisable into 81,037 shares of common stock at an exercise price of $11.06 per share. In addition, if certain criteria specified in the purchase agreement are satisfied on or before July 2006, 45,208 additional shares we have placed in escrow may be released to Diodem and we will incur an expense equal to the fair market value of those shares at the time of their release. These escrowed shares had a fair market value of $500,000 at the time of the Binding Letter of Intent. The total consideration was estimated to have a value of $7.0 million, excluding the value of the shares held in escrow. As of December 31, 2004, we accrued $6.4 million for the settlement of the existing litigation. In January 2005, we recorded an intangible asset of $530,000 representing the estimated fair value of the intellectual property acquired. As a result of the acquisition, Diodem immediately withdrew its patent infringement claims against us and the case was formally dismissed on May 31, 2005. We did not pay and have no obligation to pay any royalties to Diodem on past or future sales of our products.

In March 2005, we acquired a fully-paid license related to patents owned or licensed by SurgiLight, Inc. As a result of the acquisition, BIOLASE received fully-paid license rights in the U.S. and international markets to patents in the field of presbyopia and other patents related to the field of ophthalmology. BIOLASE acquired the fully paid license for a total consideration of $2.0 million in cash, of which $1.8 million was paid during the first quarter of 2005 and $200,000 remains outstanding.

Competition

We compete with a number of companies that market traditional dental products, such as dental drills, as well as other companies that market laser technologies in dental and other medical markets. In the domestic hard tissue dental market, we believe our Waterlase system primarily competes with laser systems manufactured by Hoya ConBio, a subsidiary of Hoya Photonics, a large Japanese manufacturer primarily of optics and crystals, and OpusDent Ltd., a subsidiary of Lumenis, an Israeli company. In the international market, our Waterlase system competes primarily with products manufactured by several other companies, including KaVo, Deka Dental Corporation and Fotona d.d.

The Waterlase system also competes with non-laser based systems, including traditional high and low-speed dental drills and air abrasion systems that are used for dental procedures. Our Diode system competes with other semiconductor diode lasers, as well as with scalpels, scissors and a variety of other cutting tools that have been traditionally used to perform soft tissue procedures. In the market for tooth whitening, the LaserSmile competes with other products and instruments used by dentists, as well as tooth whitening strips and other over the counter products.

Traditional and commonly used cutting tools are less expensive for performing dental procedures. For example, a high speed drill or an electro surge device can be purchased for less than $1,000 each. However, we believe our systems offer substantial benefits that outweigh cost concerns. In addition, our systems are not

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designed to perform certain functions that high speed drills can perform, such as cutting metal fillings and certain polishing and grinding functions. High speed drills will still be needed for these functions, and our systems are not intended to replace all applications of the high speed drill.

In general, our ability to compete in the market depends in large part on our

Some of the manufacturers that develop competing laser systems have greater financial, marketing and technical resources than we do. In addition, some competitors have developed, and others may attempt to develop, products with applications similar to those performed by our laser systems.

Government Regulation

Our products are medical devices. Accordingly, our product development, testing, labeling, manufacturing processes and promotional activities are regulated extensively by government agencies in the United States and other countries in which we market and sell our products. We have clearance from the U.S. Food and Drug Administration, or FDA, to market our laser systems in the United States. We have the clearances necessary to sell our WaterLase, Waterlase MD and LaserSmile laser systems in Canada. We also have the necessary CE Marks or clearances to sell our laser systems in the European Union and other international markets.

United States

In the United States, the FDA regulates the design, manufacture, distribution, quality standards and marketing of medical devices. We have clearance from the FDA to market our Waterlase and Diode systems in the United States for dental procedures on both adult and pediatric patients. In 1998, we received FDA clearance to market the Millennium^®, the earlier generation of our current Waterlase system, for certain dental hard tissue applications. This clearance allowed us to commence domestic sales and marketing of our technology for hard and soft tissue applications. During 1999 and 2000, to meet the demand for soft-tissue and cosmetic dentistry applications, we designed a semiconductor diode laser system, which is now marketed as our LaserSmile system. We received FDA clearance to market the system for a variety of soft tissue medical applications in September 1999. In 2001, we received FDA clearance to market the LaserSmile system for cosmetic tooth whitening. In October 2003, the LaserSmile received clearance for periodontal procedures for both early and advanced stages of periodontal disease.

In 2002, 2003 and in January 2004, our Waterlase system became the first laser system to receive FDA clearance for several new types of dental procedures. In 2002, we received clearance to market the Waterlase system for root canal, encompassing all four of the fundamental steps of the procedure. We also received clearance in 2002 to market this system for cutting, shaving, contouring and resection of oral osseous tissues, or bone. In January 2003, we received FDA clearance to market the Waterlase system for use in apicoectomy surgery, a procedure for root canal infections and complications that includes cutting gum, bone (to access the infected area) and the apex of the tooth to access the infected area. The clearance also encompasses flap surgical procedures. Flaps are frequently created in conjunction with many procedures, including periodontal, implant placement and recovery, extraction of wisdom teeth, and exposure of impacted teeth. In January 2004, our Waterlase system received FDA clearance for several new bone, periodontal and soft tissue procedures, including removal of bone to correct defects and create physiologic contours of bone, resection of bone to restore architecture, resection of bone for grafting, preparing full, partial and split thickness flaps for periodontal surgery and removal of granulation tissue from bony defects. Additionally, the Waterlase system became the first hard tissue laser to receive clearance for soft tissue curettage.

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As we develop new products and applications or make any significant modifications to our existing products or labeling, we will need to obtain the regulatory clearances or approvals necessary to market such products for dental, cosmetic and other medical procedures in our target markets.

There are two principal methods by which FDA regulated devices may be marketed in the United States: pre-market approval, or PMA, and 510(k) clearance. A PMA application is required for a device that does not qualify for clearance under 510(k) provisions. The FDA is required by law to review a PMA application within 180 days, but the FDA typically takes much longer to complete the review. As part of the approval of a PMA application, the FDA typically requires human clinical testing to determine safety and efficacy of the device. To conduct human clinical testing, typically the FDA must approve an Investigational Device Exemption, or an IDE. To date, none of our products have required a PMA application to support marketing approval.

To obtain 510(k) clearance, we must demonstrate that our device is substantially equivalent to a previously cleared 510(k) device or a device that was in commercial distribution before May 28, 1976 for which the FDA has not yet called for the submission of PMA applications. By statute and regulation, the FDA is required to clear, deny or request additional information on a 510(k) request within 90 days of submission of the application. As a practical matter, 510(k) clearance often takes significantly longer. Domestic marketing of the product must be deferred until clearance is received from the FDA. In some instances, an IDE is required for clinical trials for a 510(k) clearance. If a request for 510(k) clearance is turned down by the FDA, then a PMA application may be required. We intend to utilize the 510(k) notification procedure whenever possible. To date, all of our regulated products have qualified for 510(k) clearance.

After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, will require a new 510(k) clearance, or could require a PMA application. The FDA requires each manufacturer to make this determination initially, but the FDA can review any such decision and can disagree with a manufacturer’s determination. If the FDA disagrees with a manufacturer’s determination, the FDA can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance or PMA is obtained.

After a device is placed on the market, numerous regulatory requirements apply. These include:

We will need to invest significant time and other resources to ensure ongoing compliance with FDA quality system regulations and other postmarket regulatory requirements.

We also are subject to unannounced inspections by the FDA for both the U.S. and BIOLASE Europe offices, and the Food and Drug Branch of the California Department of Health Services for our California manufacturing facilities, and these inspections may include the manufacturing facilities of our subcontractors.

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Failure to comply with applicable regulatory requirements can result in an enforcement action by the FDA, which may include any of the following sanctions:

We are also subject to regulation under the Radiation Control for Safety and Health Act of 1968, or the Safety Act, administered by the FDA. The Safety Act regulates the energy emissions of light and sound and electronic waves from electronic products. Regulations implementing the Safety Act require a laser manufacturer to file new product and annual reports, to maintain quality control, product testing and sales records, to distribute product operation manuals, to incorporate certain design and operating features in lasers sold to end users and to certify and label each laser sold to end users as one of four classes of lasers based on the level of radiation emitted from the laser. In addition, various warning labels must be affixed to the product and certain protective features must be installed, depending upon the class of product.

Various state dental boards are considering the adoption of restrictions on the use of lasers by dental hygienists. Approximately 30 states currently allow dental hygienists to use lasers to perform certain dental procedures. In addition, dental boards in a number of states are considering educational requirements regarding the use of dental lasers. The scope of these restrictions and educational requirements is not now known, and they could have an adverse effect on sales of our laser-based products.

International

Foreign sales of our laser-based products are subject to the regulatory requirements of the foreign country or, if applicable, the harmonized standards of the European Union. These regulatory requirements vary widely among countries and may include technical approvals, such as electrical safety, as well as demonstration of clinical efficacy. We have a CE Mark for our Waterlase MD, Waterlase and LaserSmile systems, which permits us to commercially distribute these systems throughout the European Union. We rely on export certifications from the FDA to comply with certain regulatory requirements in several foreign jurisdictions, such as New Zealand, South Korea and countries in Latin America. We also received clearance to market our Waterlase and LaserSmile systems in Canada and Australia for a variety of applications. We are currently working to meet certain foreign country regulatory requirements for certain of our products, including those in Japan. There can be no assurance that additional approvals in Japan or elsewhere will be obtained.

Other Regulatory Requirements

In addition to the regulatory framework for product clearances and approvals, we are subject to extensive and frequently changing regulations under many other laws administered by U.S. and foreign governmental agencies on the national, state and local levels, including requirements regarding occupational health and safety and the use, handling and disposing of toxic or hazardous substances.

Third Party Reimbursement

Many procedures performed with our laser systems are covered by insurance to the same extent as they would be if performed using traditional dental instruments. Most therapeutic procedures performed with our laser

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systems are reimbursable to a certain extent under dental insurance plans, whereas cosmetic procedures are not. Market acceptance for our products depends, in part, on the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country, and include both government-sponsored health care and private insurance.

Employees

At December 31, 2004, we employed approximately 189 people, of which there are 75 in manufacturing and quality and control, 15 in research and development, 61 in sales and sales support, 18 in customer technical support and 20 in administration. Our employees are not represented by any collective bargaining agreement and we believe our employee relations are good.

Available Information

Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q/A, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) are available free of charge through our Web site (www.biolase.com) as soon as reasonably practicable after we electronically file the material with, or furnish it to, the SEC. You may read and copy any document we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. Our SEC filings are also available to the public at the SEC’s web site at http://www.sec.gov. Refer to the Introductory Note to Amendment No. 2 to our Annual Report on Form 10-K/A for the year ended December 31, 2002, which was filed with the SEC on December 16, 2003, for information concerning previously filed financial statements and reports on which you should not rely. Also refer to the Introductory Note to this Form 10-K and the Introductory Notes to our Form 10-Q/As for the quarters ended March 31, 2004, June 30, 2004 and September 30, 2004, which are being filed concurrently with the filing of this Form 10-K.

Item 2.    Properties

Our corporate headquarters are located at 981 Calle Amanecer, San Clemente, California, where we lease 25,000 square feet of space for research and development and administrative functions. Additionally, we lease 14,500 square feet of space for manufacturing functions, which is located within the same corporate business park of our headquarters, at 1001 Calle Amanecer, San Clemente, California. The lease on these facilities expires on February 28, 2006. Our wholly owned subsidiary, BIOLASE Europe, owns a manufacturing facility totaling approximately 20,000 square feet of space in Floss, Germany. We believe that our facilities are sufficient for our current needs and that suitable additional or substitute space will be available as needed to accommodate foreseeable expansion of our operations. Other than the land and building in Germany, with a recorded net book amount of $1.2 million, the majority of our long-lived assets are located in the United States.

Item 3.    Legal Proceedings

In August 2004, we and certain of our current and former officers were named as defendants in several putative shareholder class action lawsuits filed in the United States District Court for the Central District of California. The complaints purport to seek unspecified damages on behalf of an alleged class of persons who purchased our common stock between October 29, 2003 and July 16, 2004. The complaints allege that we and our officers violated federal securities laws by failing to disclose material information about the demand for our products and the fact that we would not achieve the alleged forecasted growth. The claimed misrepresentations include certain statements in our press releases and the registration statement we filed in connection with our public offering of stock in March 2004. In addition, three stockholders have filed derivative actions in the state court in California seeking recovery on behalf of BIOLASE, alleging, among other things, breach of fiduciary duties by those individual defendants and by the members of our Board of Directors.

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We have not yet formally responded to any of the actions and no discovery has been conducted by any of the parties. However, based on the facts presently known, our management believes we have meritorious defenses to these actions and intend to vigorously defend them. As of December 31, 2004, no amounts have been recorded in our consolidated financial statements for these matters since management believes that it is not probable that we have incurred a loss.

In January 2005, we acquired the intellectual property portfolio of Diodem LLC (“Diodem”), consisting of certain U.S. and international patents of which four were asserted against us, and settled the existing litigation between us and Diodem, for consideration of $3.0 million in cash, 361,664 shares of common stock, and a five-year warrant exercisable into 81,037 shares of common stock at an exercise price of $11.06 per share. In addition, if certain criteria specified in the purchase agreement are satisfied on or before July 2006, 45,208 additional shares we have placed in escrow may be released to Diodem and we will incur an expense equal to the fair market value of those shares at the time of their release. These shares had a fair market value of $500,000 at the time of the Binding Letter of Intent. The total consideration was estimated to have a value of $7.0 million, excluding the value of the shares held in escrow. As of December 31, 2004, we accrued $6.4 million for the settlement of the existing litigation. In January 2005, we recorded an intangible asset of $530,000 representing the estimated fair value of the intellectual property acquired. As a result of the acquisition, Diodem immediately withdrew its patent infringement claims against us and the case was formally dismissed on May 31, 2005. We did not pay and have no obligation to pay any royalties to Diodem on past or future sales of our products.

In late 2004, we were notified by Refocus Group, Inc., or Refocus, that certain of our planned activities in the field of presbyopia may infringe one or more claims of a patent held by Refocus. In late 2004 through early 2005, we engaged in negotiations with Refocus with the intent of obtaining a license to the patent at issue. Given that we were unsuccessful in reaching an agreement with respect to a license, on February 24, 2005, we filed a lawsuit in the U.S. District Court for the Central District of California against Refocus in order to obtain declaratory relief that certain of our planned activities in the field of presbyopia will not infringe the claims of a patent held by Refocus and/or that the claims are invalid. These claims were dismissed by the court in July 2005 without prejudice on the basis that we do not have a product that has been commercialized and, therefore, Refocus’ alleged infringement claims are not ripe. As of December 31, 2004, no amounts have been recorded in our consolidated financial statements for this matter since management believes that it is not probable that we have incurred a loss.

From time to time, we are involved in other legal proceedings incidental to our business, but at this time we are not party to any other litigation that is material to our business.

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

None.

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PART II

Item 5.    Market for the Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

Our common stock is listed on the NASDAQ National Market under the symbol “BLTI.” During the period in 2005 in which we have not been in compliance with Nasdaq rules, our stock has traded under the symbol “BLTIE.” The following table sets forth the high and low closing sale prices of our common stock as reported by the NASDAQ National Market for each quarter of 2004 and 2003:

As of May 31, 2005, the total number of record holders of our common stock was approximately 275. Based on information provided by our transfer agent and registrar, we believe that there are approximately 13,000 beneficial owners of our common stock.

In July 2004, we announced that our Board of Directors authorized a 1.25 million share repurchase program. On August 9, 2004, we announced that our Board of Directors authorized the repurchase of an additional 750,000 shares of our common stock, increasing the total share repurchase program to 2.0 million shares of our common stock. During 2004, we repurchased approximately 1,964,000 shares at an average price of $8.35 per share.

In the fourth quarter of 2004, we repurchased 438,500 shares in open-market transactions. Below is a summary of the repurchase activity:

Dividend Policy

In July 2004, the Board of Directors approved a dividend policy to pay a cash dividend of $0.01 per share every other month to the stockholders of record at the time when declared by the Board of Directors. Any future changes in our dividend policy or payments of cash dividends on our common stock will be at the discretion of our Board of Directors and will be dependent upon our financial condition, operating results, capital requirements and other factors that our board deems relevant.

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Equity Compensation Plan Information

Information regarding our equity compensation plans, including both plans approved by security holders and plans not approved by security holders, is contained herein in Part III.

Item 6.    Selected Consolidated Financial Data

The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and related notes contained elsewhere in this report and in our subsequent reports filed with the SEC, as well as Item 7 titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

See the Explanatory Note to this Annual Report on Form 10-K and Note 3 to the Consolidated Financial Statements for more detailed information regarding the restatement of our consolidated financial statements for the years ended December 31, 2003 and 2002.

The following discussion provides information regarding adjustments made to the previously reported consolidated financial information for the years ended December 31, 2001 and 2000:

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

The following discussion of our results of operations and financial condition should be read together with the consolidated financial statements and the notes to those statements included elsewhere in this report and other information incorporated by reference in this report, if any. This discussion may contain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from the results anticipated in any forward-looking statements as a result of a variety of factors, including those discussed in “Risk Factors” and elsewhere in this report.

Restatement of Financial Statements

The following discussion and analysis gives effect to the restatement discussed in the Explanatory Note to this Annual Report on Form 10-K and in Note 3 to our consolidated financial statements. Accordingly, some of the data set forth in this section is not comparable to discussions and data in our previously filed annual reports for the corresponding period.

Overview

We are the world’s leading dental laser company. We design, manufacture and market proprietary dental laser systems that allow dentists, periodontists, endodontists, oral surgeons and other specialists to perform a broad range of dental procedures, including cosmetic and complex surgical applications. Our systems are designed to provide clinically superior performance for many types of dental procedures, with less pain and faster recovery times than are generally achieved with drills, scalpels and other dental instruments. We have clearance from the U.S. Food and Drug Administration, or FDA, to market our laser systems in the United States and also have the necessary approvals to sell our laser systems in Canada, the European Union and other international markets. We are currently pursuing regulatory approval to market and sell our Waterlase system in Japan. Since 1998, we have sold more than 3,350 Waterlase systems and approximately 4,500 laser systems in over 45 countries.

We offer two categories of laser system products: (i) Waterlase system and (ii) Diode system. Our flagship product category, the Waterlase system, uses a patented combination of water and laser to perform most procedures currently performed using dental drills, scalpels and other traditional dental instruments for cutting soft and hard tissue. We also offer a family of Diode laser system products to perform soft tissue and cosmetic procedures, including tooth whitening.

Waterlase system.    We refer to our patented interaction of water with laser as YSGG Laser HydroPhotonics. YSGG is a shortened abbreviation referring to the unique crystal (Er, Cr: YSGG) laser used in the Waterlase, which contains the elements erbium, chromium, yttrium, scandium, gallium and garnet. This unique crystal laser produces energy with specific absorption and tissue interaction characteristics optimized for dental applications. HydroPhotonics refers to the interaction of laser with water to produce energy to cut tissue. Through YSGG Laser HydroPhotonics, the Waterlase system can precisely cut hard tissue, such as bone and teeth, and soft tissue, such as gums, with minimal or no damage to surrounding tissue. The Waterlase system is the best selling dental laser system, and we estimate it currently accounts for a majority of all dental lasers sold worldwide.

Diode system.    We also offer a family of Diode system products, which use a semiconductor diode laser to perform soft tissue and cosmetic procedures, including tooth whitening. Our Diode system serves the growing markets for cosmetic and hygiene procedures.

The Diode system, together with our Waterlase system, offer practitioners a broad product line with a range of features and price points. We also manufacture and sell accessories and consumables for our laser systems, such as hand pieces, laser tips and tooth whitening gel. The Waterlase system comprised 84%, 83% and 77% of our total revenue for the years ended December 31, 2004, 2003 and 2002 respectively. The Diode system comprised 11%, 12% and 18% of our total revenue for the same periods.

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Principal Factors Considered by Our Management

Among other things, in managing our business, our management is particularly focused on the following factors and considerations:

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our 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 us to make estimates and judgments that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses for each period.

The following represents a summary of our critical accounting policies, defined as those policies that we believe are: (i) the most important to the portrayal of our financial condition and results of operations, and (ii) that require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Revenue recognition.    We sell products domestically to customers through our direct sales force, and internationally through a direct sales force and through distributors. We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition,” which requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred and title and the risks and rewards of ownership have been transferred to our customer or services have been rendered; (3) the price is fixed or determinable; and (4) collectibility is reasonably assured.

Through August 2003, the terms of our purchase orders for products sold domestically required payment in full before title was transferred. Accordingly, with all other criteria being met, we recognized revenue when payment was received. For products sold internationally through our direct sales force we recognized revenue when all other criteria was met and we completed installation, which was when the customer became obligated to pay. In August 2003, we modified the sales arrangements with our customers so that title transfers to the customer upon shipment for domestic sales, and there is an enforceable obligation to pay upon shipment for international direct sales. Beginning in August 2003, we have been recording revenue for domestic sales and international direct sales upon shipment. As a result, during 2003 we recorded $19.9 million in revenue before the modification to our sales arrangements and $21.8 million (restated) in revenue after the modification to our sales arrangements. We recognize revenue for products sold through our distributors internationally when the product is delivered. Revenue unaffected by the changes in our customer agreements with distributors was $7.2 million for the year ended December 31, 2003.

We adopted EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables,” on July 1, 2003, which requires us to evaluate whether the separate deliverables in our arrangements can be unbundled. We determined that the sales of our Waterlase system include separate deliverables consisting of the product, disposables used with the Waterlase, installation and training. For these sales, we apply the residual value method, which requires us to allocate the total arrangement consideration less the fair value of the undelivered elements to the delivered elements. We determined that the sales of our Diode system include separate deliverables consisting of the product, disposables and training. For these sales, we apply the relative fair value method, which requires us to allocate the total arrangement consideration to the relative fair value of each element. Deferred revenue attributable to the undelivered elements, primarily training, installation and

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disposables, are included in deferred revenue when the product is shipped and are recognized when the related items are delivered or the service is performed.

The key judgment related to our revenue recognition relates to the collectibility of payment from the customer. We evaluate the customer’s credit worthiness prior to the shipment of the product. Based on our assessment of the credit information available to us, we may determine the credit risk is higher than normally acceptable, and we will either decline the purchase or defer the revenue until payment is reasonably assured.

Although all sales are final, we accept returns of products in certain, limited circumstances and record a provision for sales returns based on historical experience concurrent with the recognition of revenue. The sales returns allowance is recorded as a reduction of accounts receivable, revenue and cost of revenue.

We recognize revenue for royalties under licensing agreements for our patented technology when the product using our technology is sold. We estimate and recognize the amount earned based on historical performance and current knowledge about the business operations of our licensees. Our estimates have been historically consistent with amounts reported by the licensees.

Valuation of Accounts Receivable.    We maintain an allowance for uncollectible accounts receivable to estimate the risk of extending credit to customers. We evaluate our allowance for doubtful accounts based upon our knowledge of customers and their compliance with credit terms. The evaluation process includes a review of customers’ accounts on a regular basis which incorporates input from sales, service and finance personnel. The review process evaluates all account balances with amounts outstanding 60 days and other specific amounts for which information obtained indicates that the balance may be uncollectible. The allowance for doubtful accounts is adjusted based on such evaluation, with a corresponding provision included in general and administrative expenses. Account balances are charged off against the allowance when we feel it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers.

Valuation of Inventory.    Inventory is valued at the lower of cost (determined using the first-in, first-out method) or market. We periodically evaluate the carrying value of inventory and maintain an allowance for excess and obsolete inventory to adjust the carrying value as necessary to the lower of cost or market. We evaluate quantities on hand, physical condition and technical functionality, as these characteristics may be impacted by anticipated customer demand for current products and new product introductions. Unfavorable changes in estimates of excess and obsolete inventory would result in an increase in cost of revenue and a decrease in gross profit.

Valuation of Long-Lived Assets.    Property, plant and equipment, and certain intangibles with finite lives are amortized over their useful lives. Useful lives are based on our estimate of the period that the assets will generate revenue or otherwise productively support our business goals. We monitor events and changes in circumstances, which could indicate that the carrying balances of long-lived assets may exceed the undiscounted expected future cash flows from those assets. If such a condition were to exist, we will recognize an impairment loss based on the excess of the carrying amount over the fair value of the assets.

Valuation of Goodwill and Other Intangible Assets.    Goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment annually or whenever events or changes in circumstances indicate that the asset might be impaired. We conducted our annual impairment analysis of our goodwill and trade names as of June 30, 2004 and concluded there had not been an impairment. During the fourth quarter of 2004, we changed our strategy to focus our sales efforts on high-end laser products such as the new Waterlase MD product, which was first sold during the fourth quarter of 2004. This conclusion was due to the increased competition for relatively low-priced laser devices. As a result, the actual sales of Diolase Plus were below our original expectations and we expect this trend to continue. We estimated the fair value of the Diolase Plus trade name based on a relief from royalty approach using discounted cash flows from revised projected Diolase Plus revenue. The $747,000 excess of the carrying value over the asset’s estimated fair value has been recorded as a charge to operations in the fourth quarter of 2004.

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Warranty Cost.    Products sold directly to end users are covered by a warranty against defects in material and workmanship for a period of one year. Products sold internationally to distributors are covered by a warranty on parts for up to fourteen months. Estimated warranty expenses are recorded as an accrued liability, with a corresponding provision to cost of revenue. This estimate is recognized concurrent with the recognition of revenue. The accrual is based on our historical experience and our expectation of future conditions. An increase in warranty claims or in the costs associated with servicing those claims would result in an increase in the accrual and a decrease in gross profit.

Litigation and Other Contingencies.    We regularly evaluate our exposure to threatened or pending litigation and other business contingencies. Because of the uncertainties related to the amount of loss from litigation and other business contingencies, the recording of losses relating to such exposures requires significant judgment about the potential range of outcomes. As additional information about current or future litigation or other contingencies becomes available, we will assess whether such information warrants the recording of expense relating to contingencies. To be recorded as expense, a loss contingency must be both probable and reasonably estimable. If a loss contingency is material but is not both probable and estimable, we will disclose the matter in the notes to the financial statements. During the year ended December 31, 2004, we recorded a $6.4 million charge to operations for a patent infringement legal settlement related to the lawsuit between us and Diodem LLC.

Income Taxes.    We estimate our actual current tax expense together with assessing any temporary differences resulting from the different treatment of certain items, such as the timing for recognizing revenue and expenses, for tax and financial reporting purposes. These differences may result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We are required to assess the likelihood that our deferred tax assets, which include net operating loss carryforwards and temporary differences that are expected to be deductible in future years, will be recoverable from future taxable income or tax planning strategies. If we conclude that our deferred tax assets are more likely than not to be realized (a probability level of more than 50%), a valuation allowance is not recorded.

During the year ended December 31, 2004, we determined that it was more likely than not that our deferred tax assets, which consist primarily of net operating loss, or NOL, carryforwards, would not be realized. In this determination, we considered factors such as our earnings history, future projections and tax planning strategies. If sufficient evidence of our ability to generate sufficient future taxable income in certain jurisdictions becomes apparent, we may reduce our valuation allowance, resulting in income tax benefits in our statement of operations and in additional paid-in-capital. Management evaluates the potential realization of our deferred tax assets and assesses the need for releasing the valuation allowance periodically.

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Results of Operations

The following table sets forth certain data from our consolidated income statements for the years ended December 31, 2004, 2003 and 2002, expressed as a percentage of revenue:

Net Revenue.    Revenue consists of sales of our laser systems, related disposables and accessories, service revenue, training revenue and royalty revenue. We have at various times experienced fluctuations in revenue due to seasonality. In our experience, revenue in the first quarter typically is lower than average, and revenue in the fourth quarter typically is higher than average, due to the buying patterns of dental professionals. The fourth quarter of 2004 accounted for 32% of our revenue for the year, whereas the first quarter of 2004 accounted for 24% of revenue for the year. The third quarter accounted for 20% of our revenue in 2004, whereas the second quarter accounted for 24% of our revenue in 2004. During 2004, our third quarter was significantly impacted by two items. We believe that many customers delayed purchasing decisions pending the anticipated launching of our new Waterlase product, the Waterlase MD. In addition, some of our U.S. trade shows and seminars were impacted in the southeast by the region’s major hurricanes. Trade shows and seminars are a significant sales-generating process for us. Our historical seasonality pattern is a recurring trend that we expect to continue. Since many of our costs are fixed in the short term, if we have a shortfall in revenue resulting from a change in our historical seasonality pattern, or otherwise, we may be unable to reduce expenses quickly enough to avoid losses.

Many dentists finance their purchases through third-party leasing companies or banks. In these transactions, the dentist first enters into a purchase order with us. We then enter into a purchase order with the leasing company, which purchases the product from us, and the dentist enters into a lease agreement with the leasing company. We receive payment in full for the product by the leasing company, and we are not a party to the lease with the dentist. The dentist pays the leasing company or bank in installments, and we do not bear the credit risk that the dentist might not make payments. The leasing companies and banks do not have recourse to us for a dentist’s failure to make payments, nor do we have any obligation to take back the product at the end of the lease. Approximately 28% of our revenue in 2004, 34% of our revenue in 2003, and 36% of our revenue in 2002 were generated from dentists who financed their purchase through National Technology Leasing Corporation, an

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equipment leasing broker. We are regularly approached by leasing companies seeking to finance purchases of our products and do not believe the loss of National Technology Leasing or any other current financing source would materially harm our business.

Cost of Revenue.    Cost of revenue is comprised of all costs to manufacture our products, including materials, labor and related overhead costs such as depreciation, warranty and service costs.

Other Income, Net.    Other income consists of gain (loss) on sale of assets. The gain on sale of assets primarily related to the sale and leaseback of our manufacturing facility in San Clemente, California in March 2001. This sale resulted in a gain of $316,000 and is being recognized over the remaining term of the lease, which expires in 2006. Other income in 2004 and 2003 included the amortization of deferred gain offset by a gain (loss) on the sale of certain fixed assets.

Sales and Marketing.    Sales and marketing expenses consist of salaries and benefits, commissions, and other costs related to our direct sales force, advertising costs and expenses related to trade shows and seminars.

General and Administrative.    General and administrative expenses consist of salaries and benefits of administrative personnel as well as insurance, professional and regulatory fees, provisions for doubtful accounts, penalties and interest on amounts collected from customers but not timely remitted to the states, and subsequent gain for the amount of the liability relieved by the state.

Engineering and Development.    Engineering and development expenses consist of engineering personnel salaries and benefits, prototype supplies, contract services and consulting fees related to product development.

Patent Infringement Legal Settlement.    In January 2005, we acquired the intellectual property portfolio of Diodem LLC (“Diodem”), consisting of certain U.S. and international patents of which four were asserted against us, and settled the existing litigation between us and Diodem, for consideration of $3.0 million in cash, 361,664 shares of common stock, and a five-year warrant exercisable into 81,037 shares of common stock at an exercise price of $11.06 per share. In addition, if certain criteria specified in the purchase agreement are satisfied on or before July 2006, 45,208 additional shares we have placed in escrow may be released to Diodem and we will incur an expense equal to the fair market value of those shares at the time of their release. These escrowed shares had a fair market value of $500,000 at the time of the Binding Letter of Intent. The total consideration was estimated to have a value of $7.0 million, excluding the value of the shares held in escrow. As of December 31, 2004, we accrued $6.4 million for the settlement of the existing litigation. In January 2005, we recorded an intangible asset of $530,000 representing the estimated fair value of the intellectual property acquired. As a result of the acquisition, Diodem immediately withdrew its patent infringement claims against us and the case was formally dismissed on May 31, 2005. We did not pay and have no obligation to pay any royalties to Diodem on past or future sales of our products.

Impairment of Intangible Asset.    During 2004, we determined that our intangible assets associated with trade names were impaired based on circumstances that arose in the fourth quarter surrounding future expected sales of our Diolase product. The underlying factors contributing to our revised estimate included a reduced projected rate of sales growth for this product as a result of increased competition for relatively low-priced laser devices resulting in management’s decision to focus our sales efforts on high-end laser products such as the new Waterlase MD product launched in the fourth quarter of 2004. An expense of $747,000 was recorded related to this impairment.

Non-Operating Income (Loss).    Non-operating income (loss) consists of interest income and expense, foreign currency gains and losses and items not directly related to our operations. Interest income relates to interest earned on our cash balances and short-term investments, and interest expense relates to interest costs on our line of credit. We generate a substantial portion of our revenue from the sale of products outside the United States. Our sales in Europe are denominated principally in Euros, and our sales in other international markets are denominated in dollars. As we do not engage in hedging transactions to offset foreign currency fluctuations, we

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are at risk for changes in the value of the dollar relative to the value of the Euro. An increase in the relative value of the dollar would lead to less income from sales denominated in Euros unless we increase prices, which may not be possible due to competitive conditions in Europe. Conversely, a decrease in the relative value of the dollar would lead to more income from sales denominated in Euros. Additionally, we are obligated to pay expenses relating to our German facility in Euros. Thus, we are also at risk for changes in the value of the dollar relative to the Euro with respect to our obligation to pay expenses relating to our operations in Germany. An increase in the value of the dollar relative to the Euro would reduce the expenses associated with the operations of our German facility, whereas a decrease in the relative value of the dollar would increase the cost associated with the operations of our German facility.

Income Taxes.    We estimate our actual current tax expense together with assessing any temporary differences resulting from the different treatment of certain items, such as the timing for recognizing revenue and expenses, for tax and financial reporting purposes. These differences may result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We are required to assess the likelihood that our deferred tax assets, which include net operating loss carryforwards and temporary differences that are expected to be deductible in future years, will be recoverable from future taxable income or tax planning strategies. If we conclude that our deferred tax assets are more likely than not to be realized (a probability level of more than 50%), a valuation allowance is not recorded.

Based upon our operating losses during 2004 and the available evidence, management determined that it is more likely than not that the deferred tax assets as of December 31, 2004 will not be realized. Consequently, we recorded a valuation allowance for our net deferred tax asset in the amount of $21.1 million as of December 31, 2004. In this determination, we considered factors such as our earnings history, future projected earnings and tax planning strategies. If sufficient evidence of our ability to generate sufficient future taxable income becomes apparent, we may reduce our valuation allowance, resulting in income tax benefits in our statement of operations and in additional paid-in-capital. Management evaluates the potential realization of our deferred tax assets and assesses the need for reducing the valuation allowance periodically.

During the year ended December 31, 2003, we determined that it was more likely than not that our deferred tax assets, which consist primarily of NOL carryforwards, would be realized, resulting in an $11.9 million net deferred tax benefit. This deferred tax benefit does not include $2.2 million for stock option deduction benefits recorded as a credit to additional paid-in-capital. We considered factors such as our profitable operating history, three years of cumulative income and projections of continued profitability at that time in making this determination.

The utilization of NOL and credit carryforwards may be limited under the provisions of Internal Revenue Code Section 382 and similar state provisions. Section 382 of the Internal Revenue Code of 1986 generally imposes an annual limitation on the amount of NOL carryforwards that may be used to offset taxable income where a corporation has undergone significant changes in its stock ownership. In October 2003, we completed an analysis to determine the potential applicability of any annual limitations imposed by Section 382. Based on our analysis, we believe that, as of December 31, 2004, we have, for federal income tax purposes, approximately $39.0 million of NOL carryforwards. Of this amount, approximately $34.5 million is available to offset 2005 federal taxable income and the taxable income generated in future years. Additional NOL carryforwards will become available at the rate of approximately $1.0 million per year for the years 2005 through 2009. However, any future ownership changes qualifying under Section 382 may limit our ability to use remaining NOL carryforwards.

Year Ended December 31, 2004 Compared With Year Ended December 31, 2003 (Restated)

Net Revenue.    Revenue for the year ended December 31, 2004 was $60.7 million, an increase of $11.9 million, or 24%, as compared with revenue of $48.8 million for the year ended December 31, 2003. The increase of $11.9 million consists of increases in the number of products and services sold as a result of a greater

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marketing and sales focus. However, the rate of increase in revenue growth year over year represents a decrease from the recent historical trend. This decrease in the historical rate of growth was first observed in the second quarter of 2004 and has continued through the fourth quarter of 2004. While we have identified during the year a number of factors that could have influenced the change in the rate of growth, at this point in time we believe that the change is not an aberration but rather a shift in our growth rate. We believe this shift involves the makeup of our end customer, whereby we are in a transition from selling to “innovators” to a larger more sustainable “early adapter” market segment. This market segment is typically associated with a longer selling cycle. The size of the potential market, our position within that market and the quality and reliability of our product offerings are fundamentally unchanged; however, the change in the rate of growth has caused us to examine our sales and marketing strategies. Although we do not expect our revenue growth to reach previous historical rates that were in excess of 50%, we do expect modest revenue growth in 2005.

The results for 2003 were favorably impacted due to a change in the timing of revenue recognition. In August 2003, we modified our sales arrangements with our customers and began recognizing revenue upon shipment for our domestic sales, or on an accrual basis, which had previously been recognized upon receipt of payment in full, or on a cash basis. Additionally, we began to recognize revenue upon shipment for our international direct sales, which had previously been recognized after completion of installation. As a result, during 2003 we recorded $19.9 million in revenue under the revenue recognition policy in effect before the modification to our sales arrangements and $21.8 million in revenue under our revenue recognition policy in effect after the modification to our sales arrangements. Net revenues unaffected by the changes in our revenue recognition policy were $7.2 million for the year ended December 31, 2003.

Our Waterlase system comprised 84% and 83% of our total revenue for the years ended December 31, 2004 and 2003, respectively. Our Diolase system comprised 11% and 12% of our revenue for the years ended December 31, 2004 and 2003, respectively. We expect the Waterlase system will continue to account for the majority of our sales.

Many dentists finance their purchases through third party leasing companies. Approximately 28% of our revenue for the year ended December 31, 2004 and 34% of our revenue for the year ended December 31, 2003 were generated from dentists who financed their purchases through National Technology Leasing Corporation, an independent equipment leasing company. The recent history of low interest rates over the past several years may have benefited purchasers of our products by reducing the interest expense to finance the purchase or lease of our products, although we do not believe it is possible to measure the effect of lower interest rates on our sales.

International revenue for the year ended December 31, 2004 was $11.5 million, or 19% of revenue, as compared with $9.8 million, or 20% of revenue, for the year ended December 31, 2003. Sales to Asia, Latin America, Pacific Rim countries and Australia were approximately $4.9 million while sales to Europe, Middle East and Africa (EMEA) were approximately $6.6 million for the year ended December 31, 2004 compared to $4.5 million and $5.3 million, respectively, for the year ended December 31, 2003. We expected our international revenue to remain at approximately 20% of our total revenue for 2005.

Gross Profit.    Gross profit for the year ended December 31, 2004 was $36.0 million, or 59% of revenue, an increase of $4.7 million, as compared with gross profit of $31.3 million, or 64% of revenue for the year ended December 31, 2003. Gross profit for the year ended December 31, 2003 included $12.3 million of gross profit for domestic sales recognized on a cash basis and $13.4 million recognized on an accrual basis. Gross profit for the year ended December 31, 2003 included $1.1 million recognized for international direct sales upon completion of installation and $1.1 million recognized upon shipment. The decrease in gross profit as a percentage of revenue was due to an increase in manufacturing costs related to the launch of the new Waterlase MD product in the fourth quarter of 2004 as well to an increase in fixed manufacturing infrastructure, including quality control, materials management and other support activities. We are generating a lower gross margin on the initial production quantities of the Waterlase MD due to these factors. We expect that increased manufacturing costs associated with the new Waterlase MD will continue until our factory has achieved a proper balance between all

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products and throughput efficiency is maximized. We also experienced an increase in excess and obsolete inventory of $441,000 associated with slow-moving raw materials, which decreased our gross margin approximately 1%. Additionally, included in cost of revenue is $1.9 million and $0 of expenses for the years ended December 31, 2004 and 2003, respectively, for training and WCLI seminars related to our multiple element arrangements, which decreased our gross margin by approximately 2%. Once maximization of efficiency is achieved, we expect that our gross margins will stabilize in the low to mid 60% range.

Other Income, Net.    Other income consists of gain on sale of assets. The gain on sale of assets for the years ended December 31, 2004 and 2003 of $63,000 each year related to the sale and leaseback of our manufacturing facility in San Clemente, California in March 2001. This sale resulted in a gain of $316,000 and is being recognized over the remaining term of the lease, which expires in 2006. Other income in 2004 included the amortization of deferred gain of $63,000 offset by a loss of $31,000 on the sale of certain fixed assets. Other income in 2003 included the amortization of deferred gain of $63,000 plus a gain of $13,000 on the sale of certain fixed assets.

Operating Expenses.    Operating expenses for the year ended December 31, 2004 were $45.4 million, or 75% of revenue, a $21.0 million increase as compared with $24.4 million, or 50% of revenue for the year ended December 31, 2003. The increases in operating expenses were, for the most part, related to planned marketing expenses geared to an expected higher level of sales and general and administrative expenses driven mainly by high levels of legal and compliance costs as described below. Other increases in operating expenses represent increases in fixed organizational infrastructure costs necessary to support our growth. We expect to be able to leverage the fixed nature of these costs as our revenue increases.

Sales and Marketing.    Sales and marketing expenses for the year ended December 31, 2004 were $23.1 million, or 38% of revenue, as compared with $16.8 million, or 34% of revenue, for the year ended December 31, 2003. Approximately $3.7 million of the increase was due to personnel related costs, including commission expense on higher sales, increase in our sales force and related travel and support costs. Marketing expense, including advertising, direct mailing fees, trade shows and seminars increased approximately $2.6 million, of which approximately half related to the launch of our new Waterlase MD product. We expect our sales and marketing expenses to continue to increase, in large part due to increases in expenses associated with education and training of potential customers which is an essential component of our effort to increase market acceptance of laser technology and our products. We expect sales and marketing expense to remain relatively consistent as a percentage of revenue in 2005.

General and Administrative.    General and administrative expenses for the year ended December 31, 2004 were $11.5 million, or 19% of revenue, as compared with $5.1 million, or 10% of revenue, for the year ended December 31, 2003. Legal fees, related principally to the Diodem litigation, totaled $4.3 million, an increase of $3.4 million from the prior year. Costs related to compliance with the Sarbanes-Oxley Act, including professional expenses as well as temporary labor, were approximately $1.3 million, the majority of which were expended in the last six months of 2004. Other personnel and related costs increased approximately $848,000, representing increased infrastructure in finance, information technology, human resources and administration both in response to our growth as well as to meet the ongoing compliance standards related to the Sarbanes- Oxley Act. We expect professional fee expense to continue in response to maintenance and improvements of internal controls under the Sarbanes-Oxley Act, albeit at a lesser amount than 2004. Additionally, our general and administrative expense for the year ended December 31, 2004, included amounts accrued for sales tax liability and related penalties and interest totaling $269,000 compared to $375,000 for the same period of 2003. In 2004, we also recognized a gain of $372,000 for the abatement of certain penalties and interest related to the sales tax compared to $17,000 for the same period of 2003. Costs associated with general liability insurance, employee group insurance and workers compensation insurance increased by approximately $618,000 in 2004 as compared to 2003. We expect these insurance costs to continue to increase significantly as a function of our growth and insurance market conditions in general. We recorded a reserve for uncollectible accounts totaling $354,000 in 2004, an increase of $106,000 compared to 2003. Bank charges relating to credit card sales increased by

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$124,000 as compared to 2003 and will likely continue to grow commensurate with our sales growth. Overall, general and administrative costs are expected to decrease as a percentage of revenue primarily through reduced legal related expenses as a result of the conclusion of our patent litigation with Diodem.

Engineering and Development.    Engineering and development expenses for the year ended December 31, 2004 were $3.6 million, or 6% of revenue, as compared with $2.5 million, or 5% of revenue, for the year ended December 31, 2003. Approximately half of the increase in absolute dollars is due to materials and consulting fees related to the development of the Waterlase MD product, with the balance resulting from an increase in the level of research projects and patent development. We expect engineering and development expenses to increase during 2005 as we develop new applications for our technology and expand on the usage of recently acquired patents.

Patent Infringement Legal Settlement.     In January 2005, we acquired the intellectual property portfolio of Diodem LLC (“Diodem”), consisting of certain U.S. and international patents of which four were asserted against us, and settled the existing litigation between us and Diodem, for consideration of $3.0 million in cash, 361,664 shares of common stock, and a five-year warrant exercisable into 81,037 shares of common stock at an exercise price of $11.06 per share. In addition, if certain criteria specified in the purchase agreement are satisfied on or before July 2006, 45,208 additional shares we have placed in escrow may be released to Diodem and we will incur an expense equal to the fair market value of those shares at the time of their release. These escrowed shares had a fair market value of $500,000 at the time of the Binding Letter of Intent. The total consideration was estimated to have a value of $7.0 million, excluding the value of the shares held in escrow. As of December 31, 2004, we accrued $6.4 million for the settlement of the existing litigation. In January 2005, we recorded an intangible asset of $530,000 representing the estimated fair value of the intellectual property acquired. As a result of the acquisition, Diodem immediately withdrew its patent infringement claims against us and the case was formally dismissed on May 31, 2005. We did not pay and have no obligation to pay any royalties to Diodem on past or future sales of our products.

Impairment of Intangible Asset.    During 2004, we determined that our intangible assets associated with certain trade names were impaired based on circumstances that arose in the fourth quarter surrounding future expected sales of our Diolase product. The underlying factors contributing to our revised estimate included a reduced projected rate of sales growth for this product as a result of increased competition for relatively low-priced laser devices resulting in management’s decision to focus our sales efforts on high-end laser products such as the new Waterlase MD product launched in the fourth quarter of 2004. An expense of $747,000 was recorded related to this impairment.

Non-Operating Income (Loss)

Gain on Foreign Currency Transactions.    We realized an $86,000 gain on foreign currency transactions for the year ended December 31, 2004, compared to $232,000 for the year ended December 31, 2003 due to the changes in exchange rates between the United States dollar and Euro. Due to the relatively low volume of transactions denominated in currencies other than the U.S. dollar, we have not engaged in hedging transactions to offset foreign currency fluctuations. Therefore, we are at risk for changes in the value of the dollar relative to the value of the Euro, which is the only non-U.S. dollar denominated currency in which we have transacted business.

Gain on Sale of Marketable Securities.    Our investments are comprised of U.S. government securities and have been classified as available-for-sale. We realized a $91,000 gain on sale of marketable securities for the year ended December 31, 2004, compared to $0.0 for the year ended December 31, 2003. As a result of the $41.9 million in net proceeds received from our public offering in the first quarter of 2004, we engaged in investment transactions throughout 2004.

Interest Income.    Interest income relates to interest earned on our cash and investment balances. Interest income for the year ended December 31, 2004 was $470,000 as compared with $27,000 for the year ended December 31, 2003 due to an increase in our investment balances resulting from our public offering in the first quarter of 2004.

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Interest Expense.    Interest expense for the year ended December 31, 2004 was $88,000 as compared to $55,000 for the year ended December 31, 2003. Interest expense in 2004 consisted of interest on our outstanding balance on our line of credit, standby fees relating to our increased borrowing capacity under the line of credit, and the periodic use of the line during the year.

Income Taxes.    An income tax provision of $14.4 million was recognized for the year ended December 31, 2004. A significant component of this income tax provision was the recording of the $21.1 million valuation allowance against our deferred tax assets. For the year ended December 31, 2003, we recognized an income tax benefit of $11.9 million and a credit of $2.2 million to additional paid-in capital. The income tax benefit for the year ended December 31, 2003 was due to the reduction of the valuation allowance in the amount of $16.2 million. The credit to additional paid in capital was the result of a stock option deduction available to us in 2003 and prior year deductions included in the deferred tax assets which were previously offset by the valuation allowance. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the projected future taxable income and tax planning strategies in making this assessment. Based upon our operating losses and the weight of the available evidence, management believes it is more likely than not that we will not realize all of these deductible differences. As of December 31, 2004, we had net operating loss carryforwards for federal and state purposes of approximately $39.0 million and $11.3 million, respectively, which will begin expiring in 2005. As of December 31, 2004, we had research and development credit carryforwards for federal and state purposes of approximately $558,000 and $250,000, respectively, which will begin expiring in 2011 for federal purposes and carryforward indefinitely for state purposes. The utilization of net operating loss and credit carryforwards may be limited under the provisions of Internal Revenue Code Section 382 and similar state provisions.

Year Ended December 31, 2003 (Restated) Compared With Year Ended December 31, 2002 (Restated)

Net Revenue.    Revenue for the year ended December 31, 2003 was $48.8 million, an increase of $21.5 million, or 79%, as compared with revenue of $27.3 million for the year ended December 31, 2002. Approximately $16.2 million of the increase resulted from a 59% increase in sales of products and services and the balance was due to a change in the timing of revenue recognition described below.

In August 2003, we modified our sales arrangements with our customers and began recognizing revenue upon shipment for our domestic sales, or on an accrual basis, which had previously been recognized upon receipt of payment in full, or on a cash basis. Additionally, we began to recognize revenue upon shipment for our international direct sales, which had previously been recognized after completion of installation. As a result of the change in our revenue recognition policy during the third quarter of 2003, our revenue is not directly comparable to the year ended December 31, 2002. During the year ended December 31, 2002 domestic sales were recognized on a cash basis and international direct sales were recognized after completion of installation.

Revenue during the year ended December 31, 2003 included $18.3 million of revenue for domestic sales recognized on a cash basis and $20.1 million recognized on an accrual basis. Revenue during the year ended December 31, 2003 included $1.6 million recognized for international direct sales upon completion of installation and $1.7 million recognized upon shipment. As of December 31, 2003 our balance sheet reflects approximately $144,000 that has been deferred on product shipments for which payment has not been received in full for domestic sales and where installation has not been completed for international direct sales. We cannot provide any assurance as to the timing or whether the deferred revenue will ultimately be collected, or when or whether installations will be completed. Other than the possible recognition of this deferred revenue balance, the positive impact to revenue for the year ended December 31, 2003 that resulted from the change in our revenue recognition policy will not occur in future periods.

The Waterlase and LaserSmile systems accounted for approximately 83% and 12% of our revenue for the year ended December 31, 2003, respectively.

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Many dentists finance their purchases through third party leasing companies. Approximately 34% of our revenue for the year ended December 31, 2003 and 36% of our revenue for the year ended December 31, 2002 were generated from dentists who financed their purchases through National Technology Leasing Corporation, an independent equipment leasing company. The decline in interest rates between 2003 and 2002 may have benefited purchasers of our products by reducing the interest expense to finance the purchase or lease of our products, although we do not believe it is possible to measure the effect of lower interest rates on our sales.

International revenue for the year ended December 31, 2003 was $9.8 million, or 20% of revenue, as compared with $6.2 million, or 23% of revenue, for the year ended December 31, 2002. Revenue to Asia and Europe was $4.5 million and $5.3 million, respectively, for the year ended December 31, 2003 compared to $3.3 million and $2.9 million, respectively, for the year ended December 31, 2002. We had expected international revenue to grow as a percentage of total revenue in 2003 and in the future. Although international revenue grew 58% year over year, in line with our overall expectations for total revenue, domestic revenue growth was stronger due to higher than expected demand in the United States. During 2003, we invested more resources in international sales and marketing and related infrastructure.

Gross Profit.    Gross profit for the year ended December 31, 2003 was $31.3 million, or 64% of revenue, an increase of $14.4 million, as compared with gross profit of $16.9 million, or 62% of revenue for the year ended December 31, 2002. Gross profit for the year ended December 31, 2003 included $12.3 million of gross profit for domestic revenue recognized on a cash basis and $13.4 million recognized on an accrual basis. Gross profit for the year ended December 31, 2003 included $1.1 million recognized for international direct revenue upon completion of installation and $1.1 million recognized upon shipment. The increase in gross profit is attributable to leveraging the increase in revenue against fixed and partially fixed manufacturing costs, reflecting better absorption of fixed manufacturing costs. The increase is also due to the relative increase in domestic revenue as a percentage of total revenue, which generated higher gross margins. The gross margin associated with revenue to international distributors is generally lower as the selling price is lower in order to compensate dealers for the marketing and sales costs they must incur. International revenue increased as a percentage of total revenue from 2001 to 2002 but then decreased as a percentage in 2003. Therefore, while gross margin may continue to increase due to manufacturing efficiencies, relative increases in international revenue compared to domestic revenue may offset the effect of manufacturing efficiencies on gross profit. Revenue of the Diolase and Pulsemaster systems did not have a significant impact on gross profit.

Other Income, Net.     Other income consists of gain on sale of assets. The gain on sale of assets for the years ended December 31, 2003 and 2002 of $63,000 each year related to the sale and leaseback of our manufacturing facility in San Clemente, California in March 2001. This sale resulted in a gain of $316,000 and is being recognized over the remaining term of the lease, which expires in 2006. Other income in 2003 included the amortization of deferred gain of $63,000 plus a gain of $13,000 on the sale of certain other assets.

Operating Expenses.    Operating expenses for the year ended December 31, 2003 were $24.4 million, or 50% of revenue as compared with $16.0 million, or 58% of revenue for the year ended December 31, 2002. Approximately 72% of the increase, or $6.1 million, consists of sales and marketing costs incurred to generate the increase in revenue.

Sales and Marketing.    Sales and marketing expenses for the year ended December 31, 2003 were $16.8 million, or 34% of revenue, as compared with $10.7 million, or 39% of revenue, for the year ended December 31, 2002. Approximately 40% of the increase in absolute dollars was due to the increase in our direct sales force, development of our infrastructure for international sales, and higher commission expense related to the increase in sales, including recognition, of approximately $334,000 in deferred commission expense related to revenue recognized that had been deferred. Marketing expense increased $1.4 million due to increased staff and additional direct marketing activities in Europe. Expenses related to trade shows, seminars and the World Clinical Laser Institute increased approximately $1.0 million due to an expansion in the scope of activities related to those programs. We expect our sales and marketing expenses to continue to increase, in large part due

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to increases in expenses associated with education and training of potential customers, which is an essential component of our effort to increase market acceptance of laser technology and our products. Overall, sales and marketing expense is expected to decrease slightly as a percentage of revenue, assuming sales continue to grow in line with our expectations. Incremental costs relating to the marketing and sale of the American Dental Laser products have not had and are not expected to have a significant impact on total sales and marketing expense.

General and Administrative.    General and administrative expenses for the year ended December 31, 2003 were $5.1 million, or 10% of revenue, as compared with $3.6 million, or 13% of revenue, for the year ended December 31, 2002. Professional expenses accounted for approximately 50% of the dollar increase, including approximately $450,000 in expenses related to the restatement of our consolidated financial statements, fees related to legal proceedings and fees incurred on various consulting projects. We expect professional fee expense to continue to increase as a cost of compliance with new regulatory requirements, such as those generated from the Sarbanes-Oxley Act. Costs associated with general liability coverage, employee group insurance and workers compensation insurance increased by $465,000 in 2003 as compared to 2002. We expect these insurance costs to continue to increase significantly as a function of our growth and insurance market conditions in general. Bank charges relating to credit card sales increased by $140,000 as compared to 2002 and will likely continue to grow commensurate with our sales growth. No significant additional general and administrative expenses have been incurred or are expected from the acquisition and production of the American Dental Laser products except for amortization expense related to certain intangible assets acquired.

Engineering and Development.    Engineering and development expenses for the year ended December 31, 2003 were $2.5 million, or 5% of revenue, as compared with $1.7 million, or 6% of revenue, for the year ended December 31, 2002. The increase in absolute dollars was due to materials and consulting fees related to product development and enhancement. The change in engineering and development expenses as a percentage of revenue reflects the larger sales base and normal fluctuations in the scope of current research and development projects.

Non-Operating Income (Loss)

Gain on Foreign Currency Transactions.    We realized a $232,000 gain on foreign currency transactions for the year ended December 31 2003, compared to $51,000 for the year ended December 31, 2002 due to the changes in exchange rates between the United States dollar and Euro.

Gain on Forward Exchange Contracts.    In the years ended December 31, 2003 and 2002, we realized gains of $22,000 and $152,000, respectively, due to the increase in the fair market value of our forward exchange contracts which we purchased in connection with the debt incurred to acquire our facility in Germany. On February 3, 2003, the contracts expired and were not renewed.

Interest Income.    Interest income relates to interest earned on our cash balances. Interest income for the year ended December 31, 2003 was $27,000 as compared with $18,000 for the year ended December 31, 2002 due to an increase in our cash balance.

Interest Expense.    Interest expense decreased $80,000, or 59%, to $55,000 for the year ended December 31, 2003, as compared with the year ended December 31, 2002 due to a decrease in the effective interest rate on our credit facility. In May 2003, we entered into a $5.0 million credit facility with a bank to replace our existing line of credit. The new line of credit bears interest at LIBOR plus 2.25% as compared with the previous line of LIBOR plus 0.5%. Although the nominal rate on the new facility is higher, the previous facility was burdened by the amortization of the cost of a third-party guaranty.

Income Taxes.    An income tax benefit of $11.9 million and a credit of $2.2 million to additional paid in capital was recognized for the year ended December 31, 2003. This was primarily due to the reduction of the valuation allowance in the amount of $16.2 million. The credit to additional paid-in-capital was the result of a stock option deduction available to use in the current year and prior year deductions included in the deferred tax

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assets which were previously offset by the valuation allowance. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and the projection for future taxable income over the periods when the deferred tax assets are deductible, management believes it is more likely than not that we will realize all of these deductible differences. As of December 31, 2003, we had net operating loss carryforwards for federal and state purposes of approximately $32.4 million and $7.4 million, respectively, which will begin expiring in 2004. As of December 31, 2003, we had research and development credit carryforwards for federal and state purposes of approximately $437,000 and $54,000, respectively, which will begin expiring in 2011 for federal purposes and carryforward indefinitely for state purposes. The utilization of net operating loss and credit carryforwards may be limited under the provisions of Internal Revenue Code Section 382 and similar state provisions.

Liquidity and Capital Resources

At December 31, 2004, we had $30.0 million in net working capital, an increase of $19.9 million from $10.1 million (restated) at December 31, 2003. Our principal source of liquidity at December 31, 2004 consisted of our cash balance of $6.1 million and investments in marketable securities of $25.3 million. For the year ended December 31, 2004, our sources of cash were net proceeds of $41.9 million from our public offering and $1.3 million from the exercise of stock options. Principal uses of cash for the year ended December 31, 2004 were investments in marketable securities of $25.2 million, funds used to repurchase common stock of $16.4 million, payments totaling approximately $2.7 million to pay off debt outstanding at December 31, 2003, additions to long term assets of approximately $1.4 million and dividends paid of $689,000. Cash used in operating activities was $1.6 million for the year ended December 31, 2004. The net effect on cash of operating, investing, and financing activities for the year ended December 31, 2004 was a decrease of $5.0 million. Cash and cash equivalents and short-term investments increased $20.4 million from December 31, 2003 to December 31, 2004.

Principal among the changes in assets and liabilities which used cash were increases in accounts receivable and inventory. Net accounts receivable at December 31, 2004 increased approximately $3.9 million from December 31, 2003. The increase is primarily attributable to the increase in the sales volume experienced in 2004. Specifically, our revenue increased $3.2 million in the fourth quarter of 2004 when compared to the fourth quarter of 2003. Days sales outstanding (DSO) in accounts receivable lengthened from 40 days for the year ended December 31, 2003 to 46 days when measured at December 31, 2004 primarily attributable to the increase in the sales volume generated in the latter part of the fourth quarter of 2004 as compared to the fourth quarter of 2003. Net inventory increased approximately $4.4 million from December 31, 2003. This increase was primarily due to increased levels of production in the fourth quarter which was geared to meet revenue at a level comparable with our expected rates of growth and the introduction of our new product, the Waterlase MD during the fourth quarter of 2004. Inventory turnover declined to 4.1 turns per year when measured at December 31, 2004 compared to 5.3 (restated) turns per year when measured at December 31, 2003. As increased efficiencies in the manufacturing process of the Waterlase MD occur, we believe we will be able to manage inventory levels consistent with revenue growth. This is not anticipated to occur until the later part of 2005.

Principal among the changes in assets and liabilities which provided cash were accounts payable, accrued liabilities and deferred revenue. Accounts payable increased $3.4 million in relation to the growth in the business year over year. In addition, we incurred an obligation for 2005 insurance premiums at the end of 2004, a portion of which is reflected in accounts payable. Deferred revenue increased $1.2 million during the year due to certain deliverables we must provide under customer purchase orders. The customer is billed for these deliverables at the time of product shipment. An example of a future deliverable is training. Of these obligations, approximately $493,000 will expire if the customer does not utilize them within six months from the time the product shipped. Revenue is recorded when these deliverables are satisfied.

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Several key indicators of liquidity are summarized in the following table (in thousands, except ratio amounts):

On March 3, 2004, we completed a public offering of 2.5 million shares of common stock. Net proceeds from the offering were $41.9 million. We incurred legal, accounting and related costs of approximately $1.5 million which we had recorded as a reduction to additional paid-in capital upon closing. We used a portion of the net proceeds to repay $1.8 million on the line of credit and $888,000 in debt. The balance was invested in marketable securities consisting of U.S. Treasury Bills with durations not exceeding two years. The balance of the net proceeds of the offering have been used for general corporate purposes, working capital, and capital expenditures, including expenditures for expansion of our production capabilities, and the acquisition or investment in complementary businesses or products or the right to use complementary technologies. In addition, the Board of Directors concluded that a stock repurchase program represented a use of capital that can enhance stockholder value. Therefore, in July of 2004, we announced a stock repurchase program to acquire up to 1.25 million shares over the next 12 months. In August of 2004, the Board of Directors authorized the repurchase of an additional 750,000 shares of our common stock, increasing the total share repurchase program to 2.0 million shares of our common stock. As of December 31, 2004 we have repurchased on the open market substantially all of the 2.0 million shares at an average price of $8.35 per share. Also in July of 2004, the Board of Directors established a dividend policy that will remain in effect for an indefinite period of time and pays a regular cash dividend of $0.01 per share every other month when declared by the Board of Directors. The first dividend totaling $235,000 was declared on July 27, 2004 and paid on August 30, 2004 to stockholders of record on August 16, 2004. The second dividend totaling $229,000 was declared on October 7, 2004 and paid on October 27, 2004 to stockholders of record on October 13, 2004. The third dividend totaling $225,000 was declared on December 9, 2004 and paid on December 29, 2004 to stockholders of record on December 15, 2004.

At December 31, 2003, we had $1.8 million outstanding under a $5.0 million revolving credit facility with a bank, which was due to expire at June 30, 2004. In the first quarter of 2004, we used a portion of the net proceeds from our March 3, 2004 public offering to repay the $1.8 million outstanding on the line of credit. As of December 31, 2004, there were no amounts borrowed on the credit facility, however the facility was used and paid down at various times during the year. Borrowings under the facility bear interest at LIBOR plus 2.25% for minimum borrowing amounts of $500,000 and with two business days notice or at a variable rate equivalent to Prime rate for amounts below $500,000 or with less than two business days notice and are payable on demand upon expiration of the facility. All borrowings during 2004 were at Prime rate. Borrowings also subject us to certain covenants, including, among other things, maintaining a minimum balance of cash (including investments in U.S. Treasuries) and tangible net worth, a specified ratio of current assets to current liabilities and a covenant to remain profitable. In June 2004, this credit facility was extended to June 30, 2005 and increased to $10.0 million. In June 2005, this credit facility was extended to September 30, 2005. We were compliant with the covenants under the agreement with the exception to remain profitable on a quarterly basis. In February 2005, we notified our bank that we were in default under our covenants as of December 31, 2004 due to our operating loss for both the three months ended September 30, 2004 and December 31, 2004. In February 2005, we obtained a waiver to this covenant as of December 31, 2004. A similar waiver was obtained for our third quarter of 2004. As of April 20, 2005 we became non-compliant with our covenant relating to timely reporting and certification requirements due to the late filing of our Form 10-K for the year ended December 31, 2004. In July 2005, we

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obtained a waiver to this covenant which extended until July 21, 2005. We intend to seek additional waivers until all of our late periodic reports have been filed and for any other non-compliant covenants when and if any become necessary.

In January 2005, we acquired the intellectual property portfolio of Diodem LLC (“Diodem”), consisting of certain U.S. and international patents of which four were asserted against us, and settled the existing litigation between us and Diodem, for consideration of $3.0 million in cash, 361,664 shares of common stock, and a five-year warrant exercisable into 81,037 shares of common stock at an exercise price of $11.06 per share. In addition, if certain criteria specified in the purchase agreement are satisfied on or before July 2006, 45,208 additional shares we have placed in escrow may be released to Diodem and we will incur an expense equal to the fair market value of those shares at the time of their release. These escrowed shares had a fair market value of $500,000 at the time of the Binding Letter of Intent. The total consideration was estimated to have a value of $7.0 million, excluding the value of the shares held in escrow. As of December 31, 2004, we accrued $6.4 million for the settlement of the existing litigation. In January 2005, we recorded an intangible asset of $530,000 representing the estimated fair value of the intellectual property acquired. As a result of the acquisition, Diodem immediately withdrew its patent infringement claims against us and the case was formally dismissed on May 31, 2005. We did not pay and have no obligation to pay any royalties to Diodem on past or future sales of our products.

The following table presents our expected cash requirements for contractual obligations outstanding as of December 31, 2004 for the years ending as indicated below:

We believe that our current cash balances and marketable securities plus cash expected to be generated from our operations will be adequate to meet our capital requirements and sustain our operations, including the payment of our planned dividend and payments under the stock repurchase plan, for at least the next twelve months. Our capital requirements will depend on many factors, including among other things, the effects of any acquisitions we may pursue as well as the rate at which our business continues to grow, with corresponding demands for working capital and manufacturing capacity. During the quarter ended March 31, 2005, we paid Diodem the $3.0 million in accordance with the asset purchase agreement and purchased a license for technology from SurgiLight for $2.0 million of which $1.8 million has been paid, as more fully described in Item 1. Business of this Form 10-K. We could be required or may elect to seek additional funding through public or private equity or debt financing. However, additional funds may not be available on terms acceptable to us or at all.

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Selected Quarterly Financial Data

The Selected Quarterly Financial data set forth in this section has been revised to reflect the restatement as discussed in “Note 3. Restatement of Financial Statements” to our consolidated financial statements.