Liquidity, Capital Resources and Financial Condition

        We have incurred negative cash flow from operations since inception in 1988. For the year ended December 31, 2004, we had total revenue of $67.7 million and a net loss of $4.8 million. In 2004, net cash used by operations was $1.1 million. At December 31, 2004, we had $5.0 million of cash and cash equivalents, working capital of $5.2 million, $10.4 million of outstanding borrowings under our credit facility and $1.2 million of additional available borrowing capacity.

        At December 31, 2004, we had outstanding obligations for long-term debt and capital leases totaling $1.8 million primarily related to two term loans with Wells Fargo Business Credit, Inc. ("Wells Fargo") and a subordinated promissory note with a significant customer with the proceeds used for facilities enhancements. One of these two term loans is secured by real estate at our Des Moines facility and had an outstanding balance at December 31, 2004 of $1.12 million due in monthly installments of $17,658 plus interest, with a balloon payment of approximately $834,000 due on May 31, 2006. The other term loan is secured by machinery and equipment at our Des Moines facility and had an outstanding balance at December 31, 2004 of approximately $16,000 which was paid in full in January 2005. Both loans had a stated interest rate of prime plus 2.5% effective as of December 31, 2004. The subordinated promissory note with a remaining balance of $500,000 is secured by our Des Moines facility, is payable in May 2006 and has a stated interest rate of prime plus 1.0%. In addition, we have a promissory note with the City of Des Moines with an outstanding balance at December 31, 2004 of $102,000 due in monthly installments through June 2006. The promissory note has a stated interest rate of 3.0%. The note is secured by first security interests in essentially all of our Des Moines facility's assets and the lender has subordinated its first security interest to Wells Fargo. Our capital lease obligations totaled $33,000 at December 31, 2004. The current portion of these long term obligations is approximately $302,000 and the non-current portion is approximately $1.5 million at December 31, 2004. The terms of our credit facility agreement with Wells Fargo which includes the real estate-secured loan and the machinery and equipment-secured loan as well as a revolving line of credit discussed below, include provisions where non-compliance with certain covenants could, in specified circumstances, result in acceleration of the repayment of all of these borrowings. Due to the waiver of

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the event of non-compliance under the credit facility, which is discussed below, and our expectation of continued compliance under existing covenants, management has concluded that these borrowings are properly classified at December 31, 2004, in accordance with their terms, and that acceleration of repayment is unlikely.

        At December 31, 2004, we also had a $12.0 million asset-based revolving line of credit with Wells Fargo which expires on May 31, 2006. At December 31, 2004, $10.4 million was outstanding under this line of credit. At December 31, 2004, our remaining available borrowing capacity under the line of credit was approximately $1.2 million. On February 21, 2005, we signed an amended agreement that established our financial covenants through May 2006 and decreased our stated rate of interest from prime plus 3.50% to prime plus 2.50%, retroactive to December 15, 2004. On March 22, 2005, we signed an amended agreement that waived our non-compliance of a covenant at December 31, 2004 and increased our stated rate of interest from prime plus 2.50% to prime plus 2.75%, retroactive to January 1, 2005. Our ability to borrow under this line of credit varies based upon available cash, eligible accounts receivable and eligible inventory. Interest is charged at a stated rate of prime plus 2.75% and is payable monthly. We are required to comply with various financial and non-financial covenants, and we have made various representations and warranties. Among the financial covenants is a requirement to maintain a minimum liquidity (cash plus excess borrowing base) of $1.5 million. Additional requirements include covenants for minimum capital monthly and minimum net income quarterly. Failure to comply with any of the covenants, representations or warranties could result in our being in default on the loan and could cause all outstanding amounts payable to Wells Fargo, including those discussed above, to become immediately due and payable or impact our ability to borrow under the agreement. Based on our projections, we believe we will be in compliance with these new covenants through at least December 31, 2005.

        Net cash used by operating activities was $1.1 million in 2004, compared to providing cash of $570,000 in 2003 and using cash in 2002 of $6.5 million. Our net use of cash for operations in 2004 as compared to the net cash provided in 2003 was due to product rights and licensing arrangements generating $4.6 million less in cash in 2004 than 2003; accounts payable increasing by $1.3 million less in 2004 compared to 2003; increased net loss of $1.4 million; somewhat offset by $5.1 million less in accounts receivable increase due to the lower fourth quarter sales in 2004 as compared to 2003. The improvement in 2003 as compared to 2002 is primarily attributable to our lower net loss and up-front fees for product rights and licensing received. During 2003, we recorded deferred revenue from various transactions of approximately $6.3 million related primarily to the sale or licensing of product rights or technology rights to third parties. The related deferred revenue will be recognized on a straight-line basis over the remaining lives of the contracts, products or patents, which approximates the period over which we will complete our obligations under these agreements. Also, accounts payable and accrued liabilities increased by $1.2 million in 2003 due to higher inventory levels and accrued sales commissions as compared to a decrease of $1.6 million in 2002 related to the payments of the majority of the $2.0 million of restructuring expense and other which was accrued or payable at December 31, 2001. Accounts receivable increased by nearly $3.0 million in 2003 as a result of the record fourth quarter revenue.

        Net cash flows from investing activities used cash of $1.4 million in 2004, used cash of $1.8 million in 2003 and provided cash of $4.6 million in 2002. Expenditures for property and equipment totaled approximately $1.3 million, $1.4 million and $1.2 million in 2004, 2003 and 2002, respectively. In 2004, approximately $1.9 million in capital expenditures and capitalized patent costs were somewhat offset by approximately $400,000 of proceeds from the licensing of certain rights related to one of our products. In 2003, approximately $1.8 million in capital expenditures and capitalized patent costs were somewhat offset by approximately $35,000 of proceeds from the disposition of property and equipment. In 2002, the cash provided was primarily from licensing fees received during the year related to certain product

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rights and technology rights and was somewhat offset by the costs of replacing the roof on our manufacturing facility in Des Moines, Iowa.

        Net cash flows from financing activities provided cash of $2.5 million in 2004 as compared to using $28,000 in 2003 and providing $2.2 million in 2002. In 2004, borrowings under our revolving credit facility and proceeds from the exercise of stock options provided cash of $3.3 million. In 2003, proceeds from the exercise of stock options and a new loan from the City of Des Moines related to our Des Moines facility provided cash of $819,000. Cash was used to reduce the outstanding balances of debt and capital leases in 2003. In 2002, our primary sources of financing cash flows were $2.9 million of borrowings under our revolving credit facility and from a significant customer for the roof replacement project at Diamond.

        Our primary short-term need for capital, which is subject to change, is to fund our operations, which consist of continued research and development efforts, our sales, marketing and administrative activities, working capital associated with increased product sales and capital expenditures relating to maintaining, developing and expanding our manufacturing operations. Our future liquidity and capital requirements will depend on numerous factors, including the extent to which our present and future products gain market acceptance, the extent to which products or technologies under research or development are successfully developed, the timing of regulatory actions regarding our products, the costs and timing of expansion of sales, marketing and manufacturing activities, the cost, timing and business management of current and potential acquisitions, if any, and contingent liabilities associated with such acquisitions, and the procurement and enforcement of patents important to our business and the results of competition.

        Our financial plan for 2005 indicates that our available cash and cash equivalents, together with cash from operations and borrowings expected to be available under our revolving line of credit, will be sufficient to fund our operations through 2005 and into 2006. Our financial plan for 2005 expects that we will have positive cash flow from operations, primarily through increased revenue, improved gross margins and limiting any increase in operating expenses to a modest degree. However, our actual results may differ from this plan, and we may be required to consider alternative strategies. We may be required to raise additional capital in the future. If necessary, we expect to raise these additional funds through one or more of the following: (1) sale of equity or debt securities; (2) obtaining new loans secured by unencumbered assets, or refinancing loans currently outstanding on properties with historical appraised values significantly in excess of related debt; (3) sale of assets, products or marketing rights; and (4) licensing of technology. There is no guarantee that additional capital will be available from these sources on acceptable terms, if at all, and certain of these sources may require approval by existing lenders. If we cannot raise the additional funds through these options on acceptable terms or with the necessary timing, management could also reduce discretionary spending to decrease our cash burn rate through actions such as delaying or canceling research projects or marketing plans. These actions would likely extend the then available cash and cash equivalents, and then available borrowings. See "Factors that May Affect Results."

        At December 31, 2004, we had intangible assets of approximately $1.5 million related to deferred patent costs. These deferred patent costs are being recognized as research and development costs on a straight-line basis over the remaining lives of the agreements, products, patents or technology. We also had deferred revenue and other long term liabilities, net of current portion, of approximately $11.4 million. Included in this total is approximately $11.2 million of deferred revenue related to up-front fees that have been received for certain product rights and technology rights out-licensed. These deferred amounts are being recognized on a straight-line basis over the remaining lives of the agreements, products, patents or technology. Approximately $142,000 related to pension liabilities for a defined benefit pension plan which was frozen in October 1992 is also included in deferred revenue and other long term liabilities, net of current portion.

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        A summary of our contractual obligations at December 31, 2004 is shown below.

Net Operating Loss Carryforwards

        As of December 31, 2004, we had a net domestic operating loss carryforward, or NOL, of approximately $169.5 million, a domestic alternative minimum tax credit of approximately $23,000 and a domestic research and development tax credit carryforward of approximately $584,000. The NOL and tax credit carryforwards are subject to alternative minimum tax limitations and to examination by the tax authorities. In addition, we had a "change of ownership" as defined under the provisions of Section 382 of the Internal Revenue Code of 1986, as amended (an "Ownership Change"). We believe the latest, and most restrictive, Ownership Change occurred at the time of our initial public offering in July 1997. We do not believe this Ownership Change will place a significant restriction on our ability to utilize our NOLs in the future. We also have net operating loss carryforwards in Switzerland of approximately $3.7 million related to losses previously recorded by Heska AG.

Recent Accounting Pronouncements

        Recent accounting pronouncements that are relevant to us include Statement of Financial Accounting Standards ("SFAS") No. 123R and SFAS No. 151.

SFAS No. 123R, "Share-Based Payment" (Revised 2004)

        Statement of Financial Accounting Standards No. 123 "Share-Based Payments" ("SFAS No. 123R") was revised in December 2004 and we will adopt this standard under the modified prospective method of adoption beginning on July 1, 2005—the first day of our third quarter. Statement of Financial Accounting Standards No. 123, "Accounting For Stock-Based Compensation" ("SFAS No. 123"), which became effective in 1996, allows for the continued measurement of compensation cost for stock-based compensation using the intrinsic value based method under Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" ("APB No. 25"), provided that pro forma disclosures are made of net income or loss, assuming the fair value based method of SFAS No. 123 had been applied. We have elected to account for our stock-based compensation plans under APB No. 25 and will continue to do so through the completion of our second quarter ending June 30, 2005. When we adopt SFAS No. 123R effective July 1, 2005, we will be required to recognize compensation expense using the fair value-based model for options that vest after June 30, 2005, including those that were granted prior to the effective date of SFAS No. 123R. This will result in recording compensation expense for periods after June 30, 2005. Historically, under APB No. 25, we recorded minimal amounts of stock-based compensation, and none related to grants of options. On December 2, 2004 the Compensation Committee of our Board of Directors considered the significant impact that the use of fair values, rather than intrinsic values, would have on our future

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results of operations, as well as factors including that the management team had requested that their salaries be frozen for 2005, many non-management employees' 2005 raises were to be at below market levels, no management bonus payouts were made for 2004 and the 2005 management incentive plan calls for a performance in excess of our internal budget before any bonus payments are made, and approved an acceleration of vesting of outstanding but unvested stock options with a strike price greater than $1.08. These options were not "in-the-money" at that time, and therefore, there was no compensation expense recorded in accordance with APB No. 25 as a result of this modification. However, for pro forma purposes, in accordance with SFAS No. 123, the remaining unamortized compensation related to these options, calculated under SFAS No. 123 of approximately $2.1 million, was recorded. This action affected approximately 2.2 million options, approximately 1.1 million of which were held by our Directors and Executive Officers. Had this action not been taken, and had all approximately 2.2 million options continued to vest according to the vesting schedules in place prior to the acceleration, we would have recorded incremental compensation related to these options of approximately $485,000 on a pro forma basis for the six months ending June 30, 2005 and approximately $385,000 on an actual basis for the six months ending December 31, 2005. Similarly, on February 24, 2005, our Board of Directors approved that all options granted from that date through June 30, 2005 shall be immediately vested and authorized our Stock Option Committee, which currently consists solely of our Chief Executive Officer, to accelerate the vesting of any outstanding but unvested stock options with a strike price that is not "in-the-money" through June 30, 2005 at its discretion. On March 30, 2005, our Stock Option Committee exercised its discretion and accelerated the vesting of outstanding but unvested stock options with a strike price greater than or equal to $0.82. These options were not "in-the-money" at that time, and therefore, there was no compensation expense recorded in accordance with APB No. 25 as a result of this modification. However, for pro forma purposes, in accordance with SFAS No. 123, the remaining unamortized compensation related to these options will be reported in the footnotes to our first quarter 2005 financial statements. This action effected approximately 750,000 options, approximately 55,000 of which were held by our Directors and Executive Officers. We also have an employee stock purchase plan under which we will recognize compensation expense under SFAS No. 123R beginning on July 1, 2005.

        Under current accounting rules for fair value accounting prescribed by SFAS No. 123, an option pricing model is required to be used and we use the Black-Scholes model. Inputs into the Black-Scholes option pricing model require assumptions and estimates regarding dividend yield, risk free rate of interest, volatility and period outstanding. Changes to each estimate or assumption can have a material impact on the resulting fair value calculated for the option. As an example, our input for estimated volatility is obtained using our 2004 option valuation policy which calls for us to average two items: (1) our historical price volatility from a given point and (2) a peer group average volatility (the peer group consists of two companies in our industry which we believe are similar to us in terms of our operating and stock price characteristics, and volatility for each is calculated based on public market option trading when it is available and historical stock price volatility when it is not) to calculate our volatility assumption. This input for estimated volatility differs from our historical volatility, as we believe that the volatility in future periods will be different from our historical volatility. Our input for estimated volatility for option pricing purposes may not be indicative of actual future volatility. Similarly, we have used a software program to determine expected lives for options issued in 2004. Different assumptions could materially impact the resulting option value calculated. The following table represents the approximate relative value, in percent, of "at-the-money" options priced under different volatility and time to expiration assumptions as compared to an "at-the-money" option priced assuming volatility of 76%, time to expiration of 4.5 years, risk free interest rate of 3.62% and dividend yield of 0.0%. For example, if we assume the fair value of our stock to be $1.17 and we value 100,000 options to buy a share at that price (i.e. "at-the-money" options) using a volatility of 76%, a time to expiration of 4.5 years, a risk free interest rate of 3.62% and a dividend yield of 0.0%, we obtain a fair value for the options of approximately $71,800; if we value the options under the same assumptions except we

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assume a volatility of 50% rather than 76% and a time to expiration of 6 years instead of 4.5 years, we obtain a value of approximately $60,600, or approximately 84% of the fair value calculated under our original assumptions, as can be seen in the table below.

SFAS No. 151 "Inventory Costs"

        Statement of Financial Accounting Standards No. 151 is an amendment to ARB No. 43, Chapter 4 that will be effective for us in fiscal 2006. The standard clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and spoilage to require that those costs be expensed currently, as opposed to being included in overhead costs. We are currently evaluating the impact that SFAS No. 151 will have on our financial results when implemented.

Factors That May Affect Results

        Our future operating results may vary substantially from period to period due to a number of factors, many of which are beyond our control. The following discussion highlights these factors and the possible impact of these factors on future results of operations. If any of the following factors actually occur, our business, financial condition or results of operations could be harmed. In that case, the price of our common stock could decline and you could experience losses on your investment.

         We have historically not generated positive cash flow from operations and may need additional capital and any required capital may not be available on acceptable terms or at all.

        Our financial plan for 2005 indicates that our available cash and cash equivalents, together with cash from operations and borrowings expected to be available under our revolving line of credit, will be sufficient to fund our operations through 2005 and into 2006. Our financial plan for 2005 expects that we will have positive operating cash flow, primarily through increased revenue, improved gross margins and limiting any increase in operating expenses to a modest degree. However, our actual results may differ from this plan, and we may be required to consider alternative strategies. We may be required to raise additional capital in the future. If necessary, we expect to raise these additional funds through one or more of the following: (1) sale of equity or debt securities; (2) obtaining new loans; (3) sale of assets, products or marketing rights; and (4) licensing of technology. There is no guarantee that additional capital will be available from these sources on acceptable terms, if at all, and certain of these sources may require approval by existing lenders. If we cannot raise the additional funds through these options on acceptable terms or with the necessary timing, management could also reduce discretionary

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spending to decrease our cash burn rate through actions such as delaying or canceling research projects or marketing plans. These actions would likely extend the then available cash and cash equivalents, and then available borrowings.

        Additional capital may not be available on acceptable terms, if at all. The public markets may be unreceptive to equity financings and we may not be able to obtain additional private equity or debt financing. Furthermore, amounts we expect to be available under our existing revolving line of credit may not be available and other lenders could refuse to provide us with additional debt financing. Furthermore, any additional equity financing would likely be dilutive to stockholders and additional debt financing, if available, may include restrictive covenants and increased interest rates that would limit our currently planned operations and strategies. Alternatively, we may have to relinquish rights to certain of our intellectual property, products or marketing rights if we are required to obtain funds through collaborative agreements or otherwise. If adequate funds are not available, we may be required to curtail our operations significantly and reduce discretionary spending to extend the currently available cash resources, which would likely have a material adverse effect on our business, financial condition and our ability to continue as a going concern.

         Many of our expenses are fixed and if factors beyond our control cause our revenue to fluctuate, this fluctuation could cause greater than expected losses, cash flow and liquidity shortfalls as well as our stock price to decline.

        We believe that our future operating results will fluctuate on a quarterly basis due to a variety of factors which are generally beyond our control, including:

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supply of products from third party suppliers or termination of such relationships;

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the introduction of new products by our competitors or by us;

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competition and pricing pressures from competitive products;

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our distribution strategy and our ability to maintain relationships with distributors;

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large customers failing to purchase at historical levels;

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fundamental shifts in market demand;

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manufacturing delays;

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shipment problems;

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regulatory and other delays in product development;

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product recalls or other issues which may raise our costs;

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changes in our reputation and/or market acceptance of our current or new products; and

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changes in the mix of products sold.

        We have high operating expenses for personnel, new product development and marketing. Many of these expenses are fixed in the short term. If any of the factors listed above cause our revenues to decline, our operating results could be substantially harmed.

        We may be unable to successfully market, sell and distribute our products.

        The market for companion animal healthcare products is highly fragmented. Because our Core Companion Animal Health proprietary products are generally available only by prescription and our medical instruments require technical training, we sell our Core Companion Animal Health products only ultimately to or through veterinarians. The acceptance of our products by veterinarians is critical to our success. Therefore, we may fail to reach a substantial segment of the potential market.

        We currently market our Core Companion Animal Health products in the United States to veterinarians through approximately 13 independent third-party distributors who carry our full line of companion animal products, approximately 11 independent third-party distributors who carry portions of our companion animal product line and through a direct sales force of approximately 43 individuals. In 2002, we began to rely on distributors for a greater portion of our sales and therefore have needed to increase our training efforts directed at the sales personnel of our distributors. To be successful, we

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will have to continue to develop and train our direct sales force as well as sales personnel of our distributors and rely on other arrangements with third parties to market, distribute and sell our products. In addition, most of our distributor agreements can be terminated on 60 days notice and we believe that IDEXX, one of our largest competitors, effectively prohibits its distributors from selling competitive products, including our diagnostic instruments and heartworm diagnostic tests. We believe this restriction significantly limits our ability to engage national distributors to sell our full line of products and significantly restricts our ability to market our products to veterinarians. In 2002, one of our largest distributors informed us that they were going to carry IDEXX products and that they no longer would carry our diagnostic instruments and heartworm diagnostic tests. In late 2004, this distributor acquired another of our distributors. We believe IDEXX effectively prohibits this distributor from carrying our diagnostic instruments and heartworm diagnostic tests as a condition for having access to buy the IDEXX product line.

        We may not successfully develop and maintain marketing, distribution or sales capabilities, and we may not be able to make arrangements with third parties to perform these activities on satisfactory terms. If our marketing and distribution strategy is unsuccessful, our ability to sell our products will be negatively impacted and our revenues will decrease.

        We rely substantially on third-party suppliers. The loss of products or delays in product availability from one or more third-party supplier could substantially harm our business.

        To be successful, we must contract for the supply of, or manufacture ourselves, current and future products of appropriate quantity, quality and cost. Such products must be available on a timely basis and be in compliance with any regulatory requirements. Failure to do so could substantially harm our business.

        We currently rely on third party suppliers to manufacture those products we do not manufacture ourselves. We currently rely on third party suppliers for our veterinary diagnostic and patient monitoring instruments and consumable supplies for these instruments, for certain of our point-of-care diagnostic and other tests, for the manufacture of our allergy immunotherapy treatment products as well as other manufacturers for other products. Major suppliers who sell us products responsible for more than 5% or more of our revenue are i-STAT Corporation (acquired in 2004 by Abbott Laboratories), Arkray, Inc., Boule Diagnostics International AB and Quidel. We often purchase products from our suppliers under agreements that are of limited duration or can be terminated on an annual basis. We believe we have agreements in place to ensure supply of our major product offerings through at least the end of 2005 and we believe we are in full compliance with such agreements. There can be no assurance, however, that our suppliers will be able to meet their obligations under these agreements or that we will be able to compel them to do so. Risks of relying on suppliers include:

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The involuntary or voluntary discontinuation of a product line.     As an example, Quidel, one of our most important suppliers, is currently involved in a legal dispute with Inverness Medical Innovations, Inc. ("Inverness") regarding lateral flow intellectual property. Both Inverness and Quidel claim the other party is infringing one or more of its patents. Should this legal dispute force Quidel to discontinue the sale of our heartworm diagnostic products to us it would significantly damage our business. Similarly, should Quidel voluntarily decide to no longer produce these products, it would significantly damage our business. Unless we are able to find an alternate supply of a similar product in this or similar circumstances with any product, we would not be able to continue to offer our customers the same breadth of products and our sales would likely suffer. Even if we are able to identify an alternate supply, it may take us additional time and expense to gain the necessary approvals and launch an alternative product, especially if the product is discontinued unexpectedly.



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The loss of product rights upon expiration or termination of an existing agreement.     Unless we are able to find an alternate supply of a similar product, we would not be able to continue to offer

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our customers the same breadth of products and our sales and operating results would likely suffer. In the case of an instrument supplier, we could also potentially suffer the loss of sales of consumable supplies, which could be significant if we have built a significant installed base, further harming our sales prospects and opportunities. Even if we were able to find an alternate supply, we would likely face increased competition from the product whose rights we lost being marketed by a third party or the former supplier and it may take us additional time and expense to gain the necessary approvals and launch an alternative product.

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High switching costs.     If we need to change to other commercial manufacturing contractors for certain of our products, additional regulatory licenses or approvals must be obtained for these contractors prior to our use. This would require new testing and compliance inspections prior to sale thus resulting in potential delays. Any new manufacturer would have to be educated in, or develop substantially equivalent processes necessary for the production of our products. In addition, in certain lines of instruments, we would lose the consumable revenues from the installed base of those instruments if we were to switch to a competitive instrument.



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Inability to meet minimum obligations.     Current agreements, or agreements we may negotiate in the future, may commit us to certain minimum purchase or other spending obligations. It is possible we will not be able to create the market demand to meet such obligations, which could create an increased drain on our financial resources and liquidity.



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Loss of exclusivity.     Our agreements with various suppliers of our veterinary instruments often require us to meet minimum annual sales levels to maintain our position as the exclusive distributor of these instruments. We may not meet these minimum sales levels in the future and maintain exclusivity over the distribution and sale of these products. If we are not the exclusive distributor of these products, competition may increase.



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Limited capacity or ability to scale capacity.     If market demand for our products increases suddenly, our current suppliers might not be able to fulfill our commercial needs, which would require us to seek new manufacturing arrangements and may result in substantial delays in meeting market demand. If we consistently generate more demand for a product than a given supplier is capable of handling, it could lead to large backorders and potentially lost sales to competitive products that are readily available. This could require us to seek or fund new sources of supply.



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Inconsistent or inadequate quality control.     We may not be able to control or adequately monitor the quality of products we receive from our suppliers. Poor quality items could damage our reputation with our customers.



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Regulatory risk.     Our manufacturing facility and those of some of our third party suppliers are subject to ongoing periodic unannounced inspection by regulatory authorities, including the FDA, USDA and other federal and state agencies for compliance with strictly enforced Good Manufacturing Practices, regulations and similar foreign standards, and we do not have control over our suppliers' compliance with these regulations and standards. Violations could potentially lead to interruptions in supply that could cause us to lose sales to readily available competitive products.



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Developmental delays.     We may experience delays in the scale-up quantities needed for product development that could delay regulatory submissions and commercialization of our products in development, causing us to miss key windows of opportunity.



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Limited intellectual property rights.     We may not have intellectual property rights, or may have to share intellectual property rights, to the products themselves and any improvements to the manufacturing processes or new manufacturing processes for our products.

        Potential problems with suppliers such as those discussed above could substantially decrease sales, lead to higher costs, damage our reputation with our customers due to factors such as poor quality

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goods or delays in order fulfillment, resulting in our being unable to effectively sell our products and substantially harm our business.

        Our common stock is listed on the Nasdaq SmallCap Market and we may not be able to maintain that listing, which may make it more difficult for you to sell your shares.

        Our common stock is listed on the Nasdaq SmallCap Market. We have recently not met the $1.00 minimum bid price requirement for our shares. If we trade for 30 consecutive business days below the applicable minimum closing bid price requirement, NASDAQ will send us a deficiency notice, advising us that we have been afforded a "grace period" of 180 calendar days to regain compliance with the applicable requirements. We cannot assure you that we will be able to obtain the minimum bid price requirement or maintain our listing on the Nasdaq stock market, which includes additional quantitative and qualitative requirements in addition to a $1.00 minimum bid price. If we are delisted from the Nasdaq SmallCap Market, our common stock will be considered a penny stock under the regulations of the Securities and Exchange Commission and would therefore be subject to rules that impose additional sales practice requirements on broker-dealers who sell our securities. The additional burdens imposed upon broker-dealers discourage broker-dealers from effecting transactions in our common stock, which could severely limit market liquidity of the common stock and your ability to sell our securities in the secondary market. This lack of liquidity would also make it more difficult for us to raise capital in the future.

        We may face costly intellectual property or other legal disputes, or our technology or that of our suppliers or collaborators may become the subject of legal action.

        Our ability to compete effectively will depend in part on our ability to develop and maintain proprietary aspects of our technology and either to operate without infringing the proprietary rights of others or to obtain rights to technology owned by third parties. We have United States and foreign-issued patents and are currently prosecuting patent applications in the United States and various foreign countries. Our pending patent applications may not result in the issuance of any patents or any issued patents that will offer protection against competitors with similar technology. Patents we receive may be challenged, invalidated or circumvented in the future or the rights created by those patents may not provide a competitive advantage. We also rely on trade secrets, technical know-how and continuing invention to develop and maintain our competitive position. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets.

        We may become subject to additional patent infringement claims and litigation in the United States or other countries or interference proceedings conducted in the United States Patent and Trademark Office, or USPTO, to determine the priority of inventions. The defense and prosecution of intellectual property suits, USPTO interference proceedings, and related legal and administrative proceedings are costly, time-consuming and distracting. We may also need to pursue litigation to enforce any patents issued to us or our collaborative partners, to protect trade secrets or know-how owned by us or our collaborative partners, or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or interference proceeding will result in substantial expense to us and significant diversion of the efforts of our technical and management personnel. Any adverse determination in litigation or interference proceedings could subject us to significant liabilities to third parties. Further, as a result of litigation or other proceedings, we may be required to seek licenses from third parties which may not be available on commercially reasonable terms, if at all.

        We license technology from a number of third parties, including Synbiotics Corporation, Corixa Corporation, Roche Molecular Systems, Inc., New England Biolabs, Inc. and Hybritech Inc., as well as a number of research institutions and universities. The majority of these license agreements impose due diligence or milestone obligations on us, and in some cases impose minimum royalty and/or sales obligations on us, in order for us to maintain our rights under these agreements. Our products may

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incorporate technologies that are the subject of patents issued to, and patent applications filed by, others. As is typical in our industry, from time to time we and our collaborators have received, and may in the future receive, notices from third parties claiming infringement and invitations to take licenses under third party patents. We currently do not have any unresolved notices of infringement. Any legal action against us or our collaborators may require us or our collaborators to obtain one or more licenses in order to market or manufacture affected products or services. However, we or our collaborators may not be able to obtain licenses for technology patented by others on commercially reasonable terms, or at all, we may not be able to develop alternative approaches if unable to obtain licenses, or current and future licenses may not be adequate for the operation of our businesses. Failure to obtain necessary licenses or to identify and implement alternative approaches could prevent us and our collaborators from commercializing our products under development and could substantially harm our business.

        As an example, Quidel, one of our most important suppliers, is currently involved in a legal dispute with Inverness regarding lateral flow intellectual property. Both Inverness and Quidel claim the other party is infringing one or more of its patents. Should this legal dispute force Quidel to discontinue the sale of our heartworm diagnostic products to us it would significantly damage our business.

        We may also face legal disputes relating to other areas of our business. These disputes may require significant expenditures on our part and could have material adverse consequences on our business in the case of an unfavorable ruling or settlement.

        We anticipate future losses and may not be able to achieve sustained profitability.

        We have incurred net losses on an annual basis since our inception in 1988 and, as of December 31, 2004, we had an accumulated deficit of $210.1 million. Notwithstanding a profitable quarter in 2002 and 2003, we have never achieved profitability on an annual basis. Our ability to be profitable in future periods will depend, in part, on our ability to increase sales in our Core Companion Animal Health segment, including maintaining and growing our installed base of instruments and related consumables, to maintain or increase gross margins and to limit the increase in our operating expenses to a reasonable level. Even if we achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. If we cannot achieve or sustain profitability for an extended period, we may not be able to fund our expected cash needs or continue our operations.

        We operate in a highly competitive industry, which could render our products obsolete or substantially limit the volume of products that we sell. This would limit our ability to compete and achieve profitability.

        The market in which we compete is intensely competitive. Our competitors include independent animal health companies and major pharmaceutical companies that have animal health divisions. We also compete with independent, third party distributors, including distributors who sell products under their own private labels. In the point-of-care diagnostic testing market, our major competitors include IDEXX, Abaxis, Inc., AGEN Biomedical, Ltd. and Synbiotics Corporation. Other companies with a significant presence in the companion animal health market, such as Bayer AG, Intervet International B.V., Merial Ltd., Novartis AG, Pfizer Inc., Schering-Plough Corporation, Virbac S.A. and Wyeth (formerly American Home Products), may be marketing or developing products that compete with our products or would compete with them if developed. These and other competitors may have substantially greater financial, technical, research and other resources and larger, more established marketing, sales, distribution and service organizations than we do. Our competitors may offer broader product lines and have greater name recognition than we do. Our competitors may develop or market technologies or products that are more effective or commercially attractive than our current or future products or that would render our technologies and products obsolete. Further, additional competition could come from new entrants to the animal health care market. Moreover, we may not have the financial resources, technical expertise or marketing, distribution or support capabilities to compete

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successfully. Novartis has a marketing agreement with us, but the agreement does not restrict its ability to develop and market competing products. We believe that one of our largest competitors, IDEXX, effectively prohibits its distributors from selling competitive products, including our diagnostic instruments and heartworm diagnostic tests. The products manufactured by OVP for sale by third parties compete with similar products offered by a number of other companies, some of which have substantially greater financial, technical, research and other resources than us and may have more established marketing, sales, distribution and service organization's than OVP's customers. Competitors may have facilities with similar capabilities to OVP, which they may operate at a lower unit price to their customers, which could cause us to lose customers. If we fail to compete successfully, our ability to achieve sustained profitability will be limited and sustained profitability, or profitability at all, may not be possible.

        We must maintain various financial and other covenants under our credit facility agreement in order to borrow and fund our operations.

        Under our credit facility agreement with Wells Fargo, we are required to comply with various financial and non-financial covenants in order to borrow under that agreement. The borrowings under this credit facility are essential to continue to fund our operations. Among the financial covenants is a requirement to maintain minimum liquidity (cash plus excess borrowing base) of $1.5 million in 2005. Additional requirements include covenants for minimum capital monthly and minimum net income quarterly. We were not in compliance with one or more of these covenants as of September 30, 3004, October 31, 2004 and December 31, 2004. Wells Fargo has subsequently granted us a waiver of non-compliance in each case. However, there can be no assurance we will be able to obtain similar waivers or other modifications if needed in the future. On February 21, 2005, we agreed to covenants through May 2006 as proposed by Wells Fargo. We believe we will be able to maintain compliance with all these covenants, although there can be no assurance thereof.

        Failure to comply with any of the covenants, representations or warranties, or failure to modify them to allow future compliance, could result in our being in default under the loan and could cause all outstanding amounts, including amounts currently classified as long-term and loans with our other lenders, to become immediately due and payable or impact our ability to borrow under the agreement. We intend to rely on available borrowings under the credit agreement to fund our operations through May 2006. If we are unable to borrow funds under this agreement, we will need to raise additional capital from other sources to fund our cash needs and continue our operations, which capital may not be available on acceptable terms, or at all.

        We have granted third parties substantial marketing rights to certain of our existing products as well as products under development. If the third parties are not successful in marketing our products our sales may not increase.

        Our agreements with our corporate marketing partners generally contain no or very small minimum purchase requirements in order for them to maintain their exclusive or co-exclusive marketing rights. We are party to an agreement with SPAH which grants distribution and marketing rights in the U.S. for our canine heartworm preventive product, TRI-HEART Chewable Tablets. Novartis Agro K.K. markets and distributes our SOLO STEP CH heartworm test in Japan. Leo Animal Health A/S currently exclusively distributes both E.R.D.-HEALTHSCREEN Urine Tests and SOLO STEP CH in Europe. In addition, Nestle Purina Petcare has exclusive rights to license our technology for nutritional applications for dogs and cats. In addition, we have entered into agreements granting Novartis certain rights to market or co-market certain of the products that we are currently developing. One or more of these marketing partners may not devote sufficient resources to marketing our products. Furthermore, there is generally nothing to prevent these partners from pursuing alternative technologies or products that may compete with our products. In the future, third-party marketing assistance may not be available on reasonable terms, if at all. If any of these events occur, we may not

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be able to commercialize our products and our sales will decline. In addition, our agreement with SPAH requires us to potentially pay termination penalties if we are unable to supply product over an extended period of time.

        We often depend on third parties for products we intend to introduce in the future. If our current relationships and collaborations are not successful, we may not be able to introduce the products we intend to in the future.

        We are often dependent on third parties and collaborative partners to successfully and timely perform research and development activities to successfully develop new products. For example, we jointly developed point-of-care diagnostic products with Quidel, and Quidel manufactures these products. In other cases, we have discussed Heska marketing in the veterinary market an instrument being developed by a third party for use in the human health care market. In the future, one or more of these third parties or collaborative partners may not complete research and development activities in a timely fashion, or at all. If these third parties or collaborative partners fail to complete research and development activities, or fail to complete them in a timely fashion, our ability to introduce new products will be impacted negatively and our revenues may decline.

        The loss of significant customers could harm our operating results.

        Revenue from one contract with AgriLabs comprised approximately 17% and 15% of consolidated revenue in 2002 and 2003, respectively. Revenue from this customer represented less than 10% of our consolidated revenue for the year ended December 31, 2004. While we do not have any other customers who have represented more than 10% of revenues over the last three years, the loss of significant customers who, for example, are historically large purchasers or who are considered leaders in their field could damage our business and financial results. As an example, in late 2004 one of our largest distributors who has historically carried our full product line informed us they were being acquired by a distributor who does not carry our full product line. We believe purchases from the acquired distributor will be significantly lower in 2005 than in 2004, which we are unlikely to completely recover through direct sales and sales through other distributors.

        We depend on key personnel for our future success. If we lose our key personnel or are unable to attract and retain additional personnel, we may be unable to achieve our goals.

        Our future success is substantially dependent on the efforts of our senior management and other key personnel, particularly Dr. Robert B. Grieve, our Chairman and Chief Executive Officer. The loss of the services of members of our senior management or other key personnel may significantly delay or prevent the achievement of product development and other business objectives. Although we have an employment agreement with Dr. Grieve, he is an at-will employee, which means that either party may terminate his employment at any time without prior notice. If we lose the services of, or fail to recruit, key scientific and other personnel, the growth of our business could be substantially impaired. We do not maintain key person life insurance for any of our key personnel.

        Interpretation of existing legislation, regulations and rules or implementation of future legislation, regulations and rules could cause our costs to increase or could harm us in other ways.

        Sarbanes-Oxley has increased our required administrative actions as a public company. The increase in general and administrative costs of complying with Sarbanes-Oxley will depend on how it is interpreted over time. Of particular concern are the level and timing of standards for internal control evaluation and reporting adopted under Section 404 of Sarbanes-Oxley. If our regulators and/or auditors adopt or interpret more stringent standards than we are anticipating, we and/or our auditors may be unable to conclude that our internal controls over financial reporting are designed and operating effectively, which could adversely affect investor confidence in our financial statements. Even if we and our auditors are able to conclude that our internal controls over financial reporting are

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designed and operating effectively in such a circumstance, our general and administrative costs are likely to increase. We may be required to obtain an audit of our internal controls for the year ending December 31, 2005 and, if so, our general and administrative costs are likely to increase. Actions by other entities, such as enhanced rules to maintain our listing on the Nasdaq SmallCap Market could also increase our general and administrative costs, as could further legislative action.

        Our stock price has historically experienced high volatility, which may increase in the future, and which could affect our ability to raise capital in the future or make it difficult for investors to sell their shares.

        The securities markets have experienced significant price and volume fluctuations and the market prices of securities of many microcap and smallcap companies have in the past been, and can in the future be expected to be, especially volatile. During the past 12 months, our closing stock price has ranged from a low of $0.82 to a high of $2.54. Fluctuations in the trading price or liquidity of our common stock may adversely affect our ability to raise capital through future equity financings. Factors that may have a significant impact on the market price and marketability of our common stock include:

•

stock sales by large stockholders or by insiders;



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our quarterly operating results, including as compared to our revenue, earnings or other guidance and in comparison to historical results;



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termination of our third party supplier relationships;



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announcements of technological innovations or new products by our competitors or by us;



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litigation;



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regulatory developments, including delays in product introductions;



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developments in our relationships with collaborative partners;



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developments or disputes concerning patents or proprietary rights;



•

releases of reports by securities analysts;



•

changes in regulatory policies;



•

economic and other external factors; and



•

general market conditions.

        In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted. If a securities class action suit is filed against us, we would incur substantial legal fees and our management's attention and resources would be diverted from operating our business in order to respond to the litigation.

        We must obtain and maintain costly regulatory approvals in order to market certain of our products.

        Many of the products we develop, market or manufacture are subject to extensive regulation by one or more of the USDA, the FDA, the EPA and foreign regulatory authorities. These regulations govern, among other things, the development, testing, manufacturing, labeling, storage, pre-market approval, advertising, promotion, sale and distribution of our products. Satisfaction of these requirements can take several years and time needed to satisfy them may vary substantially, based on the type, complexity and novelty of the product.

        The effect of government regulation may be to delay or to prevent marketing of our products for a considerable period of time and to impose costly procedures upon our activities. We have experienced in the past, and may experience in the future, difficulties that could delay or prevent us from obtaining the regulatory approval or license necessary to introduce or market our products. Such delays in approval may cause us to forego a significant portion of a new product's sales in its first year due to seasonality and advanced booking periods associated with certain products. Regulatory approval of our products may also impose limitations on the indicated or intended uses for which our products may be marketed.

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        Among the conditions for certain regulatory approvals is the requirement that our facilities and/or the facilities of our third party manufacturers conform to current Good Manufacturing Practices. Our manufacturing facilities and those of our third party manufacturers must also conform to certain other manufacturing regulations, which include requirements relating to quality control and quality assurance as well as maintenance of records and documentation. The USDA, FDA and foreign regulatory authorities strictly enforce manufacturing regulatory requirements through periodic inspections. If any regulatory authority determines that our manufacturing facilities or those of our third party manufacturers do not conform to appropriate manufacturing requirements, we or the manufacturers of our products may be subject to sanctions, including warning letters, manufacturing suspensions, product recalls or seizures, injunctions, refusal to permit products to be imported into or exported out of the United States, refusals of regulatory authorities to grant approval or to allow us to enter into government supply contracts, withdrawals of previously approved marketing applications, civil fines and criminal prosecutions. Any of these events, alone or in unison, could damage our business.

        Our future revenues depend on successful research, development, commercialization and market acceptance, any of which can be slower than we expect or may not occur.

        The research, development and regulatory approval process for many of our products is extensive and may take substantially longer than we anticipate. Research projects may fail. New products that we are developing for the veterinary marketplace may not perform up to our expectations. Because we have limited resources to devote to product development and commercialization, any delay in the research or development of one product or reallocation of resources to product development efforts that prove unsuccessful may delay or jeopardize the development of other product candidates. If we fail to successfully develop new products and bring them to market in a timely manner, our ability to generate additional revenue will decrease.

        Even if we are successful in the research and development of a product, we may experience delays in commercialization and/or market acceptance. For example, there may be delays in producing large volumes of a product or veterinarians may be slow to adopt a product. The latter is particularly likely where there is no comparable product available or historical use of such a product. For example, while we believe our E.R.D.-HEALTHSCREEN urine tests for dogs and cats represent a significant scientific breakthrough in companion animal annual health examinations, market acceptance of the product has been significantly slower than we anticipated. The ultimate adoption of a new product by veterinarians, the rate of such adoption and the extent veterinarians choose to integrate such a product into their practice are all important factors in the economic success of one of our new products and are factors that we do not control to a large extent. If our products do not achieve a significant level of market acceptance, demand for our products will not develop as expected and our revenues will be lower than we anticipate.

        Changes to financial accounting standards may affect our results of operations and cause us to change our business practices.

        We prepare our financial statements in conformance with United States generally accepted accounting principles, or GAAP. These accounting principles are established by and are subject to interpretation by the Financial Accounting Standards Board, the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions completed before a change is made effective. Changes to those rules may adversely affect our reported financial results or the way we conduct our business.

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        We may face product returns and product liability litigation and the extent of our insurance coverage is limited. If we become subject to product liability claims resulting from defects in our products, we may fail to achieve market acceptance of our products and our sales could decline.

        The testing, manufacturing and marketing of our current products as well as those currently under development entail an inherent risk of product liability claims and associated adverse publicity. Following the introduction of a product, adverse side effects may be discovered. Adverse publicity regarding such effects could affect sales of our other products for an indeterminate time period. To date, we have not experienced any material product liability claims, but any claim arising in the future could substantially harm our business. Potential product liability claims may exceed the amount of our insurance coverage or may be excluded from coverage under the terms of the policy. We may not be able to continue to obtain adequate insurance at a reasonable cost, if at all. In the event that we are held liable for a claim against which we are not indemnified or for damages exceeding the $10 million limit of our insurance coverage or which results in significant adverse publicity against us, we may lose revenue, be required to make substantial payments which could exceed our financial capacity and/or lose or fail to achieve market acceptance. Furthermore, our agreements with some suppliers of our instruments contain limited warranty provisions, which may subject us to liability if a supplier fails to meet its warranty obligations if a defect is traced to our instrument or if we cannot correct errors reported during the warranty period. If our contractual limitations are unenforceable in a particular jurisdiction, a successful claim could require us to pay substantial damages.

        We may be held liable for the release of hazardous materials, which could result in extensive clean up costs or otherwise harm our business.

        Our products and development programs involve the controlled use of hazardous and biohazardous materials, including chemicals, infectious disease agents and various radioactive compounds. Although we believe that our safety procedures for handling and disposing of such materials comply with the standards prescribed by applicable local, state and federal regulations, we cannot eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for any fines, penalties, remediation costs or other damages that result. Our liability for the release of hazardous materials could exceed our resources, which could lead to a shutdown of our operations. In addition, we may incur substantial costs to comply with environmental regulations if we choose to expand our manufacturing capacity.