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: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred and title and the risks and rewards of ownership have been transferred to our customer or services have been rendered; (iii) the price is fixed or determinable; and (iv) 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 to 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

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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 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 consistent with amounts historically 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

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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.

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.

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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Net Revenue.  Net 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 net revenue due to seasonality. In our experience, net revenue in the first quarter typically is lower than average, and net 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 net revenue for the year, whereas the first quarter of 2004 accounted for 24% of net revenue for the year. The third quarter accounted for 20% of our net revenue in 2004, whereas the second quarter accounted for 24% of our net 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

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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 32% of our net revenue in the first nine months of 2005, 28% of our net revenue in 2004, 34% of our net revenue in 2003, and 36% of our net revenue in 2002 were generated from dentists who financed their purchase through National Technology Leasing Corporation, an 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 Expense.  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 Expense.  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 Expense.  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 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, upon issuance of the consideration, we also 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, but we agreed to pay additional consideration if any of the acquired patents or certain other patents held by us are licensed to a third party.

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.

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Non-Operating Income (Loss).  Non-operating income (loss) consists of interest income and expense, foreign currency transaction 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 net 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 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.

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Three and nine months ended September 30, 2005 compared with three and nine months ended September 30, 2004

Net Revenue. Net revenue for the third quarter of 2005 decreased from $12.3 million to $11.7 million, or 5.3% less than the third quarter of 2004. Net revenue for the first nine months of 2005 increased $1.4 million or 3.5% compared with the same period in 2004. We have experienced a shift in our sales which was first observed in the second quarter of 2004 and has continued through the third quarter of 2005. We believe this shift primarily involves the makeup of our end customer, whereby we are in a transition from selling to “innovators” to a larger more sustainable “early adoptor” market segment. We believe this market segment typically is associated with a longer selling cycle. We believe the size of the potential market, our position within that market and the expected long-term 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. In addition, we have experienced a decline in buying activity due to start-up issues and design changes associated with our Waterlase MD product, which we believe is causing some of our customers to defer their ultimate purchasing decision.

We incurred an operating loss of $5.2 million and $16.0 million for the three and nine months ended September 30, 2005, respectively, compared to an operating loss of $2.1 million and operating income of $149,000 for the same periods in 2004. Our cost of revenue has been impacted by higher production costs and design improvements of our Waterlase MD, costs as a result of recent quality issues and the cost of customer training. Our sales and marketing expense has increased due to higher salaries and sales commissions, convention and speaker fees, and general overhead costs. General and administrative expense increased due to the cost of audit fees for our 2004 year end audit and expenses associated with our Sarbanes-Oxley Section 404 compliance, headcount increases, with an offset to the total by a reduction of legal fees. Engineering and development expense included costs of $2.0 million in the first quarter of 2005 to purchase a license to use certain patent rights from Surgilight for technology related to the field of presbyopia and the related expenses of the transaction. This payment was recorded as research and development expense under the provisions of SFAS No. 2 as the technology is solely used for our research and development function and has no alternative future use to us.

We had a net loss of $5.2 million or $0.23 per diluted share for the third quarter of 2005 and a net loss of $16.3 million or $0.71 per diluted share for the nine months ended September 30, 2005. Net loss for the third quarter of 2004 was $1.1 million or $0.05 per diluted share for the three months ended September 30, 2004 and net income of $344,000 or $0.01 per diluted share for the nine months ended September 30, 2004.

Sales of lasers were slower in the third quarter of 2005 compared to the preceding first and second quarter of 2005. As previously mentioned, we believe that our net revenue for the third quarter of 2005, as well as the second quarter of 2005, has been impacted by delayed purchasing decisions associated with design changes of our Waterlase MD. We believe this purchasing pattern may also impact our fourth quarter of 2005.

Domestic sales comprised approximately 72% of total sales for both the three and nine months ended September 30, 2005 compared to approximately 74% and 73% of total sales for the same periods in 2004, respectively. The lower percentage total for the third quarter of 2005 is associated with the aforementioned Waterlase MD design changes and deferred purchasing decisions of our customers. We believe this buying trend may continue through the fourth quarter of 2005.

Sales of our Waterlase system accounted for approximately 78% and 83% of net revenue for the three and nine months ended September 30, 2005, respectively, compared to approximately 80% and 81% for the same periods of 2004. For the year ended December 31, 2004, Waterlase system sales were 84% of net revenue. We expect that our Waterlase system will account for approximately 80% to 85% of net revenue for 2005.

Significant estimates affecting sales include the reserve for sales returns. The reserve is based on historical experience from 1998 through the present. Our overall historical trend stayed consistent for the third quarter of 2005. Our reserve for sales returns resulted in a net decrease of $62,000, from $420,000 at December 31, 2004 to $358,000 at September 30, 2005.

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Gross Profit. Gross margin decreased from 58.0% to 45.5% from the third quarter of 2004 compared to the third quarter of 2005 as a result of higher production costs, costs of redesign of the Waterlase MD related to quality improvements, and the costs of customer training associated with our multiple element arrangements, which are classified as cost of revenue. Training negatively impacted gross margins for the three and nine months ended September 30, 2005 by 2% and 3%, respectively, compared to the impact on gross margins for the three and nine months ended September 30, 2004, of 3% and 3%, respectively. We believe that our gross margin will continue to be impacted until our Waterlase MD reaches a mature state of production, which will impact the full fiscal year of 2005. We expect that increased manufacturing costs associated with the Waterlase MD will continue until our factory has achieved a proper balance between all products and throughput efficiency is maximized. In addition, as compared to the three and nine months ended September 30, 2004, we have increased our fixed costs of manufacturing with the addition of a new facility in May 2004 and higher labor costs for quality control, materials management and other support activities. During the first nine months of 2005, we increased our reserve for excess and obsolete inventory by $694,000 related to unusable raw materials resulting from design changes to the Waterlase MD.

Sales and Marketing Expense. Sales and marketing expense for the three and nine months ended September 30, 2005 increased $345,000 and $1.8 million, respectively, compared to the comparable prior year periods. As a percentage of net revenue, sales and marketing expense increased from 46.4% for the three months ended September 30, 2004 to 52.0% for the three months ended September 30, 2005. While some of our sales and marketing costs are fixed, most are discretionary expenditures aimed at furthering our market penetration and positioning us for sustained long-term growth. We did not reduce our discretionary expenditure level in the third quarter or first nine months of the fiscal year 2005. The increase in absolute dollars for the third quarter of 2005 compared to the third quarter of 2004 is primarily related to increases in salaries and wages of $256,000, increases in conventions and seminars of $149,000 and increases in overall infrastructure support of $871,000, offset by decreases totaling $931,000 for advertising and promotions and international operations. The increase in absolute dollars for the nine months of 2005 compared to the nine months of 2004 is primarily related to increases of $416,000 for higher salaries and commissions, $878,000 for conventions and seminars, $369,000 for overall infrastructure support, and $92,000 for our international operations. During the first quarter and continuing into the second quarter of 2005, we realigned our domestic sales force affecting sales representative commission and territory configurations. As part of this planned process, we experienced some involuntary and voluntary attrition in the sales force. While we believe that the effects of these changes will allow us to better service our customers, especially those in the “early adoptor” market segment, there continues to be an impact on product sales as the newly configured sales force ramps up to a full state of productivity resulting in lower sales volume for the three months ended September 30, 2005. As of September 30, 2005, we had 35 direct sales staff in North America and 7 direct sales staff covering Europe. We expect our sales and marketing expense to continue to increase in the fourth quarter of 2005, in large part due to increases in costs 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 decrease as a percentage of revenue in the fourth quarter of 2005.

General and Administrative Expense. General and administrative expense was $3.3 million in the third quarter of 2005, compared to $2.5 million for the third quarter of 2004, representing an absolute dollar increase of $707,000 and an increase from 20.6% of net revenue for the third quarter of 2004 to 27.9% of net revenue for the third quarter of 2005. For the nine months ended September 30, 2005 general and administrative expense increased $7.5 million compared to the nine months of 2004. The most significant portions of this increase for the third quarter related to increased professional fees of $377,000 associated with the audit of 2004 and the restated financial statements (an increase of $3.1 million comparing the first nine months of 2005 to the comparable period of 2004). Other personnel and administrative costs increased approximately $622,000 and $2.7 million for the three and nine months ended September 30, 2005, respectively, as compared to the comparable periods of 2004, representing increased infrastructure in finance, information technology, human resources and administration, in response to meeting the ongoing compliance standards related to the Sarbanes-Oxley Act. The costs related to compliance with the Sarbanes-Oxley Act, which included professional fees as

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well as temporary labor, increased $132,000 when comparing the three months ended September 30, 2005 to the three months ended September 30, 2004, however the increase for the first nine months of 2005 to the comparable period of 2004 was $1.7 million. The total increase in expense for the three months ended September 30, 2005 was offset by a decrease in legal fees of $424,000 primarily associated with the settlement of the lawsuit with Diodem. The increase in our general and administrative expense for the nine months ended September 30, 2005 was offset by a gain in the amount of $99,000 on the abatement of penalties and interest on sales tax during the period. We expect general and administrative expense of the third quarter of 2005 to stay relatively constant in the fourth quarter of 2005.

Engineering and Development Expense . Engineering and development expense for the three and nine months ended September 30, 2005 was $1.2 million and $5.3 million, respectively, representing an increase of $151,000 and $2.8 million, respectively, compared to the same periods of 2004. As a percentage of net revenue, engineering and development expense increased from 8.5% for the third quarter of 2004 to 10.3% for the third quarter of 2005, and from 6.1% for the first nine months of 2004 to 12.3% for the first nine months of 2005. The increase in the third quarter of 2005 is due primarily to higher employee costs and patent fees and overall infrastructure support costs attributable to engineering and development, offset by special project costs incurred in the prior year. The increase in the nine month period is primarily the result of our acquiring a license to use certain patent rights totaling $2.0 million from Surgilight in the field of presbyopia and the related expenses of the transaction. We did not acquire the underlying patents, nor was there a business combination in connection therewith. Under the terms of the agreement, we will pay an additional $200,000 in total to Surgilight commencing in 2006 through 2010. The entire consideration, including the transaction costs, has been expensed as in-process research and development. The remaining $200,000 will be expensed as incurred, in accordance with FAS No. 2, “Accounting for Research and Development Costs.” During the third quarter of 2005, we filed with the FDA for market approval to use our laser technology in the field of ophthalmology and oculoplasty. Our filing with the FDA requested marketing clearance for the OCULASE MD™ laser designed to perform various indications for general tissue ablation, anterior capsulotomy (secondary cataract removal), skin resurfacing, and treatment of wrinkles of tissue surrounding the eye and orbit. We believe that this filing represents a significant milestone for our research and development efforts in new fields of medical use for our lasers. We expect to modestly increase our spending in product development during the remainder of 2005, excluding the cost of this license during the first quarter of 2005.

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 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,

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during 2003 we recorded $19.9 million in net revenue under the revenue recognition policy in effect before the modification to our sales arrangements and $21.8 million in net 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 net 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 net revenue for the year ended December 31, 2004 and 34% of our net 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 net revenue, as compared with $9.8 million, or 20% of net 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 net revenue for 2005.

Gross Profit . Gross profit for the year ended December 31, 2004 was $36.0 million, or 59% of net revenue, an increase of $4.7 million, as compared with gross profit of $31.3 million, or 64% of net 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 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 net revenue, a $21.0 million increase as compared with $24.4 million, or 50% of net revenue for the year

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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 Expense . Sales and marketing expenses for the year ended December 31, 2004 were $23.1 million, or 38% of net revenue, as compared with $16.8 million, or 34% of net 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 net revenue in 2005.

General and Administrative Expense.  General and administrative expenses for the year ended December 31, 2004 were $11.5 million, or 19% of net revenue, as compared with $5.1 million, or 10% of net 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 $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 Expense.  Engineering and development expenses for the year ended December 31, 2004 were $3.6 million, or 6% of net revenue, as compared with $2.5 million, or 5% of net 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, 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

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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, but we agreed to pay additional consideration if any of the acquired patents or certain other patents held by us are licensed to a third party.

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 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.

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

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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.  Net revenue for the year ended December 31, 2003 was $48.8 million, an increase of $21.5 million, or 79%, as compared with net 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 net 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 net 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 net revenue for the year ended December 31, 2003, respectively.

Many dentists finance their purchases through third party leasing companies. Approximately 34% of our net 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 net revenue for the year ended December 31, 2003 was $9.8 million, or 20% of net revenue, as compared with $6.2 million, or 23% of net 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

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net revenue to grow as a percentage of net revenue in 2003 and in the future. Although international net revenue grew 58% year over year, in line with our overall expectations for net 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 net revenue, an increase of $14.4 million, as compared with gross profit of $16.9 million, or 62% of net 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 net 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 net 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 net 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 net 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 Expense.  Sales and marketing expenses for the year ended December 31, 2003 were $16.8 million, or 34% of net revenue, as compared with $10.7 million, or 39% of net 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 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 Expense.  General and administrative expenses for the year ended December 31, 2003 were $5.1 million, or 10% of net revenue, as compared with $3.6 million, or 13% of net 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

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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 Expense.  Engineering and development expenses for the year ended December 31, 2003 were $2.5 million, or 5% of net revenue, as compared with $1.7 million, or 6% of net 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 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

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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

September 30, 2005

At September 30, 2005, we had approximately $14.2 million in net working capital, a decrease of $15.8 million from $30.0 million at December 31, 2004. During the first nine months of 2005 we paid the $3.0 million cash portion of our obligation under the legal settlement with Diodem, $2.0 million to Surgilight, related to our acquiring a license to use certain patent rights related to the field of presbyopia, and we used approximately $13.1 million in operations, net of the payments for Diodem and Surgilight. For the nine months ended September 30, 2005, our sources of cash were net borrowings on our line of credit of $5.0 million and a net $1.2 million from the exercise of stock options, offset by the use of funds in the amount of $689,000 for the payment of dividends. Our principal source of liquidity at September 30, 2005 consisted of our cash, cash equivalents, and short-term investments (see discussion below regarding the restriction that became effective in November 2005).

Accounts receivable decreased 35% or $3.4 million from the end of the fourth quarter of 2004 to the end of the third quarter of 2005 primarily due to lower sales volume in the third quarter of 2005. Days sales outstanding (DSO) in accounts receivable were 54 days when measured at September 30, 2005. Net inventory increased 29% or $2.3 million from the end of the fourth quarter of 2004 to the end of the third quarter of 2005. Inventory turnover equals 2.4 turns per year when measured at September 30, 2005.

During the quarter ended March 31, 2005, we issued 361,664 shares of our common stock (valued at approximately $3.5 million) and a five-year warrant (valued at approximately $443,000) exercisable into 81,037 shares of common stock at an exercise price of $11.06 per share, in addition to the $3.0 million cash payment, for the legal settlement with Diodem. In addition, if certain criteria specified in the agreement are satisfied 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. The common stock issued, the escrow shares and the warrant shares have certain registration rights. The total consideration was estimated to have a value of approximately $7.0 million, excluding the value of the shares held in escrow which are contingent in nature, but including the value of the patents acquired in January 2005. As of December 31, 2004, we accrued approximately $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, but we agreed to pay additional consideration if any of the acquired patents held by us are licensed to a third party. In order to secure performance by us of these financial obligations, the parties entered into an intellectual property security agreement, pursuant to which, subject to the rights of existing creditors and the rights of any future creditors to the extent provided in the agreement, we granted Diodem a security interest in all of their right, title and interest in the royalty patents. In addition, we will be required, by January, 2006, to provide Diodem a ten-year letter of credit from a bank in the amount of $500,000 as additional security.

At September 30, 2005, we had a $10.0 million credit facility with a bank. On September 19, 2005, we entered into a third amendment to our credit facility with the bank which extended the term from September 30, 2005 to September 30, 2006. In addition, certain material covenants of the credit facility were modified to decrease the required minimum tangible net worth from $30.0 million to $24.0 million, decrease the required minimum balance of cash (including investments in U.S. Treasuries) from $20.0 million to $12.0 million, and amend the quarterly profitability condition commencing with the fiscal quarter ended March 31, 2006. At September 30, 2005, $5.0 million was borrowed on the credit facility. Borrowings under the facility bear interest

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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 the first nine months of 2005 were at prime rate. We granted the bank a security interest in and to all of our equipment, inventory, accounts receivable and other assets. As of September 30, 2005, we were non-compliant with our covenants relating to minimum tangible net worth and debt to tangible net worth for which we received a waiver in November 2005.

In November 2005, we also entered into a fourth amendment to our credit facility with the bank which eliminates all of our financial covenants, including the minimum cash balance of $12.0 million. Under the new amendment, we agreed to collateralize the facility with our short-term investment in U.S. Treasury debt securities which had a fair market value of $9.9 million as of September 30, 2005, which is shown as short-term investment, restricted on our consolidated balance sheets.

We had no material commitments for capital expenditures as of September 30, 2005 and have not entered into any material commitments after that date.

The following table presents our expected cash requirements for contractual obligations outstanding as of September 30, 2005, the three months ending December 31, 2005, and for the years ending December 31, thereafter:

We believe that our current cash balances and investments, coupled with cash generated from our expected increases in revenue, expected margin enhancements associated with improving quality, and an expected decrease in expenses when measured to the first nine months of 2005, will provide adequate liquidity to meet our capital requirements and sustain our operations for at least the next twelve months. There can be no assurances of these improvements; therefore, our future capital requirements may depend on many factors, including the extent and timing of the rate at which our business grows and other improvements occur. We may be required to seek additional funding through either debt financing, or public or private equity, or a combination of funding methods to meet our capital requirements and sustain our operations. However, additional funds may not be available on terms acceptable to us or at all.

December 31, 2004

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

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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.

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.

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 could 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 had 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 to pay 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

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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. The fourth dividend totaling $229,000 was declared in February 2005 and paid on February 24, 2005 to stockholders of record on February 10, 2005. The fifth dividend totaling $230,000 was declared in April 2005 and paid on May 9, 2005 to stockholders of record on April 25, 2005. The sixth dividend totaling $230,000 was declared in June 2005 and paid on June 28, 2005 to stockholders of record on June 12, 2005. On August 22, 2005, we announced that our Board of Directors voted to discontinue our current dividend policy of paying a cash dividend of $0.01 per share every other month.

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 obtained a waiver to this covenant and subsequently filed our Form 10-K on July 19, 2005.

On May 21, 2003 we acquired the American Dental Laser product line from American Medical Technologies, Inc., or AMT, for approximately $5.8 million. The assets acquired included dental laser patents, customer lists, brand names and other intellectual property as well as laser products. No outstanding debt of AMT was assumed in the transaction. The consideration paid by us consisted of approximately $1.8 million cash, $215,000 in transaction costs directly attributable to the acquisition and 307,500 shares of common stock with a fair value of approximately $3.8 million. For purposes of computing the purchase price, the value of the common stock of $12.38 per share was determined by taking the average closing price of our common stock as quoted on the Nasdaq National Market between May 19, 2003 and May 23, 2003.

In January 2005, we acquired the intellectual property portfolio of 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 $3,000,000 in cash, 361,664 shares of common stock, (valued at the common stock fair market value on the closing date of the transaction for a total of approximately $3,500,000), 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. The common stock issued, the escrow shares and the warrant shares have certain registration rights. The total consideration was estimated to have a value of approximately $7,000,000 excluding the value of the shares held in escrow, but including the value of the patents acquired in January 2005. As of December 31, 2004, we accrued approximately $6,400,000 for the settlement of the existing litigation with $3,000,000 included in current liabilities and $3,400,000 recorded as a long-term liability. 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

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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: