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FORM 10-K

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
OR

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

COMMISSION FILE NUMBER 0-19871
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CYTOTHERAPEUTICS, INC.

(Exact name of Registrant as specified in its charter)

DELAWARE 94-3078125
(State or other jurisdiction (I.R.S. Employer Identification
of incorporation or organization) No.)

701 GEORGE WASHINGTON HIGHWAY, LINCOLN, RI 02865
(Address of principal executive offices) (zip code)

Registrant's telephone number, including area code: (401) 288-1000

Securities registered pursuant to Section 12(b) of the Act:
NONE

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

COMMON STOCK, $.01 PAR VALUE
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Title of class

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or l5(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /x/ No / /

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

Aggregate market value of Common Stock held by non-affiliates at March 9,
1998: $49,641,229. Inclusion of shares held beneficially by any person should
not be construed to indicate that such person possesses the power, direct or
indirect, to direct or cause the direction of management policies of the
registrant, or that such person is controlled by or under common control with
the Registrant. Common stock outstanding at March 9, 1998: 18,264,522 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's Definitive Proxy Statement for its 1998 Annual
Meeting of Shareholders are incorporated by reference into Part III of this
Report.

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FORWARD LOOKING STATEMENTS

This report contains certain forward-looking statements regarding, among
other things, the Company's expected results of operations, the progress of the
Company's collaborations, product development and clinical programs, the need
for, and timing of, additional capital and capital expenditures, collaboration
prospects, costs of manufacture of products, the protection of and the need for
additional intellectual property rights, regulatory matters, the need for
additional facilities and potential market opportunities. The Company's actual
results may vary materially from those contained in such forward-looking
statements because of risks to which the Company is subject such as risks of
delays in research, adverse results from the Company's development or clinical
testing programs, obsolescence of the Company's technology, lack of available
funding, competition from third parties, termination of the Company's
collaborations, intellectual property rights of third parties, unavailability of
needed raw materials, failure of the Company's or its collaborators to perform,
litigation, regulatory restrictions, and other risks to which the Company is
subject; see "Cautionary Factors Relevant to Forward-Looking Information" filed
herewith as Exhibit 99 and incorporated herein by reference.

ITEM 1.

BUSINESS

THE COMPANY

CytoTherapeutics, Inc. ("CytoTherapeutics" or the "Company") is a leader in
the development of novel cell therapies designed to treat human diseases. The
Company is developing products based on two principal technologies:
encapsulated-cell therapies and stem cell therapies. The Company's encapsulated-
cell therapies are based upon the use of living cells encapsulated in the
Company's membranes and inserted into specific sites in the body; the Company's
stem cell therapies are based on the use of unencapsulated human stem cells to
replace or repair damaged or defective cells. The Company is currently
developing encapsulated-cell products for the treatment of chronic pain and
Parkinson's disease with additional research efforts directed to other
disorders. The Company has initiated a research and development program for
neural stem/progenitor cells and has also established a research program to
discover the stem cell of the pancreas and the liver. In addition, the Company
has encapsulated-cell research programs ongoing with respect to ophthalmic
diseases. The Company currently has one product candidate in clinical trials:
its encapsulated-cell implant to treat chronic pain.

CytoTherapeutics, Inc. was incorporated in Delaware in 1988 and currently
has one subsidiary, StemCells, Inc., a California corporation acquired by the
Company in September 1997.

THE UNMET NEED

Biotechnology has discovered or created a number of new and promising
proteins, but the lack of an effective way to deliver these proteins locally has
limited their widespread use. The Company believes its encapsulated-cell
therapies may provide a platform for effective local delivery of these and other
proteins to treat diseases. Many diseases result from organ failure where organs
cannot be transplanted to cure the disease (e.g., neurodegenerative diseases and
pancreatic failure) or where there are constraints due to a short supply of
organs for transplant. The Company believes its stem cell technology may provide
the basis for replacing certain lost or damaged cells. If the Company can
successfully develop either or both of its cell therapy technologies, it
believes that its technologies may provide the basis for addressing a number of
diseases with significant unmet medical needs.

CELL THERAPY BACKGROUND

ROLE OF CELLS IN HUMAN HEALTH AND TRADITIONAL THERAPIES

In healthy individuals, cells maintain normal physiological function by
secreting or metabolizing substances, such as sugars, amino acids,
neurotransmitters and hormones, which are essential to life. When cells are
damaged or destroyed, they no longer produce, metabolize or accurately regulate
critical molecular substances required by the body. For example, the progressive
decline common to many neurodegenerative diseases, such as Parkinson's disease
and amyotrophic lateral sclerosis ("ALS"), is associated with impaired cellular
function.

Recent advances in biotechnology have led to the discovery of a number of
specific proteins that are, in certain diseases or disorders, inadequately
produced by the body's own cells. While these proteins overcome some of the
limitations of traditional pharmaceuticals, such as lack of specificity, they do
not reproduce the natural ability of cells to secrete such substances at the
precise sites of action and in the appropriate physiological quantities or for
the duration required. As a result, investigators have considered using cell
therapy to replace vital cells which are failing by implanting cells which carry
the ability to provide a needed critical molecule or by implanting cells to
replace those which have failed. In situations of

irreversible failure of vital cells, transplantation of cells offers the
possibility of replacing the functions of these failed cells, thus potentially
restoring health.

THE POTENTIAL OF CELL-BASED THERAPY

Cell-based therapy, the use of cells to treat diseases, has the potential to
provide a broad therapeutic approach of comparable importance to traditional
pharmaceuticals and the more recently developed genetically engineered
biologics. However, autologous cells (cells from the individual into whom they
are to be transplanted) are available in limited supply, may be abnormal if the
patient is ill and often can only be obtained through significant surgical
procedures. Allogeneic (same species) cellular transplants and xenogeneic
(cross-species) cellular transplants generally require the use of potent
immunosuppressive drugs. These drugs broadly compromise the patient's immune
system in order to decrease the likelihood of rejection of the transplanted
cells and expose the transplant recipient to adverse side-effect(s), such as
increased risk of infection or cancer. CytoTherapeutics believes its
encapsulation technologies may reduce or eliminate the need for
immunosuppression, as well as allow site-specific delivery and relative control
of cell output. CytoTherapeutics believes its unencapsulated stem cell
technologies may provide a way to replace specific cells that have been damaged
or destroyed. This approach may be necessary when cell replacement requires
repair of cellular architecture or direct cell-to-cell contact. Such replacement
with stem cells, which may grow and differentiate to produce differentiated
progeny (i.e., mature, lineage-restricted cells), may allow for the restoration
of function through the replacement of normal cells where this has not been
possible in the past.

CYTOTHERAPEUTICS' PORTFOLIO TECHNOLOGIES:
ENCAPSULATED-CELL THERAPIES AND STEM CELL THERAPIES

ENCAPSULATED-CELL THERAPIES

Encapsulated-cell therapies represent a potentially broadly applicable
delivery platform for treating a number of diseases which are currently
untreatable or poorly treated with present technologies. The Company is
employing its proprietary encapsulation techniques to develop semipermeable
polymer implants containing living cells which are designed to be placed into
selected sites in the body to treat specific diseases or conditions. The
implants are also designed to allow nutrients to reach the encapsulated cells
and to allow wastes and the therapeutic protein(s) to pass out of the implant
while protecting the cells from elements of the patient's immune system.

The Company's implants are designed to be biocompatible, remaining in
contact with the recipient's tissues without generating a response that would
significantly inhibit the functioning of the encapsulated cells or cause
significant injury to host tissues. When such biocompatibility is achieved, the
membrane can selectively permit nutrients and oxygen to pass from the recipient
through the membrane into the implant, nourishing the cells and allowing them to
function. Similarly, such biocompatibility, together with the permeability of
the membrane, enables the substances produced by the encapsulated cells to pass
through the membrane and produce the desired therapeutic effect.

ADVANTAGES OF THE COMPANY'S ENCAPSULATED-CELL THERAPIES

Many diseases have no satisfactory treatment today, in certain cases,
because therapeutic substances generally do not reach the required sites in
appropriate concentrations when administered by conventional methods. The
Company believes that its encapsulated-cell technology represents an approach
that may offer a number of advantages over other forms of delivery for
therapeutics.

SITE SPECIFIC DELIVERY

Researchers have identified a number of substances which may be beneficial
in the treatment of human disorders. However, it has been difficult or
impossible to find a safe and effective way to deliver

many of these potent substances to the required sites at the required
concentrations and at reasonable costs. Systemic delivery, such as oral or
intravenous delivery, may cause significant side-effects since very potent
molecules are being delivered to sites in the body where they are not normally
present or needed. This is especially likely where large amounts are
administered systemically to achieve therapeutic levels in the central nervous
system ("CNS"). A recent clinical trial of a new protein, CNTF, sponsored by
another company, for example, resulted in significant side-effects after
systemic administration.

In contrast, CytoTherapeutics' cell-containing devices are designed to
deliver these therapeutic substances to specific locations where they are
needed, thus avoiding many of the side-effects associated with conventional
routes of administration. This form of delivery should result in better
therapeutic ratios--reflecting an ability to provide effective doses with lower
toxicity. In addition, because the therapeutic substances are produced by living
cells sustained within the implant, these substances potentially may be
delivered over extended periods of time. The production of these substances at
the site of action eliminates the problems of drug stability which hampers
effective treatment with pumps and polymer carriers.

RETRIEVABILITY

The Company's implants are designed with a tether at the end of the active
portion of the implant to allow them to be retrieved with relative ease. By
exposing the tether, which is sutured below the skin, and withdrawing the
device, a physician should be able to retrieve or replace the implant. Should
complications arise, or if a new implant is desired, a physician should be able
to retrieve the capsule. Moreover, the capsule keeps the cells in the location
intended as opposed to unencapsulated cells which cannot be so constrained.

DELIVERY OF MULTIPLE SUBSTANCES

The Company's implants may also provide the advantage of delivering multiple
therapeutic substances simultaneously at a single site. The Company believes
that such an ability could lead to development of improved therapies. The
Company's implant to treat chronic pain is one such example of delivery of
multiple substances.

GENE THERAPY

The Company believes that its encapsulated-cell therapies may provide an
effective way to deliver gene therapy: the use of encapsulated cells to deliver
genetic information over an extended period may be able to increase the
efficiency of gene transfer to the host and hence improve the effectiveness of
gene therapy. In addition, the implant could be retrieved, if desired or
required. The Company does not presently have commercial access to any such
genes for use in gene therapy.

There can be no assurance that the Company will successfully develop its
encapsulated-cell therapies commercially or that, if successfully developed, it
will achieve the benefits described above or that the advantages of such
technology will be greater than the potential disadvantages.

STEM CELL TECHNOLOGY

Stem cells may be functionally characterized as cells whose progeny include,
both daughter stem cells (by self-renewal) as well as more differentiated cells.
Stem cells exist in humans as a self-renewing source of cells needed in the
various systems of the body (e.g., hematopoietic, neural and neural crest,
hepatic, pancreatic endocrine cells, and mesenchymal stem cells). These rare,
self-renewing stem cells are present in many tissues and are responsible for
organ regeneration after injury or during normal cell replacement. The Company
believes that these cells can form the basis of therapies which have the
potential to replace specific subsets of cells that have been injured or lost
through disease, injury or genetic defect.

The Company is seeking to identify, isolate and find methods of expanding a
variety of different human stem cell cultures for use in treatment of a variety
of human disorders. The Company believes that there are a finite number of stem
cells in the human system and that it is possible for the person or entity that
first identifies and isolates a given stem cell culture to obtain patent
protection for such cells. The Company's strategy is to be the first to
identify, isolate and patent multiple types of human stem/progenitor cell
cultures with commercial importance.

Neurodegenerative diseases such as Parkinson's disease, ALS and Alzheimer's
disease affect a significant portion of the U.S. population and currently have
no effective long-term therapies. The Company believes that its neural
stem/progenitor cells may be useful in treating such diseases. The Company is
continuing research into, and has initiated the development of, its human neural
stem/ progenitor cell-based therapies.

The Company has also initiated research programs to discover the human
pancreatic islet stem cell and the liver stem cell. Pancreatic islet stem cells
may be useful in the treatment of Type 1 diabetes. Liver stem cells may be
useful in the treatment of diseases such as hepatitis, cirrhosis of the liver
and liver cancer.

There can be no assurance that the Company will successfully develop its
stem cell therapies commercially or that, if successfully developed, it will
achieve the benefits described above or will achieve benefits therapeutically
equal to or better than the standard of treatment at time of testing or that the
advantages of such technology will be greater than the potential disadvantages.

ADVANTAGES OF THE COMPANY'S STEM CELL TECHNOLOGY

NO OTHER TREATMENT

To the best of the knowledge of the Company, no one has developed an
approved method for replacing lost or damaged tissues from the human nervous
system; replacement of tissues in other areas of the human body is limited to
those few areas where autologous transplantation is now feasible; in a few
additional areas, allogeneic transplantation is now used, but is limited by the
paucity of organs available through donation. The Company believes that its stem
cell technologies have the potential to reestablish function in at least some of
the patients who have suffered the losses referred to above.

NATURE OF REPLACEMENT CELLS

The Company believes that stem cells can self-renew and differentiate into
the multiple kinds of cells that are commonly lost in, for example,
neurodegenerative diseases. Transplantation of these stem cells may allow these
cells to migrate limited distances to the proper location within the body, to
expand and differentiate and to replace damaged or defective cells. If the
Company can show that the foregoing process occurs, the cells that are
substituted could form new cells that could facilitate the return to proper
function. The Company believes that such replacement of damaged or defective
cells by functional cells is unlikely to be achieved with any other treatment.

PRODUCT DEVELOPMENT PROGRAMS AND RESEARCH EFFORTS

OVERVIEW OF RESEARCH AND PRODUCT DEVELOPMENT STRATEGY

The Company believes that its encapsulated-cell technology can be used to
deliver a wide variety of therapeutic substances or vital cells to the sites
where they are required. The Company's lead product, its implant for treatment
of chronic pain, is designed to provide a new means of delivering substances
with known therapeutic effects directly to the CNS. The next group of proposed
products in the Company's pipeline seeks to build on the Company's expertise in
encapsulating living cells that deliver therapeutics directly to the CNS for the
treatment of such chronic and disabling CNS disorders such as Parkinson's

disease. The Company has also established a program to look at potential
treatments for diseases of the eye, based on its encapsulated-cell technology.
In addition, the Company is attempting to isolate and develop a series of
stem/progenitor cells to serve as a basis for replacing diseased or injured
cells, especially cells of the human nervous system, liver and pancreas.

The following table lists the potential therapeutic indications for and
current status of CytoTherapeutics' primary product development programs and
research projects and is qualified in its entirety by reference to the more
detailed descriptions of such programs and projects appearing elsewhere in this
Report. The Company continually evaluates its research and product development
efforts and reallocates resources among existing programs or to new programs in
light of experimental results, commercial potential, availability of third-party
funding, likelihood of near-term efficacy, collaboration success or significant
technology enhancement, as well as other factors. The Company's research and
product development programs are at relatively early stages of development and
will require substantial resources to commercialize. There can be no assurance
that the Company will successfully develop any product or obtain regulatory
approvals, enter clinical trials, achieve other milestones or commercialize any
products in accordance with currently anticipated timetables, or at all.

PRODUCT DEVELOPMENT PROGRAMS
AND RESEARCH PROGRAMS

PROGRAM CELL TYPE(1) STATUS(2) PARTNER

ENCAPSULATED-CELL THERAPIES
Chronic Pain Bovine adrenal Phase I studies of prototype Astra AB
chromaffin cells devices completed in
approximately 50 patients;
Phase IIA trials initiated to
investigate new device version
in neuropathic pain patients;
mulitcenter placebo controlled
Phase IIB trial initiated in pain patients.
Enrollment in all trials voluntarily halted to
allow modification of implant and device
fixation procedures
Engineered cells releasing analgesics Research** Astra AB
Parkinson's Engineered cells releasing neurotrophic Research** Genentech,
Disease factor(s) Inc.
Amyotrophic Engineered cells releasing human CNTF Swiss pilot clinical study (investigator+ IND)
Lateral enrollment completed
Sclerosis
Engineered cells releasing NT4/5 and CT-1 Research** Genentech,
Inc.*
Huntington's Engineered cells releasing French pilot clinical trial (investigator++
Disease CNTF IND) scheduled to begin 2nd quarter of 1998
Engineered cells releasing neurotrophic Research** Genentech,
factors Inc.*
Ophthalmologic Engineered cells Research; preliminary
Diseases releasing rodent experiments
neurotrophic factor(s), completed
anti-inflammatory(s)
and/or antiangiogenic(s)
STEM CELL THERAPIES
CNS Disorders Neural stem cells (unencapsulated) Research/Preclinical
Disorders of the Stem cell discovery Research
liver and (unencapsulated)
pancreas

(1) All cells are encapsulated unless otherwise indicated.

(2) "Research" refers to early stage research and product development activities
IN VITRO, including the selection and characterization of product candidates
for preclinical testing.

"Preclinical" refers to further testing of a defined product candidate IN
VITRO and in animals prior to clinical studies.

"Pilot clinical study" refers to an initial clinical study in a small number
of patients.

* Genentech has commercialization options in these programs; they are funded
by CytoTherapeutics.

** Progress in these programs is dependent upon CytoTherapeutics developing an
appropriate platform cell(s) for these programs; in particular, the Company
is trying to develop hardy cell lines that will survive for appropriately
long periods within the Company's capsules.

+ This trial is being conducted by Dr. Patrick Aebischer; the Company is
paying certain costs associated with the trial.

++ This trial is being conducted by a third-party clinical investigator; the
Company is paying certain costs associated with the trial.

ENCAPSULATED-CELL THERAPIES--LEAD PROGRAMS

CHRONIC PAIN PROGRAM

The Company estimates that more than one million patients in the United
States suffer unrelieved severe, chronic pain. Chronic, intractable pain often
accompanies or is the result of a number of serious diseases, procedures and
conditions including cancer, infection, nerve damage, back surgery, arthritis,
amputation, fractures and other conditions. Even where therapies exist, they
often have limits to their effectiveness in treating severe, chronic pain.
Patients may become intolerant of or unresponsive to narcotics such as morphine,
and may experience undesirable side-effects.

The Company believes that its encapsulated-cell technology can be used to
treat chronic pain by implanting encapsulated cells which release naturally
occurring analgesic substances, such as catecholamines and opioid peptides. The
Company, together with certain of its academic collaborators, has developed
methods for the encapsulation of bovine adrenal chromaffin cells for
implantation into the lumbar region of the spinal column for the treatment of
chronic pain. The Company believes that encapsulating properly chosen cell types
which secrete desired therapeutic substances may provide more effective pain
relief than traditional approaches and/or may enable treatment of patients who
experience little or no relief with other therapies.

During 1993 and 1994, the Company collaborated on a pilot clinical study of
its chronic pain implant technology with Dr. Patrick Aebischer, a founding
scientist of the Company. The study conducted at the Centre Hospitalier
Universitaire Vaudois ("CHUV") in Switzerland included nine seriously or
terminally ill patients experiencing severe, intractable pain for whom
narcotics, such as morphine, provided inadequate relief or could not be
tolerated. The implant procedure was performed safely in all nine patients.
Viable implants containing cells were retrieved from eight of the nine patients
upon the death of the patient or at or beyond the end of the intended trial
period.

In May 1995, the Company commenced its first Company-sponsored
Investigational New Drug ("IND") trial in the United States. The Phase I trial
was an open label study which included 15 terminally ill cancer patients
experiencing severe, intractable pain and having a life expectancy of less than
five months. According to the trial protocol, patients were to receive treatment
for the remainder of their lives. By February 26, 1997, all 15 patients had
completed the study.

In February 1996, the Company initiated an extension of the Phase I trial.
In this extension, four patients received a device containing approximately
three times the number of cells used in the devices implanted in the first 15
patients. By February 9, 1998, three of the four patients had completed the
study. The one patient that remains in the study has had a device in place for
nearly two years without any related significant safety issues.

A Phase IIA clinical trial for the treatment of neuropathic pain was then
initiated in Switzerland in May 1997. A parallel study was initiated in August
1997 in the United States. These trials were designed to evaluate the safety and
retrievability of the larger device. Neuropathic pain patients were implanted
with the device for 10 weeks. During the period, patients were monitored for
safety and pain scores. Following removal of the original device, patients could
elect to be reimplanted for six months.

In addition, in November 1997, a 150-patient, Phase IIB, placebo-controlled,
double-blinded, multicenter trial in cancer patients was initiated in central
Europe and Switzerland. In this trial, patients with end-stage cancer were and
will be implanted with either a cell-containing device or a placebo device for
10 weeks and will be monitored for pain scores, concurrent pain-related drug
usage and quality of life. Following removal of the original device, patients
can elect to be implanted with an active device for six months.

In December 1997, the Company became aware, after explant of devices from
some patients enrolled in the Phase IIA trials, that a significant number of
devices had migrated into or out of the intrathecal

space during the evaluation period. In some cases migration resulted in device
breakage. To date, there have been no reports of significant medical
complications related to device migration or breakage. The Company has
investigated this migration phenomenon and has determined that it is necessary
to modify the device and the implantation procedure to secure the devices to
prevent migration. These modifications have included the development of a
"tether clip" to assist in securing the implants. The Company and its partner,
Astra Pain Control, have halted accrual in the Phase II trials until the
modifications to the implantation procedure can be implemented.

All clinical trials are being conducted by Astra Pain Control.

The Company has been closely monitoring the development of regulatory
regimes intended to deal with the risks of xenotransplantation and the use of
bovine cells. See "Government Regulations." Although the FDA has proposed
guidelines for the conduct of xenotransplantation trials, a number of European
countries, for example, have been more restrictive. The FDA has imposed strict
and potentially onerous restrictions on the clinical use of non-human cells.
These proposed FDA regulations may substantially increase the production costs
of implants for the Company's pain program. In addition, such regulations may
adversely affect physicians' and patients' perceptions about
xenotransplantation. The Company cannot predict the effect of existing
regulations or possible future regulatory actions except that, if not modified,
they will likely increase the cost of producing pain implants. There can be no
assurance that such regulations will not block sales (at least in some
countries) or make the product commercially non-viable.

There can be no assurances that the Company will receive regulatory and/or
ethical committee approvals to continue the Phase II trials or to initiate other
clinical trials in a timely manner or that such clinical trials will be
successfully completed or that, if successfully completed, such trials will lead
to the commercialization of such product.

In March 1995, the Company entered into a Collaborative Research and
Development Agreement with Astra AB for the development and marketing of certain
encapsulated-cell products to treat pain. Astra has the right to terminate this
Areement anytime after April 1998. See "Corporate Collaborations-- Astra AB."

PARKINSON'S DISEASE PROGRAM

Parkinson's disease ("PD") is a progressively debilitating neurological
disorder characterized by tremor, rigidity and reduced spontaneous movement. The
symptoms of PD result from inadequate levels of the neurotransmitter dopamine in
the striatum (a portion of the brain) due to the death of dopamine-producing
cells in the substantia nigra (a related area of the brain). The causes of the
disease are unknown. There is no known cure for PD nor is there any known method
for arresting or reversing the fundamental neurodegenerative process that
results in the death of dopamine-producing cells.

PD affects approximately 500,000 individuals in the United States, and it is
estimated that one in 500 people over 50 years of age will develop this
disorder. It is thought that approximately 50,000 new cases are diagnosed
annually in the United States, and this number is expected to increase as the
population ages. The Company's proposed product is expected to initially be
targeted for use by the estimated 300,000 mid-to-late-stage PD patients in the
United States.

Currently approved therapies for PD generally provide adequate treatment of
the disease for a limited period. Patients become increasingly resistant to the
benefits of such medications while concurrently becoming susceptible to a
variety of motor and cognitive side effects. Under these circumstances, they
often require extensive supportive care.

The Company is developing an implant to treat PD. The goal of this program
is to slow or prevent progression of the underlying degeneration of dopaminergic
neurons by delivering neurotrophic factors to the brain. The initial focus of
the program is the delivery of Neurturin, a neurotrophic factor with partial
homology to GDNF (glial derived neurotrophic factor), using human cells. The
Company believes that, if

successfully developed, its implants will be capable of delivering effective,
low doses of Neurturin to the areas of the brain where they are required.

The Company has entered into an agreement with Genentech for the development
of implants releasing certain neurotrophic factor(s) to treat PD. Under the
terms of this Agreement, if certain development milestones are not achieved
before agreed-upon dates, Genentech has the right to terminate the Agreement.
See "Corporate Collaborations--Genentech, Inc."

ENCAPSULATED-CELL THERAPIES--OTHER NEURODEGENERATIVE DISEASES

The Company has entered into two additional agreements with Genentech, Inc.
under which the Company is attempting to develop encapsulated-cell treatments
for ALS and Huntington's disease. The Company has concluded, due to regulatory
considerations, that these programs should be based on human cell lines, rather
than the xenogeneic cell lines previously envisioned. At the present time,
progress in these programs in largely dependent upon the Company's success in
identifying human cell lines under its Parkinson's disease program which can
survive for appropriately long periods in the encapsulated environment.

ALS PROGRAM

Amyotrophic lateral sclerosis ("ALS"), also known as Lou Gehrig's disease,
is characterized by progressive loss of motor control and death due to
degeneration of neurons in the motor system. The Company estimates that
approximately 25,000 patients have ALS in the United States. The cause of ALS is
unknown in most cases. There is no known cure for the disease.

The Company is sponsoring research to evaluate the feasibility and
tolerability of using encapsulated human cells to deliver neurotrophic factors
into the CNS to treat ALS. Dr. Patrick Aebischer, a scientific founder of the
Company, has completed enrollment of an investigator-sponsored, 12-patient,
pilot trial of CNTF-releasing encapsulated cells in ALS patients. Results are
not yet available.

In November 1996, the Company signed an agreement with Genentech, Inc., for
the development and marketing of implants that release NT4/5 and CT-1 (a
cytokine related to CNTF) to treat ALS; the Agreement requires certain specific
due diligence of the Company (see "Corporate Collaborations-- Genentech, Inc.").

HUNTINGTON'S RESEARCH

Huntington's disease ("HD") is an autosomal dominant, progressive
neurodegenerative disease resulting in movement disorders, psychiatric
disturbances, and death. The symptoms of HD are caused primarily by the death of
striatal neurons. In 1993, there were approximately 25,000 patients with
symptomatic HD in the United States. There is no known cure or treatment for the
disease.

The Company is sponsoring research to evaluate the feasibility and
tolerability of using encapsulated cells to deliver neurotrophic factors into
the CNS and to treat HD. An investigator-sponsored trial to treat six
Huntington's disease patients has been approved by regulatory authorities in
France. The trial, expected to start in the first half of 1998, is intended to
test CNTF-releasing encapsulated cells.

In November 1996, CytoTherapeutics entered into an agreement with Genentech,
Inc. for the development and marketing of implants that release CT-1 to treat
HD; the Agreement requires certain specific due diligence by the Company. See
"Corporate Collaborations--Genentech, Inc.".

OPHTHALMOLOGY PROGRAM

Many diseases of the eye are presently ineffectively treated, which can lead
to reduced vision and blindness. There are more than one million blind people in
the United States and many more Americans

suffer from potentially visually impairing ophthalmologic disorders. The
worldwide populations at risk are much larger.

Certain diseases of the eye, e.g., glaucoma and anterior segment
inflammation, can be treated today with topical preparations, although the
efficacy of these treatments is variable. These disorders are treatable largely
because some or all of the disease processes occur in the anterior portion of
the eye, which is accessible to topical drugs. Other serious diseases, such as
diabetic retinopathy and age-related macular degeneration, are not treatable, in
part because they occur in the posterior portion of the eye, an area that is
essentially unreachable with most current treatment methods.

Many of these untreatable diseases affect the retina, a posterior part of
the eye critical to sight. The retina is part of the CNS and the Company
believes that its encapsulated-cell implant technologies can be applied to
bypass the blood-retinal barrier of the eye using the same approach as bypassing
the blood-brain barrier in the rest of the CNS. If these implants are
successfully developed, the Company believes this delivery platform could allow
treatment of serious sight-threatening disorders.

CytoTherapeutics has begun design and production of implants adapted for use
in the eye and has started initial testing in animals with these implants.

TECHNOLOGY DEVELOPMENT

The Company continues to develop its encapsulated-cell technology. Through
its cell biology program, the Company is developing genetically engineered cell
lines that will function optimally when encapsulated. The Company's present work
focuses on identification of appropriately hardy human cells because of the
increasing regulatory constraints on use of non-human cells. There can be no
assurance such development will be successful.

The Company is developing cell lines which may represent important
components in second generation products (e.g., an engineered cell line to
deliver analgesics in its pain program) or new products (such as a single device
to deliver multiple therapeutic substances). It is also conducting research to
improve cell line expression levels of therapeutic substances, as well as
regulation and consistency of output.

The Company continues to evaluate new and modified forms of membranes for
use in its implants. These evaluations are focused on developing membranes with
increased strength, improved handling characteristics, enhanced transport
qualities and greater biocompatibility. These efforts are undertaken internally,
as well as externally with Akzo Nobel Faser AG. See "Corporate
Collaborations--Akzo Nobel Faser AG."

The Company is also assessing and developing distribution, handling, and
insertion systems to facilitate the distribution of its implants to clinicians
and enable clinicians both to surgically implant these devices into patients and
to retrieve and replace them, as necessary. See "Manufacturing."

STEM CELL THERAPIES

The Company's portfolio of stem cell technology results from the Company's
earlier licensing of neural stem/progenitor cell technology the Company's own
research and development efforts, and the acquisition of StemCells, Inc. in
1997.

NEURAL STEM/PROGENITOR CELL DEVELOPMENT PROGRAM

The Company began its work with neural stem/progenitor cultures in
collaboration with NeuroSpheres, Ltd., in 1992. The Company believes that
NeuroSpheres, Ltd., was the first to invent these cultures and NeuroSpheres has
filed patent applications on its inventions relating to these cultures. The
Company has obtained a license from NeuroSpheres to such inventions for
transplantation. See "License Agreements and Sponsored Research
Agreements--NeuroSpheres, Ltd."

The Company has in the past and continues today to conduct its own research,
as well as sponsoring research, in the area of neural/progenitor cells and their
use.

In 1997, Company scientists invented a reproducible method for isolating and
growing human neural stem/progenitor cultures. In preclinical IN-VITRO and early
IN-VIVO studies, the Company demonstrated that these cells differentiate into
all three of the cell types of the CNS. Based on these results, the Company
believes that these cells may form the basis for replacement of cells lost in
certain degenerative diseases. The Company is continuing research into, and has
initiated the development of, its human neural stem/ progenitor cell cultures.
The Company has isolated the cultures and demonstrated that these cultures can
be expanded for a number of generations IN VITRO in defined media. A
collaborator of the Company, Dr. Anders Bjorklund, has shown that these cultures
can be successfully engrafted into the brains of rodents. The Company is
expanding its preclinical efforts in this area with an initial goal of selecting
the proper indications to pursue.

The Company's neural stem/progenitor cell program is at an early stage and
there can be no assurance that it will result in any commercial product.

STEM CELL DISCOVERY PROGRAM

The Company, through its 100% owned subsidiary, StemCells, Inc., has begun a
program seeking to discover and isolate various stem cells from the human body.
The Company believes that stem cells represent a fundamentally new approach to
the treatment of diseases caused by lost or damaged tissue. The Company has
assembled a very experienced team of scientists and scientific advisors,
including Irving L. Weissman, M.D., of Stanford University, Fred H. Gage, Ph.D.,
of The Salk Institute and David Anderson, Ph.D., of the California Institute of
Technology, to search for new stem cells and, in conjunction with a number of
academic researchers, has initiated programs for the isolation of the stem cell
for the pancreas and the liver. The Company has obtained rights to certain
inventions relating to stem cells from, and is conducting stem-cell related
research at, several academic institutions. See "License Agreement and Sponsored
Research Agreements." The Company expects to expand its search for new stem
cells and expects to acquire rights to additional inventions relating to stem
cells from third parties.

An important element of the Company's program in stem cell discovery is the
development of intellectual property positions with respect to stem and
progenitor cells. The Company believes that the first person or entity to
isolate and perfect intellectual property rights in new stem/progenitor cells
will be able to exclude others from using such cells commercially. To this end
the Company, through StemCells, Inc., has entered into several research
collaborations with academic institutions.

SUBSIDIARY

STEMCELLS, INC.

On September 26, 1997, CytoTherapeutics acquired by merger StemCells, Inc.,
a California corporation ("StemCells"). Through the merger, CytoTherapeutics
acquired StemCells in exchange for 1,320,691 shares of the Company's common
stock and options and warrants for the purchase of 259,296 common shares.
Simultaneously with the acquisition of StemCells, Richard M. Rose, M.D.,
President of StemCells, Inc., became President, Chief Executive Officer and a
director of CytoTherapeutics, and Irving L. Weissman, M.D., a founder of
StemCells, Inc., became a director of CytoTherapeutics.

The Company's current stem cell research is being conducted pursuant to the
provisions of an agreement between CytoTherapeutics and Drs. Weissman and Gage
providing for a two-year research plan. If the goals of the research plan are
accomplished, the stem cells research will continue to be funded under an
extension of such Research Plan approved by a Research Committee consisting of
two persons chosen by Drs. Weissman and Gage, two persons chosen by the Company
and a fifth member appointed by Drs. Weissman and Gage, subject to the
reasonable approval of the Company. Increases in stem cells

research funding of not more than 25% a year approved by the Committee will be
funded by CTI for as long as the goals of the Research Plan are being met,
provided however, that CTI will retain the option of ceasing or reducing neural
stem research even if all of Research Plan goals are being met by accelerating
the vesting of all still-achievable performance-based options granted to Drs.
Weissman and Gage and other scientists and ceasing or reducing non-neural stem
cell research even if all Plan goals are being met by affording StemCells'
scientific founders the opportunity to continue development of the non-neural
stem research by licensing the technology related to such research to them in
exchange for a payment to CytoTherapeutics equal to all funding for such
research, plus royalty payments.

CORPORATE COLLABORATIONS

ASTRA AB

In March 1995, the Company signed a collaborative research and development
agreement with Astra for the development and marketing of certain
encapsulated-cell products to treat pain. Astra made an initial, non-refundable
payment of $5,000,000 and may make up to $16,000,000 in additional payments
subject to the achievement of certain development milestones. Under the
agreement, the Company is obligated to conduct certain research and development
pursuant to a four-year research plan agreed upon by the parties. Over the term
of the research plan, the Company expects to receive annual research payments
from Astra of approximately $5-7 million, which the Company expects should
approximate the research and development costs incurred by the Company under the
plan. Approximately $29 million of research and development funding has been
received by the Company through December 31, 1997. Subject to the successful
development of such candidate products and obtaining necessary regulatory
approvals, Astra is obligated to fund and to conduct all clinical trials of
candidate products arising from the collaboration and to seek approval for their
sale and use. Astra has the exclusive worldwide right to market products covered
by the agreement. Until the later of either the last to expire of all patents
included in the licensed technology or a specified fixed term, the Company is
obligated to manufacture and supply products and is entitled to a fixed royalty
on the worldwide net sales of such products in return for the license granted to
Astra and the supply of product. Astra has the right to terminate the agreement
for any reason after April 1, 1998.

As is described in more detail under the caption "Encapsulated-Cell
Therapies--Lead Programs-Chronic Pain Program," enrollment in ongoing clinical
trials of the Company's implant for the treatment of chronic pain has been
voluntarily halted in order to implement modifications to the implantation
procedure. There can be no assurance that Astra will continue to fund the
research plan under the Agreement after April 1998, or that sufficient
modifications to the Company's implant can be made to permit resumption of
clinical trials, or that a suitable human cell line can be developed (if
necessary because of regulatory considerations) on a timely basis, or at all.

GENENTECH, INC.

On November 25, 1996 the Company entered into three agreements with
Genentech, Inc. ("Genentech") to develop treatments for Parkinson's disease,
Huntington's disease and amyotrophic lateral sclerosis ("ALS"). Under the
agreements the Company and Genentech expect to pursue treatments for these
diseases that utilize the Company's encapsulated-cell technology to deliver
several of Genentech's neurotrophic factors, potentially including
neurotrophin-4/5 ("NT-4/5"), cardiotrophin-1 ("CT-1"), Neurturin and nerve
growth factor ("NGF"). These agreements supersede the Development Collaboration
and License Agreement between the Company and Genentech entered into in March
1994 which related in part to the development of a product for the treatment of
Alzheimer's disease using NGF.

The following is a brief overview of each of the agreements:

PARKINSON'S AGREEMENT

The initial focus of the research under the Development Collaboration and
License Agreement relation to Parkinson's disease (the "Parkinson's Agreement")
is the development of a treatment for Parkinson's disease using Neurturin. Under
the Parkinson's Agreement, the Company is obligated to perform certain
preclinical studies and initiate a pilot Phase I clinical study using Neurturin
(unless another growth factor is agreed upon by the parties). Genentech
purchased $8.3 million of the Company's Common Stock (829,171 shares at $10.01
per share) to fund the Company's expenses associated with such preclinical and
pilot clinical studies. If the parties agree that additional funds are required
to complete such studies, Genentech will purchase additional shares of the
Company's Common Stock (at the then current market price of the Company's Common
stock) to provide the Company the additional required funding.

Under the terms of the Agreement signed in 1996, Genentech has the right to
terminate development under the Parkinson's Agreement after the completion of
each of (i) certain preclinical studies, (ii) the pilot Phase I clinical trial
and (iii) a specified Phase II clinical trial. Should Genentech decide to
proceed to Phase II clinical trials, Genentech will purchase additional shares
of the Company's Common Stock (at the then current market price of the Company's
Common Stock) to fund such study. If following completion of the preclinical
studies, the pilot clinical study or the Phase II study, Genentech decides to
terminate further development under the Parkinson's Agreement or if Genentech
terminates the Parkinson's Agreement as a result of a breach of the Parkinson's
Agreement by the Company, and the funds the Company received from the sale of
stock to Genentech pursuant to the Parkinson's Agreement exceed the expenses
incurred by the Company in connection with such studies by more than $1 million,
Genentech has the right to require the Company to repurchase from Genentech
shares of Company Common Stock having a value equal to the amount of overfunding
(based on the per share price at which Genentech purchased such shares of Common
Stock from the Company). The Company is obligated to use reasonable efforts to
complete its development obligations under the Parkinson's Agreement within
prescribed periods. In addition, if certain development milestones are not
completed prior to agreed-upon dates, Genentech has the right to terminate the
Agreement. The first of these dates may occur as early as May 1998. There can be
no assurance that such milestones will be completed in a timely manner or that
Genentech will not terminate the Agreement when it is permitted to do so.

In the event Genentech decides to continue with Phase III clinical trials,
Genentech and the Company will share the cost of U.S. Phase III clinical trials
and Genentech will pay for any clinical testing required to sell products
developed under the Parkinson's Agreement outside the United States. Genentech
will extend the Company a line of credit to provide the Company cash to fund the
Company's share of the expenses of the Phase III trials in the United States.
The line of credit, together with interest thereon, is repayable, at the option
of the Company, in either cash or through the issuance of shares of the
Company's Common Stock having a value (based on the then current market price of
the Company's Common Stock) equal to the outstanding amount of the loan.

Upon commercialization, Genentech and the Company will share profits in the
United States at an agreed upon percentage, and Genentech will pay the Company a
royalty based on sales outside the United States. The Company will retain
manufacturing rights and will be paid manufacturing costs for products sold. In
the event the Parkinson's Agreement is terminated because of the Company's
default or bankruptcy, the Company is required to grant Genentech a license to
the Company's cell encapsulation technology and transfer to Genentech related
technology for use solely with the products developed under the Parkinson's
Agreement.

Under the Parkinson's Agreement, the Company has granted Genentech an
exclusive license to use the Company's cell encapsulation technology in certain
cases with certain of Genentech's growth factors

for the treatment of Parkinson's disease. Under the Parkinson's Agreement, the
Company is also prohibited from entering into certain agreements relating to the
development of treatments for Parkinson's disease using certain compounds.

ALS AGREEMENT

Pursuant to the License Agreement between the Company and Genentech Relating
to Treatment of Amyotrophic Lateral Sclerosis (the "ALS Agreement") Genentech
has granted the Company a license to CT-1 and NT-4/5 to develop products for the
treatment of ALS using the Company's cell encapsulation technology. Subject to
certain limitations discussed below, the Company is responsible for all expenses
associated with the preclinical and clinical development under the ALS Agreement
and is obligated to pay Genentech royalties on net sales of products developed
under the ALS Agreement. The Company's license to CT-1 and NT-4/5 is dependent
upon the Company using reasonable efforts to achieve certain development
milestones within prescribed periods.

The Company has the right to commercialize the product outside the United
States. Upon the successful completion of a specified Phase II clinical trial,
Genentech has the option to obtain exclusive rights to sell products developed
under the ALS Agreement in the United States by agreeing to pay an agreed upon
percentage of the expenses of United States Phase III clinical development of
such products. If Genentech makes such an election, the parties will share
profits on sales of such products in the United States, subject to a royalty
payable to Genentech. In the event the ALS Agreement is terminated because of
the Company's default or bankruptcy, the Company is required to grant Genentech
a license to the Company's cell encapsulation technology and to transfer to
Genentech-related technology for use solely with the products developed under
the ALS Agreement.

HUNTINGTON'S AGREEMENT

Under the License Agreement Relating to Treatment of Huntington's Disease
(the "Huntington's Agreement"), Genentech has granted the Company an exclusive
license to CT-1 to develop, make, use and sell products for the treatment of
Huntington's disease that utilize CT-1 and the Company's cell encapsulation
technology. The Company is responsible for all preclinical and clinical
development under the Huntington's Agreement, including all expenses associated
with such development. The Company will pay Genentech a royalty based on net
sales of any products developed under the Huntington's Agreement. The Company's
license to CT-1 is dependent upon the Company using reasonable efforts to
achieve certain development milestones within prescribed periods.

Upon the earlier of (i) the Company agreeing to grant a third party
sublicense rights under the Huntington's Agreement, and (ii) the successful
completion of the specified Phase II trial on a product developed under the
Huntington's Agreement, Genentech has the option to require the Company to
negotiate exclusively with Genentech for a limited period regarding Genentech
co-developing and co-marketing products developed under the Huntington's
Agreement. In the event the parties are unable to reach an agreement, the
Company would have the right to sublicense its rights under the Huntington's
Agreement to a third party, provided such third party offers the Company terms
more favorable to the Company than the terms of Genentech's last offer. In the
event the Huntington's Agreement is terminated because of the Company's default
or bankruptcy, the Company is required to grant Genentech a license to the
Company's cell encapsulation technology and transfer to Genentech related
technology for use solely with products developed under the Huntington's
Agreement.

MODEX THERAPEUTIQUES SA

In July 1996, CytoTherapeutics, together with certain founding scientists,
established Modex Therapeutiques SA as a Swiss biotherapeutics company to pursue
extensions of CytoTherapeutics' broad-based, encapsulated-cell technology for
certain applications outside the central nervous system. Modex, headquartered in
Lausanne, Switzerland, was formed to integrate technologies developed at three
universities

located in Lausanne--the University of Lausanne, the Centre Hospitalier
Universitaire Vaudois (CHUV), the Ecole Polytechnique Federale de Lausanne--as
well as from the Albert Einstein College of Medicine of Yeshiva University in
New York City and CytoTherapeutics--to develop products to treat non-CNS
diseases such as diabetes, obesity and anemia. In October 1997, the Company
completed a series of transactions which resulted in the establishment of Modex
as an independent company in which CytoTherapeutics has an equity position of
approximately 25%.

In October 1997, as part of Modex obtaining funds from outside investors,
the Company and Modex modified the terms of their existing royalty-bearing Cross
License Agreement to (i) expand the field in which Modex is exclusively licensed
to apply the Company's encapsulated-cell technology to include, in addition to
the original field of diabetes, obesity and anemia, the treatment of hemophilia
A and B utilizing Factor VIII and/or Factor IX, and two additional applications
to be agreed to by the Company and Modex; (ii) eliminate the requirement to make
future milestone payments to Modex of up to 300,000 shares of the Company's
Common Stock; (iii) limit the scope of the Company's technology licensed to
Modex to existing and future encapsulation technology; and (iv) specify the
terms under which the Company will manufacture any products Modex may develop
based on the Company's technology and grant Modex an option to manufacture or
have manufactured such products on payment of a higher royalty. The Cross
License Agreement continues to provide for the payment of royalties from Modex
to the Company on the sale of any licensed products. The revised agreement
similarly limits the scope of the Modex technology exclusively licensed, on a
royalty-bearing basis, to the Company for the application of diseases,
conditions and disorders of the central nervous system to existing and future
encapsulation technology and to certain additional existing technology.

AKZO NOBEL FASER AG

To develop additional new membranes to be used in the Company's
encapsulated-cell products and to obtain access to membrane expertise from one
of the world's leading membrane companies, the Company entered into a
Development and Supply Agreement with Akzo Nobel Faser AG ("Akzo") dated
December 1, 1993. Akzo is the world's largest supplier of medical grade
membranes. Under the terms of the agreement, Akzo and the Company are evaluating
Akzo's existing membranes to determine if the membranes can be used in
connection with the Company's proposed products. In addition, Akzo has begun
development of improved membranes for use by the Company. The Company has agreed
to reimburse Akzo for a portion of Akzo's costs incurred in the development. In
the event the Company determines to use membranes developed by Akzo in the
Company's products, Akzo will supply membranes to the Company at Akzo's cost
plus a certain profit. Akzo will also be entitled to a royalty on sales of the
Company's products utilizing Akzo's membranes. Akzo has agreed not to supply
membranes to any other third party for encapsulation of cells for in vivo
therapeutic applications. Either Akzo or the Company can terminate the Agreement
in the event Akzo is unable or unwilling to supply sufficient quantity of
membranes to meet the Company's needs. In such event, Akzo would license the
technology necessary to manufacture the membranes to CytoTherapeutics.

The Company has the right to utilize membranes from other manufacturers in
its products provided the Company pays a small royalty to Akzo on the sales of
such products. The Company will also continue its internal membrane development
efforts, and may utilize internally developed membranes in its products without
obligation to Akzo.

For the years ending December 31, 1997, 1996 and 1995, the Company paid Akzo
under the terms of the agreement approximately $98,000, $295,000 and $118,000,
respectively.

SIGNAL PHARMACEUTICALS, INC.

In December 1997, StemCells, Inc. entered into two license agreements with
Signal Pharmaceuticals, Inc. under which each party licensed to the other
certain patent rights and biological materials for use in

defined fields. The parties are in disagreement as to the interpretation of the
rights licensed to StemCells, Inc. The Company cannot presently determine
whether this dispute will lead to litigation.

LICENSE AGREEMENTS AND SPONSORED RESEARCH AGREEMENTS

NEUROSPHERES, LTD.

In March 1994, the Company entered into a Contract Research and License
Agreement with NeuroSpheres, Ltd. Under the agreement, the Company obtained from
NeuroSpheres an exclusive, worldwide, royalty-bearing license for the commercial
development and use of certain neural stem cells for transplantation to treat
human disease. In 1997, the Company settled a dispute that arose between it and
NeuroSpheres, Ltd. under the agreement. Pursuant to the settlement, the Company
has obtained an exclusive patent license from NeuroSpheres in the field of
transplantation, subject to a limited right of NeuroSpheres to purchase a
nonexclusive license from the Company. The Company has developed additional
intellectual property relating to the subject matter of the license.

COGNETIX, INC.

In February 1997, CytoTherapeutics, Inc. and Cognetix, Inc. entered into a
Collaboration and Development agreement to screen selected peptides isolated by
Cognetix for possible development into therapeutic products aimed at a broad
range of human disease states using CytoTherapeutics' cell-based delivery
technology. The Company and Cognetix are reexamining their relationship; the
Company expects this reexamination will lead to termination of the joint project
under the agreement signed in February 1997.

The Company and Cognetix have also entered into an option agreement giving
CytoTherapeutics the right to option up to three of Cognetix's compounds for use
in treating eye diseases. CytoTherapeutics has exercised its right as to one
protein.

STATE OF RHODE ISLAND

In 1989, the Company entered into an agreement with the State of Rhode
Island pursuant to which an agency of the State reimbursed the Company
$1,172,000 for certain research activities the Company funded at Brown
University. Under the terms of this grant, the Company is obligated to pay
royalties ranging from three to five percent of revenues from products developed
under the agreement, to a maximum of $1,758,000.

ACADEMIC RELATIONSHIPS

The Company and its wholly owned subsidiary, StemCells, Inc., have entered
into a number of research and/or license agreements with academic organizations.
These research agreements provide that the Company will fund certain research
costs and in return will have a license or an option for a license to the
resulting inventions. Under these license agreements, the Company and/or
StemCells, Inc. will typically be subject to obligations of due diligence and
the requirement to pay royalties on products which use patented technology
licensed under such agreements.

CYTOTHERAPEUTICS, INC.

The Company has expended and expects to continue to expend substantial sums
to support academic research programs. To date, the Company's principal academic
collaborations have been with Brown University and Dr. Patrick Aebischer at the
Centre Hospitalier Universitaire Vaudois in Switzerland. Research and
development expenses paid in connection with these collaborations aggregated
approximately $1,326,000, $1,337,000 and $1,008,000 for the years ended December
31, 1997, 1996 and 1995, respectively. The Company and StemCells, Inc. also have
a number of collaborative relationships with other academic institutions and
academic researchers.

STEMCELLS, INC.

StemCells, Inc. has entered into a number of research agreements with
academic institutions. These include a Sponsored Research Agreement with The
Scripps Research Institute and a Sponsored Research Agreement with Oregon Health
Sciences University. These agreements require StemCells, Inc. to fund certain
research (in the amounts of approximately $931,000 over three years and $105,000
over one year, respectively) in return for licenses or options to license the
inventions resulting from such research.

In addition, StemCells, Inc. has entered into license agreements with the
California Institute of Technology and the University of Utah Research
Foundation. These license agreements and the agreements referred to in the
foregoing paragraph relate largely to stem cells or to progenitor cells and to
their isolation and identification.

MANUFACTURING

ENCAPSULATED CELLS

The Company believes the ability to manufacture encapsulated-cell products
which are safe and effective will be a key source of competitive advantage in
its encapsulated-cell therapy business. Thus, the Company intends to manufacture
its proposed products and maintain control of this important proprietary element
of its business wherever possible.

The manufacturing process for the Company's lead product (its chronic pain
implant) is comprised of five modules: (i) manufacture of the fiber membrane;
(ii) assembly of implants; (iii) acquisition and culturing of the cells; (iv)
placement of the cells within the implant; and (v) packaging of the cell-loaded
implants for shipping to the clinical site. The Company is employing this
process, using current Good Manufacturing Practices ("cGMP"), for manufacturing
its pain implants for use in clinical trials. Quality control tests are
performed on each batch of the finished pain devices to assess sterility and
potency. Only batches meeting all specifications are released for use in
clinical trials. Critical equipment and processes have been validated to assure
manufacturing consistency and control. A 21,000-square foot laboratory and pilot
manufacturing facility is now in operation.

Implants for clinical trials are currently produced in small quantities. The
commercial-scale manufacture of these products is expected to require
specialized automated or semi-automated equipment and expansion of manufacturing
facilities. The Company's current manufacturing process has been designed to
facilitate the incorporation of additional automation over time.

The facilities and equipment required to manufacture the Company's
encapsulated-cell implants are different from those required to manufacture
potentially competitive biopharmaceutical products.

The Company's pilot manufacturing plant, without additional expansion or
increasing staffing, does not have sufficient capacity to permit the Company to
produce all of the products necessary to complete clinical trials in all
indications the Company may wish to develop. In addition, the Company has not
yet developed the capability to manufacture any of its proposed products on a
commercial scale and is unaware of any other company which has manufactured any
membrane encapsulated-cell product on a commercial scale. Manufacture of the
Company's proposed products is expected to require specialized, automated
equipment capable of forming complex polymer membranes into implants which
combine media, matrices and living cells, and this process must be carried out
on a precisely controlled basis, under sterile conditions in a clean-room
environment. Failure to achieve commercial scale manufacturing capability at a
reasonable cost or to demonstrate consistent results using manufactured
prototypes in preclinical animal studies or clinical trials could prevent or
delay submission of products for regulatory approval and initiation of new
development programs, which could have a materially adverse effect on the
Company. Regulatory restrictions have substantially increased the likely cost of
manufacturing a product containing xenogeneic cells for commercial use. Since in
certain cases the Company has agreed on pricing for supply of its products
before commercial production begins, additional costs of production arising from

regulations or otherwise, may cause the Company's cost of production to exceed
the price it receives for producing such products. In addition, fearing
liability, certain suppliers of raw materials used by the Company in connection
with its implants have or may restrict use of such materials in humans.

There can be no assurance that the Company will be able to develop the
capability of manufacturing any of its proposed products on a cost-effective
basis, or to identify and contract with manufacturers to produce such products
or needed raw materials, at a cost or in the quantities necessary to make a
commercially viable product.

STEM CELLS

The keys to successful commercialization of neural stem/progenitor cells
include efficacy, safety, consistency of the product and economy of the process.
The Company will address these issues by appropriate testing and banking
representative vials of large-scale cultures. Commercial production is expected
to involve expansion of banked cells and packaging them in an appropriate
container(s) after formulating the cells in an effective carrier (which may also
be used to affect the stability and engrafting of the stem cells or their
progeny). Because of the early stage of the Company's stem/progenitor cell
programs, the issues which will affect manufacture of stem/progenitor cell
products is relatively unclear.

MARKETING

The Company expects to market and sell its products primarily through
co-marketing, licensing or other arrangements with third parties. The Company
does not have experience in sales, marketing or distribution and does not expect
to develop such capabilities in the near future. Generally, the Company in its
commercial arrangements with third parties intends to have the marketing of its
products undertaken by its partners, although the Company may seek to retain
limited marketing rights in specific markets, particularly where the product may
be addressed by a specialty or niche sales force.

PATENTS, PROPRIETARY RIGHTS AND LICENSES

The Company believes that proprietary protection of its inventions will be
of major importance to its future business. The Company has a program of
vigorously seeking and protecting intellectual property it believes may be
useful in connection with its products; the Company believes that its know-how
will also provide a significant competitive advantage and intends to continue to
develop and protect its know-how. The Company may also, from time to time, seek
to acquire licenses to important externally developed technologies.

The Company has exclusive or non-exclusive rights to a portfolio of patents
and patent applications related to the encapsulation of cells and related
technologies and to various stem cells and methods of deriving and using them.
In general, these encapsulation patents and patent applications pertain to the
release of neurotransmitters from encapsulated cells, use of various cell types,
encapsulation devices and their manufacture, encapsulation methods and various
aspects of the therapeutic use of capsules in the treatment of various diseases.
The stem/progenitor cell patents and patent applications relate mainly to
compositions of matter, methods of obtaining such cells, and methods for
preparing and utilizing such cells. Currently, the Company's U.S. patent
portfolio includes rights to 36 issued U.S. patents and a number of pending
patent applications.

The patent positions of pharmaceutical and biotechnology companies,
including those of the Company, are uncertain and involve complex and evolving
legal and factual questions. The coverage sought in a patent application can be
denied or significantly reduced before or after the patent is issued.
Consequently, the Company does not know whether any of its pending applications
will result in the issuance of patents, or if any existing or future patents
will provide significant protection or commercial advantage or will be
circumvented by others. Since patent applications are secret until patents are
issued in the United States or the applications are published in foreign
countries, and since publication of discoveries in the scientific or

patent literature often lags behind actual discoveries, the Company cannot be
certain that it was the first to make the inventions covered by each of its
pending patent applications or that it was the first to file patent applications
for such inventions. There can be no assurance that patents will issue from the
Company's pending or future patent applications or, if issued, that such patents
will be of commercial benefit to the Company, afford the Company adequate
protection from competing products or not be challenged or declared invalid.

In the event that a third party has also filed a patent application relating
to inventions claimed in Company patent applications, the Company may have to
participate in interference proceedings declared by the United States Patent and
Trademark Office to determine priority of invention, which could result in
substantial uncertainties and cost for the Company, even if the eventual outcome
is favorable to the Company. There can be no assurance that the Company's
patents, if issued, would be held valid by a court of competent jurisdiction.

A number of pharmaceutical, biotechnology and other companies, universities
and research institutions have filed patent applications or have been issued
patents relating to cell therapy and encapsulation, stem cells and other
technologies potentially relevant to or required by the Company's expected
products. In particular, a third party has received a U.S. patent which such
third party asserts relates to cells for alleviating chronic pain in humans. The
Company cannot predict which, if any, of such applications will issue as patents
or the claims which might be allowed. The Company is aware that a number of
companies have filed applications relating to stem cells. The Company is also
aware of a number of patent applications and patents claiming use of genetically
modified cells to treat disease, disorder or injury. The Company also cannot
predict the impact of the application of existing patent applications and
patents on future unencapsulated products. The Company is aware of two issued
patents to a competitor claiming certain methods for treating defective,
diseased or damaged cells in the mammalian CNS by grafting genetically modified
donor cells from the same mammalian species. The Company is also aware of third
party patents and patent applications claiming rights to the neurotrophic
factors which the Company hopes to deliver with its cell encapsulation
technology, and to the production of these factors through the use of
genetically modified cells. The Company expects to use genetically modified
cells to produce these factors for use in its products.

The Company may also be required to seek licenses in regard to other cell
lines, the techniques used in creating or obtaining such cell lines, growth
factors required to obtain and maintain such cell lines, the materials used in
the manufacture of its implants or otherwise. If third party patents or patent
applications contain claims infringed by the Company's technology and such
claims or claims in issued patents are ultimately determined to be valid, there
can be no assurance that the Company would be able to obtain licenses to these
patents at a reasonable cost, if at all, or be able to develop or obtain
alternative technology. If the Company is unable to obtain such licenses at a
reasonable cost, it may be adversely affected. There can be no assurance that
the Company will not be obliged to defend itself in court against allegations of
infringement of third-party patents. Patent litigation is very expensive and
could consume substantial resources and create significant uncertainties. An
adverse outcome in such a suit could subject the Company to significant
liabilities to third parties, require disputed rights to be licensed from third
parties, or require the Company to cease using such technology.

The Company also relies upon trade-secret protection for its confidential
and proprietary information. There can be no assurance that others will not
independently develop substantially equivalent proprietary information or
techniques, gain access to the Company's trade secrets or disclose such
technology, or that the Company can meaningfully protect its trade secrets.

The Company's policy is to require its employees, consultants, significant
scientific collaborators and sponsored researchers to execute confidentiality
agreements upon the commencement of an employment or consulting relationship
with the Company. These agreements generally provide that all confidential
information developed or made known to the individual by the Company during the
course of the

individual's relationship with the Company is to be kept confidential and not
disclosed to third parties except in specific circumstances. In the case of
employees and consultants, the agreements generally provide that all inventions
conceived by the individual in the course of rendering services to the Company
shall be the exclusive property of the Company. There can be no assurance,
however, that these agreements will provide meaningful protection or adequate
remedies for the Company in the event of unauthorized use, transfer or
disclosure of such information or inventions.

The Company has obtained rights from universities and research institutions
to technologies, processes and compounds that it believes may be important to
the development of its products. These agreements typically require the Company
to pay license fees, meet certain diligence obligations and, upon commercial
introduction of certain products, pay royalties. These include exclusive license
agreements with Brown University and NeuroSpheres, Ltd. to certain patents and
know-how regarding present and certain future developments in encapsulation
technology and neural stem cells, respectively. The Company's licenses may be
canceled or converted to non-exclusive licenses if the Company fails to use the
relevant technology or the Company breaches its agreement. Loss of such licenses
could expose the Company to the risks of third party patents and/or technology.
There can be no assurance that any of these licenses will provide effective
protection against the Company's competitors.

COMPETITION

The Company's initial products are expected to compete with a variety of
therapeutic products and procedures. Major pharmaceutical companies currently
offer a number of pharmaceutical products to treat chronic pain, Parkinson's
disease, and other diseases for which the Company's technologies may be
applicable. The Company believes that its products, if successfully developed,
will compete with these products principally on the basis of improved and
extended efficacy and safety and the overall economic benefit to the health care
system offered by such products. However, many pharmaceutical and biotechnology
companies are investigating new drugs and therapeutic approaches to treat
neurodegenerative diseases, which may achieve new and better efficacy profiles,
extend the therapeutic window, alter the prognosis of these diseases or prevent
their onset.

The market for therapeutic products that address degenerative diseases is
large, and competition is intense and is expected to increase. The Company's
most significant competitors are expected to be fully integrated pharmaceutical
companies and more established biotechnology companies. Such competitors have
significant resources and expertise in research and development, manufacturing,
testing, obtaining regulatory approvals and marketing and also have
significantly greater capital resources. Smaller companies may also prove to be
significant competitors, particularly through collaborative arrangements with
large pharmaceutical or biotechnology companies. Many of these competitors have
significant products approved or in development which could be competitive with
the Company's potential products, and also operate large, well-funded research
and development programs. In addition, the Company competes with other companies
and institutions for highly qualified scientific and management personnel.

The Company's products to treat chronic pain, if successfully developed,
will compete with epidural and intrathecal opiates, such as morphine and its
analogs, and with adjuvant analgesics, antidepressants and anticonvulsants, as
well as with new therapeutics under development such as SNX 111, a conopeptide.
New delivery and dose control methods for traditional pain treatments, such as
morphine pumps, may also compete with the Company's products.

The Company's products to treat Parkinson's disease, if successfully
developed, may compete with orally administered drugs which contain L-dopa,
other forms of cell transplantation, ablative and stimulative procedures and new
drugs under development. Neurotrophic factors delivered to the patient other
than with the Company's encapsulation technology, such as by gene therapy, also
represent potential products that may compete with the Company's products. In
addition, certain companies are attempting to

develop gene therapies including products (which may or may not involve
neurotrophic factors) for the treatment of a number of neurodegenerative
diseases, including Parkinson's disease.

The Company's stem/progenitor cell products, if successfully developed,
might face competition from existing products like those referred to in the
preceding paragraph. In addition, the Company believes that its competitors are
trying to develop stem/progenitor cell-based technologies. The Company expects
that these products, if developed, will compete with the Company's potential
stem/progenitor cell products based on efficacy, safety, cost and intellectual
property positions. The Company expects that gene therapy, if successfully
developed, will also be a source of competition for potential stem/progenitor
cell products.

There can be no assurance that the Company's competitors will not succeed in
developing technologies and products that are more effective than those being
developed by the Company or that would render the Company's technology obsolete
or non-competitive. The Company may also face competition from companies which
have filed patent applications relating to cell encapsulation and the use of
genetically modified cells to treat disease, disorder or injury. The Company may
be required to seek licenses from these competitors in order to commercialize
certain of its proposed products and there can be no assurance that the Company
will be able to obtain such licenses at a reasonable cost, if at all.

Any product that the Company succeeds in developing and for which it gains
regulatory approval must then compete for market acceptance and market share.
For certain of the Company's potential products, an important competitive factor
will be the timing of market introduction of competitive products. Accordingly,
the Company expects that an important competitive factor will be the relative
speed with which the Company and its competitors can develop products, complete
the clinical testing and approval processes and supply commercial quantities of
a product to market. With respect to clinical testing, competition may delay
progress by limiting the number of clinical investigators and patients available
to test the Company's potential products.

Competition for the Company's products is also expected to be based on
product efficacy, safety, the timing and scope of regulatory approvals
including, in certain instances, obtaining marketing exclusivity under the
Orphan Drug Act, availability of supply, marketing and sales capability,
reimbursement coverage, price and patent and technology position. There can be
no assurance that the Company's technology, if fully developed, will become
commercially viable.

GOVERNMENT REGULATION

The manufacturing and marketing of the Company's potential products and its
research and development activities are and will continue to be subject to
regulation for safety and efficacy by numerous governmental authorities in the
United States and other countries. In the United States, pharmaceuticals,
biologicals and medical devices are subject to rigorous FDA regulation. The
Federal Food, Drug and Cosmetic Act, as amended, and the Public Health Service
Act, as amended, the regulations promulgated thereunder, and other Federal and
state statutes and regulations govern, among other things, the testing,
manufacture, safety, efficacy, labeling, storage, export, record keeping,
approval, marketing, advertising and promotion of the Company's potential
products. Product development and approval within this regulatory framework
takes a number of years and involves substantial uncertainty combined with the
expenditure of substantial resources. In addition, the United States, states and
other jurisdictions have restrictions on the use of fetal tissue which could
restrict the Company's use of such materials.

Three branches of the FDA, the Center for Drug Evaluation and Research, the
Center for Biologics Evaluation and Research and the Center for Devices and
Radiological Health, review and approve drugs, biologics and devices,
respectively. The FDA has indicated to the Company that the Center for Biologics
Evaluation and Research will have primary jurisdiction for premarket review of
the Company's potential products that utilize the Company's encapsulated-cell
technology. However, the FDA has also indicated that the Center for Drug
Evaluation and Research and the Center for Devices and Radiological Health will
play a role in the agency's review of the Company's potential products. In
addition, the FDA has

published certain guidelines regarding living cells and their transplantation
and has begun to develop guidelines for the regulation of xenotransplantation of
cells and organs.

The steps required before the Company's potential products may be marketed
in the United States include (i) preclinical laboratory and animal tests, (ii)
the submission to the FDA of an application for an Investigational New Drug
Exemption ("IND"), which must become effective before U.S. human clinical trials
may commence, (iii) adequate and well-controlled human clinical trials to
establish the safety and efficacy of the product, (iv) the submission to the FDA
of a marketing authorization application(s) and (v) FDA approval of the
application(s) prior to any commercial sale or shipment of the drug. Biologic
product manufacturing establishments located in certain states also may be
subject to separate regulatory and licensing requirements.

Preclinical tests include laboratory evaluation of the product and animal
studies to assess the potential safety and efficacy of the product and its
formulation as well as the quality and consistency of the manufacturing process.
The results of the preclinical tests are submitted to the FDA as part of an IND,
and the IND becomes effective 30 days following its receipt by the FDA, absent
questions, requests for delay or objections from the FDA.

Clinical trials involve the evaluation of the product in healthy volunteers
or in patients under the supervision of a qualified principal physician.
Clinical trials are conducted in accordance with protocols that detail the
objectives of the study, the parameters to be used to monitor safety and the
efficacy criteria to be evaluated. Any product administered in a U.S. clinical
trial must be manufactured in accordance with cGMP. Each protocol is submitted
to the FDA as part of the IND. The protocol for each clinical study must be
approved by an independent Institutional Review Board ("IRB") at the institution
at which the study is conducted and the informed consent of all participants
must be obtained. The IRB will consider, among other things, the existing
information on the product, ethical factors, the safety of human subjects, the
potential benefits of therapy and the possible liability of the institution.

Clinical development is traditionally conducted in three sequential phases.
The phases may overlap, however. In Phase I, products are typically introduced
into healthy human subjects or into selected patient populations to test for
safety (adverse reactions), dosage tolerance, absorption and distribution,
metabolism, excretion and clinical pharmacology. Phase II involves studies in a
limited patient population to (i) determine the efficacy of the product for
specific targeted indications and populations, (ii) determine optimal dosage and
dosage tolerance and (iii) identify possible adverse effects and safety risks.
When a dose is chosen and a candidate product is found to be effective and to
have an acceptable safety profile in Phase II evaluations, Phase III trials are
undertaken to conclusively demonstrate clinical efficacy and to test further for
safety within an expanded patient population, generally at multiple study sites.
In certain instances, as may be the case with the Company's potential products,
the FDA permits Phase I clinical trials to be conducted using a small number of
patients instead of healthy volunteers. The FDA continually reviews the clinical
trial plans and results and may suggest changes or may require discontinuance of
the trials at any time if significant safety issues arise. The results of the
preclinical studies and clinical studies are submitted to the FDA in the form of
a marketing approval authorization application.

The testing and approval process is likely to require substantial time,
effort and expense and there can be no assurance that any FDA approval will be
granted on a timely basis, if at all. The time to approval is affected by a
number of factors, including relative risks and benefits demonstrated in
clinical trials, the availability of alternative treatments and the severity of
the disease. Additional animal studies or clinical trials may be requested
during the FDA review period and may delay marketing approval. After FDA
approval for the initial indications and requisite approval of the manufacturing
facility, further clinical trials may be necessary to gain approval for the use
of the product for additional indications. The FDA may also require unusual or
restrictive post-marketing testing and surveillance to monitor for adverse
effects, which can involve significant expense or grant only conditional
approvals.

Among the conditions for product licensure is the requirement that the
prospective manufacturer's quality control and manufacturing procedures conform
to cGMP. Even after product licensure approval, the manufacturer must comply
with cGMP on a continuing basis, and what constitutes cGMP may change as the
state of the art of manufacturing changes. Domestic manufacturing facilities are
subject to regular FDA inspections for cGMP compliance (normally at least every
two years), and foreign manufacturing facilities are subject to periodic FDA
inspections or inspections by the foreign regulatory authorities with reciprocal
inspection agreements with the FDA. Domestic manufacturing facilities may also
be subject to inspection by foreign authorities.

The Orphan Drug Act provides incentives to drug manufacturers to develop and
manufacture drugs for the treatment of diseases or conditions that affect fewer
than 200,000 individuals in the United States. Orphan drug status can also be
sought for treatments for diseases or conditions that affect more than 200,000
individuals in the United States if the sponsor does not realistically
anticipate its product becoming profitable from sales in the United States. The
Company may apply for orphan drug status for certain of its therapies. Under the
Orphan Drug Act, a manufacturer of a designated orphan product can seek tax
benefits, and the holder of the first FDA approval of a designated orphan
product will be granted a seven-year period of marketing exclusivity in the
United States for that product for the orphan indication. While the marketing
exclusivity of an orphan drug would prevent other sponsors from obtaining
approval of the same compound for the same indication, it would not prevent
other types of products from being approved for the same use including in some
cases, slight variations on the originally designated orphan product.
Legislation has been introduced in the U.S. Congress in the past, and is likely
to be introduced again in the future, that would restrict the extent and
duration of the market exclusivity of an orphan drug, and there can be no
assurance that the benefits of the existing statute will remain in effect.

Export of the Company's investigational products is governed by laws and
regulations administered by the FDA. The Company has sought and received FDA
clearance for export of finished products for clinical trials outside the United
States. However, both the Company's past and future export practices could be
subject to FDA challenge and there can be no assurance that the FDA would agree
that such practices are in compliance with applicable law and regulations or
that such exports would be allowed.

Proposed regulations of the FDA and other governmental agencies would place
restrictions, including disclosure requirements, on researchers who have a
financial interest in the outcome of their research. Under the proposed
regulations, the FDA could also apply heightened scrutiny to, or exclude the
results of, studies conducted by such researchers when reviewing applications to
the FDA which contain such research. Certain of the Company's collaborators have
stock options or other equity interests in the Company that could subject such
collaborators and the Company to the proposed regulations.

There has been increasing regulatory concern about the risks of
xenotransplantation. Concern has focused on the use of cells derived from cows
(such as are used in the Company's pain program) and cells from primates and
pigs. The United Kingdom has adopted a moratorium on xenotransplantation pending
further research and discussion; the EC Commission has introduced a ban on the
use of "high-risk material" from cattle and sheep in the Member States of the
European Union in the manufacture of pharmaceuticals (this ban would apparently
not include the type of cells used in the Company's pain program). In addition,
the FDA has recently proposed guidelines which impose significant constraints on
the clinical use of non-human cells. The regulations proposed, particularly if
they are made more restrictive, could impact significantly on the cost of
clinical trials and the cost to manufacture products using xenogeneic cells; the
Company has begun to concentrate on the use of human cells as opposed to cells
derived from non-human animals. Furthermore, the FDA has published a "Proposed
Approach to Regulation of Cellular and Tissue-Based Products" which relates to
the use of human cells. The Company cannot presently determine the effects of
such actions nor what other actions might be taken. Restrictions on the testing
or use of cells, whether human or nonhuman, as human therapeutics could
adversely affect the Company's product development programs and the Company
itself and could prevent the Company

from producing and/or selling certain products or make the cost of production by
the Company prohibitively high.

In addition to safety regulations enforced by the FDA, the Company is also
subject to regulations under the Occupational Safety and Health Act, the
Environmental Protection Act, the Toxic Substances Control Act and other present
and potential future supranational, foreign, Federal, state and local
regulations.

Outside the United States, the Company will be subject to regulations which
govern the import of drug and device products from the United States or other
manufacturing sites and foreign regulatory requirements governing human clinical
trials and marketing approval for its products. The requirements governing the
conduct of clinical trials, product licensing, pricing and reimbursements vary
widely from country to country. In particular, the European Union ("EU") is
revising its regulatory approach to high tech products and representatives from
the United States, Japan and the EU are in the process or harmonizing and making
more uniform the regulations for the registration of pharmaceutical products in
these three markets. Although certain of such proposals have been adopted, the
Company cannot anticipate what effect the adoption of the final forms of this
harmonization or the changes to the EU high tech procedure may have.

Switzerland is expected to conduct a referendum in 1998 to determine the
extent to which the use of recombinant DNA technologies may be restricted within
Switzerland. The Company cannot predict the results of the referendum or
determine the effects of such restrictions.

REIMBURSEMENT AND HEALTH CARE COST CONTROL

The Company's ability to commercialize products successfully may depend in
part on the extent to which reimbursement for the costs of such products and
related treatments will be available from government health administration
authorities, private health insurers and others both in the United States and
abroad. Significant uncertainty exists as to the reimbursement status of newly
approved health care products. Reimbursement limitations or prohibitions with
respect to any product developed by the Company could adversely affect the
Company's ability to establish and maintain price levels sufficient for
realization of an appropriate return on its investment in developing new
therapies. Government and other third party payers are increasingly attempting
to contain health care costs by limiting both coverage and the level of
reimbursement for new therapeutic products approved for marketing by the FDA and
by refusing, in some cases, to provide any coverage for uses of approved
products for disease indications for which the FDA has not granted marketing
approval. If adequate coverage and reimbursement levels are not provided by
third party payers for uses of the Company's therapeutic products, the market
acceptance of these products would be adversely affected.

The revenues and profitability of health care-related companies may be
affected by the continuing efforts of governmental and third party payers to
contain or reduce the cost of healthcare through various means. For example, in
certain foreign markets pricing or profitability of prescription pharmaceuticals
is subject to government control. In the United States, there have been, and the
Company expects that there will continue to be, a number of Federal and state
proposals to implement government control over healthcare costs. Efforts at
healthcare reform are likely to continue in future legislative sessions. It is
uncertain what legislative proposals will be adopted or what actions Federal,
state or private payers for healthcare goods and services may take in response
to healthcare reform proposals of legislation. The Company cannot predict the
effect healthcare reforms may have on its business. Any such reforms as well as
the uncertainty their proposal engenders could have a material adverse effect on
the Company.

EMPLOYEES

As of March 9, 1998, the Company had 120 full-time employees, including 20
employees with Ph.D. or M.D. degrees. Approximately 101 employees work in
research and development, regulatory affairs,

prototype manufacturing, quality assurance and control and laboratory support
services. A number of the Company's employees have held positions with other
biotechnology or pharmaceutical companies or have worked in university research
programs. No employees are covered by collective bargaining agreements.

SCIENTIFIC ADVISORY BOARD

Members of the Company's Scientific Advisory Board provide the Company with
strategic guidance in regard to its research and product development programs,
as well as assistance in recruiting employees and collaborators. Each Scientific
Advisory Board member has entered into a consulting agreement with the Company.
These consulting agreements typically specify the compensation to be paid to the
consultant and require that all information about the Company's products and
technology be kept confidential. All of the Scientific Advisory Board members
are employed by employers other than the Company and may have commitments to or
consulting or advising agreements with other entities which may limit their
availability to the Company. The Scientific Advisory Board members have
generally agreed, however, for so long as they serve as consultants to the
Company, not to provide any services to any other entities which would conflict
with the services the member provides to the Company. Members of the Scientific
Advisory Board offer consultation on specific issues encountered by the Company
as well as general advice on the directions of appropriate scientific inquiry
for the Company. In addition, certain Scientific Advisory Board members assist
the Company in assessing the appropriateness of moving the Company's projects to
more advanced stages. The following persons are members of the Company's
Scientific Advisory Board:

IRVING L. WEISSMAN, M.D., is the Karel and Avice Beekhuis Professor of
Cancer Biology, Professor of Pathology and Professor of Developmental Biology at
Stanford University. Dr. Weissman is a cofounder of Systemix, Inc., and Chairman
of the Scientific Advisory Board of Systemix, Inc. He has served on the
Scientific Advisory Boards of Amgen Inc., DNAX and T-Cell Sciences, Inc. Dr.
Weissman is Chairman of the Scientific Advisory Board of CytoTherapeutics.

PATRICK AEBISCHER, M.D., PH.D., is the Director of the Gene Therapy Center
at the Centre Hospitalier Universitaire Vaudois, Lausanne, Switzerland and
Professor of Biomaterials, Brown University. He is also Professor of the Swiss
Polytechnical School in Lausanne. Dr. Aebischer is a founding scientist of the
Company and a member of its Board of Directors and Chairman of the Board of
Modex Therapeutiques SA.

DAVID J. ANDERSON, PH.D., is Professor of Biology, California Institute of
Technology, Pasadena, California and Investigator, Howard Hughes Medical
Institute.

ANDERS BJORKLUND, M.D., is Professor, University of Lund, Lund, Sweden.

CONSTANCE L. CEPKO, PH.D., is Professor, Department of Genetics, Harvard
Medical School, Boston, Massachusetts.

FRED H. GAGE, PH.D., is Professor, Laboratory of Genetics, The Salk
Institute for Biological Studies, La Jolla, California and Adjunct Professor,
Department of Neurosciences, University of California, San Diego, California.

WILLIAM F. HICKEY, M.D., is Chairman of Pathology, Dartmouth-Hitchcock
Medical Center, Lebanon, New Hampshire.

SIR PETER J. MORRIS, PH.D., is Professor, Nuffield Department of Surgery,
Oxford University, Oxford, England.

MEDICAL ADVISORY BOARD

The Company is creating a Medical Advisory Board to advise the Company on
the clinical aspects of its projects, including the indications to be pursued
and the trial strategies that are most efficient and effective. Edwin Cadman,
M.D., Chief of Staff, Yale-New Haven Hospital and former Chairman of Abbott

Laboratories Medical Advisory Board, has agreed to assist the Company in
establishing the Board and to be its Chairman.

ITEM 2. PROPERTIES

The Company's research laboratories and administrative offices are located
in a 65,000 square-foot multipurpose building housing wet labs, specialty
research areas and administrative offices located in Lincoln, RI. The facilities
are leased pursuant to a fifteen-year lease agreement with the Company having
certain renewal options. The Company has also leased a 21,000 square-foot pilot
manufacturing facility and a 3,000 square-foot cell processing facility for its
pain program in Lincoln, Rhode Island. This facility was financed by bonds
issued by the Rhode Island Industrial Facilities Corporation. The Company has
also leased additional space near its pilot plant for expanded research and
development. In 1998, the Company entered into a three-year lease for
approximately 6,000 square feet of laboratory space in Sunnyvale, California.
This space is being refitted to serve as the laboratory for the research
activities of the Company's subsidiary, StemCells, Inc.

The Company's current facilities are expected to be sufficient to
accommodate the Company's needs at least past the end of 1999.

ITEM 3. LEGAL PROCEEDINGS

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS

The Common Stock of CytoTherapeutics is traded on the National Market System
of NASDAQ under the Symbol CTII. The quarterly ranges of high and low sales
prices since January 1, 1996 are shown below:

1998 HIGH LOW
- -------------------------------------------------- -------- ---------

First Quarter (through March 12).................. $ 4 3/16 $ 2 9/16

1997 HIGH LOW
- -------------------------------------------------- -------- ---------

Fourth Quarter.................................... $ 7 1/8 $ 3 11/16
Third Quarter..................................... $ 6 1/8 $ 4 3/4
Second Quarter.................................... $ 8 3/4 $ 4 15/16
First Quarter..................................... $10 7/8 $ 8 3/8

1996 HIGH LOW
- -------------------------------------------------- -------- ---------

Fourth Quarter.................................... $11 $ 7 5/8
Third Quarter..................................... $12 5/8 $ 7 1/8
Second Quarter.................................... $15 1/2 $10 5/8
First Quarter..................................... $18 3/4 $12 3/4

No cash dividends have been declared on the Common Stock since the Company's
inception.

As of March 9, 1998, there were approximately 268 holders of record of the
Common Stock.

On December 11, 1996, the Company sold 829,171 shares of Common Stock to
Genentech in connection with the Company's collaboration agreement with
Genentech for $10.01 per share. The shares were issued as a transaction exempt
from registration pursuant to Section 4(2) of the Securities Act of 1933 based
on, among other things, availability of information about the issuer and
representations by the purchaser as to sophistication.

ITEM 6. SELECTED FINANCIAL DATA

YEAR ENDED DECEMBER 31,
-----------------------------------------------------
1997 1996 1995 1994 1993
--------- --------- --------- --------- ---------

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
STATEMENT OF OPERATIONS DATA
Revenue from collaborative agreements....................... $ 10,617 $ 7,104 $ 11,761 $ 1,250 $ 190
Research and development expenses........................... 18,604 17,130 14,730 13,514 11,807
Acquired research and development........................... 8,344 -- -- -- --
Net loss.................................................... (18,114) (13,759) (8,891) (16,461) (12,544)
Net loss per share(1)....................................... (1.08) (0.89) (0.69) (1.52) (1.47)
Shares used in computing net loss per share(1).............. 16,704 15,430 12,799 10,833 8,541

DECEMBER 31,
-----------------------------------------------------
1997 1996 1995 1994 1993
--------- --------- --------- --------- ---------

(IN THOUSANDS)
BALANCE SHEET DATA
Cash and cash equivalents and marketable securities........ $ 29,050 $ 42,607 $ 44,192 $ 19,138 $ 30,855
Total assets............................................... 44,301 58,397 56,808 32,194 40,996
Long-term debt, including capitalized leases............... 4,108 8,223 5,441 5,641 3,428
Redeemable common stock.................................... 5,583 8,159 -- -- --
Stockholders' equity....................................... 28,900 34,747 45,391 22,637 34,509

- ------------------------

(1) See Note 2 to consolidated financial statements.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion of the financial condition and results of
operations of CytoTherapeutics, Inc. should be read in conjunction with the
accompanying financial statements and the related footnotes thereto.

OVERVIEW

Since its inception in August 1988, the Company has been primarily engaged
in research and development of human therapeutic products. No revenues have been
derived from the sale of any products, and the Company does not expect to
receive revenues from product sales for at least several years. The Company
expects that its research and development expenditures will increase
substantially in future years as research and product development efforts
accelerate and clinical trials are initiated or broadened. The Company has
incurred annual operating losses since inception and expects to incur
substantial operating losses in the future. As a result, the Company is
dependent upon external financing from equity and debt offerings and revenues
from collaborative research arrangements with corporate sponsors to finance its
operations. The Company's results of operations have varied significantly from
year to year and quarter to quarter and may vary significantly in the future due
to the occurrence of material, non recurring events, including without
limitation, the receipt of one-time, non recurring licensing payments.

RESULTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

Revenues from collaborative agreements totaled $10,617,000, $7,104,000 and
$11,761,000 for the years ending December 31, 1997, 1996 and 1995, respectively.
Revenues were earned primarily from a Development, Marketing and License
Agreement with Astra AB, which was signed in March 1995. Included in the 1997
revenue is a $3,000,000 milestone payment from Astra AB related to the Phase II
clinical program for the Company's pain control implant. Included in 1995
revenue is a one-time licensing fee from Astra AB of $5,000,000.

Research and development expenses totaled $18,604,000 in 1997, as compared
to $17,130,000 in 1996 and $14,730,000 in 1995. The increase of $1,474,000, or
9% from 1996 to 1997 was primarily attributable to an increase in manufacturing
supplies associated with Phase II clinical trials and an additional $917,000 of
expense from Modex Therapeutiques SA ("Modex") the Company's formerly 50% owned
subsidiary, which was included in CytoTherapeutics' operating results through
October 1997. The increase of $2,400,000, or 16% from 1995 to 1996 was primarily
attributable to increases in the number of research, development and production
staff, spending for company sponsored research at academic and other
institutions and scientific consulting.

Acquired research and development consists of a one-time charge of
$8,344,000 related to the acquisition of StemCells, Inc. Commercialization of
the acquired technology will require significant incremental research
expenditures over a number of years.

General and administrative expenses were $6,158,000 for the year ended
December 31, 1997, compared with $5,679,000 in 1996 and $4,620,000 in 1995. The
increase of $479,000 , or 8%, from 1996 to 1997 was primarily attributable to
increased spending for legal fees associated with the NeuroSpheres, Ltd.
arbitration, patents, recruiting fees and other professional services. The
increase of $1,059,000, or 23%, from 1995 to 1996 was principally due to
increases in the number of administrative personnel, one-time hiring bonuses, as
well as consulting costs attributable to the establishment of Modex, a formerly
50% owned Swiss subsidiary.

Interest income for the years ended December 31, 1997, 1996 and 1995 totaled
$1,931,000, $2,260,000 and $1,714,000, respectively. The average cash and
investment balances were $33,343,000, $37,600,000 and

$26,907,000 in 1997, 1996 and 1995, respectively. The decrease in interest
income from 1996 to 1997 was attributable to lower average balances. The
increase in interest income from 1995 to 1996 was principally due to higher
average balances.

In 1997, interest expense was $438,000, compared with $618,000 in 1996 and
$685,000 in 1995. The decrease from 1996 to 1997 was attributable to
capitalization of interest on the new facility in the amount of $210,000. The
decrease in 1995 to 1996 is principally due to decreasing balances of
capitalized lease obligations only partially offset by additional collateralized
loan obligations.

In October 1997, the Company recognized a gain in the amount of $3,387,000
related to the sale of half of the Company's interest in Modex.

In December 1995, the Company recognized a loss on its investment in Neocrin
Company of $2,330,848, as it determined that the carrying value in its
investment had been permanently impaired. The valuation reserve of $2,330,848
reduced the valuation of the investment to $200,000.

The net loss in 1997, 1996 and 1995 was $18,114,000, $13,759,000, and
$8,891,000, respectively. The loss per share was $1.08, $0.89 and $0.69 in 1997,
1996 and 1995, respectively. The large increase in 1997 is attributable to a
one-time charge of $8,344,000 for acquired research and development related to
the purchase of StemCells, Inc. offset by a gain on partial sale of the
Company's interest in Modex Therapeutiques, SA in the amount of $3,387,000. The
decreased loss in 1996 and 1995 is principally due to revenue earned for
research funding under the Company's agreement with Astra AB.

LIQUIDITY AND CAPITAL RESOURCES

Since its inception, the Company has financed its operations through the
sale of common and preferred stock, the issuance of long-term debt and
capitalized lease obligations, revenues from collaborative agreements, research
grants and interest income.

The Company had unrestricted cash, cash equivalents and marketable
securities totaling $29,050,000 at December 31, 1997. Cash equivalents and
marketable securities are invested in agencies of the U.S. government,
investment grade corporate bonds and money market funds.

In May 1996, the Company secured an equipment loan facility with a bank in
the amount of $2,000,000. The Company has borrowed $741,000 under this agreement
as of December 31, 1997. The loan requires interest payments only for the first
two years; principal payments are payable over a three-year period beginning May
1998. Any unused commitment expires on May 15, 1998. The loan is secured by
equipment purchased with the proceeds of the credit facility.

In October 1997, the Company completed a series of transactions which
resulted in the establishment of its previously 50%-owned Swiss subsidiary,
Modex as an independent company. In the transactions, the Company reduced its
ownership interest from 50% to approximately 25% in exchange for $4 million cash
and elimination of its prior contingent obligation to contribute an additional
Sfr 2.4 million (approximately $1.7 million) to Modex in July 1998. In the
transactions, all of the put and call arrangements between the Company and other
stockholders of Modex were eliminated and the Company forgave $463,000 due from
Modex Therapeutiques, SA, to the Company. The Company recorded a gain on the
transaction of $3,387,000 and will account for its now 25% ownership interest
under the equity method.

(iv) specify the terms under which the Company will manufacture any products
Modex may develop based on the Company's technology and grant Modex an option to
manufacture or have manufactured such products on payment of a higher royalty.
The Cross License Agreement continues to provide for the payment of royalties
from Modex to the Company on the sale of any licensed products. The revised
agreement similarly limits the scope of the Modex technology exclusively
licensed, on a royalty-bearing basis, to the Company for the application of
diseases, conditions and disorders of the central nervous system to existing and
future encapsulation technology and certain additional existing technology.

In September 1997, a merger of a wholly owned subsidiary of the Company and
StemCells, Inc. was completed in the form of a purchase. Through the merger, the
Company acquired StemCells, Inc. for a purchase price totaling approximately
$9,475,000 consisting of 1,320,691 shares of the Company's common stock and
options and warrants for the purchase of 259,296 common shares at nominal
consideration, valued at $7,900,000, the assumption of certain liabilities of
$934,000 and transaction costs of $641,000. The purchase price was allocated,
through a valuation, to license agreements valued at $1,131,000 to be amortized
over three years and acquired research and development of $8,344,000 which has
been expensed. As part of the acquisition of StemCells, Inc., Richard M. Rose,
M.D. , became President, Chief Executive Officer and a director of
CytoTherapeutics, Inc. and Dr. Irving Weissman became a director of
CytoTherapeutics, Inc. Upon consummation of the merger, the Company entered into
consulting arrangements with the principal scientific founders of StemCells,
Inc.; Dr. Irving Weissman, Dr. Fred H. Gage and Dr. David Anderson.
Additionally, in connection with the merger, the Company was granted an option
by the former principal shareholders of StemCells, Inc. to repurchase
approximately 500,000 of the Company's shares of Common Stock exchanged for
StemCells Inc. shares, upon the occurrence of certain events as defined.

To attract and retain Drs. Rose, Weissman, Gage and Anderson, and to
expedite the progress of the Company's stem cell program, the Company awarded
these individuals options to acquire a total of approximately 1.6 million shares
of the Company's common stock, at an exercise price of $5.25 per share, the
quoted market price of the grant date; approximately 100,000 of these options
are exercisable immediately, 1,031,000 of these options vest and become
exercisable only on the achievement of specified milestones related to the
Company's stem cell development program and the remaining 469,000 options vest
over eight years. In connection with the 469,000 options issued to a
non-employee, Dr. Anderson, the Company has recorded deferred compensation of
$1,750,000, the fair value of such options at the date of grant, which will be
amortized over an eight-year period. If the milestones specified relating to the
1,031,000 option grant are achieved, at that time the Company will record
compensation expense for the excess of the quoted market price of the common
stock over the exercise price of $5.25 per share for 562,000 options and the
fair market value for 469,000 of such options determined using the Black-Scholes
method. The Company has also designated a pool of 400,000 options to be granted
to persons in a position to make a significant contribution to the success of
the stem cells program.

Stem cell research will be conducted pursuant to the provisions of an
agreement between the Company and Drs. Weissman and Gage providing for a
two-year research plan. If the goals of the research plan are accomplished, the
Company has agreed to fund continuing stems cells research. Increases in stem
cells research funding of not more than 25% a year will be funded by the Company
as long as the goals of the research plan are being met, provided, however, that
the Company will retain the option of (i) ceasing or reducing neural stem cell
research even if all research plan goals are met by accelerating the vesting of
all still-achievable performance based options and (ii) ceasing or reducing
non-neural stem cell research even if all plan goals are being met by affording
the scientific research founders the opportunity to continue development of the
non-neural stem cell research by licensing the technology related to such
research to the founders in exchange for a payment to the Company equal to all
funding for such research, plus royalty payments.

In 1997, the Company entered into an agreement with NeuroSpheres, Ltd. which
superseded all previous license agreements and settled a dispute with
NeuroSpheres, Ltd. Under the terms of the

settlement, the Company has an exclusive royalty bearing license to
growth-factor responsive stem cells for transplantation and NeuroSpheres, Ltd.
has an option to acquire co-exclusive rights in exchange for an up front payment
of $5,000,000. NeuroSpheres, Ltd.' option expires in 1998, if unexercised. The
parties have no further research obligations to each other.

In February 1997, the Company and Cognetix, Inc. entered into a
collaboration and development agreement to screen selected peptides isolated by
Cognetix, Inc. for possible development into therapeutic products aimed at a
broad range of human disease states using the Company's cell-based delivery
technology. Due to lack of certain successes under the Agreement, the Company
and Cognetix, Inc. are reexamining their relationship; the Company expects this
reexamination will lead to termination of the joint project under the agreement
signed in February 1997. As part of the agreement with Cognetix, Inc., the
Company purchased $250,000 of Cognetix, Inc. preferred stock and subject to
certain milestones, is obligated to purchase as much as $1,500,000 of additional
Cognetix, Inc. preferred stock. In July 1997, the Company loaned $250,000 to
Cognetix, inc. which was repaid with interest in October 1997. The Company and
Cognetix, Inc. have also entered into an option agreement giving the Company the
right to purchase an option for up to three of Cognetix, Inc.'s compounds for
use in treating eye diseases. In January 1998, the Company has exercised its
option as to one protein for $100,000.

In November 1996, the Company signed collaborative development and licensing
agreements with Genentech, Inc. relating to the development of products using
the Company's technology to deliver certain of Genentech's proprietary growth
factors to treat certain diseases of the central nervous system. Under the terms
of the agreement for Parkinson's disease, Genentech, Inc. purchased 829,171
shares of Common Stock for $8,300,000 to fund development of products to treat
Parkinson's disease. Additional equity purchases and other funding by Genentech,
Inc. may be available for future clinical development if agreed by the parties.
Upon commercialization, Genentech, Inc. and the Company will share profits from
product sales in the U.S. at an agreed upon percentage and Genentech, Inc. will
pay the Company a royalty for product sales outside the U.S. The Company
retained manufacturing rights for all products sold.

The Company also licensed certain growth factors for the treatment of
Huntington's disease and amyotrophic lateral sclerosis ("ALS"). Under the terms
of the agreements, the Company is responsible for conducting and funding all
preclinical and clinical development, subject to specified rights of Genentech,
Inc. to participate in the development and marketing of the proposed products.
Should Genentech, Inc. share in the development cost of the proposed products,
the companies will share profits from certain territories at negotiated
percentages. Where Genentech, Inc. does not participate in the development, upon
commercialization, the Company will pay Genentech, Inc. an agreed upon royalty
based on sales.

In March 1995, the Company signed a collaborative research and development
agreement with Astra AB for the development and marketing of certain
encapsulated-cell products to treat pain. Astra AB made an initial,
non-refundable payment of $5,000,000, included in revenue from collaborative
agreements in 1995, a milestone payment of $3,000,000 in 1997 and may remit up
to an additional $13,000,000 subject to the achievement of certain development
milestones. Under the agreement, the Company is obligated to conduct certain
research and development pursuant to a four-year research plan agreed upon by
the parties. Over the term of the research plan, the Company expects to receive
annual research payments of $5 million to $7 million from Astra AB which should
fund the majority of the research and development costs incurred by the Company
under the Plan. Subject to the successful development of such products and
obtaining necessary regulatory approvals, Astra AB is obligated to conduct all
clinical trials of products arising from the collaboration and to seek approval
for their sale. Astra AB has the exclusive worldwide right to market products
covered by the agreement. Until the later of either the last to expire of all
patents included in the licensed technology or a specified fixed term, the
Company is entitled to a royalty on the worldwide net sales of such products in
return for the marketing license granted to Astra AB and the Company's
obligation to manufacture and supply products. Astra AB has the right to
terminate the agreement after April 1, 1998.

Substantial additional funds will be required to support the Company's
research and development programs, for acquisition of technologies and
intellectual property rights, for preclinical and clinical testing of its
anticipated products, pursuit of regulatory approvals, acquisition of capital
equipment, expansion of laboratory and office facilities, establishment of
production capabilities and for general and administrative expenses. Until the
Company's operations generate significant revenues from product sales, cash
reserves and proceeds from equity and debt offerings, grants and funding from
collaborative arrangements will be used to fund operations.

The Company intends to pursue opportunities to obtain additional financing
in the future through equity and debt financing, lease agreements related to
capital equipment, grants and collaborative research arrangements. The source,
timing and availability of any future financing will depend principally upon
equity market conditions, interest rates and, more specifically, on the
Company's continued progress in its exploratory, preclinical and clinical
development programs. There can be no assurance that such funds will be
available on favorable terms, if at all.

The Company expects that its existing capital resources, revenues from
collaborative agreements and income earned on invested capital will be
sufficient to fund its operations through 1999. The Company's cash requirements
may vary, however, depending on numerous factors. Lack of necessary funds may
require the Company to delay, scale back or eliminate some or all of its
research and product development programs and/or its capital expenditures or to
license its potential products or technologies to third parties.

The Company has conducted a review of its computer systems to identify the
systems that could be affected by the "Year 2000" issue and is developing an
implementation plan to resolve the issue. The Year 2000 problem is the result of
computer programs being written using two digits rather than four to define the
applicable year. Any of the Company's programs that have time-sensitive software
may recognize a date using "00" as the year 1900 rather than the year 2000. This
could result in system failures or miscalculations to existing software and
converting to new software. The Year 2000 problem is not expected to pose a
significant problem for the Company.

ITEM 7A. QUANTITIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

REPORT OF INDEPENDENT AUDITORS

Stockholders and Board of Directors
CytoTherapeutics, Inc.

We have audited the accompanying consolidated balance sheets of
CytoTherapeutics, Inc. as of December 31, 1997 and 1996, and the related
consolidated statements of operations, changes in redeemable stock and
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1997. Our audits also included the financial statement
schedule listed in the Index at Item 14(a). These financial statements and
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
CytoTherapeutics, Inc. at December 31, 1997 and 1996, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1997, in conformity with generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.

/s/ ERNST & YOUNG LLP

Boston, Massachusetts
February 6, 1998

CYTOTHERAPEUTICS, INC.

CONSOLIDATED BALANCE SHEETS

December 31,
----------------------
1997 1996
----------------------

ASSETS
Current assets:
Cash and cash equivalents........................................ $15,941,701 $19,921,584
Marketable securities............................................ 13,108,497 22,685,855
Accrued interest receivable...................................... 553,186 653,190
Other current assets............................................. 576,008 491,582
----------------------
TOTAL CURRENT ASSETS............................................... 30,179,392 43,752,211
Property, plant and equipment, net................................. 7,922,751 10,732,102
Other assets, net.................................................. 6,199,323 3,912,430
----------------------
TOTAL ASSETS....................................................... $44,301,466 $58,396,743
----------------------
----------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable................................................. $ 867,804 $1,850,925
Accrued expenses................................................. 3,241,547 2,308,844
Deferred revenue................................................. 16,144 1,859,092
Current maturities of capitalized lease obligations.............. 419,095 553,557
Current maturities of long-term debt............................. 658,986 695,570
----------------------
TOTAL CURRENT LIABILITIES.......................................... 5,203,576 7,267,988

Capitalized lease obligations, less current maturities............. 3,552,500 3,971,594
Long-term debt, less current maturities............................ 555,525 4,251,008

Commitments and contingencies
Redeemable common stock, $.01 par value; 557,754 and 815,065 shares
issued and outstanding at December 31, 1997 and 1996,
respectively..................................................... 5,583,110 8,158,798

Common stock to be issued.......................................... 506,600 --

Stockholders' equity:
Convertible preferred stock, $.01 par value; 1,000,000 shares
authorized; no shares issued and outstanding................... -- --
Common stock, $.01 par value; 45,000,000 shares authorized;
17,526,220 and 15,614,333 shares issued and outstanding at
December 31, 1997 and 1996, respectively....................... 175,262 156,144
Additional paid-in capital....................................... 121,472,844 107,649,659
Accumulated deficit.............................................. (91,036,254) (72,922,674)
Unrealized gains (losses) on marketable securities............... (8,877) 14,760
Cumulative translation adjustment................................ -- (60,416)
Deferred compensation............................................ (1,702,820) (90,118)
----------------------
TOTAL STOCKHOLDERS' EQUITY......................................... 28,900,155 34,747,355
----------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY......................... $44,301,466 $58,396,743
----------------------
----------------------

See accompanying notes to consolidated financial statements.

CYTOTHERAPEUTICS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

YEAR ENDED DECEMBER 31,
---------------------------------------------
1997 1996 1995
-------------- -------------- -------------

Revenue from collaborative agreements............................. $ 10,617,443 $ 7,104,284 $ 11,760,666
Operating expenses:
Research and development........................................ 18,603,523 17,130,392 14,729,703
Acquired research and development............................... 8,343,684 -- --
General and administrative...................................... 6,158,410 5,678,783 4,619,733
---------------------------------------------
33,105,617 22,809,175 19,349,436
---------------------------------------------
LOSS FROM OPERATIONS.............................................. (22,488,174) (15,704,891) (7,588,770)
Other income (expense):
Interest income................................................. 1,931,260 2,259,886 1,713,849
Interest expense................................................ (437,991) (618,213) (685,470)
Gain on partial sale of Modex................................... 3,386,808 -- --
Loss on sale/leaseback.......................................... (342,014) -- --
Loss on equity investment....................................... (105,931) -- --
Other income (expense).......................................... (57,538) 404,128 --
Currency exchange loss.......................................... -- (100,048) --
Loss on other investment........................................ -- -- (2,330,848)
---------------------------------------------
4,374,594 1,945,753 (1,302,469)
---------------------------------------------
NET LOSS.......................................................... $ (18,113,580) $ (13,759,138) $ (8,891,239)
---------------------------------------------
---------------------------------------------
NET LOSS PER SHARE................................................ $ (1.08) $ (.89) $ (.69)
---------------------------------------------
---------------------------------------------
SHARES USED IN COMPUTING NET LOSS PER SHARE....................... 16,704,144 15,429,564 12,799,008
---------------------------------------------
---------------------------------------------

See accompanying notes to consolidated financial statements.

CYTOTHERAPEUTICS, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN REDEEMABLE COMMON STOCK AND STOCKHOLDERS'
EQUITY

REDEEMABLE UNREALIZED
COMMON STOCK COMMON STOCK ADDITIONAL GAINS (LOSSES) CUMULATIVE
----------------------- ---------------------- PAID-IN ACCUMULATED ON MARKETABLE TRANSLATION
SHARES AMOUNT SHARES AMOUNT CAPITAL DEFICIT SECURITIES ADJUSTMENTS
--------- ------------ ----------- --------- ------------- ------------- -------------- -----------

Balances, January 1,
1995................ -- $ -- 11,003,568 $ 110,036 $ 73,008,958 $ (50,272,297) $ (100,356) $ --
Issuance of common
stock............... -- -- 4,070,598 40,706 30,797,086 -- --
----
Exercise of stock
options............. -- -- 102,831 1,028 465,614 -- -- --
Amortization of
deferred
compensation........ -- -- -- -- -- -- -- --
Change in unrealized
gains on marketable
securities.......... -- -- -- -- -- -- 231,842 --
Net loss.............. -- -- -- -- -- (8,891,239) -- --
----------------------------------------------------------------------------------------------------------
Balances, December 31,
1995................ -- -- 15,176,997 151,770 104,271,658 (59,163,536) 131,486 --
Issuance of common
stock............... -- -- 168,260 1,683 1,526,118 -- -- --
Issuance of common
stock under the
stock purchase
plan................ -- -- 18,338 184 140,557 -- -- --
Exercise of warrants.. -- -- 6,128 61 (61) -- -- --
Issuance of common
stock to consultants
and employees....... -- -- 48,700 487 429,079 -- -- --
Common stock issued
pursuant to employee
benefit plan........ -- -- 13,719 137 162,231 -- -- --
Issuance of redeemable
common stock........ 829,171 8,300,000 -- -- -- -- -- --
Redeemable common
stock lapses........ (14,106) (141,202) 14,106 141 141,061 -- -- --
Exercise of stock
options............. -- -- 168,085 1,681 979,016 -- -- --
Amortization of
deferred
compensation........ -- -- -- -- -- -- -- --
Change in unrealized
losses on marketable
securities.......... -- -- -- -- -- -- (116,726) --
Change in cumulative
translation
adjustment.......... -- -- -- -- -- -- -- (60,416)
Net loss.............. -- -- -- -- -- (13,759,138) -- --
----------------------------------------------------------------------------------------------------------
Balances, December 31,
1996................ 815,065 $ 8,158,798 15,614,333 $ 156,144 $ 107,649,659 $ (72,922,674) $ 14,760 $ (60,416)

TOTAL
DEFERRED STOCKHOLDERS'
COMPENSATION EQUITY
------------- -------------

Balances, January 1,
1995................ $ (109,271) $ 22,637,070
Issuance of common
stock............... -- 30,837,792

Exercise of stock
options............. -- 466,642
Amortization of
deferred
compensation........ 109,271 109,271
Change in unrealized
gains on marketable
securities.......... -- 231,842
Net loss.............. -- (8,891,239)

Balances, December 31,
1995................ -- 45,391,378
Issuance of common
stock............... -- 1,527,801
Issuance of common
stock under the
stock purchase
plan................ -- 140,741
Exercise of warrants.. -- --
Issuance of common
stock to consultants
and employees....... (185,201) 244,365
Common stock issued
pursuant to employee
benefit plan........ -- 162,368
Issuance of redeemable
common stock........ -- --
Redeemable common
stock lapses........ -- 141,202
Exercise of stock
options............. -- 980,697
Amortization of
deferred
compensation........ 95,083 95,083
Change in unrealized
losses on marketable
securities.......... -- (116,726)
Change in cumulative
translation
adjustment.......... -- (60,416)
Net loss.............. -- (13,759,138)

Balances, December 31,
1996................ $ (90,118 ) $ 34,747,355

CYTOTHERAPEUTICS, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN REDEEMABLE COMMON STOCK AND STOCKHOLDERS'
EQUITY (CONTINUED)

UNREALIZED
GAINS
REDEEMABLE (LOSSES)
COMMON STOCK COMMON STOCK ADDITIONAL ON CUMULATIVE
--------------------- -------------------- PAID-IN ACCUMULATED MARKETABLE TRANSLATION DEFERRED
SHARES AMOUNT SHARES AMOUNT CAPITAL DEFICIT SECURITIES ADJUSTMENTS COMPENSATION
-------------------------------------------------------------------------------------------------------------

Issuance of common
stock............ -- -- 307,548 3,074 1,552,432 -- -- -- --
Issuance of common
stock under the
stock purchase
plan............. -- -- 31,822 319 180,103 -- -- -- --
Deferred
compensation
recorded in
connection with
the granting of
stock options.... -- -- -- -- 1,750,000 -- -- -- (1,750,000)
Common stock issued
pursuant to
employee benefit
plan............. -- -- 25,588 256 169,196 -- -- -- --
Issuance of common
stock --
StemCells,
Inc.............. -- -- 1,219,381 12,194 7,381,206 -- -- -- --
Redeemable common
stock lapses..... (257,311) (2,575,688) 257,311 2,573 2,573,115 -- -- -- --
Exercise of stock
options.......... -- -- 75,237 752 244,427 -- -- -- --
Deferred
compensation--
amortization and
cancellations.... -- -- (5,000) (50) (27,294) -- -- -- 137,298
Change in
unrealized losses
on marketable
securities....... -- -- -- -- -- -- (23,637 ) -- --
Change in
cumulative
translation
adjustment....... -- -- -- -- -- -- -- 60,416 --
Net loss........... -- -- -- -- -- (18,113,580) -- -- --
-------------------------------------------------------------------------------------------------------------
Balances, December
31, 1997......... 557,754 $5,583,110 17,526,220 $ 175,262 $121,472,844 $(91,036,254) $ (8,877 ) $ -- $(1,702,820)
-------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------

TOTAL
STOCKHOLDERS'
EQUITY

Issuance of common
stock............ 1,555,506
Issuance of common
stock under the
stock purchase
plan............. 180,422
Deferred
compensation
recorded in
connection with
the granting of
stock options.... --
Common stock issued
pursuant to
employee benefit
plan............. 169,452
Issuance of common
stock --
StemCells,
Inc.............. 7,393,400
Redeemable common
stock lapses..... 2,575,688
Exercise of stock
options.......... 245,179
Deferred
compensation--
amortization and
cancellations.... 109,954
Change in
unrealized losses
on marketable
securities....... (23,637)
Change in
cumulative
translation
adjustment....... 60,416
Net loss........... (18,113,580)
Balances, December
31, 1997......... $28,900,155

See accompanying notes to consolidated financial statements.

CYTOTHERAPEUTICS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

YEAR ENDED DECEMBER 31,
------------------------------------

1997 1996 1995

------------------------------------

CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss.......................................... $(18,113,580) $(13,759,138) $(8,891,239)
Adjustments to reconcile net loss to net cash used
for operating activities:
Depreciation and amortization................... 1,968,234 1,671,068 1,465,351
Acquired research and development............... 8,343,684 -- --
Amortization of deferred compensation........... 109,954 95,083 109,271
Common stock issued as compensation............. -- 406,733 --
Equity interest loss............................ 105,931 -- --
Loss (gain) on investment....................... (3,386,808) -- 2,330,848
Loss on sale of fixed assets.................... 413,856 871 --
Changes in operating assets and liabilities:
Accrued interest receivable................... 100,004 140,025 (606,395)
Other current assets.......................... (232,604) 220,688 (293,909)
Accounts payable and accrued expenses......... (1,233,501) 1,077,350 183,680
Deferred revenue.............................. (1,842,948) 109,092 1,750,000
------------------------------------
NET CASH USED IN OPERATING ACTIVITIES............. (13,767,778) (10,038,228) (3,952,393)
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of Modex, net of cash
disposed........................................ 2,958,199 -- --
Purchases of marketable securities................ (14,182,521) (3,083,621) (48,127,842)
Proceeds from sales of marketable securities...... 23,736,242 14,924,200 24,139,057
Purchase of property, plant and equipment......... (7,710,126) (4,412,190) (1,405,522)
Proceeds on sale of fixed assets.................. 8,003,926 3,000 --
Purchase of other investment...................... (250,000) -- (500,100)
Acquisition of other assets....................... (1,599,418) (811,305) (550,116)
StemCells assets acquired......................... (640,490) -- --
Advance to Cognetix............................... 250,000 -- --
Repayment from Cognetix........................... (250,000) -- --
------------------------------------
NET CASH PROVIDED BY (USED IN) INVESTING
ACTIVITIES...................................... 10,315,812 6,620,084 (26,444,523)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of redeemable common
stock........................................... -- 8,300,000 --
Proceeds from issuance of common stock............ 1,905,380 1,668,542 30,837,792
Proceeds from the exercise of stock options and
warrants........................................ 245,179 980,697 466,642
Proceeds from debt financings..................... -- 4,059,947 859,832
Repayments of debt and lease obligations.......... (2,496,849) (1,171,926) (934,661)
------------------------------------
NET CASH PROVIDED BY (USED IN) FINANCING
ACTIVITIES...................................... (346,290) 13,837,260 31,229,605
Effect of exchange rate on cash and cash
equivalents..................................... (181,627) (46,111) --
------------------------------------
INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS..................................... (3,979,883) 10,373,005 832,689
Cash and cash equivalents, January 1.............. 19,921,584 9,548,579 8,715,890
------------------------------------
CASH AND CASH EQUIVALENTS, DECEMBER 31............ $15,941,701 $19,921,584 $9,548,579
------------------------------------
------------------------------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
INTEREST PAID................................... $ 436,461 $ 616,671 $ 700,806

See accompanying notes to consolidated financial statements.

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 1997

1. NATURE OF BUSINESS

CytoTherapeutics, Inc. (the "Company") is a biopharmaceutical company
engaged in the development of cell-based therapeutics designed to deliver
therapeutic substances to the central nervous system or regenerate damaged
tissue.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION

The 1997 consolidated financial statements include accounts of the Company
and StemCells, Inc., a wholly owned subsidiary. The 1996 consolidated financial
statements include accounts of the Company and Modex Therapeutiques SA, a
50%-owned subsidiary. Significant intercompany accounts have been eliminated in
consolidation.

USE OF ESTIMATES

The preparation of the consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates.

CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES

Cash and cash equivalents include funds held in investments with original
maturities of three months or less. The Company's policy regarding selection of
investments, pending their use, is to insure safety, liquidity, and capital
preservation while obtaining a reasonable rate of return. Marketable securities
consist of investments in agencies of the U.S. government, investment-grade
corporate notes and money market funds. The fair values for marketable
securities are based on quoted market prices.

The Company determines the appropriate classification of cash equivalents
and marketable securities at the time of purchase and reevaluates such
designation as of each balance sheet date. The Company has classified such
holdings as available-for-sale securities, which are carried at fair value, with
unrealized gains and losses reported as a separate component of stockholders'
equity.

PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment, including that held under capitalized lease
obligations, is stated at cost and depreciated using the straight-line method
over the estimated life of the respective asset, as follows:

Building and improvements...................................... 3 - 15
years
Machinery and equipment........................................ 3 - 10
years
Furniture and fixtures......................................... 3 - 10
years

PATENT COSTS

The Company capitalizes certain patent costs related to patent applications.
Accumulated costs are amortized over the estimated economic life of the patents,
not to exceed 17 years, using the straight-line method, commencing at the time
the patent is issued. Costs related to patent applications are written off to

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
expense at the time such patents are deemed to have no continuing value. At
December 31, 1997 and 1996, total costs capitalized were $3,486,000 and
$2,887,000 and the related accumulated amortization was $208,000 and $126,000,
respectively. Patent expense totaled $365,000, $249,000, and $195,000 in 1997,
1996 and 1995, respectively.

STOCK BASED COMPENSATION

The Company grants qualified stock options for a fixed number of shares to
employees with an exercise price equal to the fair market value of the shares at
the date of grant. The Company accounts for stock option grants in accordance
with APB Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and,
accordingly, recognizes no compensation expense for qualified stock option
grants.

For certain non-qualified stock options granted, the Company recognizes as
compensation expense the excess of the deemed fair value of the common stock
issuable upon exercise of such options over the aggregate exercise price of such
options. The compensation is amortized over the vesting period of each option or
the recipient's term of employment, if shorter.

INCOME TAXES

The liability method is used to account for income taxes. Deferred tax
assets and liabilities are determined based on differences between financial
reporting and income tax bases of assets and liabilities as well as net
operating loss carryforwards and are measured using the enacted tax rates and
laws that are expected to be in effect when the differences reverse. Deferred
tax assets may be reduced by a valuation allowance to reflect the uncertainty
associated with their ultimate realization.

REVENUE FROM COLLABORATIVE AGREEMENTS

Revenues from collaborative agreements are recognized as earned upon either
the incurrence of reimbursable expenses or the achievement of certain
milestones. Payments received in advance of research performed are designated as
deferred revenue.

FOREIGN CURRENCY TRANSLATION

Prior to the sale of a majority ownership position in Modex, assets and
liabilities of operations outside the United States are translated into United
States dollars using current exchange rates; revenue and expense items are
translated into United Stated dollars using a weighted average exchange rate for
the period. The gains and losses resulting from such translation are accumulated
as a separate component of shareholders' equity, whereas gains and losses
resulting from foreign currency transactions generally are included in results
of operations.

NET LOSS PER SHARE

Net loss per share is computed using the weighted average number of shares
of common stock outstanding. Common equivalent shares from stock options and
warrants are excluded, as their effect is antidilutive.

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
In 1997, the Company adopted Statement of Accounting Standards No. 128,
EARNINGS PER SHARE (EPS) which is effective for both interim and annual
financial statements for periods ended after December 15, 1997. Under Statement
128, primary EPS computed in accordance with Opinion 15 has been replaced with a
simpler calculation called basic EPS. Basic EPS is calculated by dividing income
available to common stockholders by the weighted average common shares
outstanding. Fully dilutive EPS did not change significantly, but has been
renamed diluted EPS. The adoption of Statement 128 had no effect on the
Company's financial statements since common equivalent shares from stock options
and warrants have been excluded as their effect is antidilutive.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

In June 1997, the FASB issued Statement No. 130, "REPORTING COMPREHENSIVE
INCOME," and Statement No. 131, "DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND
RELATED INFORMATION." Statement No. 130 establishes standards for reporting and
display of comprehensive income and its components. Statement No. 131
establishes standards for the way that public companies report information about
operating segments in financial statements. This Statement supersedes Statement
No. 14, "FINANCIAL REPORTING FOR SEGMENTS OF A BUSINESS ENTERPRISE," but retains
the requirements to report information about major customers. Statements 130 and
131 are effective for the Company in fiscal 1998. The Company does not believe
that the adoption of these Statements will have a material effect on the
Company's financial statements.

3. STEMCELLS, INC.

Upon consummation of the merger, the Company entered into consulting
arrangements with the principal scientific founders of StemCells: Dr. Irving
Weissman, Dr. Fred H. Gage and Dr. David Anderson. Additionally, in connection
with the merger, the Company was granted an option by the former principal
shareholders of StemCells to repurchase approximately 500,000 of the Company's
shares of Common Stock exchanged for StemCells shares, upon the occurrence of
certain events as defined.

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

3. STEMCELLS, INC. (CONTINUED)
options vest over eight years. In connection with the 469,000 options issued to
a non-employee, Dr. Anderson, the Company has recorded deferred compensation of
$1,750,000, the fair value of such options at the date of grant, which will be
amortized over an eight-year period. If the milestones specified relating to the
1,031,000 option grant are achieved, at that time the Company will record
compensation expense for the excess of the quoted market price of the common
stock over the exercise price of $5.25 per share for 562,000 options and the
fair market value for 469,000 of such options determined using the Black-Scholes
method. The Company has also designated a pool of 400,000 options to be granted
to persons in a position to make a significant contribution to the success of
the stem cell program.

Stem cell research will be conducted pursuant to the provisions of an
agreement between the Company and Drs. Weissman and Gage providing for a
two-year research plan. If the goals of the research plan are accomplished, the
Company has agreed to fund continuing stem cell research. Increases in stem
cells research funding of not more than 25% a year will be funded by the Company
as long as the goals of the research plan are being met. However, the Company
will retain the option of (i) ceasing or reducing neural stem cell research even
if all research plan goals are met, but will be required to accelerate the
vesting of all still-achievable performance based stock options, and (ii)
ceasing or reducing non-neural stem cell research even if all plan goals are
being met by affording the scientific research founders the opportunity to
continue development of the non-neural stem cell research by licensing the
technology related to such research to the founders in exchange for a payment to
the Company equal to all prior Company funding for such research, plus royalty
payments.

4. MODEX

In October 1997, the Company completed a series of transactions which
resulted in the establishment of its previously 50%-owned Swiss subsidiary,
Modex Therapeutiques SA ("Modex") as an independent company. In the
transactions, the Company reduced its ownership interest from 50% to
approximately 25% in exchange for $4 million cash and elimination of its prior
contingent obligation to contribute an additional Sfr 2.4 million (approximately
$1.7 million) to Modex in July 1998. In the transactions, all of the put and
call arrangements between the Company and other stockholders of Modex were
eliminated and the Company forgave $463,000 due from Modex to the Company. The
Company recorded a gain on the transactions of $3,387,000 and will account for
its now approximately 25% investment under the equity method.

The Company and Modex also modified the terms of their existing
royalty-bearing Cross License Agreement to (i) expand the field in which Modex
is exclusively licensed to apply the Company's proprietary encapsulated cell
technology to include, in addition to the original field of diabetes, obesity
and anemia, the treatment of hemophilia A and B utilizing Factor VIII and/or
Factor IX and two additional applications to be agreed to by the Company and
Modex; (ii) eliminate the requirement to make future milestone payments to Modex
of up to 300,000 shares of the Company's common stock; (iii) limit the scope of
the Company's technology licensed to Modex to existing and future encapsulation
technology; and (iv) specify the terms under which the Company will manufacture
any products Modex may develop based on the Company's technology and grant Modex
an option to manufacture or have manufactured such products on payment of a
higher royalty. The Cross License Agreement continues to provide for the payment
of royalties from Modex to the Company on the sale of any licensed products. The
revised agreement similarly limits the scope of the Modex technology exclusively
licensed, on a royalty-bearing

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

4. MODEX (CONTINUED)
basis, to the Company for the application of diseases, conditions and disorders
of the central nervous system to existing and future encapsulation technology
and certain additional existing technology.

5. MARKETABLE SECURITIES

The following is a summary of available-for-sale securities:

DECEMBER 31, 1997
------------------------------------------------
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
------------------------------------------------

U.S. government securities..................... $3,153,834 $ 92 $ (3,951) $3,149,975
U.S. corporate securities...................... 21,261,850 1,645 (6,663) 21,256,832
------------------------------------------------
Total debt securities.......................... $24,415,684 $ 1,737 $ (10,614 ) 24,406,807
------------------------------------
------------------------------------
Debt securities included in cash and cash
equivalents.................................. (11,298,310)
----------
Debt securities included in marketable
securities................................... $13,108,497
----------
----------

DECEMBER 31, 1996
------------------------------------------------
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
------------------------------------------------

U.S. government securities..................... $2,007,823 $ -- $ (14,023) $1,993,800
U.S. corporate securities...................... 21,651,507 28,784 -- 21,680,291
------------------------------------------------
Total debt securities.......................... $23,659,330 $ 28,784 $ (14,023 ) 23,674,091
------------------------------------
------------------------------------
Debt securities included in cash and cash
equivalents.................................. (988,236)
----------
Debt securities included in marketable
securities................................... $22,685,855
----------
----------

Maturities of marketable securities held at December 31, 1997, are as follows:

Less than one year............................................................. $22,397,607
One through five years......................................................... 2,009,200
----------
$24,406,807
----------
----------

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

6. OTHER INVESTMENT

In December 1993, the Company sold substantially all of the assets of its
primary cell diabetes product development program, including related equipment,
and licensed related intellectual property to Neocrin Company in exchange for
preferred stock representing a then 10% ownership interest with a fair market
value of $2,030,748. The transaction resulted in a gain before closing expenses
of $1,957,913 and a net gain of $1,780,209. In February 1995, the Company
purchased an additional $500,100 of Neocrin's preferred stock at the current
market value, as required under the original purchase agreement.

In December 1995, Neocrin completed an equity offering, in which the Company
did not participate, at a valuation substantially lower than prior financings.
As a result, the Company determined that the carrying value in its investment
had been permanently impaired and provided a $2,330,848 valuation reserve to
reduce the investment value to $200,000.

7. PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment consists of the following:

DECEMBER 31,
---------------------------
1997 1996

---------------------------
Land....................................................................... $ -- $ 278,774
Building and improvements.................................................. 4,977,906 6,207,679
Machinery and equipment.................................................... 8,549,405 7,554,825
Furniture and fixtures..................................................... 717,377 1,424,907
Construction in progress................................................... 23,947 2,214,318
---------------------------
14,268,635 17,680,503
Less accumulated depreciation and amortization............................. 6,345,884 6,948,401
---------------------------
$ 7,922,751 $ 10,732,102
---------------------------
---------------------------

Depreciation and amortization expense was $1,778,000, $1,564,000, and
$1,431,000 for the years ending December 31, 1997, 1996 and 1995, respectively.

Certain property, plant and equipment have been acquired under capitalized
lease obligations. These assets totaled $6,587,000 and $8,910,000, at December
31, 1997 and 1996, respectively, with related accumulated amortization of
$2,297,000 and $3,947,000 at December 31, 1997 and 1996, respectively.

In connection with the Company's new facility, the Company capitalized
$210,000 and $42,000 of interest costs in 1997 and 1996, respectively.

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

8. OTHER ASSETS

Other assets are as follows:

DECEMBER 31,
--------------------------
1997 1996

--------------------------
Patents, net................................................................ $ 3,278,709 $ 2,760,593
License agreements, net..................................................... 1,036,750 --
Security deposit--building lease............................................ 750,000 --
Restricted cash............................................................. 552,357 497,956
Other investments........................................................... 450,000 200,000
Deferred financing costs, net............................................... 131,507 297,698
Organizational costs, net................................................... -- 156,183
--------------------------
$ 6,199,323 $ 3,912,430
--------------------------
--------------------------

At December 31, 1997 and 1996, accumulated amortization was $302,000 and
$126,000, respectively, for patents and license agreements.

9. ACCRUED EXPENSES

Accrued expenses are as follows:

DECEMBER 31,
--------------------------
1997 1996

--------------------------
External services........................................................... $ 1,709,818 $ 537,605
Employee compensation....................................................... 755,951 824,910
Collaborative research...................................................... 499,575 413,497
Other....................................................................... 276,203 532,832
--------------------------
$ 3,241,547 $ 2,308,844
--------------------------
--------------------------

10. LEASES

The Company has undertaken direct financing transactions with the State of
Rhode Island and received proceeds from the issuance of industrial revenue bonds
totaling $5,000,000 to finance the construction of its pilot manufacturing
facility. The related leases are structured such that lease payments will fully
fund all semiannual interest payments and annual principal payments through
maturity in August 2014. Fixed interest rates vary with the respective bonds'
maturities, ranging from 5.1% to 9.5%. The bonds contain certain restrictive
covenants which limit, among other things, the payment of cash dividends and the
sale of assets. In addition, the Company is required to maintain a debt service
reserve, which totals $532,000, until December 1999.

In 1997, the Company completed construction of a new headquarters and
laboratory facility. In November 1997, the Company entered into sale and
leaseback agreement with a real estate investment trust. Under the terms of
these agreements, the Company sold its new facility for $8,000,000 incurring a
$342,000 loss on the sale. The Company simultaneously entered into a
fifteen-year lease for the facility. The lease agreement calls for minimum rent
of $750,000 for the first five years, $937,500 for years six to

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

10. LEASES (CONTINUED)
ten, $1,171,900 for years eleven to fourteen and $1,465,000 in year fifteen with
a $750,000 security deposit held for the term of the lease.

Future minimum capitalized lease obligations with noncancelable terms in
excess of one year at December 31, 1997, are as follows:

1998............................................................ $ 753,788
1999............................................................ 624,030
2000............................................................ 607,518
2001............................................................ 589,634
2002............................................................ 510,553
Thereafter...................................................... 3,568,452
---------
Total minimum lease payments.................................... 6,653,975
Less amounts representing interest.............................. 2,682,380
---------
Present value of minimum lease payments......................... 3,971,595
Less current maturities......................................... 419,095
---------
Capitalized lease obligations, less current maturities.......... $3,552,500
---------
---------

Rent expense for the years ended December 31, 1997, 1996 and 1995, was
$499,000, $495,000, and $463,000, respectively.

11. LONG-TERM DEBT

Long-term debt is as follows:

DECEMBER 31,
--------------------------
1997 1996

--------------------------
Term note payable, interest at the prime rate plus 1/2% (9% at December 31,
1997), principal payments commence in August 1998, due ratably through May
2000; secured by certain equipment........................................ $ 740,700 $ 740,700
Term note payable, interest at the prime rate plus 1/2% (9% at December 31,
1997), due ratably through December 1998; secured by certain equipment.... 432,588 867,227
Convertible subordinated note (Sfr 2,400,000)............................... -- 1,788,775
Facilities term note payable................................................ -- 1,450,000
Other....................................................................... 41,223 99,876
--------------------------
1,214,511 4,946,578
Current maturities of long-term debt........................................ 658,986 695,570
--------------------------
Long-term debt, less current maturities..................................... $ 555,525 $ 4,251,008
--------------------------
--------------------------

Both term note agreements include certain restrictive covenants that limit,
among other things, the payment of dividends, sale of assets and the incurrence
of additional indebtedness. As noted above, in

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

11. LONG-TERM DEBT (CONTINUED)
1997, the Company ceased to consolidate the accounts of Modex Therapeutiques SA,
which included the convertible subordinated note. In conjunction with the sale
and leaseback of the Company's headquarters facility in 1997, the facilities
term note was repaid.

Maturities of long-term debt for the years ending December 31 are as
follows:

1998............................................ $ 658,986
1999............................................ 370,350
2000............................................ 185,175
---------
$1,214,511
---------
---------

12. REDEEMABLE COMMON STOCK

Under a research agreement to fund development of products to treat
Parkinson's disease (see Note 15), Genentech, Inc. purchased 829,171 shares of
common stock for $8.3 million in December 1996. If the agreement is terminated
and the funds received from the sale of common stock exceed by more than $1
million the expenses incurred by the Company in connection with such
development, Genentech, Inc. has the right to require the Company to repurchase
shares of its Common Stock having a value equal to the amount of overfunding, at
the share price paid by Genentech. Accordingly, the common stock is classified
as redeemable common stock until such time as the related funds are expended. At
December 31, 1997, $2,717,000 had been spent on the collaboration with Genentech
and, accordingly, the Company has reclassified those common shares and related
value to stockholders' equity.

13. COMMON STOCK TO BE ISSUED

The merger with StemCells, Inc. required that StemCells shareholders tender
their StemCells shares and receive shares of CytoTherapeutics in exchange. At
December 31, 1997, 27,087 shares of StemCells common stock and promissory notes
totaling $168,750 remained to be tendered in exchange for 101,310 shares of
CytoTherapeutics' Common Stock with a value of $506,600 at the date of merger.

14. STOCKHOLDERS' EQUITY

STOCK OPTION AND EMPLOYEE STOCK PURCHASE PLANS

The Company has adopted several stock plans which provide for the issuance
of incentive and nonqualified stock options, performance awards and stock
appreciation rights, at prices to be determined by the Board of Directors, as
well as the purchase of Common Stock under an employee stock purchase plan at a
discount to the market price. In the case of incentive stock options, such price
will not be less than the fair market value on the date of grant or within 3
months of termination. Options generally vest ratably over four years and are
exercisable for ten years from the date of grant or within three months of
termination. At December 31, 1997, the Company had reserved 3,116,312 shares of
common stock for the exercise of stock options.

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

14. STOCKHOLDERS' EQUITY (CONTINUED)
The following table presents the combined activity of the Company's stock
option plans (exclusive of the plans noted below) for the years ended December
31:

1997 1996 1995
--------------------------- --------------------------- ---------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
OPTIONS EXERCISE PRICE OPTIONS EXERCISE PRICE OPTIONS EXERCISE PRICE

-------------------------------------------------------------------------------------
Outstanding at January 1.............. 2,423,025 $ 8.34 1,921,284 $ 7.72 1,480,844 $ 7.21
Granted............................... 679,074 5.33 852,160 9.48 678,604 8.35
Exercised............................. (82,737) 2.96 (168,085) 5.83 (102,831) 4.54
Canceled.............................. (572,789) 9.21 (182,334) 9.42 (135,333) 7.77
-------------------------------------------------------------------------------------
Outstanding at December 31............ 2,446,573 $ 7.48 2,423,025 $ 8.34 1,921,284 $ 7.72
-------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------
Options exercisable at
December 31......................... 1,338,163 $ 7.79 1,105,251 $ 7.11 839,260 $ 6.33
-------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------

In addition to the options noted above, in conjunction with the StemCells
merger, StemCell's options were exchanged for options to purchase 250,344 shares
of the Company's common stock at $.01 per share originally issued under a prior
StemCells option plan; 75,384 of these options are exercisable at December 31,
1997, 96,750 of these options vest and become exercisable only upon achievement
of specified milestones, and the remaining 78,210 options vest over three years
from the date of grant. Additionally, the Company adopted the 1997
CytoTherapeutics, Inc. StemCells Research Stock Option Plan (the StemCells
Research Plan) whereby an additional 2,000,000 shares of common stock has been
reserved. During 1997, the Company awarded options under the StemCells Research
Plan to purchase 1.6 million shares of the Company's Common Stock to the Chief
Executive Officer and scientific founders of StemCells at an exercise price of
$5.25 per share; approximately 100,000 of these options are exercisable
immediately, 1,031,000 of these options vest and become exercisable only upon
achievement of specified milestones and the remaining 469,000 options vest over
eight years.

FAS 123 DISCLOSURES

The Company has adopted the disclosure provisions only of Statement of
Financial Accounting Standards No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION
("FAS 123") and will continue to account for its stock option plans in
accordance with the provisions of APB 25, ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES.

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

14. STOCKHOLDERS' EQUITY (CONTINUED)
The following table presents weighted average price and life information
about significant option groups outstanding at December 31, 1997:

OPTIONS OUTSTANDING
------------------------------------- OPTIONS EXERCISABLE
WEIGHTED -----------------------
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
RANGE OF EXERCISE PRICES OUTSTANDING LIFE (YRS.) PRICE EXERCISABLE PRICE

--------------------------------------------------------------
Less than $5.00..................................... 286,189 4.85 $ 1.85 256,216 $ 1.73
$5.01 - $10.00...................................... 1,593,654 8.13 6.89 662,756 7.59
Greater than $10.00................................. 566,730 6.74 12.01 419,191 11.81
----------- ----------
2,446,573 1,338,163
----------- ----------
----------- ----------

Pursuant to the requirements of FAS 123, the following are the pro forma net
loss and net loss per share for 1997, 1996, and 1995, as if the compensation
cost for the option plans and the stock purchase plan had been determined based
on the fair value at the grant date for grants in 1997, 1996, and 1995,
consistent with the provisions of FAS 123:

--------------------------------------------------------------------------------------------
1997 1996 1995

AS REPORTED PRO FORMA AS REPORTED PRO FORMA AS REPORTED PRO FORMA
--------------------------------------------------------------------------------------------
Net loss................... $ (18,113,580) $ (19,924,437) $ (13,759,138) $ (14,931,000) $ (8,891,239) $ (9,161,000)
Net loss per share......... $ (1.08) $ (1.19) $ (.89) $ (.97) $ (.69) $ (.72)

The weighted average fair value per share of options granted during 1997,
1996 and 1995, was $3.40, $5.67, and $4.84, respectively. The fair value of
options and shares issued pursuant to the stock purchase plan at the date of
grant were estimated using the Black-Scholes model with the following weighted
average assumptions:

----------------------------------------------------------------
OPTIONS STOCK PURCHASE PLAN

1997 1996 1995 1997 1996 1995
----------------------------------------------------------------
Expected life (years)........................................ 5 5 5 .5 5 .5
Interest rate................................................ 6.2% 6.5% 5.8% 5.5% 6.5% 5.1%
Volatility................................................... 59.0% 63.0% 62.0% 59.0% 63.0% 62.0%

The Company has never declared nor paid dividends on any of its capital
stock and does not expect to do so in the foreseeable future.

The effects on 1997, 1996 and 1995 pro forma net loss and net loss per share
of expensing the estimated fair value of stock options and shares issued
pursuant to the stock purchase plan are not necessarily representative of the
effects on reporting the results of operations for future years as the period
presented includes only one, two and three years, respectively, of option grants
under the Company's plans. As required by FAS 123, the Company has used the
Black-Scholes model for option valuation, which method may not accurately value
the options described.

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

14. STOCKHOLDERS' EQUITY (CONTINUED)
STOCK WARRANTS

In conjunction with StemCells merger, the Company has exchanged StemCells
warrants for warrants to purchase 8,952 shares of Company common stock at $4.71
per share. In conjunction with various equipment leasing agreements, the Company
has outstanding warrants to purchase 31,545 shares of common stock at prices
ranging from $4.00 to $9.00 per share. The warrants expire through October 2000.

In connection with a public offering of common stock in April 1995, the
Company issued warrants to purchase 434,500 shares of common stock at $8 per
share. The warrants are nontransferable and expire in April 2000, subject to
certain required exercise provisions. In addition to the foregoing rights, the
holder of such warrants has the right, in the event the Company issues
additional shares of common stock or other securities convertible into common
stock, to purchase at the then market price of such common stock, sufficient
additional shares of common stock to maintain the warrant holder's percentage
ownership of the Company's Common Stock at 15%. This right, subject to certain
conditions and limitations, expires in April 2000.

COMMON STOCK RESERVED

The Company has reserved 7,374,000 shares of common stock for the exercise
of options, warrants and other contingent issuances of common stock.

15. RESEARCH AGREEMENTS

In November 1997, StemCells, Inc., a wholly-owned subsidiary of the Company,
signed a Research Funding and Option Agreement with The Scripps Research
Institute ("Scripps") relating to stem-cell research. Under the terms of the
Agreement, StemCells agreed to fund $931,000 of research at Scripps over a
period of three years. StemCells has paid $77,000 at December 31, 1997. In
addition, the Company agreed to issue to Scripps 4,837 shares of the Company's
common stock and a stock option to purchase 9,674 shares of the Company's Common
Stock with an exercise price of $.01 per share upon the achievement of specified
milestones. Under the Agreement, StemCells has an option for an exclusive
license to the inventions resulting from the sponsored research, subject to the
payment of royalties and certain other amounts, and is obligated to make
payments totaling $425,000 for achievement of certain milestones.

In February 1997, the Company and Cognetix, Inc. entered into a
Collaboration and Development Agreement to screen selected peptides isolated by
Cognetix for possible development into therapeutic products aimed at a broad
range of human disease states using CytoTherapeutic's cell-based delivery
technology. Continuation of the Agreement is contingent upon meeting an
agreed-upon proof of concept test. The companies will generally share expenses
associated with the development of any specific product candidate and any
resulting revenues, except as otherwise determined on a product-by-product
basis. As part of the agreement with Cognetix, the Company has purchased
$250,000 of Cognetix preferred stock and, subject to certain milestones, is
obligated to purchase as much as $1,500,000 of additional Cognetix stock over
the next year. In July 1997, the Company loaned $250,000 to Cognetix which was
repaid with interest in October 1997.

In 1997, the Company entered into an agreement with Neurospheres, Ltd. which
superseded all previous licensing agreements and settled a dispute with
Neurospheres. Under the terms of the settlement,

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

15. RESEARCH AGREEMENTS (CONTINUED)
the Company has an exclusive royalty bearing license for growth-factor
responsive stem cells for transplantation and Neurospheres has an option to
acquire co-exclusive rights in exchange for an upfront payment of $5,000,000.
Neurospheres' option expires in 1998, if unexercised. The parties have no
further research obligations to each other.

In November 1996, the Company signed collaborative development and licensing
agreements with Genentech, Inc. relating to the development of products using
the Company's technology to deliver certain of Genentech's proprietary growth
factors to treat certain diseases of the central nervous system. Under the terms
of the agreement, Genentech purchased 829,171 shares of redeemable common stock
for $8.3 million to fund development of products to treat Parkinson's disease.
Additional equity purchases and other funding by Genentech may be available for
future clinical development if agreed by the parties. Upon commercialization,
Genentech and the Company will share profits from product sales in the United
States at an agreed upon percentage and Genentech will pay the Company a royalty
for product sales outside the U.S. The Company retained manufacturing rights for
all products sold.

The Company also licensed growth factors for the treatment of Huntington's
disease and for amyotrophic lateral sclerosis ("ALS"). Under the terms of the
agreements, the Company is responsible for conducting and funding all
preclinical and clinical development, subject to specified rights of Genentech
to participate in the development and marketing of the proposed products. Should
Genentech share in the development costs of the proposed products, the companies
will share profits from certain territories at negotiated percentages. Where
Genentech does not participate in the development, upon commercialization, the
Company will pay Genentech an agreed upon royalty based on sales.

In March 1995, the Company signed a collaborative research and development
agreement with Astra AB for the development and marketing of encapsulated-cell
products to treat pain. Astra made an initial, nonrefundable payment of
$5,000,000, included in revenue from collaborative agreements in 1995, a
milestone payment of $3,000,000 in 1997 and may remit up to an additional
$13,000,000 subject to the achievement of certain development milestones. Under
the agreement, the Company is obligated to conduct certain research and
development pursuant to a four-year research plan agreed upon by the parties.
Over the term of the research plan, the Company expects to receive annual
payments of $5 million to $7 million from Astra which should approximate the
research and development costs incurred by the Company under the Plan. Subject
to successful product development and obtaining necessary regulatory approvals,
Astra is obligated to conduct all clinical trials of products arising from the
collaboration and to seek approval for their sale. Astra has the exclusive
worldwide right to market products covered by the agreement. Until the later of
either expiration of all patents included in the licensed technology or a
specified term, the Company is entitled to a royalty on the worldwide net sales
of such products in return for the marketing license granted to Astra and the
Company's obligation to manufacture and supply products. Astra has the right to
terminate the agreement after April 1, 1998.

The Company has entered into other collaborative research agreements whereby
the Company funds specific research programs. Pursuant to such agreements, the
Company is typically granted rights to the related intellectual property or an
option to obtain such rights on terms to be agreed, in exchange for research
funding and specified royalties on any resulting product revenue. To date, the
Company's principal academic collaborations have been with Brown University and
Dr. Aebischer and Centre Hospitalier Universitaire Vaudois in Switzerland.
Research and development expenses incurred under

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

15. RESEARCH AGREEMENTS (CONTINUED)
these collaborations amounted to approximately $1,326,000, $1,337,000, and
$1,008,000 for the years ended December 31, 1997, 1996 and 1995, respectively.

16. INCOME TAXES

Due to net losses incurred by the Company in each year since inception, no
provision for income taxes has been recorded. At December 31, 1997, the Company
had tax net operating loss carryforwards of $24,943,000 and research and
development tax credit carryforwards of $2,963,000 which expire at various times
through 2012. Due to the "change in ownership" provisions of the Tax Reform Act
of 1986, the Company's utilization of its net operating loss carryforwards and
tax credits may be subject to annual limitation in future periods.

Significant components of the Company's deferred tax assets and liabilities
are as follows:

DECEMBER 31,
------------------------------
1997 1996

------------------------------
Deferred tax assets:
Capitalized research and development costs............................ $ 23,876,000 $ 21,286,000
Net operating losses.................................................. 9,977,000 8,648,000
Research and development credits...................................... 2,963,000 2,251,000
Other................................................................. 275,000 316,000
------------------------------
37,091,000 32,501,000
Deferred tax liabilities:
Patents............................................................... 1,296,000 1,096,000
------------------------------
35,795,000 31,405,000
Valuation allowance................................................... (35,795,000) (31,405,000)
------------------------------
Net deferred tax assets................................................. $ -- $ --
------------------------------
------------------------------

Since there is uncertainty relating to the ultimate use of the loss
carryforwards and tax credits, a valuation allowance has been recognized at
December 31, 1997 and 1996, to fully offset the Company's deferred tax assets.
The valuation allowance increased $4,390,000 in 1997, due primarily to the
increases in capitalized research and development costs, net operating loss
carryforwards and tax credits.

17. EMPLOYEE RETIREMENT PLAN

The Company has a qualified defined contribution plan covering substantially
all employees. Participants are allowed to contribute a fixed percentage of
their annual compensation to the plan and the Company may match a percentage of
that contribution. The Company matches 50% of employee contributions, up to 6%
of employee compensation, with the Company's common stock. The related expense
was $169,000, $162,000, and $131,000 for the years ended December 31, 1997, 1996
and 1995, respectively.

CYTOTHERAPEUTICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1997

18. CONTINGENCIES

The Company is routinely involved in arbitration, litigation and other
matters as part of the ordinary course of its business. While the resolution of
any matter may have an impact on the Company's financial results for a
particular reporting period, management believes the ultimate disposition of
these matters will not have a materially adverse effect on the Company's
consolidated financial position or results of operations.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT, PROMOTERS AND
CONTROL PERSONS

DIRECTORS AND EXECUTIVE OFFICERS

The sections entitled "Election of Directors" and "Executive Officer" in the
Company's definitive proxy statement for its 1998 Annual Meeting of Shareholders
are hereby incorporated by reference.

ITEM 11. EXECUTIVE COMPENSATION

The section entitled "Executive Compensation" in the Company's definitive
proxy statement for its 1998 Annual Meeting of Shareholders is hereby
incorporated by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The section entitled "Share Ownership" in the Company's definitive proxy
statement for its 1998 Annual Meeting of Shareholders is hereby incorporated by
reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The section entitled "Certain Relationships and Related Transactions" in the
Company's definitive proxy statement for its 1998 Annual Meeting of Shareholders
is hereby incorporated by reference.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) DOCUMENTS FILED AS PART OF THIS FORM 10-K.

(1) Financial Statement Schedules:

ITEM LOCATION
- ------------------------------------------------------------------------------------ -------------

Schedule II--Valuation and Qualifying Accounts S-1

Schedules not included herein are omitted because they are not applicable or
the required information appears in the Financial Statements or Notes thereto.

(2) Exhibits.

EXHIBIT NO. TITLE OR DESCRIPTION
- ----------------- -----------------------------------------------------------------------------------------------

3.1* Restated Certificate of Incorporation of the Registrant.

3.2++ Amended and Restated By-Laws of the Registrant.

4.1* Specimen Common Stock Certificate.

4.2++++ Form of Warrant Certificate issued to a certain purchaser of the Registrant's Common Stock in
April 1995.

10.4* Amendment to Registration Rights dated as of February 14, 1992 among the Registrant and certain
of its stockholders.

10.5* ** Research Agreement dated March 1, 1989 between the Registrant and Brown University as amended
by Modification No. 1 dated December 21, 1990, Modification No. 2 dated February 22, 1991 and
Modification No. 3 dated November 1, 1991.

EXHIBIT NO. TITLE OR DESCRIPTION
- ----------------- -----------------------------------------------------------------------------------------------

10.5A* Letter Agreement dated March 4, 1992 between the Registrant and Brown University.

10.6* License Agreement dated March 16, 1989 between the Registrant and Brown University, as amended
by Amendment Agreement dated May 2, 1991.

10.7* Research Agreement dated March 16, 1989 between Registrant and Washington University.

10.12* Employment Agreement dated January 3, 1991 between the Registrant and Dr. Seth A. Rudnick.

10.15* Form of at-will Employment Agreement between the Registrant and most of its employees.

10.16* Agreement for Consulting Services dated March 16, 1989 between the Registrant and Dr. Patrick
Aebischer.

10.18* Agreement for Consulting Services dated March 16, 1989 between the Registrant and Dr. Paul
Lacy.

10.20* Form of Agreement for Consulting Services between the Registrant and members of its Scientific
Advisory Board.

10.21* Form of Nondisclosure Agreement between the Registrant and its Contractors.

10.22* Funding Agreement dated June 22, 1989 between the Registrant and the Rhode Island Partnership
for Science and Technology.

10.28* Master Lease and Warrant Agreement dated April 23, 1991 between the Registrant and PacifiCorp
Credit, Inc.

10.29* 1988 Stock Option Plan.

10.30* 1992 Equity Incentive Plan.

10.31* 1992 Stock Option Plan for Non-Employee Directors.

10.32* 1992 Employee Stock Purchase Plan.

10.35# Consulting Agreement dated as of September 1, 1992 between Dr. Edwin C. Cadman and the
Registrant.

10.36**# Letter Agreement between Registrant and Dr. Patrick Aebischer dated October 13, 1992 as amended
by a letter agreement dated December 23, 1993.

10.37+ Employment Agreement dated September 9, 1992 between Registrant and Frederic A. Eustis, III.

10.41**!!!! Development and Supply Agreement dated December 1993, between Registrant and AKZO Faser AG.

10.42**!!!! Asset Transfer Agreement dated as of December 23, 1994, between Registrant and Neocrin Company.

10.43##** Research Agreement dated as of February 1, 1994 between Genentech, Inc. and Registrant.

10.44##** Research Agreement dated as of March 16, 1994 between NeuroSpheres, Ltd. and Registrant.

EXHIBIT NO. TITLE OR DESCRIPTION
- ----------------- -----------------------------------------------------------------------------------------------

10.46++ Termination Agreement dated as of August 4, 1994 between Registrant and Medtronic, Inc.

10.47++ Term Loan Agreement dated as of September 30, 1994 between The First National Bank of Boston
and Registrant.

10.48++ Lease Agreement between the Registrant and Rhode Island Industrial Facilities Corporation,
dated as of August 1, 1992.

10.49++ First Amendment to Lease Agreement between Registrant and The Rhode Island Industrial
Facilities Corporation dated as of September 15, 1994.

10.50++ Supplementary Agreement dated as of July 1, 1994 between Akzo Nobel Faser AG and the
Registrant.

10.51**++++ Development, Marketing and License Agreement, dated as of March 30, 1995, between Registrant
and Astra AB.

10.52++++ Form of Unit Purchase Agreement to be executed by the purchasers of the Common Stock and
Warrants offered in April 1995.

10.53+++ Form of Common Stock Purchase Agreement to be executed among the Registrant and certain
purchasers of the Registrant's Common Stock.

10.54!** Research and Commercialization Agreement dated as of September 4, 1995 among the Company, Dr.
Patrick Aebischer and Canton of Vaud, Switzerland.

10.55!! Employment agreement dated as of July 2, 1996 between Dr. Sandra Nusinoff Lehrman and
Registrant.

10.56!! Consulting agreement dated as of September 1, 1996 between Dr. Edwin C. Cadman and the
Registrant.

10.57!! Convertible loan agreement dated as of July 10, 1996 between the Company and Modex
Therapeutiques SA.

10.58 Lease Agreement dated as of November 21, 1997 by and between Hub RI Properties Trust, as
Landlord, and CytoTherapeutics, Inc., as Tenant.

10.59!! Modex Therapeutiques SA stockholders voting agreement dated as of July 10, 1996 among Modex,
the Company, the Societe Financiere Valoria SA and the other stockholders listed therein.

10.60!! CTI individual stockholders option agreement dated as of July 10, 1996 among the Company and
the individuals listed therein.

10.61!! CTI--Valoria option agreement dated of July 10, 1996 between the Company and the Societe
Financiere Valoria SA.

10.62**!!! Development Collaboration and License Agreement dated as of November 22, 1996 between
Genentech, Inc. and the Registrant.

10.63!!! Consulting Agreement dated as of December 1, 1996, between Peter Simon and the Registrant.

10.64!!! Term Loan Agreement dated as of October 22, 1996 between The First National Bank of Boston and
the Registrant.

EXHIBIT NO. TITLE OR DESCRIPTION
- ----------------- -----------------------------------------------------------------------------------------------

10.65*** Agreement and Plan of Merger dated as of August 13, 1997 among StemCells, Inc., the Registrant
and CTI Acquisition Corp.

10.67*** Consulting Agreement dated as of September 25, 1997 between Dr. Irving Weissman and the
Registrant.

10.68 Letter Agreement between each of Dr. Irving Weissman and Dr. Fred H. Gage and the Registrant.

10.69** Amended and Restated Cross License Agreement dated as of October 29, 1997 between Modex
Therapeutiques SA and the Registrant.

10.70 Letter Agreement dated as of September 30, 1997 between Dr. Seth Rudnick and the Registrant.

10.71**** StemCells, Inc. 1996 Stock Option Plan.

10.72**** 1997 StemCells Research Stock Option Plan (the "1997 Plan").

10.73**** Form of Performance-Based Incentive Option Agreement issued under the 1997 Plan.

10.74 Employment Agreement dated as of September 25, 1997 between Dr. Richard M. Rose and the
Registrant.

10.75 Employment agreement dated as of April 17, 1997, between John S. McBride and the Registrant.

10.76 Severance agreement dated as of July 21, 1997, between Dr. Sandra Nusinoff Lehrman and the
Registrant.

10.77 Severance agreement dated as of July 29, 1997 between Dr. E. Edward Baetge and the Registrant.

10.78 Loan Agreement dated as of May 15, 1996 between Fleet National Bank and Registrant together
with the related Promissory Note executed by Registrant and an amendatory agreement dated as of
May 15, 1997.

21 Subsidiaries of the Registrant.

23.1 Consent of Ernst & Young LLP, Independent Auditors.

27 Financial Data Schedule for fiscal year ended December 31, 1997.

99 Cautionary Factors Relevant to Forward-Looking Information.

- ------------------------

++ Previously filed with the Commission as Exhibits to, and incorporated
herein by reference to, the Registrant's Registration Statement on Form
S-1, File No. 33-85494.

+++ Previously filed with the Commission as Exhibits to, and incorporated
herein by reference to, the Registrant's Registration Statement on Form
S-3, File No. 33-97272.

++++ Previously filed with the Commission as Exhibits to, and incorporated
herein by reference to, the Registrant's Registration Statement on Form
S-1, File No. 33-91228.

* Previously filed with the Commission as Exhibits to, and incorporated
herein by reference to, Registration Statement on Form S-1, File No.
33-45739.

# Previously filed with the Commission as Exhibits to, and incorporated
herein by reference to, the Registrant's Annual Report on Form 10-K for
fiscal year ended December 31, 1992 and filed March 30, 1993.

** Confidential treatment requested as to certain portions. The term
"confidential treatment" and the mark "**" as used throughout the
indicated Exhibits mean that material has been omitted and separately
filed with the Commission.

## Previously filed with the Commission as Exhibits to, and incorporated
herein by reference to, the Registrant's Quarterly Report on Form 10-Q for
the quarter ended March 31, 1994 and filed on May 14, 1994.

+ Previously filed with the Commission as Exhibits to, and incorporated
herein by reference to, the Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1993 and filed on March 30, 1994.

! Previously filed with the Commission as an Exhibit to and incorporated
by reference to, the Registrant's Quarterly Report on Form 10-Q for the
quarter ended March 31, 1996.

!! Previously filed with the Commission as an Exhibit to and incorporated
by reference to, the Registrant's Quarterly Report on Form 10-Q for the
quarter ended September 30, 1996.

!!! Previously filed with the Commission as an Exhibit to, and incorporated
herein by reference to, the Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1996 and filed on March 31, 1997.

!!!! Previously filed with the Commission as an Exhibit to, and incorporated
herein by reference to, the Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1995.

*** Previously filed with the Commission as Exhibits to, and incorporated
herein by reference to, the Registrant's Quarterly Report on Form 10-Q
for the quarter ended September 30, 1997 and filed on November 14, 1997.

**** Previously filed with the Commission as Exhibits to, and incorporated
herein by reference to, the Registrant's Registration Statement on Form
S-8, File No. 333-37313.

(b) CURRENT REPORTS ON FORM 8-K.

On October 7, 1997, the Company filed a Report on Form 8-K with the
Securities and Exchange Commission describing the StemCells, Inc. arrangements.
See "Subsidiary--StemCells, Inc."

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
behalf by the undersigned, thereunto duly authorized.

CYTOTHERAPEUTICS, INC.

BY: /S/ RICHARD M. ROSE, M.D.
-----------------------------------------
Richard M. Rose, M.D.
President and Chief Executive Officer

Dated: March 30, 1998

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

SIGNATURE CAPACITY DATE
- ------------------------------ --------------------------- -------------------

President, Chief Executive
/s/ RICHARD M. ROSE, M.D. Officer, and Director
- ------------------------------ (principal executive March 30, 1998
Richard M. Rose, M.D. officer)

Chief Financial Officer and
Treasurer (principal
/s/ JOHN S. MCBRIDE financial and accounting
- ------------------------------ officer); Senior Vice March 30, 1998
John S. McBride President, Business
Operations

/s/ PATRICK AEBISCHER, M.D., Director
PH.D.
- ------------------------------ March 30, 1998
Patrick Aebischer, M.D., Ph.D.

/s/ EDWIN C. CADMAN, M.D. Director
- ------------------------------ March 30, 1998
Edwin C. Cadman, M.D.

/s/ DONALD R. CONKLIN Director
- ------------------------------ March 30, 1998
Donald R. Conklin

/s/ MARK J. LEVIN Director
- ------------------------------ March 30, 1998
Mark J. Levin

/s/ SETH A. RUDNICK, M.D. Chairman of the Board
- ------------------------------ March 30, 1998
Seth A. Rudnick, M.D.

/s/ RICHARD J. RAMSDEN Director
- ------------------------------ March 30, 1998
Richard J. Ramsden

/s/ PETER K. SIMON Director
- ------------------------------ March 30, 1998
Peter K. Simon

/s/ IRVING L. WEISSMAN, M.D. Director
- ------------------------------ March 30, 1998
Irving L. Weissman, M.D.

(This page has been left blank intentionally.)

EXHIBIT 99

CAUTIONARY FACTORS RELEVANT TO FORWARD-LOOKING INFORMATION

CYTOTHERAPEUTICS, INC. (THE "COMPANY") WISHES TO CAUTION READERS THAT THE
FOLLOWING IMPORTANT FACTORS, AMONG OTHERS, IN SOME CASES HAVE AFFECTED AND IN
THE FUTURE COULD AFFECT THE COMPANY'S RESULTS AND COULD CAUSE ACTUAL RESULTS AND
NEEDS OF THE COMPANY TO VARY MATERIALLY FROM FORWARD-LOOKING STATEMENTS MADE IN
THIS ANNUAL REPORT BY THE COMPANY ON THE BASIS OF MANAGEMENT'S CURRENT
EXPECTATIONS. THE BUSINESS IN WHICH THE COMPANY IS ENGAGED IS RAPIDLY CHANGING,
EXTREMELY COMPETITIVE AND INVOLVES A HIGH DEGREE OF RISK, AND ACCURACY WITH
RESPECT TO FORWARD-LOOKING PROJECTIONS IS DIFFICULT.

EARLY STAGE DEVELOPMENT; HISTORY OF OPERATING LOSSES -- Substantially all of
the Company's revenues to date have been derived, and for the foreseeable future
substantially all of the Company's revenues will be derived, from collaborative
agreements, research grants and income earned on invested funds. The Company
will incur substantial operating losses in the future as the Company conducts
its research, development, clinical trial and manufacturing activities. There
can be no assurance that the Company will achieve revenues from product sales or
become profitable.

FUTURE CAPITAL NEEDS; UNCERTAINTY OF ADDITIONAL FUNDING -- The development
of the Company's products will require the commitment of substantial resources
to conduct the time-consuming research, preclinical development and clinical
trials that are necessary for regulatory approvals and to establish production
and marketing capabilities, if such approvals are obtained. The Company will
need to raise substantial additional funds to continue its product development
efforts and intends to seek such additional funds through partnership,
collaborative or other arrangements with corporate sponsors, public or private
equity or debt financings, or from other sources. Future cash requirements may
vary from projections based on changes in the Company's research and development
programs, progress in preclinical and clinical testing, the Company's ability to
enter into, and perform successfully under, collaborative agreements,
competitive and technological advances, the need to obtain proprietary rights
owned by third parties, facilities requirements, changes in regulations and
other factors. Lack of necessary funds may require the Company to delay, reduce
or eliminate some or all of its research and product development programs or to
license its potential products or technologies to third parties. No assurance
can be given that funding will be available when needed, if at all, or on terms
acceptable to the Company.

UNCERTAINTIES OF CLINICAL DEVELOPMENT AND NEW MODE OF THERAPY -- None of the
Company's proposed products has been approved for commercial sale or entered
Phase III clinical trials. Even if the Company's proposed products appear to be
promising at an early stage of research or development such products may later
prove to be ineffective, have adverse side effects, fail to receive necessary
regulatory approvals, be difficult or uneconomical to manufacture or market on a
commercial scale, be adversely affected by government price controls or
limitations on reimbursement, be precluded from commercialization by proprietary
rights of third parties, by regulatory restrictions, or be subject to
significant competition from other products. There can be no assurance that the
Company will be able to demonstrate, as required, that its implants, on a
consistent basis and on a commercial scale, among other things: (i) successfully
isolate transplanted cells from the recipient's immune system; (ii) remain
biocompatible with the tissue into which they are implanted, including, for
certain implants, brain tissue; (iii) adequately maintain the viability of cells
contained within the membrane for a sufficiently long time to be efficacious and
commercially viable; (iv) safely permit the therapeutic substances produced by
the cells within the membrane to pass through the membrane unto the patient in
controlled doses for extended periods; and (v) are sufficiently durable for the
intended indication. While clinicians have generally had little difficulty in
retrieving the Company's implants, there have been cases where the implant broke
on attempted explant. The Company has changed its implantation procedure and its
implants and is continuing a program of developing stronger implants. In
addition, the viability of implanted encapsulated cells varies depending of the
cell type, the implantation location and other factors. Lack of viability could
restrict certain of the Company's programs to indications

where long-term delivery of the therapeutics substances is not required. There
can also be no assurance that the products that may be generated in the
Company's stem cell programs will: (i) survive and persist in the desired
locations, (ii) provide the therapeutic benefits intended, (iii) properly
differentiate and integrate into existing tissue in the desired manner, or (iv)
not cause tumors or other side effects.

There has been increasing regulatory concern about the risks of cell
transplantation. Concern has focused on the use of cells derived from cows (such
as are used in the Company's pain program) and cells from primates and pigs. The
United Kingdom has adopted a moratorium on xenotransplantation pending further
research and discussion; the EC Commission has introduced a ban on the use of
"high-risk material" from cattle and sheep in the Member States of the European
Union in the manufacture of pharmaceuticals (this ban would apparently not
include the type of cells used in the Company's pain program). In addition, the
FDA has proposed guidelines which impose significant constraints on the conduct
of clinical trials utilizing xenotransplantion and are likely to significantly
affect the cost of producing the Company's products using nonhuman cells; such
costs could make the Company's products cost more to produce than the Company
receives for their production. Furthermore, the FDA has published a "Proposed
Approach to Regulation of Cellular and Tissue-Based Products" which relates to
the use of human cells. The Company cannot presently determine the effects of
such actions nor what other actions might be taken. Restrictions on the testing
or use of cells, whether human or nonhuman, as human therapeutics, could
adversely affect the Company's product development programs and the Company
itself. See "Government Regulation."

DEPENDENCE ON OUTSIDE PARTIES -- The Company's strategy for the research,
development, commercialization and marketing of its products contemplates that
the Company will enter into various arrangements with corporate sponsors,
pharmaceutical companies, universities, research groups and others. There is no
assurance that the Company will be able to enter into any additional
arrangements on terms acceptable to the Company, or successfully perform its
obligations under its existing or any additional arrangements. If any of the
Company's collaborators fails to perform its obligations in a timely manner or
terminate their agreement with the Company, the development or commercialization
of the Company's product candidate or research program under such collaborative
agreement may be adversely affected. Moreover, the Company is particularly
dependent on its pain program partner, Astra AB, because changes in the
development of this particular program may significantly affect the Company's
stock price. In addition, because of the Company's obligation to repurchase
certain of the stock it sold to Genentech in connection with certain
terminations of the Parkinson's Agreement, any such termination could have an
adverse effect on the Company's liquidity.

NEED FOR AND UNCERTAINTY OF OBTAINING PATENT PROTECTION -- Patent protection
for products such as those the Company proposes to develop is highly uncertain
and involves complex factual and evolving legal questions. No assurance can be
given that any patents issued or licensed to the Company will not be challenged,
invalidated or circumvented, or that the rights granted under such patents will
provide competitive advantages to the Company.

EXISTENCE OF THIRD PARTY PATENTS AND PROPRIETARY RIGHTS; NEED TO OBTAIN
LICENSE -- A number of pharmaceutical, biotechnology and other companies,
universities and research institutions have filed patent applications or have
been issued patents relating to cell therapy and encapsulation and other
technologies potentially relevant to or required by the Company's expected
products. The Company cannot predict which, if any, of such applications will
issue as patents or the claims which might be allowed. The Company is aware that
a number of entities have filed applications relating to stem and/or progenitor
cells. The Company is also aware of a number of third-party patent applications
and patents relating to cell encapsulation or claiming use of genetically
modified cells to treat disease, disorder or injury. In particular, the Company
is aware of a third-party U.S. patent which relates the use of cells for
alleviating chronic pain in humans and of two issued U. S. patents claiming
certain methods for treating defective, diseased or damaged cells in the
mammalian CNS by grafting genetically modified cells. The Company cannot predict

the effect of existing patent applications and patents on future unencapsulated
products. In addition, the Company is aware of third-party patents and patent
applications claiming rights to the neurotrophic factors (such as CNTF, NT 4/5,
Neurturin, and CT-1) which the Company hopes to deliver with its technology, and
to the production of these factors through the use of genetically modified
cells. The Company expects to use genetically modified cells to produce these
factors for use in its encapsulated products and expects that it may wish to
genetically modify its stem/progenitor cells. The Company may also be required
to seek licenses in regard to other cell lines, the techniques used in creating,
obtaining or maintaining such cell lines, the materials used in the manufacture
of its implants or otherwise. There can be no assurance that the Company will be
able to establish collaborative arrangements or obtain licenses to the foregoing
technology or to other necessary or desirable technology on acceptable terms, if
at all, or that the patents underlying any such licenses will be valid and
enforceable. See "Patents, Proprietary Rights and Licenses" in the Company's
Annual Report on Form 10-K.

GOVERNMENT REGULATION -- The Company's research, preclinical development and
clinical trials, as well as the manufacturing and marketing of its potential
products, are subject to extensive regulation by governmental authorities in the
United States and other countries. The process of obtaining FDA and other
required regulatory approvals is lengthy, expensive and uncertain. There can be
no assurance that the Company or its collaborators will be able to obtain the
necessary approvals to commence or continue clinical testing or to manufacture
or market its potential products in anticipated time frames, if at all. In
addition, several legislative proposals have been made to reform the FDA. If
such proposals are enacted they may result in significant changes in the
regulatory environment the Company faces. These changes could result in
different, more costly or more time consuming approval requirements for the
Company's products, in the dilution of FDA resources available to review the
Company's products, or in other unpredictable consequences. See "Government
Regulation" in the Company's Annual Report on Form 10-K.

SOURCES OF CELLS AND OTHER MATERIALS -- The Company's potential products
require genetically engineered cell lines or living cells harvested from animal
or human sources. There can be no assurance that the Company will successfully
identify or develop sources of the cells required for its potential products and
obtain such cells in quantities sufficient to satisfy the commercial
requirements of its potential products. These supply limitations may apply, in
particular, to primary cells which must be drawn directly from animal or human
sources, such as the bovine adrenal chromaffin cells currently used in the
Company's product for the treatment of pain. As an alternative to primary cells,
the Company is developing products based on the use of genetically altered
cells. Intellectual property rights to important genetic constructs used in
developing such cells, including the constructs used to develop cells producing
neurotrophic factors, are or may be claimed by one or more companies, which
could prevent the Company from using such cells. In addition, many suppliers of
materials used by the Company in its media, implants, and other components have
restricted the use of such materials for implantation into humans; if the
Company cannot obtain the necessary materials for its implants, the Company
would be adversely affected.

MANUFACTURING UNCERTAINTIES -- The Company's pilot manufacturing plant, may
not have sufficient capacity to permit the Company to produce all the products
for all of the clinical trials it anticipates developing. In addition, the
Company has not developed the capability to commercially manufacture any of its
proposed products and is unaware of any other company which has manufactured any
membrane-encapsulated cell product on a commercial scale. There can be no
assurance that the Company will be able to develop the capability of
manufacturing any of its proposed products at a cost or in the quantities
necessary to make a commercially viable product, if at all.

COMPETITION -- Competitors of the Company are numerous and include major
pharmaceutical and chemical companies, biotechnology companies, universities and
other research institutions. Currently, several of these competitors market and
sell therapeutic products for the treatment of chronic pain, Parkinson's disease
and other CNS conditions. In addition, most of the Company's competitors have

substantially greater capital resources, experience in obtaining regulatory
approvals and, in the case of commercial entities, experience in manufacturing
and marketing pharmaceutical products, than the Company. A number of other
companies are attempting to develop methods of delivering therapeutic substances
within or across the blood brain barrier. There can be no assurance that the
Company's competitors will not succeed in developing technologies and products
that are more effective than those being developed by the Company or that would
render the Company's technology and products obsolete or non-competitive. See
"Competition" in the Company's Annual Report on Form 10-K.

DEPENDENCE ON KEY PERSONNEL -- The Company is highly dependent on the
principal members of its management and scientific staff and certain of its
outside consultants. Loss of the services of any of these individuals could have
a material adverse effect on the Company's operations. In addition, the
Company's operations are dependent upon its ability to attract and retain
additional qualified scientific and management personnel. There can be no
assurance the Company will be able to attract and retain such personnel on
acceptable terms given the competition among pharmaceutical, biotechnology and
health care companies, universities and research institutions for experienced
personnel.

REIMBURSEMENT AND HEALTH CARE REFORM -- In both domestic and foreign
markets, sales of the Company's potential products will depend in part upon the
availability and amounts of reimbursement from third-party health care payor
organizations, including government agencies, private health care insurers and
other health care payors such as health maintenance organizations and
self-insured employee plans. There is considerable pressure to reduce the cost
of therapeutic products. There can be no assurance that reimbursement will be
provided by such payors at all or without substantial delay, or, if such
reimbursement is provided, that the approved reimbursement amounts will provide
sufficient funds to enable the Company to sell its products on a profitable
basis. See "Reimbursement and Health Cost Control" in the Company's Annual
Report on Form 10-K.

SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS

ADDITIONS
---------
BALANCE AT CHARGED TO CHARGED TO
BEGINNING OF COSTS AND OTHER BALANCE AT
YEAR EXPENSES ACCOUNTS DEDUCTIONS END OF YEAR
------------- ---------- ------------ ------------ -------------

Year Ended Dec. 31 1997:

Other Investments, net $2,330,848 0 0 0 $2,330,848

Year Ended Dec. 31, 1996:

Other Investments, net $2,330,848 0 0 0 $2,330,848

Year Ended Dec. 31, 1995:

Other Investments, net 0 $2,330,848 0 0 $2,330,848

S-1

EXHIBIT INDEX

EXHIBIT
NO. DESCRIPTION
- -------- --------------------------------------------------------------------
10.58 Lease Agreement dated as of November 21, 1997 by and between Hub RI
Properties Trust, as Landlord, and CytoTherapeutics, Inc., as Tenant

10.68 Letter Agreement between each of Dr. Irving Weissman and Dr. Fred H.
Gage and the Registrant

10.69 Amended and Restated Cross License Agreement dated as of October 29,
1997 between Modex Therapeutiques SA and the Registrant

10.70 Letter Agreement dated as of September 30, 1997 between Dr. Seth
Rudnick and the Registrant

10.74 Employment agreement dated as of September 25, 1997 between Dr.
Richard M. Rose and the Registrant

10.75 Employment agreement dated as of April 17, 1997, between John S.
McBride and the Registrant

10.76 Severance agreement dated as of July 21, 1997, between Dr. Sandra
Nusinoff Lehrman and the Registrant

10.77 Severance agreement dated as of July 29, 1997 between Dr. E. Edward
Baetge and the Registrant

10.78 Loan Agreement dated as of May 15, 1996 between Fleet National Bank
and Registrant together with the related Promissory Note and an
amendatory agreement dated as of May 15, 1997

21 Subsidiaries of the Registrant

23.1 Consent of Ernst & Young LLP, Independent Auditors

27 Financial Data Schedule for fiscal year ended December 31, 1997

99 Cautionary Factors Relevant to Forward Looking Statements