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FORM 10-K



SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

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



/X/    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934



FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998

OR



/ /    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934



COMMISSION FILE NUMBER 0-19871

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



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

JUNIOR PREFERRED STOCK PURCHASE RIGHTS

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



Title of class



Indicate by check mark whether the Registrant (1) has filed all reports

required to be filed by Section 13 or 15(d) of the Securities Exchange Act of

1934 during the preceding 12 months (or for such shorter period that the

registrant was required to file such reports), and (2) has been subject to such

filing requirements for the past 90 days. Yes /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 31,

1999: $21,819,231. 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 31, 1999: 18,374,089 shares.



DOCUMENTS INCORPORATED BY REFERENCE



Portions of the Registrant's Definitive Proxy Statement for its 1999 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 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: stem cell

therapies and encapsulated cell therapies. The Company's stem cell therapies are

based on the transplantation of human stem cells to replace or repair damaged or

defective cells; the Company's encapsulated cell therapies are based upon the

use of living cells encapsulated in the Company's proprietary membranes and

inserted into specific sites in the body. The Company believes that it has

achieved a leadership position in the neural stem cell area with its research

and development program for neural stem/progenitor cells. The Company has also

established a research program to discover the stem cells of the pancreas and of

the liver, and has established a broad intellectual property position with

respect to stem/progenitor cell therapies through its own patented discoveries

and exclusive licensing arrangements. The Company is currently developing an

encapsulated cell product for the treatment of chronic pain, with additional

research efforts directed to other disorders including, but not limited to,

ophthalmic diseases and disorders. 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



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 technologies may provide the basis for replacing

certain lost or damaged cells or regenerating organs damaged by disease.

Furthermore, 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. 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



1

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, more recently, to 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 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 also 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' PORTFOLIO TECHNOLOGIES:

STEM CELL TECHNOLOGY AND ENCAPSULATED CELL TECHNOLOGY



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 that 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 diseases and 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, epilepsy 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 advanced its research programs to discover the human

pancreatic stem cell and the liver stem cell. Pancreatic stem cells may be

useful in the treatment of Type 1 diabetes and other diseases characterized by

loss of pancreatic function. Liver stem cells may be useful in the treatment of

diseases such as hepatitis, cirrhosis of the liver and liver cancer.



2

There can be no assurance that the Company will successfully develop its

stem cell therapies. Even in the event that such therapies are successfully

developed, there can be no assurances that they will achieve the benefits

described above, that these therapies 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

scarcity 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, after transplantation 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.



ENCAPSULATED CELL TECHNOLOGY



Encapsulated cell therapies represent a potentially broadly applicable

delivery platform for treating a number of diseases that 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 that 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 TECHNOLOGY



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 that 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



3

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 previous

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 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 could eliminate problems of drug stability that hampers

effective treatment with other methods such as 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 that 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 or that, if successfully developed, such therapies

will achieve the benefits described above or that the advantages of such

therapies will be greater than the potential disadvantages.



RESEARCH EFFORTS AND PRODUCT DEVELOPMENT PROGRAMS



OVERVIEW OF RESEARCH AND PRODUCT DEVELOPMENT STRATEGY



STEM CELL TECHNOLOGY.  The Company has devoted substantial resources to its

research programs to isolate and develop a series of stem/progenitor cells that

the Company believes can serve as a basis for replacing diseased or injured

cells. The focus of the Company's efforts to date have been directed at the

identification, isolation and the development of methods to expand a variety of

stem/progenitor cells of the human nervous system, liver and pancreas.



4

ENCAPSULATED CELL TECHNOLOGY.  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 Company has also established a research program to

examine and develop applications of the Company's encapsulated-cell technology

to potential treatments for diseases of the eye, based on its encapsulated-cell

technology. Furthermore, the Company has focused research efforts directed to

identifying and banking a "hardy" human cell that can survive for sustained

periods and be engineered to produce multiple therapeutic substances.



The following table lists the potential therapeutic indications for and

current status of CytoTherapeutics' primary research and product development

programs and 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.



RESEARCH AND PRODUCT DEVELOPMENT PROGRAMS



<TABLE>

<CAPTION>

PROGRAM DESCRIPTION                                                 STAGE/STATUS(1)

<C>                                          <S>



STEM CELL TECHNOLOGY

HUMAN NEURAL STEM CELL                                                  PRECLINICAL

Repair or replace damaged CNS tissue      - IN VITRO ability to initiate and expand stem cell-containing human neural cultures

and differentiation into three types of CNS cells

- Direct isolation of neurosphere-initiating stem cells from brain

- IN VIVO demonstration of proper differentiation and engraftment of human neural

cell cultures containing CNS stem cells in rodent CNS

OPHTHALMOLOGIC DISEASES                                            PRECLINICAL RESEARCH

Repair or replace damaged retinal tissue    Proof-of-concept in preclinical animal model(s)

STEM CELL DISCOVERY                                                    RESEARCH

Repair or replace damaged pancreatic islet   Discovery program to identify, isolate and patent human stem cells for the pancreas

or liver tissue                and liver



ENCAPSULATED CELL TECHNOLOGY

CHRONIC PAIN                                                     CLINICAL TRIALS

PARTNER: ASTRA AB               Phase IIB--enrollment for double-blind, placebo-controlled clinical trial for cancer

Encapsulated bovine adrenal chromaffin     patients completed

cells to deliver natural analgesic

substances to CNS via the intrathecal

space/lumbar region

OPHTHALMOLOGIC DISEASES (2)                                          PRECLINICAL RESEARCH

Delivery of growth factors via encapsulated  Proof-of-concept in preclinical animal model(s)

cells

HUMAN HARDY CELL DISCOVERY(2)                                               RESEARCH

Multiple therapeutic applications for     Identify and bank human cell for use in encapsulated cell implants which survive for

encapsulated cell implants           extended periods in vivo and can be engineered to produce multiple products

</TABLE>



(1) "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.



(2) Progress in these programs is dependent upon CytoTherapeutics developing an

appropriate platform cell(s) for these programs.



5

RESEARCH AND DEVELOPMENT PROGRAMS



STEM CELL TECHNOLOGY



The Company's portfolio of stem cell technology results from the Company's

exclusive licensing of neural stem/progenitor cell technology and other

technologies applicable to the pancreas and liver, the Company's own research

and development efforts to date, and the acquisition of StemCells, Inc. in 1997.

The Company, through its subsidiary, StemCells, 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 an

experienced team of scientists and scientific advisors to consult with and

advise the Company's scientists on their continuing research and development of

stem/progenitor cells. This team includes, among others, 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.



NEURAL STEM/PROGENITOR CELL RESEARCH AND DEVELOPMENT PROGRAM



The Company began its work with neural stem/progenitor cultures in

collaboration with NeuroSpheres, Ltd., in 1992. The Company believes that

NeuroSpheres was the first to invent these cultures and NeuroSpheres has filed

patent applications on its inventions relating to these cultures. The Company is

the exclusive, worldwide licensee from NeuroSpheres to such inventions for

transplantation in the human body. See "License Agreements and Sponsored

Research Agreements--NeuroSpheres, Ltd." In December 1998, the Company announced

that the US Patent and Trademark Office had granted patent No. 5,851,832,

covering the Company's methods for the human neural cell cultures containing

central nervous system stem cells, for compositions of human neural cell

cultures expanded by these methods, and for use of these cultures in human

transplantation and remyelination. These human neural stem/progenitor cell

cultures may be useful for repairing or replacing damaged central nervous system

tissue, including the brain and the spinal cord.



Previously, 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 initiated 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 cells from these cultures can be successfully engrafted into the

brains of rodents where they migrated and differentiated into the appropriate

cell lineages for the site of the brain into which they were transplanted.



In 1998, the Company expanded its preclinical efforts in this area by

initiating programs aimed at the discovery and use of specific monoclonal

antibodies to facilitate identification and isolation of neural and other stem

and progenitor cells or their differentiated progeny. Also in 1998, Company

researchers devised methods to advance the IN-VITRO culture and passage of human

neural stem cells that have resulted in a 100-fold increase in cell production

of these neural stem/progenitor cells after 6 passages. The Company is expanding

its preclinical efforts toward the 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.



PANCREATIC AND LIVER STEM CELLS DISCOVERY RESEARCH PROGRAMS



The Company's discovery program for the pancreatic stem/progenitor cell is

currently being conducted by Nora Sarvetnick, Ph.D. of The Scripps Research

Institute, who has initiated programs for the



6

identification and isolation of the stem/progenitor cell for the pancreas. An

estimated 16 million people in the United States have diabetes mellitus, a

serious, lifelong condition, with approximately 650,000 new patients diagnosed

annually. Diabetes is widely recognized as one of the leading causes of death

and disability in the United States and is associated with long term

complications that affect almost every major part of the body. Diabetes-related

treatment costs exceed $100 billion annually. In 1998 the Company obtained an

exclusive, worldwide license from The Scripps Research Institute to novel

technology, developed by Dr. Sarvetnick as a result of the research sponsored by

the Company, which may be useful in identifying and isolating pancreatic islet

stem/progenitor cells. The Company believes that this technology may facilitate

their isolation using specific markers and leading to the development of

cell-based treatments for diabetes and other diseases characterized by loss of

pancreatic function.



The Company initiated its discovery work for the liver stem/progenitor cell

through a sponsored research agreement with Markus Grompe, Ph.D. of Oregon

Health Sciences University. Dr. Grompe's work focuses on the discovery and

development of a suitable method for identifing and assessing liver

stem/progenitor cells for use in transplantation. Approximately 1 in 10

Americans suffers from diseases and disorders of the liver for which there are

currently no effective, long-term treatments. In 1998, Company researchers

continued to advance methods for establishing enriched cell populations suitable

for transplantation in preclinical animal models for evaluating these methods.

The Company is focused on discovering and utilizing its proprietary methods to

identify, isolate and culture liver stem/progenitor cells and to evaluate these

cells in preclinical animal models.



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 has also 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/progenitor cells and to seek

to acquire rights to additional inventions relating to stem/progenitor cells

from third parties.



The Company's pancreatic and liver stem/progenitor cells programs are at an

early stage and there can be no assurance that they will result in any

commercial products.



ENCAPSULATED-CELL TECHNOLOGY



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 such as 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. For

example, 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 that continuously release

small quantities of 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 to treat 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.



7

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 three 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 Phase IIB, placebo-controlled,

double-blinded, multi-center trial in cancer patients was initiated in central

Europe and Switzerland. In this trial, patients with end-stage cancer were

implanted with either a cell-containing device or a placebo device for 10 weeks

and are being monitored for pain scores, concurrent pain-related drug usage and

quality of life. According to the trial protocol and following removal of the

original device, patients could elect to be implanted with an active device for

six months. Upon completion of enrollment in March 1999, approximately 85

evaluable patients had participated in the trial.



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. However, in January 1998, the Company and its partner, Astra Pain

Control, announced that they had halted accrual of patients into the Phase IIB

trial in order to allow for a full investigation and the development of

implantation procedure modifications. The Company investigated the migration

phenomenon and determined that it was necessary to modify the device and the

implantation procedure to prevent migration. These modifications included the

development of a "tether clip" to assist in securing the implants. After the

development and implementation of modifications to the implantation procedure,

the Company and its partner, Astra Pain Control, announced they had resumed

accrual of patients in the Phase II trials in June 1998.



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 could substantially



8

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 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 any 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

Agreement anytime after April 1998. However, in May 1998, Astra AB agreed to

increase its annual research and development payments to the Company under this

Agreement in order to facilitate the completion of the Phase IIB clinical trial.

The Company expects that the results from this trial will be available about

mid-1999. The Company expects Astra to make a decision on continued support for

the Company's chronic pain program based in substantial part on Astra's review

of the results of this trial. Continuation of the Company's chronic pain program

will likely depend on a prompt decision by Astra to continue or increase such

support. See "Corporate Collaborations--Astra AB."



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 pre-clinical testing in animals with these

implants.



OTHER ENCAPSULATED CELL PROGRAMS



The Company has sponsored research to evaluate the feasibility and

tolerability of using encapsulated cells to deliver neurotrophic factors into

the CNS to treat neurodegenerative diseases such as ALS and Huntington's

disease. An investigator-sponsored pilot clinical study of the Company's

encapsulated cell implant to deliver CNTF (ciliary neurotrophic factor) into the

brain ventricles of six Huntington's patients is currently underway in France.



9

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 Membrana GmbH. See "Corporate

Collaborations-- Akzo Nobel Membrana GmbH."



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."



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

CytoTherapeutics (although CytoTherapeutics also retains the right to fund such

programs at a higher level) for as long as the goals of the Research Plan are

being met, provided however, that CytoTherapeutics will retain the option of (i)

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 (ii) 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.



10

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 $38 million of research and development funding has been

received by the Company through December 31, 1998. 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.



In May 1998, after the resumption of the Phase II clinical trial of the lead

product candidate, Astra AB agreed to increase annual research and development

payments under this Agreement in order to fund the completion of the Phase IIB

clinical trials. It is expected that results from this trial will be available

in about mid-1999. There can be no assurance that Astra will continue to fund

this program beyond mid-1999.



MODEX THERAPEUTIQUES SA



In July 1996, CytoTherapeutics, together with certain founding scientists,

established Modex Therapeutiques SA ("Modex") 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 17%.



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



11

diseases, conditions and disorders of the central nervous system to existing and

future encapsulation technology and to certain additional existing technology.



AKZO NOBEL MEMBRANA GMBH



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 Membrana GmbH ("Akzo") dated

December 1, 1993. Akzo is the world's largest supplier of medical grade

membranes. Under the terms of the agreement, 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, Akzo will 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, 1998, 1997 and 1996, the Company paid Akzo

under the terms of the agreement approximately $192,000, $98,000 and $295,000,

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. An

initial disagreement as to the interpretation of the rights licensed to

StemCells, Inc. was resolved by the parties, and the agreements are operating in

accordance with their terms.



GENENTECH, INC.



In November 1996, the Company signed collaborative development and licensing

agreements with Genentech relating to the development of products using the

Company's technology to deliver certain of Genentech's proprietary growth

factors to treat Parkinson's disease, Huntington's disease and amyotrophic

lateral sclerosis ("ALS").



Under the terms of the agreement for Parkinson's disease, Genentech had the

right, in its discretion, to terminate the Parkinson's program at specified

milestones in the program, and on May 21, 1998, Genentech exercised its right to

terminate the Parkinson's collaboration. For information regarding certain

financial consequences of such termination, see "Management's Discussion and

Analysis of Financial Condition and Results of Operations--Liquidity and Capital

Resources."



Under the terms of the Company's agreements with Genentech relating to

Huntington's disease and ALS, the Company is responsible for conducting and

funding all pre-clinical 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 cost of the proposed

products, the Companies will share profits at a negotiated percentage upon

commercialization. Should Genentech elect not to participate in the development,

upon commercialization, the Company will pay Genentech an agreed-upon royalty

based upon sales. Under these agreements, the Company's license to Genentech's

proprietary growth factors (neurotrophin 4/5 and cardiotrophin-1) is dependent

upon the Company using reasonable



12

efforts to achieve certain development milestones within prescribed periods. The

Company does not presently intend to devote significant resources to the

continuing pursuit of these projects and thus does not currently expect to

maintain such licenses.



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. Such right was unexercised by

Neurospheres and expired in April 1998. The Company and NeuroSpheres have no

further research obligations to one another. The Company has developed

additional intellectual property relating to the subject matter of the license.



COGNETIX, INC.



In February 1997, CytoTherapeutics 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 have also entered into an option agreement

giving the Company the right to option up to three of Cognetix's compounds for

use in treating eye diseases. CytoTherapeutics has exercised its right to one

protein, ConG. The Company and Cognetix are presently discussing revisions to

their relationship under the agreements.



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 that 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 $701,000, $1,326,000 and $1,337,000 for the years ended December

31, 1998, 1997 and 1996, respectively. The Company and StemCells, Inc. also have

a number of collaborative relationships with other academic institutions and

academic researchers.



13

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

in 1997 and $558,000 in 1998) 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

that 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 that 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



14

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 are

expected to include efficacy, safety, consistency of the product and economy of

the process. The Company expects to 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 that will affect manufacture of stem/progenitor cell

products are 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 10 issued U.S. patents in the stem cell therapy area, an

increase of 5 issued patents in 1998, with an additional 28 patent applications

pending in the stem cell therapy area (three of which have been allowed and are

pending issuance), and also includes 56 issued U.S. patents in the

encapsulated-cell therapy area, an increase of 20 additional patents in 1998.



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



15

until 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 that 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 patents

issued 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



16

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 to certain patents and know-how regarding

present and certain future developments in encapsulation technology; and with

NeuroSpheres, Ltd., The Scripps Institute and the California Institute of

Technology to certain patents and know-how regarding present and certain future

developments in neural and pancreatic stem cells. 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,

neurodegenerative diseases, 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 for such

products, 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 stem/progenitor cell products, if successfully developed,

might face competition from orally administered drugs, other forms of cell

transplantation, ablative and stimulative procedures, gene therapy and new drugs

under development. 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,



17

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 that 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 pre-market 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

transplantation of xenogeneic 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



18

(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, as may be the case with the Company's potential products, in a small number

of patients under the supervision of a qualified 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.

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.



19

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. Certain of these concerns have 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 or what other actions

might be taken. Restrictions on the testing or use of cells, whether human or

non-human, 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



20

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.



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 health care 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 health care 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 31, 1999, the Company had 82 full-time employees, including 11

employees with Ph.D. or M.D. degrees. Approximately 70 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



21

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.



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, Rhode Island. 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.



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.



22

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:

<TABLE>

<CAPTION>

1999                                                 HIGH         LOW

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

<S>                                                <C>         <C>

First Quarter (through March 29, 1999)............ $ 1 3/4     $ 1 5/32



<CAPTION>



1998                                                 HIGH         LOW

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

<S>                                                <C>         <C>

Fourth Quarter.................................... $ 2 5/32    $   7/8

Third Quarter..................................... $ 1 5/16    $   7/8

Second Quarter.................................... $ 3 7/16    $ 1 1/4

First Quarter..................................... $ 4 3/16    $ 2 9/16

<CAPTION>



1997                                                 HIGH         LOW

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

<S>                                                <C>         <C>

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

<CAPTION>



1996                                                 HIGH         LOW

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

<S>                                                <C>         <C>

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

</TABLE>



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

inception.



As of March 29, 1998, there were approximately 277 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.



23

ITEM 6. SELECTED FINANCIAL DATA

<TABLE>

<CAPTION>

YEAR ENDED DECEMBER 31,

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

<S>                                                          <C>         <C>        <C>        <C>        <C>

1998       1997       1996       1995       1994

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



<CAPTION>

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<S>                                                          <C>         <C>        <C>        <C>        <C>

STATEMENT OF OPERATIONS DATA

Revenue from collaborative agreements......................  $    8,803  $  10,617  $   7,104  $  11,761  $   1,250

Research and development expenses..........................      17,659     18,604     17,130     14,730     13,514

Acquired research and development..........................                  8,344

Net loss...................................................     (12,628)   (18,114)   (13,759)    (8,891)   (16,461)

Basic and diluted net loss per share(1)....................       (0.69)     (1.08)     (0.89)     (0.69)     (1.52)

Shares used in computing basic and diluted net loss per

share(1).................................................      18,291     16,704     15,430     12,799     10,833

</TABLE>

<TABLE>

<CAPTION>

DECEMBER 31,

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

<S>                                                          <C>        <C>        <C>        <C>        <C>

1998       1997       1996       1995       1994

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



<CAPTION>

(IN THOUSANDS)

<S>                                                          <C>        <C>        <C>        <C>        <C>

Balance Sheet Data

Cash, cash equivalents and marketable securities...........  $  17,386  $  29,050  $  42,607  $  44,192  $  19,138

Total assets...............................................     32,866     44,301     58,397     56,808     32,194

Long-term debt, including capitalized leases...............      3,762      4,108      8,223      5,441      5,641

Redeemable common stock....................................      5,249      5,583      8,159

Stockholders' equity.......................................     17,897     28,900     34,747     45,391     22,637

</TABLE>



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



(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, nonrecurring events, including without

limitation, the receipt of one-time and nonrecurring licensing and milestone

payments.



24

RESULTS OF OPERATIONS



YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996



Revenues from collaborative agreements totaled $8,803,000, $10,617,000 and

$7,104,000 for the years ending December 31, 1998, 1997 and 1996, 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 related to the Phase II

clinical program for the Company's pain control implant. Revenue for 1998

reflects an increase in funding by more than 20% from Astra.



Research and development expenses totaled $17,659,000 in 1998, as compared

to $18,604,000 in 1997 and $17,130,000 in 1996. The decrease of $945,000, or 5%,

from 1997 to 1998 was primarily attributable to a reduction in spending on

research agreements and a reduction in research and development personnel. 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, the

Company's formerly 50%-owned subsidiary, which was included in the Company's

operating results through October 1997.



Acquired research and development consists of a one-time charge of

$8,344,000 related to the acquisition of StemCells, Inc. in 1997.

Commercialization of the acquired technology will require significant

incremental research expenditures over a number of years.



General and administrative expenses were $4,603,000 for the year ended

December 31, 1998, compared with $6,158,000 in 1997 and $5,679,000 in 1996. The

reduction of $1,555,000, or 25%, from 1997 to 1998 was primarily attributable to

a reduction in legal fees, recruiting and relocation expenses as well as a

reduction in employees. 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.



Interest income for the years ended December 31, 1998, 1997 and 1996 totaled

$1,254,000, $1,931,000 and $2,260,000, respectively. The average cash and

investment balances were $21,795,000, $33,343,000 and $37,600,000 in 1998, 1997

and 1996, respectively. The decrease in interest income from 1996 to 1997 to

1998 was attributable to lower average balances.



In 1998, interest expense was $472,000, compared with $438,000 in 1997 and

$618,000 in 1996. The Company capitalized $210,000 of interest expense on the

new facility in 1997. The changes in interest expense in 1996, 1997 and 1998 are

primarily attributable to interest capitalization and debt repayment.



In October 1997, the Company recognized a gain in the amount of $3,387,000

related to the sale of 50% of the Company's interest in Modex.



The net loss in 1998, 1997 and 1996 was $12,628,000, $18,114,000, and

$13,759,000, respectively. The loss per share was $0.69, $1.08 and $0.89 in

1998, 1997 and 1996, 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 in the amount of $3,387,000.



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 $17,386,000 at December 31, 1998. Cash equivalents and

marketable securities are invested in agencies of the U.S. government,

investment grade corporate bonds and money market funds.



25

The Company's liquidity and capital resources have been and will continue to

be significantly affected by the Company's relationships with corporate

partners.



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. In May 1998, Astra agreed to

increase annual research and development payments from $7 million to $8.5

million for the calendar year 1998. This increase in funding was recognized as

revenue in the third and fourth quarters of 1998.



The current Phase II pain trial completed patient enrollment in March 1999,

with efficacy data from the trial expected by the third quarter of 1999. Astra

has agreed to fund the first and second quarters of 1999 at the rate of $2.5

million per quarter. Funding for the second half of 1999 is contingent upon,

among other factors, the results of the current Phase II trial. Should Astra

determine to discontinue funding for the Company's development of

encapsulated-cell products to treat pain, or to reduce such funding or otherwise

modify the terms of the Company's relationship with Astra, any such action could

have a material, adverse effect on the Company's liquidity and capital

resources, and, unless other funding sources were obtained, would likely result

in the Company's inability to continue to fund further development of its

proposed encapsulated-cell products.



The Company's liquidity and capital resources will also be affected by the

termination of the Company's collaborative development and licensing agreement

with Genentech, Inc. relating to the development of products for the treatment

of Parkinson's disease. In November 1996, the Company signed collaborative

development and licensing agreements with Genentech relating to the development

of products using the Company's technology to deliver certain of Genentech's

proprietary growth factors to treat Parkinson's disease, Huntington's disease

and amyotrophic lateral sclerosis ("ALS"). Under the terms of the agreement for

Parkinson's disease, Genentech purchased 829,171 shares of the Company's Common

Stock for $8.3 million to fund development of products to treat Parkinson's

disease. Genentech had the right, in its discretion, to terminate the

Parkinson's program at specified milestones in the program. Under the agreement,

if the Parkinson's program was terminated and the funds the Company received

from the sale of stock to Genentech pursuant to the Parkinson's agreement

exceeded the expenses incurred by the Company in connection with such product

development efforts by more than $1 million, Genentech had the right to require

the Company to repurchase from Genentech shares of the Company's Common Stock

having a value equal to the amount of the overfunding, at the same per share

price paid by Genentech ($10.01 per share). As such, a portion of the Common

Stock purchased by Genentech has been classified by the Company as Redeemable

Common Stock; as of December 31, 1998, based upon prior accountability, the

Company classified $5.2 million of such stock as Redeemable Common Stock. On May

21, 1998, Genentech exercised its right to terminate the Parkinson's

collaboration and has requested that the Company redeem, at a price of $10.01

per share, shares of the Company's Common Stock having an aggregate value of at

least $3.1 million. The Company is negotiating with Genentech regarding the

amount of such redemption (which the Company currently expects may be

approximately $3.1 million) and the



26

manner of payment for such redemption. Any such redemption would have a material

adverse effect on the Company's liquidity and capital resources.



In May 1996, the Company secured an equipment loan facility with a bank in

the amount of $2,000,000. The Company has borrowed $2,000,000 under this

agreement as of December 31, 1998. The loan required interest-only payments for

the first two years; principal payments are payable over a two-year period which

began in August 1998. The loan is secured by equipment purchased with the

proceeds of the credit facility. Current balance on this credit facility is

$1.25 million. While the Company was in compliance with financial covenants

under this credit facility as of December 31, 1998, the Company expects that it

will be required to seek a waiver of certain financial covenants under this

facility as of the end of the first or second quarter of 1999; there can be no

assurance that the Company will be able to obtain such a waiver.



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, 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 transaction of $3,387,000. In April 1998, Modex completed a financing, in

which the Company elected not to participate, which resulted in a further

reduction of its ownership interest to less than 20%.



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 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

addition to their purchase of Modex Common Stock from the Company, the investors

participating in the transaction invested $1.6 million directly in Modex.



In September 1997, a merger of the Company's wholly owned subsidiary and

StemCells, Inc., was completed in the form of a purchase. Through the merger,

the Company acquired StemCells for a purchase price totaling approximately

$9,475,000, consisting of 1,580,000 new shares of the Company's Common Stock at

$0.01 par value, 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, Richard M. Rose, M.D.,

became President, Chief Executive Officer and a Director of CytoTherapeutics;

and Irving Weissman, M.D., became a Director of CytoTherapeutics. Upon

consummation of the merger, the Company entered into consulting arrangements

with the principal scientific founders of StemCells, Dr. Weissman, Fred H. Gage,

Ph.D., and David J. Anderson, Ph.D. Each such scientific founder has joined the

Company's Scientific Advisory Board.



27

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.

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. If the milestones specified

relating to the 1,031,000 options 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.



Stem cells 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 cells research. Increases in stem

cells research funding of not more than 25% per year will be funded by the

Company (although the Company retains the right to fund such programs at a

higher level) 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 April 1997, CytoTherapeutics entered into an agreement with NeuroSpheres

Ltd. replacing all previous agreements and resolving its dispute with

NeuroSpheres. The pending action in the United States District Court, its

counterpart actions in Calgary, Alberta, Canada, as well as all arbitration

proceedings, have been discontinued. Under the terms of the settlement, the

Company has an exclusive royalty-bearing license to growth factor-responsive

neural stem/progenitor cells for transplantation. NeuroSpheres had an option to

acquire co-exclusive rights, but failed to exercise the option by the April 1998

deadline. Accordingly, the NeuroSpheres option to acquire co-exclusive rights

has lapsed, and the Company retains exclusive rights for transplantation. 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 for possible development into therapeutic products aimed at a broad

range of human disease states using CytoTherapeutics' encapsulated cell-based

delivery technology. The Company and Cognetix have also entered into an option

agreement giving the Company the right to option up to three of Cognetix's

compounds for use in treating eye diseases. As part of the agreement with

Cognetix, CytoTherapeutics had purchased $250,000 of Cognetix preferred stock

and, subject to certain milestones, was obligated to purchase up to a total of

$1,750,000 of Cognetix's stock over the next year. In July 1997, the Company

loaned $250,000 to Cognetix that was repaid with interest in October 1997. In

October 1998, the Company sold the $250,000 of preferred stock back to Cognetix

for $298,914. The Company and Cognetix are presently discussing proposed

revisions to their relationship under the agreements.



Under the terms of the Company's agreements with Genentech entered into in

November 1996 relating to the development of products using the Company's

technology to deliver certain of Genentech's proprietary growth factors to treat

Huntington's disease and ALS, the Company is responsible for conducting and

funding all pre-clinical 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 cost of the proposed

products, the Companies will share profits at a negotiated percentage upon

commercialization. Should Genentech elect not to participate in the development,

upon commercialization, the Company will pay Genentech an agreed-upon royalty

based upon sales. Under these agreements, the Company's license to Genentech's

proprietary growth factors is dependent upon the Company using reasonable

efforts to achieve certain development milestones within prescribed periods. The



28

Company does not presently intend to devote significant resources to the

continuing pursuit of these projects and thus does not currently expect to

maintain such licenses.



In both the encapsulated cell and stem cell areas, 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, 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, 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 financings, 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 into the first quarter of 2000. 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.



YEAR 2000



The year 2000 problem results from the fact that computer programs were

often written using two digits rather than four to define the applicable year.

Computer programs that have date-sensitive software may recognize a date using

"00" as the year 1900 rather than the year 2000. The Company has tested its

material software applications to determine whether each program is prepared to

accommodate date information for the year 2000 and beyond. The Company found all

of its material software programs to be year 2000 compliant and does not

anticipate any significant disruption of its operations as a result of the

failure of any of its software programs to be year 2000 compliant.



The Company is also testing the status of its facilities systems such as

phones, voice mail, heating/air conditioning, electricity and security systems

and its laboratory and manufacturing equipment to determine if they are year

2000 compliant. The Company expects to complete this testing in the third

quarter of 1999. If any of the systems or equipment is found not to be year 2000

compliant, the Company intends to either seek to repair the systems or equipment

to cause it to be year 2000 compliant or replace such systems or equipment with

year 2000 compliant products. The cost to repair or replace any such system or

equipment that is not year 2000 compliant could be material. The Company is also

polling its major vendors and suppliers to determine if they are year 2000

compliant and to identify any potential issues. Each of the suppliers and

vendors that has responded to the Company's inquiry has confirmed either orally

or in writing that it does not believe that its sales of products or provision

of services to the Company will be interrupted as a result of the year 2000

issue. As a result of its investigations, the Company does not currently believe

that it is reasonably likely that its operations will be significantly impacted

by the year 2000 issue. Although the Company believes that the cost of

remediation associated with achieving year 2000 compliance or the costs

associated with systems failures will not be significant, there can be no

assurance that the failure of one or more of the Company's major suppliers to be

year 2000 compliant will not have an adverse effect on the Company's operations

or financial results.



29

ITEM 7A. QUANTITIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



The Company is exposed to market risk from changes in interest rates with

respect to its investments in marketable securities. Interest rate risk with

respect to the Company short and long-term debt is considered to be immaterial.



The Company maintains an investment portfolio of various issuers, types and

maturities. These securities are classified as available-for-sale, and

consequently, are recorded on the balance sheet at fair value with unrealized

gains or losses reported as accumulated other comprehensive income in

stockholders' equity, net of taxes. At any time, a sharp rise in interest rates

could adversely affect the fair value of the investment portfolio. The Company

currently does not hedge these interest rate exposures.



The table below presents principal amounts and related weighted average

interest rates by year of maturity and fair value for the debt securities

included in the Company's investment portfolio. Such debt securities are

principally fixed rate financial instruments.



<TABLE>

<CAPTION>

FAIR

1999          2000         TOTAL         VALUE

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

<S>                                                        <C>           <C>           <C>           <C>

Available-for-sale debt securities.......................    10,219,171       501,720    10,720,891    10,715,693

Average interest rate....................................          5.44%         5.61%

</TABLE>



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



30

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, 1998 and 1997, and the related

consolidated statements of operations, changes in redeemable common stock and

stockholders' equity, and cash flows for each of the three years in the period

ended December 31, 1998. 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, 1998 and 1997, and the consolidated

results of its operations and its cash flows for each of the three years in the

period ended December 31, 1998, 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.



Ernst & Young LLP



Boston, Massachusetts

February 12, 1999



31

CYTOTHERAPEUTICS, INC.



CONSOLIDATED BALANCE SHEETS



<TABLE>

<CAPTION>

DECEMBER 31,

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

1998         1997

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

<S>                                                               <C>           <C>

ASSETS

Current assets:

Cash and cash equivalents.....................................  $  7,864,788  $15,941,701

Marketable securities.........................................     9,520,939   13,108,497

Accrued interest receivable...................................       206,609      553,186

Other current assets..........................................       841,674      576,008

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

Total current assets............................................    18,434,010   30,179,392

Property, plant and equipment, net..............................     8,356,009    7,922,751

Other assets, net...............................................     6,075,663    6,199,323

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

Total assets....................................................    32,865,682  $44,301,466

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

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

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:

Accounts payable..............................................  $    710,622  $   867,804

Accrued expenses..............................................     1,020,119    3,241,547

Deferred revenue..............................................     2,500,000       16,144

Current maturities of capitalized lease obligations...........       317,083      419,095

Current maturities of long-term debt..........................     1,000,000      658,986

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

Total current liabilities.......................................     5,547,824    5,203,576

Capitalized lease obligations, less current maturities..........     3,261,667    3,552,500

Long-term debt, less current maturities.........................       500,000      555,525

Deferred rent...................................................       222,673           --

Commitments and contingencies

Redeemable common stock, $.01 par value; 524,337 and 557,754

shares issued and outstanding at December 31, 1998 and 1997,

respectively..................................................     5,248,610    5,583,110

Common stock to be issued.......................................       187,500      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;

17,800,323 and 17,526,220 shares issued and outstanding at

December 31, 1998 and 1997, respectively....................       178,003      175,262

Additional paid-in capital....................................   122,861,606  121,472,844

Accumulated deficit...........................................  (103,664,084) (91,036,254)

Unrealized gains (losses) on marketable securities............        (5,198)      (8,877)

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

Accumulated other comprehensive income (loss).................  (103,669,282) (91,045,131)

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

Deferred compensation.........................................    (1,472,919)  (1,702,820)

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

Total stockholders' equity......................................    17,897,408   28,900,155

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

Total liabilities and stockholders' equity......................  $ 32,865,682  $44,301,466

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

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

</TABLE>



See accompanying notes to consolidated financial statements.



32

CYTOTHERAPEUTICS, INC.



CONSOLIDATED STATEMENTS OF OPERATIONS



<TABLE>

<CAPTION>

YEAR ENDED DECEMBER 31,

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

<S>                                                                <C>             <C>             <C>

1998            1997            1996

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

Revenue from collaborative agreements............................  $    8,803,163  $   10,617,443  $    7,104,284

Operating expenses:

Research and development.......................................      17,658,530      18,603,523      17,130,392

Acquired research and development..............................              --       8,343,684              --

General and administrative.....................................       4,602,758       6,158,410       5,678,783

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

22,261,288      33,105,617      22,809,175

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

LOSS FROM OPERATIONS.............................................     (13,458,125)    (22,488,174)    (15,704,891)

Other income (expense):

Interest income................................................       1,253,781       1,931,260       2,259,886

Interest expense...............................................        (472,400)       (437,991)       (618,213)

Gain on partial sale of Modex..................................              --       3,386,808              --

Loss on sale/leaseback.........................................              --        (342,014)             --

Loss on equity investment......................................              --        (105,931)             --

Other income (expense).........................................          48,914         (57,538)        404,128

Currency exchange loss.........................................              --              --        (100,048)

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

830,295       4,374,594       1,945,753

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

NET LOSS.........................................................  $  (12,627,830) $  (18,113,580) $  (13,759,138)

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

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

BASIC AND DILUTED NET LOSS PER SHARE.............................  $         (.69) $        (1.08) $         (.89)

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

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

SHARES USED IN COMPUTING BASIC AND DILUTED NET LOSS PER SHARE....      18,290,548      16,704,144      15,429,564

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

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

</TABLE>



See accompanying notes to consolidated financial statements.



33

CYTOTHERAPEUTICS, INC.



CONSOLIDATED STATEMENTS OF CHANGES IN REDEEMABLE COMMON STOCK AND STOCKHOLDERS'

EQUITY

<TABLE>

<CAPTION>

REDEEMABLE                                                                  UNREALIZED

COMMON STOCK             COMMON STOCK        ADDITIONAL                    GAINS (LOSSES)  CUMULATIVE

-----------------------  ----------------------     PAID-IN      ACCUMULATED    ON MARKETABLE   TRANSLATION

SHARES       AMOUNT       SHARES      AMOUNT       CAPITAL        DEFICIT        SECURITIES    ADJUSTMENTS

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

<S>                    <C>        <C>           <C>          <C>        <C>            <C>             <C>             <C>

Balances, January 1,

1996...............     --      $    --        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)       --            --

Comprehensive income

(loss).............

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

Balances, December

31, 1996...........    815,065     8,158,798   15,614,333    156,144    107,649,659     (72,922,674)        14,760      (60,416)



<CAPTION>



TOTAL

DEFERRED     STOCKHOLDERS'

COMPENSATION      EQUITY

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

<S>                    <C>            <C>

Balances, January 1,

1996...............   $   --        $  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)

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

Comprehensive income

(loss).............                   (13,936,280)



Balances, December

31, 1996...........       (90,118)     34,747,355

</TABLE>



34

CYTOTHERAPEUTICS, INC.



CONSOLIDATED STATEMENTS OF CHANGES IN REDEEMABLE COMMON STOCK AND STOCKHOLDERS'

EQUITY (CONTINUED)

<TABLE>

<CAPTION>

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

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

<S>                  <C>        <C>         <C>        <C>        <C>          <C>          <C>           <C>          <C>

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..     --          --      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)     --            --           --

Comprehensive

income (loss)....

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

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)



<CAPTION>



TOTAL

STOCKHOLDERS'

EQUITY



<S>                  <C>

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..    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)

-----------

Comprehensive

income (loss)....  (18,076,801)



Balances, December

31, 1997.........   28,900,155

</TABLE>



35

CYTOTHERAPEUTICS, INC.



CONSOLIDATED STATEMENTS OF CHANGES IN REDEEMABLE COMMON STOCK AND STOCKHOLDERS'

EQUITY (CONTINUED)

<TABLE>

<CAPTION>

UNREALIZED

GAINS

REDEEMABLE                                                           (LOSSES)

COMMON STOCK           COMMON STOCK      ADDITIONAL                      ON

---------------------  --------------------    PAID-IN    ACCUMULATED    MARKETABLE    DEFERRED

SHARES      AMOUNT     SHARES     AMOUNT      CAPITAL      DEFICIT      SECURITIES   COMPENSATION

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

<S>                            <C>        <C>         <C>        <C>        <C>          <C>           <C>           <C>

Issuance of common stock

under the stock purchase

plan.......................     --          --         43,542        436       83,622

Common stock issued pursuant

to employee benefit plan...     --          --         84,812        848      143,025       --           --            --

Issuance of common stock--

StemCells..................     --          --        101,320      1,013      505,587       --           --            --

Redeemable common stock

lapses.....................    (33,417)   (334,500)    33,417        334      334,166       --           --            --

Exercise of stock options....     --          --         11,012        110        1,254       --           --            --

Deferred compensation--

amortization and

cancellations..............     --          --         --         --          321,108       --           --           229,901

Change in unrealized losses

on marketable securities...     --          --         --         --          --            --             3,679       --

Net loss.....................     --          --         --         --          --        (12,627,830)     --            --

Comprehensive income (loss)

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

Balances, December 31,

1998.......................    524,337  $5,248,610  17,800,323 $ 178,003  $122,861,606 $(103,664,084) $    (5,198 ) $(1,472,919)

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

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



<CAPTION>

TOTAL

STOCKHOLDERS'

EQUITY

<S>                            <C>

Issuance of common stock

under the stock purchase

plan.......................       84,058

Common stock issued pursuant

to employee benefit plan...      143,873

Issuance of common stock--

StemCells..................      506,600

Redeemable common stock

lapses.....................      334,500

Exercise of stock options....        1,364

Deferred compensation--

amortization and

cancellations..............      551,009

Change in unrealized losses

on marketable securities...        3,679

Net loss.....................  (12,627,830)

-----------

Comprehensive income (loss)    (12,624,151)

Balances, December 31,

1998.......................  $17,897,408

</TABLE>



See accompanying notes to consolidated financial statements.



36

CYTOTHERAPEUTICS, INC.



CONSOLIDATED STATEMENTS OF CASH FLOWS



<TABLE>

<CAPTION>

YEAR ENDED DECEMBER 31,

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

<S>                                                <C>          <C>          <C>

1998         1997         1996

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

CASH FLOWS FROM OPERATING ACTIVITIES:

Net loss.........................................  $(12,627,830) $(18,113,580) $(13,759,138)

Adjustments to reconcile net loss to net cash

used for operating activities:

Depreciation and amortization..................    2,244,146    1,968,234    1,671,068

Acquired research and development..............           --    8,343,684           --

Amortization of deferred compensation..........      551,009      109,954       95,083

Other non cash charges.........................      410,173      105,931      406,733

Loss (gain) on investment......................           --   (3,386,808)          --

Loss on sale of fixed assets...................           --      413,856          871

Changes in operating assets and liabilities:

Accrued interest receivable..................      346,577      100,004      140,025

Other current assets.........................     (265,665)    (232,604)     220,688

Accounts payable and accrued expenses........   (2,378,613)  (1,233,501)   1,077,350

Deferred revenue.............................    2,483,856   (1,842,948)     109,092

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

NET CASH USED IN OPERATING ACTIVITIES............   (9,236,347) (13,767,778) (10,038,228)

CASH FLOWS FROM INVESTING ACTIVITIES:

Proceeds from sale of Modex, net of cash

disposed.......................................           --    2,958,199           --

Purchases of marketable securities...............  (18,982,387) (14,182,521)  (3,083,621)

Proceeds from sales of marketable securities.....   22,573,624   23,736,242   14,924,200

Purchase of property, plant and equipment........   (2,153,524)  (7,710,126)  (4,412,190)

Proceeds on sale of fixed assets.................           --    8,003,926        3,000

Purchase of other investment.....................           --     (250,000)          --

Acquisition of other assets......................     (400,219)  (1,599,418)    (811,305)

StemCells assets acquired........................           --     (640,490)          --

Advance to Cognetix..............................           --      250,000           --

Repayment from Cognetix..........................           --     (250,000)          --

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

NET CASH PROVIDED BY (USED IN) INVESTING

ACTIVITIES.....................................    1,037,494   10,315,812    6,620,084

CASH FLOWS FROM FINANCING ACTIVITIES:

Proceeds from issuance of redeemable common

stock..........................................           --           --    8,300,000

Proceeds from issuance of common stock...........      227,931    1,905,380    1,668,542

Proceeds from the exercise of stock options and

warrants.......................................        1,364      245,179      980,697

Proceeds from debt financings....................    1,259,300           --    4,059,947

Repayments of debt and lease obligations.........   (1,366,655)  (2,496,849)  (1,171,926)

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

NET CASH PROVIDED BY (USED IN) FINANCING

ACTIVITIES.....................................      121,940     (346,290)  13,837,260

Effect of exchange rate on cash and cash

equivalents....................................           --     (181,627)     (46,111)

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

INCREASE (DECREASE) IN CASH AND CASH

EQUIVALENTS....................................   (8,076,913)  (3,979,883)  10,373,005

Cash and cash equivalents, January 1.............   15,941,701   19,921,584    9,548,579

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

CASH AND CASH EQUIVALENTS, DECEMBER 31...........  $ 7,864,788  $15,941,701  $19,921,584

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

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

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

INTEREST PAID....................................  $   444,047  $   436,461  $   616,671

</TABLE>



Non-cash: During 1998, the Company issued 101,320 shares of common stock to

liquidate a common stock liability.



See accompanying notes to consolidated financial statements.



37

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS



DECEMBER 31, 1998



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 1998 and 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

S.A., 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:



<TABLE>

<S>                                                              <C>

Building and improvements......................................  3-15 years

Machinery and equipment........................................  3-10 years

Furniture and fixtures.........................................  3-10 years

</TABLE>



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



38

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

expense at the time such patents are deemed to have no continuing value. At

December 31, 1998 and 1997, total costs capitalized were $4,285,000 and

$3,486,000 and the related accumulated amortization was $347,000 and $208,000,

respectively. Patent expense totaled $3,000, $365,000, and $249,000 in 1998,

1997 and 1996, 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. Substantially all of the Company's revenues and all of the

Company's long-lived assets attribute to research performed in the United

States; the Company derives significant revenues from its collaboration with

Astra AB, a company head-quartered in Sweden (See Note 15).



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.



39

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

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.



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



As of January 1, 1998, the Company adopted Statement 130, REPORTING

COMPREHENSIVE INCOME. Statement 130 establishes new rules for the reporting and

display of comprehensive income and its components; however, the adoption of

this Statement had no impact on the Company's net income or shareholders'

equity. Statement 130 requires unrealized gains or losses on the Company's

available-for-sale securities and the foreign currency translation adjustments,

which prior to adoption were reported separately in shareholders' equity, to be

included in other comprehensive income. Prior year financial statements have

been reclassified to conform to the requirements of Statement 130.



Effective January 1, 1998, the Company adopted the Financial Accounting

Standards Board's Statement of Financial Accounting Standards No. 131,

DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION (Statement

131). Statement 131 superseded FASB Statement No. 14, Financial Reporting for

Segments of a Business Enterprise. Statement 131 establishes standards for the

way that public business enterprises report information about operating segments

in annual financial statements and requires that those enterprises report

selected information about operating segments in interim financial reports.

Statement 131 also establishes standards for related disclosures about products

and services, geographic areas, and major customers. Inasmuch as the Company's

activities are all directed toward research and development of cell-based

therapeutic projects that have similar basic and economic characteristics, the

Company believes that aggregation of all such projects is consistant with the

objectives and basic principles of Statement 131.



3. STEMCELLS, INC.



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 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 in the aggregate, the assumption of certain

liabilities of $934,000 and transaction costs of $641,000. The purchase price

was allocated, based upon 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



40

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



3. STEMCELLS, INC. (CONTINUED)

has been expensed. As part of the acquisition of StemCells, Richard M. Rose,

M.D., became President, a Chief Executive Officer and a director of the Company,

and Irving L. Weissman, M.D. became a director of the Company.



Upon consummation of the merger, the Company entered into consulting

arrangements with the principal scientific founders of StemCells: Dr. Irving

Weissman, Fred H. Gage, Ph.D. and David Anderson, Ph.D. Additionally, in

connection with the merger, the Company was granted an option by the former

shareholders of StemCells to repurchase 500,000 of the Company's shares of

Common Stock exchanged for StemCells 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 at the grant date; approximately 100,000 of these options

are exercisable immediately, 1,031,000 of these options vest and become

exercisable only upon 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 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, S.A. (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



41

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



4. MODEX (CONTINUED)

transactions of $3,387,000 and accounted for its now approximately 25%

investment under the equity method.



In April 1998, Modex completed an additional equity offering, in which the

Company did not participate. This resulted in a reduction in the Company's

ownership interest to less than 20%; therefore, the Company began to account for

this investment under the cost 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 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.



42

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



5. MARKETABLE SECURITIES



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



<TABLE>

<CAPTION>

DECEMBER 31, 1998

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

<S>                                              <C>            <C>                <C>               <C>

GROSS UNREALIZED   GROSS UNREALIZED    ESTIMATED

COST             GAINS             LOSSES        FAIR VALUE

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

U.S. government securities.....................  $   1,500,994  $        1,720     $         (504  ) $   1,502,210

U.S. corporate securities......................      9,225,095           3,244             (9,658  )     9,218,681

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

Total debt securities..........................  $  10,726,089  $        4,964     $      (10,162  )    10,720,891

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

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

Debt securities included in cash and cash

equivalents..................................                                                         (1,199,952)

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

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

Debt securities included in marketable

securities...................................                                                      $   9,520,939

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

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

</TABLE>



<TABLE>

<CAPTION>

DECEMBER 31, 1997

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

<S>                                             <C>            <C>                <C>               <C>

GROSS UNREALIZED   GROSS 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

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

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

</TABLE>



Maturities of marketable securities held at December 31, 1998, are as

follows:



<TABLE>

<S>                                                                              <C>

Less than one year.............................................................  $10,219,171

One through five years.........................................................     501,720

----------

$10,720,891

----------

----------

</TABLE>



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.



43

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



6. OTHER INVESTMENT (CONTINUED)

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 $2,530,848 valuation reserve to

reduce the investment value to zero.



7. PROPERTY, PLANT AND EQUIPMENT



Property, plant and equipment consists of the following:



<TABLE>

<CAPTION>

DECEMBER 31,

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

<S>                                                              <C>            <C>

1998           1997

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

Land...........................................................  $          --  $          --

Building and improvements......................................      5,665,077      4,977,906

Machinery and equipment........................................      9,887,251      8,549,405

Furniture and fixtures.........................................        869,831        717,377

Construction in progress.......................................             --         23,947

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

16,422,159     14,268,635

Less accumulated depreciation and amortization.................      8,066,150      6,345,884

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

$   8,356,009  $   7,922,751

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

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

</TABLE>



Depreciation and amortization expense was $1,720,000, $1,778,000, and

$1,564,000 for the years ending December 31, 1998, 1997 and 1996, respectively.



Certain property, plant and equipment have been acquired under capitalized

lease obligations. These assets totaled $6,587,000, at December 31, 1998 and

1997 with related accumulated amortization of $2,860,000 and $2,297,000 at

December 31, 1998 and 1997, respectively.



In connection with the Company's new facility, the Company capitalized

$210,000 of interest costs in 1997.



44

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



8. OTHER ASSETS



Other assets are as follows:



<TABLE>

<CAPTION>

DECEMBER 31,

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

<S>                                                                 <C>           <C>

1998          1997

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

Patents, net......................................................  $  3,938,755  $  3,278,709

License agreements, net...........................................       659,750     1,036,750

Security deposit--building lease..................................       750,000       750,000

Restricted cash...................................................       603,457       552,357

Other investments.................................................            --       450,000

Deferred financing costs, net.....................................       123,701       131,507

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

$  6,075,663  $  6,199,323

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

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

</TABLE>



At December 31, 1998 and 1997, accumulated amortization was $818,000 and

$302,000, respectively, for patents and license agreements.



9. ACCRUED EXPENSES



Accrued expenses are as follows:



<TABLE>

<CAPTION>

DECEMBER 31,

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

<S>                                                                 <C>           <C>

1998          1997

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

External services.................................................  $    412,253  $  1,709,818

Employee compensation.............................................       262,679       755,951

Collaborative research............................................       196,505       499,575

Other.............................................................       148,682       276,203

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

$  1,020,119  $  3,241,547

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

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

</TABLE>



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 $583,000, 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 ten, $1,171,900

for years eleven to fourteen and $1,465,000 in year fifteen with a $750,000

security deposit



45

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



10. LEASES (CONTINUED)

held for the term of the lease. The Company is recognizing rent expense on a

straight line basis. At December 31, 1998, the Company has incurred $223,000 in

deferred rent expense. Future minimum capitalized lease obligations with

noncancelable terms in excess of one year at December 31, 1998, are as follows:



<TABLE>

<S>                                                               <C>

1999............................................................  $ 623,614

2000............................................................    606,684

2001............................................................    589,217

2002............................................................    519,719

2003............................................................    436,909

Thereafter......................................................  3,150,294

---------

Total minimum lease payments....................................  5,926,437

Less amounts representing interest..............................  2,347,687

---------

Present value of minimum lease payments.........................  3,578,750

Less current maturities.........................................    317,083

---------

Capitalized lease obligations, less current maturities..........  $3,261,667

---------

---------

</TABLE>



Rent expense for the years ended December 31, 1998, 1997 and 1996, was

$1,052,000, $499,000 and $495,000, respectively.



11. LONG-TERM DEBT



Long-term debt is as follows:



<TABLE>

<CAPTION>

DECEMBER 31,

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

<S>                                                                 <C>           <C>

1998          1997

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

Term note payable, interest at the prime rate plus 1/2% (8.75% at

December 31, 1998), principal payments commence in August 1998,

due ratably through May 2000; secured by certain equipment......  $  1,500,000  $    740,700

Term note payable, interest at the prime rate plus 1/2% (8.75% at

December 31, 1998), due ratably through December 1998; secured

by certain equipment............................................            --       432,588

Other.............................................................            --        41,223

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

1,500,000     1,214,511

Current maturities of long-term debt..............................     1,000,000       658,986

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

Long-term debt, less current maturities...........................  $    500,000  $    555,525

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

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

</TABLE>



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.



46

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



11. LONG-TERM DEBT (CONTINUED)

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

follows:



<TABLE>

<S>                                                               <C>

1999............................................................  $1,000,000

2000............................................................    500,000

---------

$1,500,000

---------

---------

</TABLE>



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. The agreement provided that 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 Common Stock having a value equal to the amount

of over funding, 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, 1998, $3,051,000 had been spent on the

collaboration with Genentech and, accordingly, the Company has reclassified

those common shares and related value to stockholders' equity. On May 21, 1998,

Genentech exercised its right to terminate the Parkinson's collaboration and has

requested that the Company redeem, at a price of $10.01 per share, shares of the

Company's Common Stock having an aggregate value of at least $3.1 million. The

Company is negotiating with Genentech regarding the amount of such redemption

(which the Company currently expects may be approximately $3.1 million) and the

manner of payment for such redemption.



13. COMMON STOCK TO BE ISSUED



In 1998, the Company entered into an agreement with a Company advisor, under

which the advisor prepared a strategic and business overview and provided

related implementation support for the Company. The advisor agreed to accept

cash and the Company's Common Stock as payment for its services. At December 31,

1998, the Company had paid the cash portion but had not issued the 85,258 shares

of Common Stock ($187,500) due to the advisor.



In 1997, 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. Options

generally vest ratably over four years and are



47

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



14. STOCKHOLDERS' EQUITY (CONTINUED)

exercisable for ten years from the date of grant or within three months of

termination. At December 31, 1998, the Company had reserved 3,560,826 shares of

common stock for the exercise of stock options. 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:



<TABLE>

<CAPTION>

1998                         1997                         1996

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

<S>                                    <C>          <C>              <C>         <C>              <C>         <C>

WEIGHTED                     WEIGHTED                     WEIGHTED

AVERAGE                      AVERAGE                      AVERAGE

OPTIONS    EXERCISE PRICE    OPTIONS    EXERCISE PRICE    OPTIONS    EXERCISE PRICE

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

Outstanding at January 1.............    2,446,573     $    7.48      2,423,025     $    8.34      1,921,284     $    7.72

Granted..............................    1,174,118          1.70        679,074          5.33        852,160          9.48

Exercised............................      (11,012)          .12        (82,737)         2.96       (168,085)         5.83

Canceled.............................   (1,955,553)         7.08       (572,789)         9.21       (182,334)         9.42

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

Outstanding at December 31...........    1,654,126     $    3.62      2,446,573     $    7.48      2,423,025     $    8.34

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

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

Options exercisable at December 31...    1,108,936     $    4.33      1,338,163     $    7.79      1,105,251     $    7.11

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

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

</TABLE>



In addition to the options noted above, in conjunction with the StemCells

merger, StemCells' 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 options 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.



On July 10, 1998 the Company's Board of Directors approved a stock repricing

program for all permanent employees who held stock options. The price of the new

options was $1.281, the closing price on July 10, 1998. Options were exchanged

based on a .75 to 1 ratio. Employees surrendered 1,064,472 options for repricing

and the Company granted 751,018 repriced options, net of departures, in

accordance with this plan. All exchanged options were subject to a six month

blackout period that expired on February 12, 1999. The effect of this repricing

is reflected in the above rollforward.



In July 1998, the Company adopted a shareholder rights plan, and the Board

of Directors declared a dividend consisting of one purchase right (a "Right")

for each share of Common Stock outstanding on August 4, 1998. Each share of

Common Stock issued after that date will be issued with an attached Right. Each

Right entitles the holder, upon the occurrence of certain events, to purchase

1/100th of a share of Junior Preferred Stock at an initial exercise price of

$10, subject to adjustments for stock dividends, splits and similar events. The

Rights are exercisable only if a person or group acquires 15 percent or more of

the Company's Common Stock or commences a tender of exchange offer, the

consummation of which would result in ownership by such person or group of 15

percent or more of the Company's Common Stock. The



48

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



14. STOCKHOLDERS' EQUITY (CONTINUED)

Rights may be redeemed by the Board of Directors at any time prior to the

expiration of the rights plan on July 27, 2008 at the redemption price of $.01

each and may be amended by the Board at any time prior to becoming exercisable.

At March 31, 1999 there were 18,370,663 Junior Preferred Stock Purchase Rights

outstanding.



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. The following table presents weighted average price and life

information about significant option groups outstanding at December 31, 1998:



<TABLE>

<CAPTION>

OPTIONS OUTSTANDING               OPTIONS EXERCISABLE

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

<S>                               <C>          <C>              <C>          <C>         <C>

WEIGHTED

AVERAGE       WEIGHTED                 WEIGHTED

REMAINING       AVERAGE                  AVERAGE

RANGE OF                NUMBER       CONTRACTUAL     EXERCISE      NUMBER     EXERCISE

EXERCISE PRICES           OUTSTANDING    LIFE (YRS.)       PRICE     EXERCISABLE    PRICE

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

Less than $5.00.................   1,180,750           7.44      $    1.30      689,246   $    1.25

$5.01 - $10.00..................     240,876           6.07           7.31      203,856        7.13

Greater than $10.00.............     232,500           4.97          11.59      215,834       11.50

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

1,654,126                                  1,108,936

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

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

</TABLE>



Pursuant to the requirements of FAS 123, the following are the pro forma net

loss and net loss per share for 1998, 1997, and 1996, 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 1998, 1997, and 1996,

consistent with the provisions of FAS 123:



<TABLE>

<CAPTION>

1998                            1997                            1996

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

<S>                        <C>             <C>             <C>             <C>             <C>             <C>

AS REPORTED      PRO FORMA      AS REPORTED      PRO FORMA      AS REPORTED      PRO FORMA

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

Net loss.................  $  (12,627,830) $  (14,919,389) $  (18,113,580) $  (19,924,437) $  (13,759,138) $  (14,931,000)

Net loss per share.......  $         (.69) $         (.82) $        (1.08) $        (1.19) $         (.89) $         (.97)

</TABLE>



The weighted average fair value per share of options granted during 1998,

1997 and 1996, was $0.82, $3.40, and $5.67, 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:



<TABLE>

<CAPTION>

OPTIONS                    STOCK PURCHASE PLAN

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

<S>                                    <C>        <C>        <C>        <C>        <C>        <C>

1998       1997       1996       1998       1997       1996

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

Expected life (years)................          5          5          5         .5         .5          5

Interest rate........................        5.2%       6.2%       6.5%      4.64%       5.5%       6.5%

Volatility...........................       63.5%      59.0%      63.0%      63.5%      59.0%      63.0%

</TABLE>



49

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



14. STOCKHOLDERS' EQUITY (CONTINUED)

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 1998, 1997 and 1996 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.



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 7,818,936 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 research on certain stem-cell research. Under

the terms of the agreement, StemCells agreed to fund research in the total

amount of approximately $931,000 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



50

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



15. RESEARCH AGREEMENTS (CONTINUED)

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 purchased $250,000 of

Cognetix preferred stock and, subject to certain milestones, was 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 October 1998, the Company sold the $250,000 of

preferred stock back to Cognetix for $298,914. The Company and Cognetix are

presently discussing proposed revisions to their relationship under the

agreement.



In April 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, the Company has an exclusive

royalty bearing license for growth-factor responsive stem cells for

transplantation. Neurospheres had an option to acquire co-exclusive rights but

did not exercise by the April 1998 deadline. The Company retains exclusive

rights for transplantation. 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. Genentech had the right, at its discretion to

terminate the Parkinson's program at specified milestones in the program. The

agreement provided that if the Parkinson's agreement was terminated and the

funds of 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 had the right to

require the Company to repurchase from Genentech shares of the Company's common

stock having a value equal to the overfunding, based upon the share price paid

by Genentech. As such, the common stock purchased by Genentech is classified as

redeemable common stock until the funds are expended on the program. On May 21,

1998, Genentech, exercised its right to terminate the collaboration and

negotiations are currently underway to determine the balance of redeemable

common stock to be redeemed in accordance with the agreement. (See Note 12)



The Company also licensed growth factors for the treatment of Huntington's

disease and for amyotrophic lateral sclerosis (ALS) from Genentech. Under the

terms of such 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 elect to 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



51

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



15. RESEARCH AGREEMENTS (CONTINUED)

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.



In May 1998, Astra AB agreed to increase annual research and development

payments from $7 million to $8.5 million for the calendar year 1998. This

increase in funding was recognized as revenue in the third and fourth quarters

of 1998. The current Phase II pain trial is expected to complete patient

enrollment by March 31, 1999, with efficacy data from the trial expected by the

third quarter of 1999. Astra AB has agreed to fund the first and second quarters

of 1999 at the rate of $2.5 million per quarter. Funding for the second half of

1999 is contingent on the results of the current Phase II trial. Should Astra

determine to discontinue funding for the Company's development of

encapsulated-cell products to treat pain, or to reduce such funding or otherwise

modify the terms of the Company's relationship with Astra, any such action could

have a material, adverse effect on the Company's liquidity and capital

resources, and, unless other funding sources were obtained, would likely result

in the Company's inability to continue to fund further development of its

proposed encapsulated-cell products.



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 these collaborations amounted

to approximately $1,259,000, $1,326,000, and $1,337,000 for the years ended

December 31, 1998, 1997 and 1996, 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, 1998, the Company

had tax net operating loss carryforwards of $26,966,000 and research and

development tax credit carryforwards of $3,646,000 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.



52

CYTOTHERAPEUTICS, INC.



NOTES TO CONSOLIDATED FINANACIAL STATEMENTS (CONTINUED)



DECEMBER 31, 1998



16. INCOME TAXES (CONTINUED)

Significant components of the Company's deferred tax assets and liabilities

are as follows:



<TABLE>

<CAPTION>

DECEMBER 31,

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

<S>                                                             <C>             <C>

1998            1997

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

Deferred tax assets:

Capitalized research and development costs..................  $   28,124,000  $   23,876,000

Net operating losses........................................      10,786,000       9,977,000

Research and development credits............................       3,646,000       2,963,000

Other.......................................................         235,000         275,000

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

42,791,000      37,091,000

Deferred tax liabilities:

Patents.....................................................      (1,537,000)     (1,296,000)

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

41,254,000      35,795,000

Valuation allowance.........................................     (41,254,000)    (35,795,000)

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

Net deferred tax assets.......................................  $           --  $           --

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

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

</TABLE>



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, 1998 and 1997, to fully offset the Company's deferred tax assets.

The valuation allowance increased $5,459,000 in 1998, 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 $146,000, $169,000, and $162,000 for the years ended December 31, 1998, 1997

and 1996, respectively.



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.



53

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 1999 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 1999 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 1999 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 1999 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:



<TABLE>

<CAPTION>

ITEM                                                                                    LOCATION

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

<S>                                                                                   <C>

Schedule II--Valuation and Qualifying Accounts......................................          S-1

</TABLE>



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.



<TABLE>

<CAPTION>

EXHIBIT NO.                                             TITLE OR DESCRIPTION

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

<C>                <S>



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.

</TABLE>



54

<TABLE>

<CAPTION>

EXHIBIT NO.                                             TITLE OR DESCRIPTION

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

<C>                <S>

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.



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.

</TABLE>



55

<TABLE>

<CAPTION>

EXHIBIT NO.                                             TITLE OR DESCRIPTION

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

<C>                <S>

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



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.

</TABLE>



56

<TABLE>

<CAPTION>

EXHIBIT NO.                                             TITLE OR DESCRIPTION

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

<C>                <S>

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

the Registrant.



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 among 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 the Registrant,

together with the related Promissory Note executed by the Registrant, and an amendatory

agreement dated as of May 15, 1997.



10.79~           Rights Agreement, dated as of July 27, 1998 between Bank Boston, N.A. as Rights Agent and the

Registrant.



10.80            Employment Agreement dated as of June 8, 1998 between Philip K. Yachmetz and the Registrant.



10.81            Consulting Services Agreement dated as of July 27, 1998, as amended December 19, 1998 between

Dr. John J. Schwartz and the Registrant.



10.82            Letter Agreement dated as of December 19, 1998 between John J. Schwartz and the Registrant.



10.83**          License Agreement dated as of October 27, 1998 between The Scripps Research Institute and the

Registrant.



10.84**          License Agreement dated as of October 27, 1998 between The Scripps Research Institute and the

Registrant.



10.85**          License Agreement dated as of November 20, 1998 between The Scripps Research Institute and the

Registrant.

</TABLE>



57

<TABLE>

<CAPTION>

EXHIBIT NO.                                             TITLE OR DESCRIPTION

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

<C>                <S>

10.86            Employment Agreement dated as of March 20, 1998 between Billie M. York and the Registrant



21               Subsidiaries of the Registrant.



23.1             Consent of Ernst & Young LLP, Independent Auditors.



27               Financial Data Schedule for fiscal year ended December 31, 1998.



99               Cautionary Factors Relevant to Forward-Looking Information.

</TABLE>



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



++ 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.



### 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, 1997 and filed on March 30, 1998.



~ Previously filed with the Commission as an Exhibit to, and incorporated

herein by reference to, the Registrant's current report on Form 8-K filed

on August 3, 1998.



(B) CURRENT REPORTS ON FORM 8-K.



On December 29, 1998, the Company filed a Report on Form 8-K with the

Securities and Exchange Commission announcing the election of two new directors

and a new Chairman of the Board of Directors.



58

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.



<TABLE>

<S>                             <C>  <C>

CYTOTHERAPEUTICS, INC.



BY:          /S/ RICHARD M. ROSE, M.D.

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

Richard M. Rose, M.D.

President and Chief Executive Officer

</TABLE>



Dated: March 31, 1999



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.



<TABLE>

<CAPTION>

SIGNATURE                      CAPACITY                   DATE

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

<C>                             <S>                          <C>

President, Chief Executive

/s/ RICHARD M. ROSE, M.D.       Officer, and Director

- ------------------------------    (principal executive         March 31, 1999

Richard M. Rose, M.D.         officer)



Chief Financial Officer and

Treasurer (principal

/s/ JOHN S. MCBRIDE          financial and accounting

- ------------------------------    officer); Executive Vice     March 31, 1999

John S. McBride            President, Business

Operations



/s/ PATRICK AEBISCHER, M.D.,   Director

PH.D.

- ------------------------------                                 March 31, 1999

Patrick Aebischer, M.D., Ph.D.



/s/ MOSES GODDARD, M.D.      Director

- ------------------------------                                 March 31, 1999

Moses Goddard, M.D.



/s/ MARK J. LEVIN         Director

- ------------------------------                                 March 31, 1999

Mark J. Levin



/s/ RICHARD J. RAMSDEN      Director

- ------------------------------                                 March 31, 1999

Richard J. Ramsden



/s/ JOHN J. SCHWARTZ, PH.D.    Director, Chairman of the

- ------------------------------    Board                        March 31, 1999

John J. Schwartz, Ph.D.



/s/ IRVING L. WEISSMAN, M.D.   Director

- ------------------------------                                 March 31, 1999

Irving L. Weissman, M.D.

</TABLE>



59