PART I - FINANCIAL INFORMATION

Item 1.

CLARIENT, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in thousands, except share and per share amounts)

	September 30,			December 31,
	2005			2004
	(Unaudited)
Current assets:
Cash and cash equivalents	$	2,092		$	10,045
Accounts receivable, net of allowance for doubtful accounts of $175 and $135 in 2005 and 2004, respectively (Instrument Systems and Other)	1,229			1,387
Accounts receivable, net of allowance for doubtful accounts of $642 and $140 in 2005 and 2004, respectively (Diagnostic Services)	3,015			1,273
Net investment in sales type leases	45			—
Prepaid expenses and other current assets	898			528
Total current assets	7,279			13,233
Property and equipment, net of accumulated depreciation	6,306			6,084
Patents, net of accumulated amortization	735			743
Net investment in sales type leases	244			—
Other	76			97
Total assets	$	14,640		$	20,157

Liabilities and Stockholders’ Equity
Current liabilities:
Revolving line of credit	$	2,000		$	—
Accounts payable	1,979			1,566
Accrued payroll	1,709			1,148
Accrued liabilities	1,244			1,040
Deferred revenue	1,431			98
Current maturities of long-term debt, including capital lease obligations	2,128			2,031
Total current liabilities	10,491			5,883
Long-term debt, including capital lease obligations	1,607			2,386
Deferred rent	1,148			—
Total long term liabilities	2,755			2,386

Commitments and contingencies
Stockholders’ equity:
Common stock $0.01 par value, authorized 100,000,000 shares, issued and outstanding 51,805,151 shares in 2005 and 51,428,084 in 2004	519			516
Additional paid-in capital	117,878			117,481
Accumulated deficit	(116,585		)	(105,483		)
Unamortized deferred compensation	(360		)	(576		)
Accumulated other comprehensive loss	(58		)	(50		)
Total stockholders’ equity	1,394			11,888
Total liabilities and stockholders’ equity	$	14,640		$	20,157

See accompanying notes to condensed consolidated financial statements.

CLARIENT, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

(in thousands, except share and per share amounts)

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Revenue:

Diagnostic services	$	3,030		$	812		$	7,556		$	981
Instrument systems and other	1,876			1,751			6,566			5,905

Total revenue	4,906			2,563			14,122			6,886
Cost of revenue:
Diagnostic services	2,334			1,300			6,207			1,446
Instrument systems and other	559			867			1,847			2,778
Total cost of revenue	2,893			2,167			8,054			4,224
Gross profit	2,013			396			6,068			2,662
Operating expenses:
Selling, general and administrative	3,713			3,467			9,824			10,302
Diagnostic services administration	1,554			1,045			4,525			2,553
Research and development	952			1,241			2,668			3,570
Total operating expenses	6,219			5,753			17,017			16,425
Loss from operations	(4,206		)	(5,357		)	(10,949		)	(13,763		)
Other expense (income)	91			(5		)	153			72
Loss before income taxes	(4,297		)	(5,352		)	(11,102		)	(13,835		)

Income taxes	—			—			—			—
Net loss	$	(4,297	)	$	(5,352	)	$	(11,102	)	$	(13,835	)
Basic and diluted net loss per common share	$	(0.08	)	$	(0.10	)	$	(0.21	)	$	(0.29	)
Weighted average number of common shares outstanding	51,854,049			51,428,084			51,748,212			48,123,157

See accompanying notes to condensed consolidated financial statements.

CLARIENT, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(in thousands, except share and per share amounts)

(Unaudited)

	Nine Months Ended September 30,
	2005			2004

Cash flows from operating activities:
Net loss	$	(11,102	)	$	(13,835	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	2,190			2,248
Non-cash compensation charges	424			586
Provision for bad debt	542			195

Changes in operating assets and liabilities:
Accounts receivable, net (Instrument Systems & Other)	128			402
Accounts receivable, net (Diagnostic Services)	(2,254		)	—
Net investment in sales type leases	(289		)	—
Prepaid expenses and other assets	(179		)	153
Accounts payable	413			1,303
Accrued payroll	561			787
Accrued liabilities	204			(34		)
Deferred rent	1,148			—
Deferred revenue	1,333			145
Net cash used in operating activities	(6,881		)	(8,050		)

Cash flows used in investing activities:
Additions to patents	(96		)	(246		)
Purchase of property and equipment	(2,478		)	(2,878		)
Net cash used in investing activities	(2,574		)	(3,124		)

Cash flows from financing activities:
Proceeds from exercise of stock options	192			—
Repayments on long-term debt, including capital lease obligation	(1,598		)	(810		)
Borrowings on long-term debt, including capital lease obligation	916			1,628
Borrowings on revolving line of credit	2,000			—
Issuance of common stock	—			26,068
Offering costs	—			(1,580		)
Net cash provided by financing activities	1,510			25,306

Effect of exchange rate changes on cash and cash equivalents	(8		)	28

Net increase (decrease) in cash and cash equivalents	(7,953		)	14,160

Cash and cash equivalents at beginning of period	10,045			1,699

Cash and cash equivalents at end of period	$	2,092		$	15,859

See accompanying notes to condensed consolidated financial statements.

CLARIENT, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(1) Interim Financial Statements

These interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our annual report on Form 10-K for the fiscal year ended December 31, 2004 filed with the Securities and Exchange Commission.

The accompanying unaudited condensed consolidated financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the financial position and the results of operations for the interim periods presented. All such adjustments are of a normal, recurring nature. Certain amounts have been reclassified to conform to the current period presentation. The results of operations for any interim period are not necessarily indicative of the results to be obtained for a full fiscal year.

Stock Options

The pro forma information presented below assumes the Company had accounted for stock options granted using the fair value method prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-based Compensation.”

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting periods. The Company’s historical and pro forma net loss per share for the three and nine month periods ended September 30, 2005 and 2004 and the per share weighted-average fair value of options granted for the three and nine month periods ended September 30, 2005 and 2004 are as follows (in thousands, except per share data):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Consolidated net loss attributable to common stock:
As reported	$	(4,297	)	$	(5,352	)	$	(11,102	)	$	(13,835	)
Add: Stock-based employee compensation expense included in net loss	167			84			424			586
Deduct: Total stock-based employee compensation expense determined under fair value based methods for all awards	(507		)	(328		)	(1,484		)	(1,353		)
Pro forma net loss	$	(4,637	)	$	(5,596	)	$	(12,162	)	$	(14,602	)

Net loss per share – Basic and diluted:
As reported	$	(0.08	)	$	(0.10	)	$	(0.21	)	$	(0.29	)
Pro forma	$	(0.09	)	$	(0.11	)	$	(0.24	)	$	(0.30	)

Per share weighted-average fair value of stock options granted	$	1.18		$	1.03		$	0.99		$	1.50

The following assumptions were used to determine the fair value of stock options granted using the Black-Scholes option-pricing model:

	2005		2004
Dividend yield	0.0	%	0.0	%
Volatility	100	%	108	%
Average expected option life	4 years		4 years
Risk-free interest rate	4.49	%	3.16	%

(2) Net Loss Per Share

Basic and diluted loss per common share is calculated by dividing net loss by the weighted average common shares outstanding during the period. Options and warrants to purchase an aggregate of 10,354,247 and 9,639,229 shares of common stock were outstanding at September 30, 2005 and 2004, respectively. These outstanding options and warrants were not included in the computation of diluted earnings per share because the Company incurred a net loss in all periods presented and therefore, the impact would be anti-dilutive.

(3) Patents

Patents with estimated useful lives are amortized over their respective estimated useful lives to their respective estimated residual values. The following table provides a summary of the Company’s patents with definite useful lives recorded as of September 30, 2005 (in thousands):

	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Amortization Period in Years
Technology related	$	1,273	$	(538	)	$	735	10

The following table summarizes future estimated annual pretax amortization expense for these assets (in thousands):

Fiscal Year
2005	$	33
2006	132
2007	132
2008	132
2009 & thereafter	306
Total	$	735

(4) Net Investment in Sales-Type Leases

The Company derives a portion of its revenues under leasing arrangements. Such arrangements provide for monthly payments covering the system sale, maintenance and interest. These arrangements meet the criteria to be accounted for as sales-type leases pursuant to Statement of Financial Accounting Standards No. 13, “Accounting for Leases.” Accordingly, the system sale is recognized upon delivery of the system and acceptance by the customer. Upon the recognition of revenue, an asset is established for the “investment in sales-type leases.” Maintenance revenue and interest income are recognized monthly over the lease term.

The components of the net investment in sales-type leases as of September 30, 2005 (in thousands) are listed below:

Total minimum lease payments to be received	$	395
Less: Amounts representing estimated maintenance costs including profit thereon, included in total minimum lease payments	(62		)
Net minimum lease payments receivable	333
Less: Unearned income & interest	(44		)
Net investment in sales-type leases	$	289

(5) Currency Translation

The financial position and results of operations of the Company’s foreign subsidiaries are determined using the applicable local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate in effect at each quarter-end. Income statement accounts are translated at the average rate of exchange prevailing during applicable period. The effects of currency translations are included in comprehensive loss.

(6) Comprehensive Loss

The total comprehensive loss is summarized as follows (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Net loss	$	(4,297	)	$	(5,352	)	$	(11,102	)	$	(13,835	)
Foreign currency translation adjustment	(14		)	26			(8		)	28
Comprehensive loss	$	(4,311	)	$	(5,326	)	$	(11,110	)	$	(13,807	)

(7) Business Segments

The Company operates primarily in two segments – “diagnostic services” (which consists of the Company’s diagnostic laboratory services business) and “instrument systems and other” (which comprises the development, manufacture and marketing of an automated cellular imaging system designed to assist physicians in making critical medical decisions, including services to biopharmaceutical companies and other research organizations). The segments are determined based on product and/or services delivered to customer groups. The Company’s chief operating decision maker is the Chief Executive Officer and President. The chief operating decision maker allocates resources and assesses performance and other activities at the operating segment level.

Results from operations for our operating segments are as follows (in thousands):

	Three Months Ended September 30, 2005							Three Months Ended September 30, 2004
	Diagnostic Services		Instrument Systems & Other		Total			Diagnostic Services			Instrument Systems & Other		Total
Total revenues	$	3,030	$	1,876	$	4,906		$	812		$	1,751	$	2,563

Cost of revenue	2,334		559		2,893			1,300			867		2,167
Gross profit (loss)	$	696	$	1,317	$	2,013		$	(488	)	$	884	$	396
Selling, general and administrative (including diagnostic services administration)					5,267								4,512
Research and development					952								1,241
Loss from operations					$	(4,206	)						$	(5,357	)
Other expense					91								(5		)
Net loss					$	(4,297	)						$	(5,352	)

	Nine Months Ended September 30, 2005							Nine Months Ended September 30, 2004
	Diagnostic Services		Instrument Systems & Other		Total			Diagnostic Services			Instrument Systems & Other		Total
Total revenues	$	7,556	$	6,566	$	14,122		$	981		$	5,905	$	6,886

Cost of revenue	6,207		1,847		8,054			1,446			2,778		4,224
Gross profit (loss)	$	1,349	$	4,719	$	6,068		$	(465	)	$	3,127	$	2,662
Selling, general and administrative (including diagnostic services administration)					14,349								12,855
Research and development					2,668								3,570
Loss from operations					$	(10,949	)						$	(13,763	)
Other expense					153								72
Net loss					$	(11,102	)						$	(13,835	)

	September 30,2005		December 31,2004
Identifiable assets
Diagnostic Services	$	7,954	$	14,292
Instrument systems & other	6,686		5,865
Total assets	$	14,640	$	20,157

The following table represents business segment information by geographic area (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Revenue
United States	$	4,898		$	2,441		$	13,982		$	6,041
Europe (a)	8			122			140			845
Total revenue	$	4,906		$	2,563		$	14,122		$	6,886

Operating loss
United States	$	(4,157	)	$	(5,378	)	$	(10,779	)	$	(13,740	)
Europe (a)	(49		)	21			(170		)	(23		)
Loss from operations	$	(4,206	)	$	(5,357	)	$	(10,949	)	$	(13,763	)

	September 30,2005		December 31,2004
Identifiable assets
United States	$	14,586	$	20,115
Europe (a)	54		42
Total assets	$	14,640	$	20,157

(a) European operations represent business activities conducted primarily in Germany and Great Britain.

(8) Recent Accounting Pronouncements

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) will require companies to measure all employee stock-based compensation awards using a fair value method and record such expense in their consolidated financial statements. The adoption of SFAS No. 123(R) requires additional accounting and disclosure related to the income tax and cash flow effects resulting from share-based payment arrangements. SFAS No. 123(R) would have been effective beginning as of the first interim or annual reporting period beginning after June 15, 2005. On April 14, 2005, the Securities and Exchange Commission changed the effective date for most public companies with annual periods that begin after June 15, 2005. The Company is in the process of determining the impact of the requirements of SFAS No. 123(R) which could have a material impact on its consolidated financial statements.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs,” (“SFAS No. 151”), an amendment of Accounting Research Bulletin No. 43, Inventory Pricing. SFAS No. 151 requires all companies to recognize a current-period charge for abnormal amounts of idle facility expense, freight, handling costs and wasted materials. The statement also requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. This new standard will be effective for fiscal years beginning after June 15, 2005. The Company is currently evaluating the effect that the accounting change will have on its financial position, results of operations, and cash flows.

In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections-a replacement of APB No. 20 and FAS No. 3” (“SFAS No. 154”). SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS No. 154 also provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The correction of an error in previously issued financial statements is not an accounting change. However, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. Therefore, the reporting of a correction of an error by restating previously issued financial statements is also addressed by SFAS No. 154. SFAS No. 154 is required to be adopted in fiscal years beginning after December 15, 2005. We do not believe its adoption will have a material impact on our financial position, results of operation or cash flows.

In June 2005, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination” (“EITF 05-6”). This guidance requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized over the shorter of the useful life of the assets or a term that includes required lease periods and renewals that are reasonably assured at the date of the business combination or purchase. This guidance is applicable only to leasehold improvements that are purchased or acquired in reporting periods beginning after June 29, 2005. The adoption of EITF 05-6 is not expected to have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

(9) Stock Transactions

Due to its beneficial ownership of a majority of the Company’s outstanding common stock, Safeguard has the power to elect all of the directors of the Company. Safeguard has preemptive rights with respect to issuances of the Company’s capital stock and other contractual rights enabling it to exercise significant control over the Company.

(10) Line of Credit

The Company currently has an $8.5 million revolving credit agreement, which expires on January 31, 2006 (the line of credit was increased from $5.5 million to $8.5 million in August 2005) and bears interest at the bank’s prime rate minus one-half percent. The borrowings under the line of credit are being used for working capital purposes and to provide a $3.0 million stand-by letter of credit to the landlord of our new facility. The agreement also includes an annual facility fee of $27,500 and various restrictive covenants and requirements to maintain certain financial ratios. The Company paid Safeguard a commitment fee of $15,000 and issued to Safeguard a warrant to purchase 50,000 shares of common stock for an exercise price of $2.00 per share as additional consideration for Safeguard’s $3.0 million increase in the guarantee in August 2005. The Company is also obligated to pay Safeguard an amount equal to 4.5% per annum of the daily-weighted average principal balance outstanding under the line of credit. The revolving credit agreement has only one financial covenant related to tangible net worth, which is required to be greater than ($2,000,000). As of September 30, 2005, the Company was in compliance with its tangible net worth covenant.

(11) Equipment and Financing

In August 2003, the Company entered into an agreement for an equipment financing line from General Electric Capital Corporation (“GE Capital”). The equipment financing line provides for $3.0 million in immediate financing resources and an additional $2.0 million as the Company achieves certain system placement objectives. The loan principal amortizes ratably over a 33 month term. In September 2003, the Company borrowed $3.0 million at an interest rate of 8.16% under the equipment financing agreement. These borrowings under the equipment financing agreement are being used for working capital purposes and are secured by substantially all of the assets of the Company. The agreement also provides for various restrictive covenants, maintenance of certain financial ratios and a collateral monitoring fee of $5,000 per year.

The equipment financing agreement also includes a provision whereby a material adverse change in the Company’s financial condition may be considered an event of default. Based on current operations, current borrowings and the Company’s $2.1 million cash balance as of September 30, 2005, the Company believes that it will remain in compliance with its debt covenants over the next twelve months and that it is not probable that GE Capital will exercise the material adverse change

clause as an event of default. The covenants in the equipment financing agreement incorporate the restrictive covenants and certain other requirements of the Comerica revolving credit agreement described in Note 10, including any subsequent waivers or amendments granted by Comerica. As of September 30, 2005, the debt balance outstanding on the equipment financing line was $1.0 million of which all $1.0 million was classified as current.

In June 2004, the Company entered into a master lease agreement with GE Capital for capital equipment financings of diagnostic services (laboratory) related equipment. During 2004, the Company financed $2.6 million of capital equipment under this arrangement, which was recorded as a capital lease obligation. Each lease financing has a term of 36 months and provides for an early purchase option by the Company after 30 months at 26.6% of the cost of the equipment. As of September 30, 2005, the Company had financed $2.2 million of capital equipment, which was recorded as a capital lease obligation. Approximately $0.9 million of this balance was classified as current and $1.1 million was classified as long-term.

In January 2005, GE Capital approved additional equipment lease financings of up to $2.3 million under this master lease agreement for equipment leases during 2005, subject to execution of definitive documentation for each separate equipment lease and subject to GE Capital’s review of the Company’s financial condition at the time of each funding request. These additional equipment lease financings have a term of 36 months for each equipment purchase and provide for an early purchase option by the Company after 24 months for a purchase price equal to 40.5% of the cost of the equipment. As of September 30, 2005, the Company had financed $0.9 million of capital equipment under this line, which was recorded as a capital lease obligation. As of September 30, 2005, approximately $0.3 million of this balance was classified as current and $0.6 million was classified as long-term.

The debt and capital lease obligations as of September 30, 2005 were as follows (in thousands):

Fiscal Year:
2005	$	561
2006	1,867
2007	1,130
2008	177
Total	3,735
Less: current portion	(2,128		)
Debt and capital lease obligation, excluding current portion	$	1,607

(12) Commitments and Contingencies

Operating lease

We entered into a lease agreement dated as of July 20, 2005 for a mixed-use building with approximately 78,000 square feet in Aliso Viejo, California. The term of the lease commences on December 1, 2005 with an initial term of ten years and an option to extend the lease term for up to two additional five-year periods. The initial annual base rent will be approximately $0.5 million. As the Company occupies additional square footage, the annual base rent will be increased to $1.0 million on June 1, 2006 and to $1.4 million on December 1, 2008. The base rent is increased 3% annually effective on December 1 of each year. We are also responsible for payments of common area operating expenses for the premises. The landlord has agreed to fund approximately $3.5 million of tenant improvements toward design and construction costs associated with our build-out of the Aliso Viejo facility. Such costs will be capitalized as leasehold improvements and amortized over their estimated useful life, while the reimbursement will be recorded to deferred rent and recovered ratably over the term of the lease. Our total projected spending for the build-out of this facility, including the $3.5 million of tenant improvements which will be funded by the landlord, is approximately $8 million to $9 million.

At September 30, 2005, future minimum lease payments for all operating leases are as follows:

Fiscal Year:
2005	$	154
2006	823
2007	1,048
2008	1,104
2009	1,414
After 2009	9,264
Operating lease obligation	$	13,807

Distribution and Development Agreement with DAKO

On July 18, 2005, the Company entered into a distribution and development agreement with DakoCytomation Denmark A/S (“DAKO”), a Danish company that provides system solutions for cancer diagnostics and cell analysis worldwide. Under the terms of the agreement, DAKO will distribute and market the Company’s Automated Cellular Imaging System (ACIS^Ò) II system and related software. The distribution arrangement is exclusive on a worldwide basis in research and clinical markets, and non-exclusive with respect to biotechnology and pharmaceutical companies (and their academic research partners). The agreement has a five year initial term.

DAKO has agreed to order a minimum of 40 ACIS^Ò II systems per contract year (15 in the first year), subject to certain adjustments. Revenue from systems sold under this agreement will be recognized when title and risk of ownership have been transferred to DAKO and the product has shipped to DAKO or an end-user and no risk of return exists.

DAKO has also agreed to invest research and development funds toward a future ACIS^Ò device and related software, and such products would also be subject to the terms of the agreement. The Company will own all intellectual property created under the agreement that is related to image analysis and execution thereof, and DAKO will own all intellectual property created under the agreement that is related to DAKO’s specific implementation of the products or integration of the products with a product supplied by DAKO. Such intellectual property will be cross-licensed from one party to the other. In the event the Company fails to supply ACIS^Ò systems as set forth in the agreement, DAKO will have the right and license to manufacture the ACIS^Ò systems for that purpose, for a reduced fee. Revenue received from research and development fees (including upfront and milestone payments) will be deferred and recognized when the applicable revenue recognition criteria is met.

(13) Subsequent Events

Construction Agreement

On October 26, 2005 the Company entered into a construction agreement with LCS Constructors, Inc., (“LCS”), a team of general contractors and construction managers dedicated to the planning, design, construction, and facility support of laboratories and technical facilities, to build-out its newly-leased facility in Aliso Viejo, California. Under the terms of the agreement, LCS will provide or arrange for construction services, materials, equipment, permits and liability insurance for the construction of the Aliso Viejo facility. The project is expected to be completed in three phases, with a first phase target substantial completion date of December 31, 2005, at which time the Company anticipates moving its lab facilities to this new location. If LCS does not achieve substantial completion on or prior to the substantial completion date, the Company will be entitled to deduct and offset against sums otherwise payable to LCS an amount equal to $1,000 for each calendar day after the substantial completion date until substantial completion is achieved. The total amount to be paid for the first phase of the build-out pursuant to the contract is $3.7 million with an additional $200,000 contingency to cover change orders, in each case subject to adjustment. Fees for the remaining two phases of the build-out will be included in amendments to this contract and are estimated to be approximately $1.5 million for Phase II and $350,000 for Phase III. The anticipated substantial completion date for Phase II and Phase III is March 31, 2006. Payments for all phases will be made in installments based on the percentage of completion. The final payment on each phase will be made after LCS has completed the applicable phase in its entirety, all corrective items have been completed and the architect prepares a final completion notice.

Private Placement

On November 8, 2005, the Company entered into a securities purchase agreement with a limited number of accredited investors pursuant to which the Company has agreed to issue 15,000,000 shares of common stock, together with warrants to purchase an additional 2,250,000 shares of common stock, for an aggregate purchase price of $15,000,000. The exercise price of the warrants is $1.35 per share. The warrants are exercisable until the fourth anniversary of the date of issuance. The Company agreed to pay a placement fee of $150,000 in connection with the financing. The financing was approved by the Company’s board of directors (including a committee comprised of independent directors) and by its majority stockholders, which are subsidiaries of Safeguard Scientifics, Inc. (“Safeguard”). The Company’s board of directors received a fairness opinion from Roth Capital Partners, LLC with respect to the financing.

Under NASD Marketplace Rule 4350(i)(1)(D)(ii), stockholder approval is required for issuances of securities in an amount greater than 20% of the Company’s outstanding common stock for a purchase price of less than the greater of book or market value. Although the Company has obtained stockholder approval by written consent for the transaction, under Rule 14c under the Securities and Exchange Act of 1934, this approval will become effective 21 days after the Company mails an information statement to its stockholders disclosing that it has obtained stockholder approval for the private placement. In order to comply with Rule 4350(i)(1)(D)(ii), the private placement was structured to be completed in two closings. In the first closing, which is expected to occur on or about November 9, 2005, the Company will issue 8,900,000 shares of common stock and warrants to purchase 1,335,000 shares of common stock, for an aggregate purchase price of $8.9 million. Under the terms of the purchase agreement, the second closing will occur promptly following the effective date of the stockholder approval for the private placement, which is expected to be no earlier than December 10, 2005. At the second closing, the Company will issue the remaining 6,100,000 shares of common stock and warrants to purchase 915,000 shares of common stock for an aggregate purchase price of $6,100,000. The investors in the private placement are required to deposit the purchase price to be paid at the second closing into an escrow account, which deposit will be released to the Company on the date of the second closing.

The Company has agreed to file a registration statement covering resales of the securities acquired by the purchasers in the private placement. Safeguard is purchasing an aggregate of $9,000,000 of the securities in the new financing and will own a majority of the Company’s common stock following completion of the private placement. The securities associated with the financing are being issued to a limited number of accredited investors in a private placement exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), and may not be resold unless there is either an effective registration statement under the Securities Act or a valid exemption from the registration requirements of the Securities Act.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about us, the industries in which we operate and other matters, as well as management’s beliefs and assumptions and other statements regarding matters that are not historical facts. These statements include, in particular, statements about our plans, strategies and prospects. For example, when we use words such as “projects,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “should,” “would,” “could,” “will,” “opportunity,” “potential” or “may,” variations of such words or other words that convey uncertainty of future events or outcomes, we are making forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Our forward-looking statements are subject to risks and uncertainties. Factors that might cause actual results to differ materially, include, but are not limited to, the Company’s ability to obtain additional financing on acceptable terms or at all, the Company’s ability to continue to develop and expand its instrument systems business and its diagnostic laboratory services business, the Company’s ability to successfully move and consolidate the Company’s two operating facilities into one new facility, the performance and acceptance of the Company’s instrument systems in the market place, the Company’s ability to expand and maintain a successful sales and marketing organization, continuation of favorable third party payer reimbursement for tests performed using the Company’s system and for other diagnostic tests, unanticipated expenses or liabilities or other adverse events affecting cash flow, uncertainty of success in developing any new software applications, the Company’s ability to successfully sell instruments under its distribution and development agreement with DakoCytomation Denmark A/S, failure to obtain FDA clearance or approval for particular applications, the Company’s ability to compete with other technologies and with emerging competitors in cell imaging and dependence on third parties for collaboration in developing new tests and in distributing the Company’s systems and tests performed on the system, and those risks which are discussed in “Risk Factors” below. Many of these factors are beyond our ability to predict or control. In addition, as a result of these and other factors, our past financial performance should not be relied on as an indication of future performance. All forward-looking statements attributable to us, or to persons acting on our behalf, are expressly qualified in their entirety by this cautionary statement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this report might not occur.

Results of Operations

Overview and Outlook

We are an advanced oncology diagnostics technology and services company. Our mission is to combine innovative technologies, meaningful test results and world class expertise to improve outcomes of patients suffering from cancer. Our Automated Cellular Imaging System (ACIS^Ò)is a versatile automated microscope system that greatly improves the accuracy and reproducibility of digital cell imaging through its unique, patented technology. We also provide comprehensive laboratory services ranging from in-house pathology testing using the ACIS^Ò to other cutting-edge diagnostic technologies that assist physicians in managing cancer. In addition, we develop ACIS^®-based tools for academic and biopharmaceutical company researchers, allowing them to perform cellular-level analyses much faster and with improved accuracy. A number of the top clinical laboratories, hospitals, university medical centers and biopharmaceutical companies in the U.S. and Europe have adopted our technology.

We made the decision to provide in-house laboratory services in 2004 to give us an opportunity to capture a significant service-related revenue stream from the much broader and expanding cancer diagnostic testing marketplace while also optimizing the level of service and accuracy provided to remote pathology customers. Our business has historically been focused on the market for breast cancer testing. While this market is not insignificant, based on our market research we believe that the broader advanced cancer diagnostics market is approximately $1.5 billion. Our research indicates that this market will approach $2.5 billion by the end of this decade as a result of the substantial growth that is anticipated for both the incidence of cancer and for the development of new cancer therapies that will require a sophisticated diagnostic test. We believe that we are positioned to participate in this growth because of our proprietary analysis capabilities, the depth of experience of the staff in our diagnostic laboratory, our relationships with pharmaceutical companies, and our demonstrated ability to develop unique assays to support these new diagnostic tests.

The initial objective of our service strategy had been to support the expansion of the Access remote pathology program for community pathologists, a large customer segment. The focus of the development of the ACIS^Ò technology platformhas been to assist our customers in their diagnosis and treatment of cancer. We are now exploring numerous ways to leverage our relationship with our customers to better serve their needs and expand revenue opportunities in doing so. A logical extension of the remote pathology technical services has been the recent introduction of other esoteric tests and related professional diagnosis that support the oncology services marketplace. In order to perform these expanded services, we underwent a rigorous California state inspection process and obtained a California laboratory license in November 2004. We are now able to

provide a broad spectrum of other laboratory services, including flow cytometry, molecular diagnostics including PCR (polymerase chain reaction), analysis of tumors of unknown origin, expanded services for immunohistochemistry and cytogenetics. In 2004, we launched our Access technical services and a broad complement of additional cancer diagnostic tests in our dedicated laboratory facility in Irvine, California which we plan to relocate to Aliso Viejo, California. In September 2005, we obtained our New York laboratory license and are now licensed to perform services in all states.

This year we have placed an increased level of importance relative to prior years on the sale of the ACIS^Ò system to research accounts, which include biopharmaceutical companies, biotechnology companies, and academic medical centers. We believe that there are more than 1,000 such organizations in the U.S. that are good candidates for the ACIS^Ò. This is a customer group that will be increasingly important to us in the coming years because of the large size of this market and the collaborative development opportunities that these customers provide for the development of new diagnostic tests using ACIS^Ò. Important criteria for these customers include the flexibility and ease of use of the system, the accuracy of the system as a measurement tool in the performance of clinical trials and research studies, and the inclusion of certain key features necessary to researchers such as fluorescence or tissue micro array capabilities. By “seeding” the market with ACIS^Ò devices provided to these customers and working with them on their development activities, we believe that we can help to foster the next generation of applications for ACIS^Ò.

In July 2005, we entered into a distribution and development agreement with DakoCytomation Denmark A/S (“DAKO”), a Danish company recognized as a worldwide leader in diagnostic pathology testing services. Under the agreement, DAKO will become the exclusive distributor of the ACIS system to the clinical marketplace, which includes local hospitals and pathology practices. DAKO will also provide funding for the development milestones achieved through enhancing and adding new features to the ACIS^®system. The Company believes that this program will improve the long-term prospects for the placement of systems in the United States and overseas.

A very important driver of our success in the future will also be our ability to develop new diagnostic tests on the ACIS^® and duplicate the success and market penetration that has been achieved within the breast cancer markets. Working in collaboration with top-tier pharmaceutical companies, we are developing diagnostic tests and related assays that will target new cancer therapies to those patients most likely to benefit from their use. We believe that the increasing shift towards an aging U.S. population, a group in which cancer incidence is greatest, the large pipeline of targeted cancer therapies in various stages of clinical study, and the increasingly high cost of these drugs will result in a large and ripe market for proven diagnostic tests. Our future success will rest on our ability to develop and introduce these tests using our proprietary imaging technology and to expand our installed base of clinical system placements in the marketplace.

An important component of our strategy is to continue to build and, when necessary, defend our intellectual property position. Currently, we have 28 issued or allowed patents that were approved over known prior art. Eight key U.S. patents cover the major features necessary to develop a competitive image analysis system and cover important system features such as autoloading, whole tissue imaging, multiple magnifications, thresholds in hue, intensity and saturation. Asserting our intellectual property rights could be critical to supporting our strategy and in advancing our leadership position. Our research and development efforts have been further validated in the area of automated immunohistochemistry for which we have obtained five FDA 510(k) clearances over the past several years. These clearances help to validate the efficacy of our technology and to broaden the acceptance of our image analysis. It will be important for us to obtain FDA clearances for our portfolio of new diagnostic tests developed in our Bioanalytical Services development efforts.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods presented. Therefore, on an ongoing basis, we evaluate our estimates, including those provisions for bad debts and reserves.

For estimated bad debts, we review on an individual account basis the age of the receivable, all circumstances surrounding the transaction that gave rise to the receivable and whether the customer continues to have the financial resources to pay the receivable as of the balance sheet date and prior to the issuance of the financial statements for the related period. This process is followed for both our instrument and laboratory accounts. However, we have outsourced the direct billing and collection of laboratory related receivables and we work closely with our outsourced billing partner to review the details of each laboratory related account.

For ACIS^® in progress assets, the respective reserve is based upon the expected future use of the ACIS^® components and whether there are any lower of cost or market considerations. For other obligations, where judgment is required, we review the circumstances surrounding the obligation and evaluate the facts and circumstances to determine an appropriate level of accrual for each obligation.

We review our long-lived assets, such as fixed assets and intangibles, for impairment whenever events or changes indicate the carrying value may not be recoverable or that the useful lives are no longer appropriate. If we determine that the carrying value of the long-lived assets may not be recoverable, the asset is then written down to its estimated fair value based on a discounted cash flow basis. Included in long-lived assets is our ACIS, which is recorded in property and equipment.

Revenue for Diagnostic Services is recognized at the time of completion of services at amounts equal to the contractual rates allowed from third parties including Medicare, insurance companies, and to a small degree, private patients. These expected amounts are based both on Medicare allowable rates and our collection experience with other third party payors. Because of the requirements and nuances of billing for laboratory services, we may invoice amounts that are greater than those allowable for payment. These differences are described as contractual discounts. As noted, however, it is only the expected payment from these parties which is net of these contractual discounts that is recorded as revenue.

Revenue for “fee-per-use” agreements is obtained through the billing information via modem, which accesses the ACIS^® database. Revenue is recognized based on the greater of actual usage fees or the minimum monthly rental fee. Under this pricing model, we own most of the ACIS^® instruments that are engaged in service and, accordingly, all related depreciation and maintenance and service costs are expensed as incurred. For those instruments that are sold, we recognize and defer revenue using the residual method pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Arrangements.” At the outset of the arrangement with the customer, we defer revenue for the fair value of its undelivered elements (e.g., maintenance) and recognize revenue for the remainder of the arrangement fee attributable to the elements initially delivered in the arrangement (e.g., software license) when the basic criteria in SOP 97-2 have been met. Maintenance revenue is recognized ratably over the term of the maintenance contract, which typically is a period of twelve months.

Revenue on system sales is recognized in accordance with Staff Accounting Bulletin No. 101, as amended by Staff Accounting Bulletin No. 104, when all criteria for revenue recognition have been met. Such criteria includes, but is not limited to: persuasive evidence of an arrangement exists; the arrangement includes a product price that is fixed and determinable; the Company has satisfied the terms of the arrangement including passing title and risk of loss to our customer upon shipment; and collection from our customer is reasonably assured in accordance with the terms of the arrangement.

For system sales placed under the DAKO distribution and development agreement, we have completed preparation of nine systems and are awaiting shipping instructions. The payment received from DAKO for these systems was accounted for as deferred revenue. We anticipate that DAKO will complete sales of these systems to end users in the fourth quarter of 2005 and provide shipping instructions, so that we will be able to record this system sale revenue.

Systems sold under a leasing arrangement are accounted for as sales-type leases pursuant to SFAS No. 13, “Accounting for Leases,” if applicable. We recognize the net effect of these transactions as a sale because of the bargain purchase option granted to the lessee.

Three Months Ended September 30, 2005 Compared with Three Months Ended September 30, 2004

Revenue

Diagnostic services. Diagnostic services revenue for the quarter ended September 30, 2005 was $3.0 million. This amount compares to $0.8 million in diagnostic services revenue in the third quarter of 2004 when we first began our laboratory operations. In generating this revenue, we provided services for more than 7,700 patient cases at an average revenue per case of $393 for the quarter ended September 30, 2005. Approximately one-half of tests performed in our laboratory were related to breast cancer testing and one primary Current Procedural Terminology (“CPT”) code although the mix of tests has significantly expanded to several new tests after receipt of our California laboratory license in November 2004. Mix of testing procedures could change the average revenue per test in the future depending on the complexity of service associated with these new tests. We anticipate that diagnostic services revenues will continue to increase for the remainder of 2005 because we are now able to offer a more comprehensive suite of advanced cancer diagnostic tests.

Instrument systems and other. Revenue for this segment, which includes fee-per-use and system sale revenue, was $1.9 million for the quarter ended September 30, 2005, an increase of approximately $0.1 million or 7% over the quarter ended September 30, 2004. This was due primarily to an increase in system sale revenue, which increased from $0.4 million for the quarter ended September 30, 2004 to $0.9 million for the quarter ended September 30, 2005 due to the sale of 10 ACIS^Ò systems as compared to 3 ACIS^Ò systems in the third quarter of 2004. This improvement was offset in part by a decline in fee-per-use revenue from $1.3 million for the quarter ended September 30, 2004 to $1.0 million for the quarter ended September 30, 2005. This decline was caused by a reduction in the aggregate number of ACIS^Ò placements as a result of customers electing to purchase their equipment following the expiration of their leases. We expect revenue from the sale of systems to increase as a result of our distribution arrangement with DAKO (pursuant to which DAKO has agreed to order a minimum of 15 ACIS II

systems in the first year of the contract, which commenced July 2005 and a minimum of 40 ACIS^Ò II systems in subsequent contract years) and as a result of our own expanded sales force and marketing efforts to biotechnology and pharmaceutical companies (and their academic research partners).

Cost of revenue

Diagnostic services. Cost of revenue for the quarter ended September 30, 2005 was $2.3 million, compared to $1.3 million for the quarter ended September 30, 2004. Costs were approximately 77% of Diagnostic Services revenue in the current quarter. These costs include laboratory personnel, depreciation on equipment, laboratory supplies and other direct costs such as shipping that were required to support the launch and service of this operation. We believe that as the diagnostic services operation increases in size, margins for this business will increase to target levels of approximately 40%. However, depending on revenue growth for these services, it may take one year or longer for us to begin realizing margins of this magnitude in our gross margin.

Instrument systems and other. Cost of revenue was $0.6 million for the quarter ended September 30, 2005. This amount is $0.3 million or 35% less than the $0.9 million cost in the quarter ended September 30, 2004. The cost of revenue primarily consists of cost for manufacturing the ACIS^Ò, which includes the cost for direct material, labor costs, and manufacturing overhead, and direct customer support costs. For fee-per-use revenue, the cost of the ACIS^® is depreciated over a three-year time period and for a system sale or sales-type lease the entire cost of the ACIS^Ò system is recognized at the time of sale. Gross margins for Instrument Systems were 64% in 2005, compared to 15% in 2004. The improvement was due primarily to lower costs of sale for systems sold, which in many cases were refurbished older systems. The increase in gross margins was also due to lower costs of field service. We expect that margins for the remainder of 2005 will be similar to those achieved in the most recent quarter from the sale of systems by the Company in non-exclusive markets (such as to pharmaceutical companies) where the Company places the systems directly to its customers. We expect that the margins for systems sold through the DAKO distribution agreement will be lower as a result of the pricing terms of our arrangement with DAKO, although we anticipate an increase in the number of systems sold.

Operating and Other Expenses

Selling, general and administrative expenses. These expenses for the three months ended September 30, 2005 increased approximately $0.2 million, or 7%, in comparison to the comparable period in 2004. The increase was due to non-cash charges related to rental expense for the new facility, which is currently being built-out to our specifications, and severance costs related to the departure of a prior executive officer. We anticipate that these costs will increase in the future with the addition of sales resources to support our projected increase in service revenues and our move to a new facility.

Diagnostic services administration. These costs totaled $1.5 million for the quarter ended September 30, 2005 and included the costs of senior medical staff, senior operations personnel, collection costs, consultants and legal resources to facilitate implementation of this new operation. This amount is $0.5 million, or approximately 50%, higher than $1.0 million in the quarter ended September 30, 2004. In 2005, these costs are expected to continue to increase relative to the prior year because there will be twelve full months of costs compared to approximately eight in 2004 and because of higher collection costs on an anticipated increase in revenue. Collection costs are incurred from a third party billing and collection company that we have engaged to perform these services because of the high degree of technical complexity and knowledge required to effectively perform these operations. These costs are incurred as a percentage of amounts collected. In the future, we will consider directly providing these services but have no plans to do so in 2005.

Research and development expenses. Expenses for the three months ended September 30, 2005 decreased by approximately $0.3 million or 23%, in comparison to the comparable period in 2004. This decrease was primarily attributable to the reduction in personnel that resulted from our fourth quarter 2004 workforce reduction. We expect these costs to increase over the next several quarters to support the new development activity contemplated in our distribution and development agreement with DAKO. A portion of these expenses will be funded by DAKO under the terms of our distribution and development agreement. These new development activities, which are intended to produce features that could expand the volume of clinical tests supported by ACIS and increase the utility of the ACIS as a tool for researchers, are important to increasing clinical system test volume, expanding the number of clinical system placements, and increasing research system sales.

Other expense. Other expense for the three months ended September 30, 2005 totaled $91,000, compared to $5,000 of other income for the comparable period in 2004, and consisted of approximately $106,000 of interest expense offset by approximately $15,000 of interest income. The interest expense is due primarily to the borrowings under our $8.5 million revolving credit agreement, our $3.0 million equipment financing agreement and other equipment financing lines, which began accruing in September 2003. The $15,000 of interest income for the third quarter of 2005 compares to $52,000 of interest income for the comparable period of 2004. The decrease in interest income is primarily the result of lower cash balances in the third quarter of 2005 compared to the third quarter of 2004.

Nine Months Ended September 30, 2005 Compared with Nine Months Ended September 30, 2004

Revenue

Diagnostic services. Diagnostic services revenue for the nine months ended September 30, 2005 was $7.6 million. There is no significant comparable figure for the nine months ended September 30, 2004, as we commenced providing these services in the second quarter of 2004. In generating this revenue, we provided services for approximately 18,900 patient cases at an average revenue per case of $400 for the nine months ended September 30, 2005. The majority of tests performed in our laboratory were related to breast cancer testing and one primary CPT code although the mix of tests has been increasingly shifting to several new tests that we started providing after receipt of our California laboratory license in November 2004. This shift could change the average revenue per test in the future depending on the complexity of service associated with these new tests. We anticipate that diagnostic services revenues will continue to increase for the remainder of 2005 because we are now able to offer a more comprehensive suite of advanced cancer diagnostic tests.

Instrument systems and other. Revenue for this segment, which includes fee-per-use and system sale revenue, was $6.6 million for the nine months ended September 30, 2005, an increase of approximately $0.7 million or 11% over the nine months ended September 30, 2004. This was due primarily to an increase in instrument systems revenue, which increased $1.6 million from $1.6 million for the nine months ended September 30, 2004 to $3.2 million for the nine months ended September 30, 2005 due to the sale of 34 ACIS^Ò systems as compared to 11 ACIS^Ò systems in the comparable period in 2004. This improvement was offset in part by a decline in fee-per-use revenue of $1.0 million from $4.3 million for the nine months ended September 30, 2004 to $3.3 million for the nine months ended September 30, 2005. This decline was caused by a reduction in the aggregate number of ACIS^Ò placements as a result of customers electing to purchase their equipment following the expiration of their lease. We expect revenue from sales of systems to increase as a result of our distribution arrangement with DAKO (pursuant to which DAKO has agreed to order a minimum of 15 ACIS II systems in the first year and a minimum of 40 ACIS II systems in subsequent years) and as a result of our own expanded sales force and marketing efforts to biotechnology and pharmaceutical companies (and their academic research partners).

Cost of revenue

Diagnostic services. Cost of revenue for the nine months ended September 30, 2005 was $6.2 million. There is no significant comparable figure for the nine months ended September 30, 2004, as these services commenced late in the second quarter of 2004. Costs were approximately 82% of Diagnostic Services revenue for the current year. These costs include the laboratory personnel, depreciation on equipment, laboratory supplies and other direct costs such as shipping that were required to support the launch and service of this operation. We believe that as the diagnostic services operation increases in size, margins for this business will increase to target levels of approximately 40%. However, depending on revenue growth for these services, it may take one year or longer for us to begin realizing margins of this magnitude in our gross margin.

Instrument systems and other. Cost of revenue was $1.8 million for the nine months ended September 30, 2005. This amount is $1.0 million or 34% less than the $2.8 million cost in the nine months ended September 30, 2004. The cost of revenue primarily consists of cost for manufacturing the ACIS^Ò, which includes the cost for direct material, labor costs, and manufacturing overhead, and direct customer support costs. For fee-per-use revenue, the cost of the ACIS^® is depreciated over a three-year time period and for a system sale or sales-type lease the entire cost of the ACIS^Ò system is recognized at the time of sale. Gross margins for Instrument Systems were 69% in 2005, compared to 27% in 2004. The improvement was due primarily to lower costs of sale for systems sold, which in many cases were refurbished older systems. The increase in gross margins were also due to lower costs of field service. We expect that margins for the remainder of 2005 will be consistent with those achieved in the most recent quarter from the sale of systems in non-exclusive markets (such as to pharmaceutical companies) where the Company places the systems directly to its customers. We expect that the margins for systems sold through the DAKO distribution agreement will be lower as a result of the pricing terms of our arrangement with DAKO, although we anticipate an increase in the number of systems sold.

Operating and Other Expenses

Selling, general and administrative expenses. These expenses for the nine months ended September 30, 2005 decreased approximately $0.5 million, or 5%, in comparison to the comparable period in 2004. The decrease was due to higher expenses in the prior year related to various legal costs, non-cash compensation charges related to stock options and restricted stock, outside consulting costs for interim CEO management services, and the reduction in personnel as a result of the fourth quarter 2004 workforce reduction. We anticipate that these costs will increase in the future with the addition of sales resources to support our projected increase in service revenues and our move to a new facility.

Diagnostic services administration. These costs totaled $4.5 million for the nine months ended September 30, 2005 and included the costs of senior medical staff, senior operations personnel, collection costs, consultants and legal resources to facilitate implementation of this new operation. This amount is $1.9 million, or 77%, higher than $2.6 million in the nine months ended September 30, 2004. In 2005, these costs are expected to continue to increase relative to the prior year because there

will be twelve full months of costs compared to approximately eight in 2004 and because of higher collection costs on an anticipated increase in revenue. Collection costs are incurred from a third party billing and collection company that we have engaged to perform these services because of the high degree of technical complexity and knowledge required to effectively perform these operations. These costs are incurred as a percentage of amounts collected and are expected to increase as diagnostic services revenues increase. In the future, we will consider directly providing these services but have no plans to do so in 2005.

Research and development expenses. Expenses for the nine months ended September 30, 2005 decreased by approximately $0.9 million, or 25%, in comparison to the comparable period in 2004. This decrease for the nine-month period is primarily attributable to the reduction in personnel that resulted from our fourth quarter 2004 workforce reduction. We expect these costs to increase over the next several quarters to support the new development activity contemplated in our distribution and development agreement with DAKO. A portion of these expenses will be funded by DAKO under the terms of our distribution and development agreement. These new development activities, which are intended to produce features that could expand the volume of clinical tests supported by ACIS^Ò and increase the utility of the ACIS^Ò as a tool for researchers, are important to increasing clinical system test volume, expanding the number of clinical system placements, and increasing research system sales.

Other expense. Other expense for the nine months ended September 30, 2005 totaled $153,000, compared to $72,000 for the comparable period in 2004, and consisted of approximately $217,000 of interest expense offset by approximately $64,000 of interest income. The interest expense is due primarily to the borrowings under our $3.0 million equipment financing agreement and other equipment financing lines, which began accruing in September 2003. The $64,000 of interest income for the nine months of 2005 compares to $114,000 of interest income for the comparable period of 2004. The decrease in interest income is primarily the result of lower cash balances in the nine months ended September 30, 2005 in comparison to the comparable period of 2004.

Factors that May Affect Future Results of Operations

The year 2000 was the first full year of commercial activity during which we focused primarily on marketing and sales of the ACIS^Ò system to large hospitals, academic research centers and pathology groups, as our menu of capabilities performed with the ACIS^Ò expanded and gained commercial acceptance. While we have made significant progress, we still face significant uncertainties, including those discussed below under “Risk Factors” and “Liquidity and Capital Resources,” which include our ability to achieve market acceptance of the ACIS^Ò, our ability to sell instruments under our distribution and development agreement with DAKO, our ability to ensure satisfactory reimbursement by Medicare and other third party insurance carriers, collectibility from private payors and our ability to execute on our business plan to provide additional laboratory and bioanalytical services.

Laboratory services provided for patients with the assistance of ACIS^® technology are eligible for third party reimbursement using medical billing codes which apply to image analysis-based testing. These billing codes are known as Healthcare Common Procedure Coding System (HCPCS) codes, which include the CPT codes as the means by which Medicare and private insurers identify medical services that are provided to patients in the United States. CPT codes are established by an independent editorial panel convened by the American Medical Association (AMA). The reimbursement amounts, or relative values, associated with the CPT codes are established by the Centers for Medicare and Medicaid Services (CMS), under a process that involves recommendations from an independent Relative Value Update Committee also convened by the AMA, with advice from professional societies representing the various medical specialties.

A new CPT code appropriate for image analysis went into effect on January 1, 2004. The interim rates established for this code in 2004 were subsequently amended on January 1, 2005. Under the new code, the total Medicare reimbursement for ACIS^Ò-based procedures performed in physician offices or independent laboratories is approximately $168 per test, reflecting a technical component of approximately $100 and a professional component of approximately $68. The technical component involves preparation of the patient sample and running the test on the ACIS^Ò, while the professional component involves the physician’s reading and evaluation of the test results. The actual amount varies based upon a geographic factor index for each state and may be higher or lower than the amounts indicated above in particular cases based on one’s geographic location. In southern California, for example, where Clarient’s technical services are currently performed, the reimbursement amount for technical services is approximately $118 per slide.

We also face uncertainties with respect to our ability to complete development of additional tests for the ACIS^Ò. In order to mitigate the risk that any one test will not be successfully developed, we maintain a pipeline of tests in a prioritized queue so that we can align development efforts according to priority if any one test is not successfully developed, or market feedback suggests that a test should be given a lower priority. In addition, the ACIS^Ò is dependent upon the laboratory producing a quality stained slide for image analysis. Reagent and/or stain quality issues by stain manufacturers may impact the rate at which the ACIS^Ò technology is adopted or new applications are added to existing placements.

Other factors that may affect our future results of operations are discussed below under the caption “Risk Factors.”

Liquidity and Capital Resources

At September 30, 2005, we had approximately $2.1 million of cash and cash equivalents, $1.4 million available under our equipment financing lines (subject to lessor approval of each funding request), and $3.5 million available under our revolving line of credit. Cash used in operating activities was $6.9 million for the nine months ended September 30, 2005 due primarily to our net loss of $11.1 million and increases in working capital requirements. Cash used in investing activities of $2.6 million consisted of capital expenditures related primarily to purchases of new equipment for the diagnostic services laboratory and leasehold improvements at the new facility. Net cash provided from financing activities during the nine months ended September 30, 2005 was $1.5 million due to borrowings of $2.9 million offset by debt payments of $1.6 million and the exercise of stock options of $0.2 million.

On November 8, 2005, we entered into a securities purchase agreement with a limited number of accredited investors pursuant to which we agreed to issue 15,000,000 shares of common stock, together with warrants to purchase an additional 2,250,000 shares of common stock, for an aggregate purchase price of $15,000,000. The exercise price of the warrants is $1.35 per share. The warrants are exercisable until the fourth anniversary of the date of issuance. We structured this transaction so that a portion of the common stock and warrants (8,900,000 shares of common stock and warrants to purchase 1,350,000 shares of common stock for aggregate gross proceeds of $8.9 million) will be issued at an initial closing that is expected to occur on or about November 9, 2005. The remaining shares and warrants are expected to be issued at a second closing which is expected to occur 21 days after we mail an information statement on Schedule 14C to our stockholders disclosing that we obtained stockholder approval for the private placement. The second closing is not expected to occur before December 10, 2005. The investors in the private placement are required to deposit the purchase price to be paid at the second closing into an escrow account, and this deposit will be released to us on the date of the second closing. Safeguard is purchasing an aggregate of $9,000,000 of the securities in the private placement and will continue to own a majority of our common stock following completion of the private placement. The aggregate net proceeds to us from the financing (after payment of placement fees and expenses) are expected to be approximately $14,650,000. The securities associated with the financing are being issued to a limited number of accredited investors in a private placement exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”) and may not be resold unless there is either an effective registration statement under the Securities Act or a valid exemption from the registration requirements of the Securities Act.

We currently lease our corporate headquarters and manufacturing facility and our laboratory services facility under separate operating lease arrangements. The lease for the corporate headquarters and manufacturing facility expires in February 2006. The lease for the laboratory services facility expires at the end of January 2006. In July 2005, we signed a lease for a new, single facility, and we intend to move our laboratory, manufacturing and administrative operations to this new facility. The new facility lease has a term of 10 years beginning December 1, 2005 with two five-year renewal options. We intend to begin occupying this facility in January 2006. The landlord has agreed to fund approximately $3.5 million of tenant improvements, subject to the terms of the lease agreement. Our total projected spending for the build-out of this facility, including the $3.5 million of tenant improvements funded by the landlord, is approximately $8 million to $9 million.

Our instrument systems business generates revenues from leases of the ACIS^® system to certain customers (pursuant to which those customers pay us on a “fee-per-use” basis for each time the instrument is used to perform a test) and from sales of our ACIS^® system. Revenues from system leases are recognized over the lease term and revenues from system sales are recognized upon customer acceptance of the system. While we expect to continue to derive revenues from leased systems that have already been placed with customers, we do not anticipate leasing a significant number of new ACIS^® systems on a going forward basis. Instead, we expect that sales of our ACIS^® system to new customers will comprise the substantial majority of new system placements. These sales will include sales of systems pursuant to our distribution arrangement with DAKO and direct sales by us in markets where our distribution arrangement with DAKO is not exclusive. The rate of capital expenditures as it relates to ACIS^Ò equipment purchases has been lower than prior periods due to the slower pace of system placements. However, as a result of our new distribution arrangement with DAKO, we expect sales of systems to increase during 2006 and that the rate of related capital expenditures will also increase. We also expect our research and development expenditures to increase with respect to development of a future ACIS^® system. Future ACIS^® system development expenses will be funded in part by DAKO under the terms of our distribution and development arrangement.

We believe that we have substantially all of the laboratory equipment that is required to support our operating activities currently. Significant additions to this equipment would be dependent on a substantial increase in diagnostic service activity. We expect to fund any purchases of additional laboratory equipment from our $1.4 million equipment financing lease line.

In the past year, we have funded our operations and capital expenditure needs with the proceeds of debt and equity financings. On March 25, 2004, we entered into a securities purchase agreement with a limited number of accredited investors pursuant to which we sold 10,500,000 shares of common stock, together with warrants to purchase an additional 1,575,000 shares of common stock at an exercise price of $2.75 per share, for an aggregate purchase price of $21.0 million. The warrants issued in this transaction are exercisable for a period of four years after the date of issuance. Safeguard acquired 3,750,000 shares of common stock and warrants to purchase 562,500 shares of common stock in the March 2004 financing for an aggregate investment of $7.5 million. In connection with the financing, the Company entered into a registration rights agreement with the purchasers in that financing, and the Company has registered the resale of shares issued in the financing with the Securities and Exchange Commission.

The Company currently has an $8.5 million revolving credit agreement, which expires on January 31, 2006. The line of credit was increased from $5.5 million to $8.5 million in July 2005. The borrowings under the line of credit are being used for working capital purposes and a $3.0 million stand-by letter of credit that was provided to the landlord of our new leased facility and bears interest at the bank’s prime rate minus one-half percent. The agreement also includes an annual facility fee of $27,500 and various restrictive covenants and requirements to maintain certain financial ratios. Borrowings under the line of credit are guaranteed by Safeguard in exchange for an annual fee of 0.5% of the amount guaranteed and an amount equal to 4.5% per annum of the daily-weighted average principal balance outstanding under the line of credit. The Company also issued a warrant to Safeguard to purchase 50,000 shares of common stock for an exercise price of $2.00 per share as additional consideration for Safeguard’s guarantee. The agreement has only one financial covenant related to tangible net worth, which is required to be greater than ($2,000,000).

In August 2003, we entered into a $3.0 million equipment financing agreement with General Electric Capital Corporation (“GE Capital”). The loan principal amortizes ratably over a 33-month term. The borrowings under the equipment financing agreement were used for working capital purposes and bear interest at an annual rate of interest of 8.16%. The agreement also

provides for an incremental $2.0 million of financing available upon reaching certain system placement objectives, contains various restrictive covenants, requires maintenance of certain financial ratios and includes a collateral monitoring fee of $5,000 per year. In September 2003, the entire $3.0 million available under the financing agreement was borrowed. As of September 30, 2005, $1.0 million of debt remains outstanding under this agreement with all $1.0 million of the debt classified as current.

Borrowings under the equipment financing agreement with GE Capital are secured by substantially all of our assets. The agreement with GE Capital incorporates some of the restrictive covenants and certain other requirements of the Comerica revolving credit agreement, including any amendments granted by Comerica with respect to the incorporated covenants. The agreement with GE Capital also includes a provision whereby a material adverse change to our financial condition could be considered an event of default. Based on current operations, committed borrowings and our $2.1 million cash balance as of September 30, 2005, we believe that we will remain in compliance with our debt covenants over the next twelve months.

In June 2004, we entered into a master lease agreement with GE Capital for capital equipment financings of laboratory services related equipment. During 2004, we financed $2.6 million of capital equipment under this arrangement, which was recorded as a capital lease obligation. Each lease financing has a term of 36 months and provides for an early purchase option after 30 months at 26.6% of the cost of the equipment.

In January 2005, GE Capital approved additional equipment lease financings of up to $2.3 million under this master lease agreement for equipment leases during 2005, subject to execution of definitive documentation for each separate equipment lease and GE Capital’s review of our financial condition at the time of each funding request. These additional equipment lease financings have a term of 36 months for each equipment purchase and provide for an early purchase option by the Company after 24 months for a purchase price equal to 40.5% of the cost of the equipment. As of September 30, 2005, the Company had financed $0.9 million of capital equipment under this line, which was recorded as a capital lease obligation.

We are exploring a number of additional financing alternatives, including a sale of certain ACIS^® systems that we currently lease to customers (and the corresponding lease portfolio and future revenue stream) to a third party (from which we anticipate we can raise approximately $4.0 million to $5.0 million) and an accounts receivable credit facility (from which we anticipate we could raise approximately $2.0 million). Any such financings will be subject to the negotiation and execution of definitive financing agreements and satisfaction of the conditions set forth therein. In addition, GE Capital currently has a lien over all of our assets, and each of these financings would be conditioned on GE Capital’s agreement to release its lien on the assets covered by each of these financings. While we expect to complete one or both of these financings during the fourth quarter of 2005 or first quarter of 2006, there can be no assurance that we will be able to do so.

We believe that our existing cash resources together with access to the financing sources described above (including proceeds from the second closing of the private placement that we consummated in November 2005, the remaining $3.5 million available under our revolving line of credit with Comerica Bank, the $1.9 million of potential availability under our new equipment lease line with GE (which remains subject to GE’s ongoing review of our financial condition at the time of each funding request) and proceeds from the potential sale of ACIS^® systems that we currently lease to customers and from an accounts receivable credit facility) will be sufficient to satisfy the cash needs of our existing operations through the end of 2006. However, we may require additional debt or equity financing if we are unable to access one or more of these financing sources or if we encounter difficulties in executing our business plan. There can be no assurance that we will be able to obtain additional debt or equity financing when needed or on terms that are favorable to us and our stockholders. Furthermore, if additional funds are raised through an equity or convertible debt financing, our stockholders may experience significant dilution.

The following table summarizes our contractual obligations and commercial commitments at September 30, 2005, including our new facility lease. These commitments exclude the approximately $5.5 million which we have committed to pay to build-out our new facility and a $3.0 million standby letter of credit provided to the landlord under the lease agreement for our new facility.

Contractual Obligations	Total		Less than 1 Year		1-3 Years		Over 3 Years
Line of Credit Obligations	$	2,000	$	2,000	$	—	$	—
Long-Term Debt Obligations	987		987		—
Capital Lease Obligations-Lab	2,748		1,141		1,607		—
Facility Obligations	13,807		721		3,466		9,620
Total	$	19,542	$	4,849	$	5,073	$	9,620

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements that provide financing, liquidity or market or credit risk support or involve leasing, hedging or research and development services for our business or other similar arrangements that may expose us to liability that is not expressly reflected in the financial statements, except for facilities and automobile operating leases.

At September 30, 2005, we did not have any relationships with unconsolidated entities or financial partnerships, often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such we are not subject to any material financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

New Accounting Standards

Several new accounting standards have been issued that were adopted in 2004. None of these standards had a material impact on our financial position, results of operations, or liquidity. See Note 8 of the Notes to Condensed Consolidated Financial Statements.

RISK FACTORS

Before deciding to invest in us or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and other reports we have filed with the Securities and Exchange Commission. The risks and uncertainties described below are not the only ones facing our Company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks are realized, our business, financial condition or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.

Risks Related to Our Business

We have limited experience in providing laboratory and other services, which may cause us to experience difficulties that could delay or prevent the development, introduction and marketing of these services.

We began providing the technical component of reference laboratory services in-house beginning in April 2004 and we began to provide additional, oncology-focused laboratory services that complement our image analysis and certified Access reference laboratory services in December 2004. The success and viability of these initiatives is dependent on a number of factors including:

• our ability to develop and provide services that we have not previously provided;

• adequate reimbursement;

• medical efficacy as demonstrated by clinical studies and governmental clearances;

• governmental clearances, governmental regulations and expansion of the menu of tests performed by ACIS^® to bring greater economies of scale to our accounts operations; and

• our ability to obtain timely approval of and renewal of requisite state and federal regulatory licenses.

We may not be successful in any of these areas, we may experience difficulties that could delay or prevent the successful development, introduction and marketing of these services, and we may not adequately meet the demands of the marketplace or achieve market acceptance. Our inability to accomplish any of these endeavors may have a material adverse effect on our business, operating results, cash flows and financial condition.

Our instrument business is highly dependent on the efforts of our distribution partners and on increased market acceptance of the ACIS^®, and it is uncertain whether the ACIS^® will achieve that acceptance.

Increased market acceptance of the ACIS^® depends on a number of variables, including, but not limited to, the following:

• the ability of the ACIS^® to perform as expected;

• acceptance by patients, physicians, third party payors and laboratories of the ACIS^® to run the tests performed using it;

• our ability to develop a significant number of tests performed with the ACIS^®;

• our ability to implement our new diagnostic lab service initiative;

• the amount of reimbursement by third party payors for a test performed using the ACIS^®;

• the effectiveness of marketing, distribution and pricing strategy;

• availability of alternative and competing diagnostic products; and

• scientific studies and other publicity concerning ACIS^® or competitive products.

The future commercial success of our products will depend primarily on convincing research, reference and clinical laboratories to evaluate and offer these products as research tools for scientists and clinical investigators and as diagnostic products to physicians, laboratory professionals and other medical practitioner and convincing physicians, laboratory professionals and other medical practitioners to order tests for their patients involving our technologies. To accomplish this, we will need to convince oncologists, pathologists and other members of the medical and biotechnology communities of the benefits of our products. Additionally, if ongoing or future clinical trials result in unfavorable or inconsistent results, these products may

not achieve market acceptance. Even if the efficacy of our future products and services are established, physicians may elect not to use them for a number of reasons. These reasons might include the training required for their use or unfavorable reimbursement from health care payors.

Finally, our instrument systems business may ultimately depend on the success of our distribution and development arrangement with DAKO. If DAKO is not successful, the marketability of our products and services may be limited and our technology could become underfunded and obsolete relative to new, emerging technologies of companies that have greater financial resources.

We have a history of operating losses, and our future profitability is uncertain.

We have incurred operating losses in every year since inception, and our accumulated deficit as of September 30, 2005 was $117 million. Those operating losses are principally associated with the research and development of our ACIS^® technology, the conducting of clinical trials, preparation of regulatory clearance filings, the development of our sales and marketing organization to commercialize the ACIS^®and the capital investments we have made relating to our recently launched diagnostic services business. Although leasing and sales of the ACIS^® have been encouraging since we began the commercial distribution of the ACIS^® in late 1999 and we have recently begun to provide a wide array of laboratory services, we may not be able to achieve profitable operations at any time in the future.

Because our operating expenses are likely to increase in the near term, we will need to generate significant additional revenue to achieve profitability. We expect to continue to incur losses as a result of the expansion of the laboratory services, ongoing research and development and clinical trial expenses, as well as increased sales and marketing expenses. We are unable to predict when we will become profitable, and we may never become profitable. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. If we are unable to achieve and then maintain profitability, the market value of our common stock will decline.

Our leases of our corporate headquarters and manufacturing facility and of our laboratory facility expire as soon as February 2006 and we will be required to relocate to a new facility and make significant expenditures in relocating our operations.

We currently lease our corporate headquarters and manufacturing facility and our laboratory services facility under operating lease arrangements. The lease for the corporate headquarters and manufacturing facility expired in February 2005 and we exercised our option to extend the lease twelve months. The lease for our diagnostic services laboratory facility also expires in February 2006. We have identified a new location for our combined operations and have signed a ten-year lease, which contemplates occupancy beginning December 1, 2005. The move to our new facility could create risk of business interruption and will require substantial capital investment. There is no guarantee that we will be able to successfully complete this move to a new facility.

We may require additional financing for, among other things, planned expansion of our laboratory operations, capital expenditures and other costs, related to the move to a new facility and expenses associated with our anticipated increase in placements of our ACIS systems and it is uncertain whether such financing will be available on favorable terms, if at all.

We believe that our existing cash resources together with access to existing and anticipated financing sources described under the caption “—Liquidity and Capital Resources” (including proceeds from the second closing of the private placement that we entered into in November 2005, the remaining $3.5 available under our revolving line of credit with Comerica bank, the $1.9 million of potential availability under our new equipment lease line with GE (which remains subject to GE’s ongoing review of our financial condition at the time of each funding request) and proceeds from the potential sale of ACIS^Ò systems that we currently lease to customers to a third party and from an accounts receivable credit facility) will be sufficient to satisfy the cash needs of our existing operations through the end of 2006. However, we may require additional debt or equity financing if we are unable to access one or more of these financing sources. In addition, we have expended and will continue to expend substantial funds for research and development, clinical trials and manufacturing and marketing of our system and expanding our offerings of bioanalytical services. We will also need additional capital if our new business initiatives are not successful or we fail to achieve the level of revenues from applications and our other services in the time frame contemplated by our business plan.

Our present and future funding requirements will also depend on certain other external factors, including, among other things:

• the level of research and development investment required to maintain and improve our technology position;

• costs of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights;

• our need or decision to acquire or license complementary technologies or acquire complementary businesses;

• competing technological and market developments; and

• changes in regulatory policies or laws that affect our operations.

We do not know whether additional financing will be available on commercially acceptable terms when needed. In addition, our existing financing agreements contain covenants that prevent us from incurring additional debt (subject to limited exceptions) and prevent us from granting certain liens, claims or encumbrances on our assets. As a result, we may need the consent of our existing lenders to obtain additional debt financing. If adequate funds are not available or are not available on commercially acceptable terms, we might be required to delay, scale back or eliminate our planned expansion of our laboratory facilities, some or all of our development activities, new business initiatives, clinical studies or regulatory activities or to license to third parties the right to commercialize products or technologies that we would otherwise seek to commercialize ourselves. If additional funds are raised through an equity or convertible debt financing, our stockholders may experience significant dilution.

Our strategy for the development and commercialization of the ACIS^® platform contemplates collaborations with third parties, making us dependent on their success.

We have entered into and intend to continue to enter into corporate collaborations for the development of new applications, clinical collaborations with respect to tests using the ACIS^® and strategic alliances for the distribution of the ACIS^® and our other products, including products we may develop in the future. In July 2005, we entered into a distribution and development agreement with DAKO, which is exclusive in research and clinical markets and non-exclusive with respect to biotechnology and pharmaceutical companies (and their academic research partners). We therefore, depend upon the success of DAKO to distribute our ACIS^®products and perform their responsibilities under our collaborative arrangements. We cannot assure you that we will be able to enter into additional arrangements that may be necessary in order to develop and commercialize our products, or that we will realize any of the contemplated benefits from existing or new arrangements.

We do not have the ability to independently conduct the clinical trials required to obtain regulatory clearances for our applications. We intend to rely on third-party expert clinical investigators and clinical research organizations to perform these functions. If we cannot locate and enter into favorable agreements with acceptable third parties, or if these third parties do not successfully carry out their contractual obligations, meet expected deadlines or follow regulatory requirements, including clinical laboratory, manufacturing and good clinical practice guidelines, then we may be the subject of an enforcement action by the FDA or other regulatory bodies, and may be unable to obtain clearances for our products or to commercialize them on a timely basis, if at all.

Our ability to engage in certain business transactions may be limited by the restrictive covenants of our debt financing agreements.

Our existing financing agreements with Comerica Bank and GE Capital contain financial covenants requiring us to meet financial ratios and financial condition tests, as well as covenants restricting our ability to:

• incur additional debt;

• pay dividends or make other distributions or payments on capital stock;

• make investments;

• incur or permit to exist liens;

• enter into transactions with affiliates;

• change business, legal name or state of incorporation;

• guarantee the debt of other entities, including joint ventures;

• merge or consolidate or otherwise combine with another company; and

• transfer or sell our assets.

These covenants could adversely affect our ability to finance our future operations or capital needs and pursue available business opportunities, including acquisitions. A breach of any of these covenants could result in a default in respect of the related indebtedness. If a default occurs, the relevant lenders could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing that indebtedness. We believe that we are currently in compliance with the covenants in our financing agreements.

We have limited manufacturing experience and may encounter difficulties as we undertake to manufacture our system in increasing quantities.

We have limited commercial manufacturing experience and capabilities. We may encounter significant delays and incur significant unexpected costs in scaling-up our manufacturing operations. In addition, we may encounter delays and difficulties in hiring and training the workforce necessary to manufacture the ACIS^® in the increasing quantities required for us to achieve profitability. The failure to scale-up manufacturing operations successfully, in a timely and cost-effective manner, could have a material adverse effect on our revenues and income. We believe that we have adequate manufacturing capacity to meet anticipated demand for 2005. However, in order to meet demand thereafter, we will have to expand our manufacturing processes and facilities or rely on third-party manufacturers. We might encounter difficulties in expanding our manufacturing processes and facilities or in developing relationships with third-party manufacturers. If we are unable to overcome these difficulties our ability to meet product demand could be impaired or delayed.

We may not successfully manage our growth, which may result in delays or unanticipated difficulties in implementing our business plan.

Our success will depend upon the expansion of our operations and the effective management of our growth. We expect to experience growth in the scope of our operations and services and the number of our employees. If we grow significantly, such growth will place a significant strain on management and on administrative, operational and financial resources. To manage any growth, we would need to expand our facilities, augment our operational, financial and management systems, internal controls and infrastructure and hire and train additional qualified personnel. Our future success is heavily dependent upon growth and acceptance of our future products and services. If we are unable to scale our business appropriately or otherwise adapt to anticipated growth and new product introduction, our business, operating results, cash flows and financial condition may be harmed.

The medical imaging technology market is characterized by rapid technological change, frequent new product introductions and evolving industry standards, and we may encounter difficulties keeping pace with changes in this market.

The introduction of diagnostic tests embodying new technologies and the emergence of new industry standards can render existing tests obsolete and unmarketable in short periods of time. We expect competitors to introduce new products and services and enhancements to existing products and services. The life cycles of tests using the ACIS^®, and of the ACIS^® itself, are difficult to estimate. Our future success will depend upon our ability to enhance our current tests, to develop new tests, and to enhance and continue to develop the hardware and software included in the ACIS^®, in a manner that keeps pace with emerging industry standards and achieves market acceptance. Our inability to accomplish any of these endeavors will have a material adverse effect on our business, operating results, cash flows and financial condition.

We face substantial existing competition and potential new competition from others pursuing technologies for imaging systems.

We compete in a highly competitive industry. ACIS^® was first released in 1997 for use in research as an imaging system for the detection of rare cellular events. The primary application was for the detection of cells which contained a marker used to distinguish possible cancerous cells in bone marrow. At that time, the most significant competition to the ACIS^® for this application was use of manual microscopes and certain other cell-based techniques. These other techniques include polymerase chain reaction (PCR), a technique used in clinical labs to detect DNA sequences, and flow cytometry, a technique used to analyze biological material through the detection of the light-absorbing or fluorescing properties of cells. A natural progression for Clarient and the ACIS^® was to penetrate the manually intensive slide-based cancer testing market, with an initial focus on the breast cancer market. Companies such as DAKO, Ventana and BioGenex have greater cancer-testing market share and stronger medical laboratory relationships than we do. They also have two of the critical system components needed to drive standardization—reagents and staining automation. In July 2005, we entered into a distribution and development agreement with DAKO relating to our ACIS^® system, which is exclusive in research and clinical markets and non-exclusive with respect to biotechnology and pharmaceutical companies (and their academic research partners). Other imaging companies such as TriPath and Applied Imaging are currently expanding into this market. Advancements in alternative cancer diagnostic tests and the development of new protein-based therapies will bring increased competition to this market segment, and such competition could adversely affect our operating results, cash flows and financial condition.

The clinical laboratory business is intensely competitive both in terms of price and service. This industry is dominated by several national independent laboratories, but includes many smaller niche and regional independent laboratories as well. Large commercial enterprises, including Quest and LabCorp, have substantially greater financial resources and may have larger research and development programs and more sales and marketing channels than we do, enabling them to potentially develop and market competing assays. These enterprises may also be able to achieve greater economies of scale or establish contracts with payor groups on more favorable terms. Smaller niche laboratories compete with us based on their reputation for offering a narrow test menu. Academic and regional institutions generally lack the advantages of the larger commercial laboratories but still compete with us on a limited basis. Pricing of laboratory testing services is one of the significant factors often used by health care providers in selecting a laboratory. As a result of the clinical laboratory industry undergoing significant consolidation, larger clinical laboratory providers are able to increase cost efficiencies afforded by large-scale automated testing. This consolidation results in greater price competition. We may be unable to increase cost efficiencies sufficiently, if at all, and as a result, our operating results, cash flows and our financial position could be negatively impacted by such price competition.

Competition in the pharmaceutical and biotechnology industries, and the medical devices and diagnostic products segments in particular, is intense and has been accentuated by the rapid pace of technological development. Our competitors in this area include large diagnostics and life sciences companies. Most of these entities have substantially greater research and development capabilities and financial, scientific, manufacturing, marketing, sales and service resources than we do. Some of them also have more experience than we do in research and development, clinical trials, regulatory matters, manufacturing, marketing and sales.

Because of their experience and greater research and development capabilities, our competitors might succeed in developing and commercializing technologies or products earlier and obtaining regulatory approvals and clearances from the FDA more rapidly than we can. Our competitors also might develop more effective technologies or products that are more predictive, more highly automated or more cost-effective, and that may render our technologies or products obsolete or non-competitive.

We rely significantly on third-party manufacturers who may fail to supply us with components necessary to our products and services on a timely basis.

We rely currently and intend to continue to rely significantly in the future on third-party manufacturers to produce all of the components used in our ACIS^® device and for future instrument systems that we may develop. We are dependent on these third-party manufacturers to perform their obligations in a timely and effective manner and in compliance with FDA and other regulatory requirements.

To date, we have generally not experienced difficulties in obtaining components from our manufacturers and, in cases where a particular manufacturer was unable to provide us with a necessary component, we have been able to locate suitable secondary sources. However, if the suppliers we rely on in the manufacturing of our products were unable to supply us with necessary components and we were unable to locate acceptable secondary sources, we might be unable to satisfy product demand, which would negatively impact our business. In addition, if any of these components are no longer available in the marketplace, we will be forced to further develop our technologies to incorporate alternate components. If we incorporate new components or raw materials into our products we might need to seek and obtain additional approvals or clearances from the FDA or foreign regulatory agencies, which could delay the commercialization of these products.

Failure in our information technology systems could disrupt our operations.

Our success will depend, in part, on the continued and uninterrupted performance of our information technology systems. Information systems are used extensively in virtually all aspects of our business, including laboratory testing, billing, customer service, logistics and management of medical data. Our success depends, in part, on the continued and uninterrupted performance of our information technology, or IT, systems.

Our computer systems are vulnerable to damage from a variety of sources, including telecommunications failures, malicious human acts and natural disasters. Moreover, despite reasonable security measures we have implemented, some of our information technology systems are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems, in part because we conduct business on the Internet and because some of these systems are located at third party web hosting providers and we cannot control the maintenance and operation of the data centers. Despite the precautions we have taken, unanticipated problems affecting our systems could cause interruptions in our information technology systems, leading to lost revenue, deterioration of customer confidence, or significant business disruption. Our business, financial condition, results of operations, or cash flows could be materially and adversely affected by any problem that interrupts or delays our operations.

If a catastrophe were to strike our facility, we would be unable to operate our business competitively.

We currently assemble, test and release our ACIS^® device at our facility located in San Juan Capistrano, California and we provide diagnostic services from our laboratory facility in Irvine, California. We do not have alternative production plans in place or alternative facilities available at this time. If there are unforeseen shutdowns to our facility, we will be unable to satisfy customer orders on a timely basis.

Our facilities may be affected by catastrophes such as fires, earthquakes or sustained interruptions in electrical service. Earthquakes are of particular significance to us because all of our clinical laboratory facilities are located in Southern California, an earthquake-prone area. In the event our existing facilities or equipment are affected by man-made or natural disasters, we may be unable to process our customers’ samples in a timely manner and unable to operate our business in a commercially competitive manner.

Our ability to maintain our competitive position depends on our ability to attract and retain highly qualified managerial, technical and sales and marketing personnel.

We believe that our continued success depends to a significant extent upon the efforts and abilities of our executive officers and our scientific and technical personnel, including the following individuals:

• Michael Cola, our Chairman;

• Ronald A. Andrews, our President and Chief Executive Officer;

• Stephen T. D. Dixon, our Executive Vice President and Chief Financial Officer;

• Heather Creran, our Executive Vice President and Chief Operating Officer — Diagnostic Services;

• Ken Bloom, M.D., our Chief Medical Director;

• Karen Garza, our Vice President of Marketing and Strategic Initiatives;

• Jose de la Torre-Bueno, Ph.D., our Vice President and Chief Technology Officer;

• David J. Daly, our Vice President of Sales; and

• James Cureton, our Vice President of Instrument Systems.

We do not maintain key-person life insurance on any of our officers, scientific and technical personnel or other employees. The loss of any of our executive officers or senior managers could have a material adverse effect on our business, operating results, cash flows and financial condition.

Furthermore, our anticipated growth and expansion will require the addition of highly skilled technical, management, financial, sales and marketing personnel. In particular, we may encounter difficulties in attracting a sufficient number of qualified California licensed laboratory scientists. Competition for personnel is intense, and our failure to hire and retain talented personnel or the loss of one or more key employees could have a material adverse effect on our business. Many members of our current senior management group have been recruited and hired over the past 18 months. These individuals may not be able to fulfill their responsibilities adequately and may not remain with us.

The reimbursement rate for ACIS^®-based services has changed significantly over the past several years and further changes may result in an adverse effect on our revenues and results of operations.

The majority of the sales of our products in the US and other markets will depend, in large part, on the availability of adequate reimbursement to users of these products from government insurance plans, including Medicare and Medicaid in the US, managed care organizations, private insurance plans and other third-party payors. The continued success of the ACIS^® depends upon its ability to replace or augment existing procedures that are covered and otherwise eligible for payments and covered by the medical insurance industry.

The impact of the past years’ reimbursement changes to us was a reduction in our average revenue per system placement due to lower pricing that we began to offer to our customers in response to their reduced reimbursement rates. The net reduction of reimbursement for ACIS^®-based procedures over the past several years has reduced revenue for current ACIS^® customers, may result in sales allowances or cancellations of contracts by current customers and may negatively impact future placements of ACIS^®.

We are not able to fully assess or predict the full impact of the changes in reimbursement levels on our business at this time, nor whether Medicare will review the medical necessity and appropriateness of amounts that have been paid in prior years, although it is likely that these further reductions in reimbursement levels will impact our pricing, profitability and the demand for testing.

Our net revenue will be diminished if payors do not adequately cover or reimburse our services.

There has been and will continue to be significant efforts by both federal and state agencies to reduce costs in government healthcare programs and otherwise implement government control of healthcare costs. In addition, increasing emphasis on managed care in the U.S. may continue to put pressure on the pricing of healthcare services. Uncertainty exists as to the coverage and reimbursement status of new assays. Third party payors, including governmental payors such as Medicare and private payors, are scrutinizing new medical products and services and may not cover or may limit coverage and the level of reimbursement for our services. Third party insurance coverage may not be available to patients for any of our existing assays or assays we discover and develop. However, a substantial portion of the testing for which we bill our hospital and laboratory clients is ultimately paid by third party payors. Any pricing pressure exerted by these third party payors on our customers may, in turn, be exerted by our customers on us. If government and other third party payors do not provide adequate coverage and reimbursement for our assays, our operating results, cash flows or financial condition may decline.

Managed care organizations are using capitated payment contracts in an attempt to shift payment risks which may negatively impact our operating margins.

Managed care providers typically contract with a limited number of clinical laboratories and then designate the laboratory or laboratories to be used for tests ordered by participating physicians. The majority of managed care testing is negotiated on a fee-for-service basis at a discount. Such discounts have historically resulted in price erosion and we expect that they will negatively impact our operating margins once we commence offering laboratory services to managed care organizations.

Third party billing is extremely complicated and will result in significant additional costs to us.

Billing for laboratory services is extremely complicated. We plan to provide testing services to a broad range of healthcare providers. We consider a “payor” as the party that pays for the test and a “customer” as the party who refers tests to us. Depending on the billing arrangement and applicable law, we will need to bill various payors, such as patients, insurance companies, Medicare, Medicaid, doctors and employer groups, all of which have different billing requirements. Additionally, our billing relationships require us to undertake internal audits to evaluate compliance with applicable laws and regulations as well as internal compliance policies and procedures. Insurance companies also impose routine external audits to evaluate payments made. This adds further complexity to the billing process.

Among many other factors complicating billing are:

• pricing differences between our fee schedules and the reimbursement rates of the payors;

• disputes with payors as to which party is responsible for payment; and

• disparity in coverage and information requirements among various carriers.

We expect to incur significant additional costs as a result of our participation in the Medicare and Medicaid programs, as billing and reimbursement for clinical laboratory testing is subject to considerable and complex federal and state regulations. The additional costs we expect to incur include those related to: (1) complexity added to our billing processes; (2) training and education of our employees and customers; (3) implementing compliance procedures and oversight; (4) legal costs; and (5) costs associated with, among other factors, challenging coverage and payment denials and providing patients with information regarding claims processing and services, such as advanced beneficiary notices.

We may acquire other businesses, products or technologies in order to remain competitive in our market and our business could be adversely affected as a result of any of these future acquisitions.

We may make acquisitions of complementary businesses, products or technologies. If we identify any additional appropriate acquisition candidates, we may not be successful in negotiating acceptable terms of the acquisition, financing the acquisition, or integrating the acquired business, products or technologies into our existing business and operations. Further, completing an acquisition and integrating an acquired business will significantly divert management time and resources. The diversion of management attention and any difficulties encountered in the transition and integration process could harm our business. If we consummate any significant acquisitions using stock or other securities as consideration, our shareholders’ equity could be significantly diluted. If we make any significant acquisitions using cash consideration, we may be required to use a substantial portion of our available cash. Acquisition financing may not be available on favorable terms, if at all. In addition, we may be required to amortize significant amounts of other intangible assets in connection with future acquisitions, which would harm our operating results, cash flows and financial condition.

Risks Related to Litigation and Intellectual Property

Product liability claims could subject us to significant monetary damage.

The manufacture and sale of the ACIS^® and similar products entails an inherent risk of product liability arising from an inaccurate, or allegedly inaccurate, test or diagnosis. We currently maintain numerous insurance policies, including a $2,000,000 general liability policy, a $5,000,000 technology based errors and omissions policy and a $10,000,000 umbrella liability policy (which excludes technology based errors and omissions). These policies have deductible ranges from $5,000 to $25,000 and contain customary exclusions (including certain exclusions for medical malpractice and asbestos). Although we have not experienced any material losses to date, we cannot assure you that we will be able to maintain or acquire adequate product liability insurance in the future. Any product liability claim against us could have a material adverse effect on our reputation and operating results, cash flows and financial condition.

Clinicians or patients using our products or services may sue us and our insurance may not sufficiently cover all claims brought against us, which will increase our expenses.

The development, marketing, sale and performance of healthcare services expose us to the risk of litigation, including professional negligence. Damages assessed in connection with, and the costs of defending, any legal action could be substantial. We currently maintain numerous insurance policies, including a $3,000,000 professional liability insurance policy ($2,000,000 per incident). This policy has a deductible of $10,000 and contains customary exclusions (including exclusions relating to asbestos and biological contaminants). However, we may be faced with litigation claims which exceed our insurance coverage or are not covered under any of our insurance policies. In addition, litigation could have a material adverse effect on our business if it impacts our existing and potential customer relationships, creates adverse public relations, diverts management resources from the operation of the business or hampers our ability to perform assays or otherwise conduct our business.

If we use biological and hazardous materials in a manner that causes injury, we could be liable for damages.

Our research and development activities sometimes involve the controlled use of potentially harmful biological materials, hazardous materials, chemicals and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury to third parties from the use, storage, handling or disposal of these materials. We currently maintain numerous insurance policies, including a $2,000,000 general liability policy and a $10,000,000 umbrella liability policy (which excludes technology-based errors and omissions). These policies have deductible ranges from $5,000 to $25,000 and contain customary exclusions (including certain exclusions relating to asbestos and medical malpractice). However, in the event of contamination or injury, we could be held liable for any resulting damages, and any liability could exceed our resources or any applicable insurance coverage we may have. Additionally, we are subject on an ongoing basis to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. The cost of compliance with these laws and regulations is significant and could negatively affect our operations, cash flows and financial condition if these costs increase substantially.

Any breakdown in the protection of our proprietary technology, or any determination that our proprietary technology infringes on the rights of others, could materially affect our business.

Our commercial success will depend in part on our ability to protect and maintain our proprietary technology and to obtain and enforce patents on our technology. We rely primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. However, obtaining, defending and enforcing our patents and other intellectual property rights involve complex legal and factual questions. We cannot assure you that we will be able to obtain, defend or enforce our patent rights covering our technologies in the US or in foreign countries, or be able to effectively maintain our technologies as unpatented trade secrets or otherwise obtain meaningful protection for our proprietary technology. Moreover, we cannot assure you that third parties will not infringe, design around, or improve upon our proprietary technology or rights.

The healthcare industry has been the subject of extensive litigation regarding patents and other proprietary rights and if we are unable to protect our patents and proprietary rights, through litigation or otherwise, our reputation and competitiveness in the marketplace could be materially damaged.

We may initiate litigation to attempt to stop the infringement of our patent claims or to attempt to force an unauthorized user of our trade secrets to compensate us for the infringement or unauthorized use, patent and trade secret litigation is complex and often difficult and expensive, and would consume the time of our management and other significant resources. If the outcome of litigation is adverse to us, third parties may be able to use our technologies without payments to us. Moreover, some of our competitors may be better able to sustain the costs of litigation because they have substantially greater resources. Because of these factors relating to litigation, we may be unable to prevent misappropriation of our patent and other proprietary rights effectively.

If the use of our technologies conflicts with the intellectual property rights of third-parties, we may incur substantial liabilities and we may be unable to commercialize products based on these technologies in a profitable manner, if at all.

Our competitors or others may have or acquire patent rights that they could enforce against us. If they do so, we may be required to alter our technologies, pay licensing fees or cease activities. If our technologies conflict with patent rights of others, third parties could bring legal action against us or our licensees, suppliers, customers or collaborators, claiming damages and seeking to enjoin manufacturing and marketing of the affected products. If these legal actions are successful, in addition to any potential liability for damages, we might have to obtain a royalty or licensing arrangement in order to continue to manufacture or market the affected products. A required license or royalty under the related patent or other intellectual property may not be available on acceptable terms, if at all.

We may be unaware of issued patents that our technologies infringe. Because patent applications can take many years to issue, there may be currently pending applications, unknown to us, that may later result in issued patents upon which our technologies may infringe. There could also be existing patents of which we are unaware upon which our technologies may infringe. In addition, if third parties file patent applications or obtain patents claiming technology also claimed by us in pending applications, we may have to participate in interference proceedings in the US Patent and Trademark Office to determine priority of invention. If third parties file oppositions in foreign countries, we may also have to participate in opposition proceedings in foreign tribunals to defend the patentability of the filed foreign patent applications. We may have to participate in interference proceedings involving our issued patents or our pending applications.

If a third party claims that we infringe upon its proprietary rights, any of the following may occur:

• we may become involved in time-consuming and expensive litigation, even if the claim is without merit;

• we may become liable for substantial damages for past infringement, including possible treble damages for allegations of willful infringement, if a court decides that our technologies infringe upon a competitor’s patent;

• a court may prohibit us from selling or licensing our product without a license from the patent holder, which may not be available on commercially acceptable terms, if at all, or which may require us to pay substantial royalties or grant cross licenses to our patents; and

• we may have to redesign our product so that it does not infringe upon others’ patent rights, which may not be possible or could require substantial funds or time.

If any of these events occurs, our business, results of operation, cash flows and financial condition will suffer and the market price of our common stock will likely decline.

Risks Related to Regulation of Our Industry

FDA regulations and those of other regulatory agencies can cause significant uncertainty, delay and expense in introducing new applications for the ACIS^® and present a continuing risk to our ability to offer applications.

As a medical device, our ACIS^® product is subject to extensive and frequently changing federal, state and local governmental regulation in the U.S. and in other countries. The U.S. Food and Drug Administration (FDA) as well as various other federal and state statutes and regulations, govern the development, testing, manufacture, labeling, storage, record keeping, distribution, sale, marketing, advertising and promotion and importing and exporting of medical devices. Failure to comply with applicable governmental requirements can result in fines, recall or seizure of products, total or partial suspension of production, withdrawal of existing product approvals or clearances, refusal to approve or clear new applications or notices and criminal prosecution. In addition, changes in existing laws or regulations, or new laws or regulations, may delay or prevent us from marketing our products or cause us to reduce our pricing.

If we are not able to obtain all of the regulatory approvals and clearances required to commercialize our products, our business would be significantly harmed.

Regulatory clearance or approval of applications for the ACIS^® or other products we may develop, including the related software, may be denied or may include significant limitations on the indicated uses for which it may be marketed. The FDA actively enforces the prohibition on marketing products that have not been approved or cleared and also imposes and enforces strict regulations regarding the validation and quality of manufacturing, which are enforced through periodic inspection of manufacturing facilities. Foreign countries have comparable regulations.

In most cases, the development and commercialization of additional diagnostic applications in the U.S. will require either pre-market notification, or 510(k) clearance, or pre-market approval (PMA) from the FDA prior to marketing. The 510(k) clearance pathway usually takes from two to twelve months from submission, but can take longer. The pre-market approval pathway is much more costly, lengthy, uncertain and generally takes from one to two years or longer from submission. We do not know whether we will be able to obtain the clearances or approvals required to commercialize these products.

Applications submitted for FDA clearance or approval will be subject to substantial restrictions, including, among other things, restrictions on the indications for which we may market these products, which could result in lower revenues. The marketing claims we will be permitted to make in labeling or advertising regarding our cancer diagnostic products, if cleared or approved by the FDA, will be limited to those specified in any clearance or approval. In addition, we are subject to inspection and marketing surveillance by the FDA to determine our compliance with regulatory requirements. If the FDA finds that we have failed to comply with these requirements, it can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions, including:

• fines, injunctions and civil penalties;

• recall or seizure of our products;

• operating restrictions, partial suspension or total shutdown of production;

• denial of requests for 510(k) clearances or pre-market approvals of product candidates;

• withdrawal of 510(k) clearances or pre-market approvals already granted; and

• criminal prosecution.

Any of these enforcement actions could affect our ability to commercially distribute our products in the US and may also harm our ability to conduct the clinical trials necessary to support the marketing, clearance or approval of additional applications.

We cannot predict the extent of future FDA regulation of our in-house diagnostic laboratory services.

Neither the FDA nor any other governmental agency currently fully regulates the new in-house diagnostic laboratory services that we may develop and market to physicians, laboratory professionals and other medical practitioners. These tests are commonly referred to as “home brews.” FDA maintains that it has the authority to regulate “home brews” under the Federal Food, Drug, and Cosmetic Act as medical devices, however, as a matter of enforcement discretion, has decided not to exercise its authority. FDA is currently assessing the feasibility of applying additional regulatory controls over in-house diagnostic laboratory testing. We cannot predict the extent of future FDA regulation and there can be no assurance that the FDA will not require in-house diagnostic laboratory testing to receive premarketing clearance, or premarket approval prior to marketing. Additional FDA regulatory controls over our in-house diagnostic laboratory services could add substantial additional costs to our operations, and may delay or prevent our ability to commercially distribute our services in the U.S.

Our medical devices, facilities and products are subject to significant quality control oversight and regulations, and our failure to comply with these could result in penalties or enforcement proceedings.

Manufacturers of medical devices are subject to federal and state regulation regarding validation and the quality of manufacturing facilities, including FDA’s Quality System Regulation, or QSR, which covers the design, testing production processes, controls, quality assurance, labeling, packaging, storing and shipping of medical devices. Our failure to comply with these quality system regulations could result in civil or criminal penalties or enforcement proceedings, including the recall of a product or a “cease distribution” order requiring us to stop placing our products in service or selling, any one of which could materially adversely affect our business, results of operations and financial condition. Similar results would occur if we were to violate foreign regulations.

Our operations are subject to strict laws prohibiting fraudulent billing and other abuse, and our failure to comply with such laws could result in substantial penalties.

Of particular importance to our operations are federal and state laws prohibiting fraudulent billing and providing for the recovery of non-fraudulent overpayments, as a large number of laboratories have been forced by the federal and state governments, as well as by private payors, to enter into substantial settlements under these laws. In particular, if an entity is determined to have violated the federal False Claims Act, it may be required to pay up to three times the actual damages sustained by the government, plus civil penalties of between $5,500 to $11,000 for each separate false claim. There are many potential bases for liability under the federal False Claims Act. Liability arises, primarily, when an entity knowingly submits, or causes another to submit, a false claim for reimbursement to the federal government. Submitting a claim with reckless disregard or deliberate ignorance of its truth or falsity could result in substantial civil liability. A trend affecting the healthcare industry is the increased use of the federal False Claims Act and, in particular, actions under the False Claims Act’s “whistleblower” or “qui tam” provisions. Those provisions allow a private individual to bring actions on behalf of the government alleging that the defendant has submitted a fraudulent claim for payment to the federal government. The government must decide whether to intervene in the lawsuit and to become the primary prosecutor. If it declines to do so, the individual may choose to pursue the case alone, although the government must be kept apprised of the progress of the lawsuit. Whether or not the federal government intervenes in the case, it will receive the majority of any recovery. In recent years, the number of suits brought against healthcare providers by private individuals has increased dramatically. In addition, various states have enacted laws modeled after the federal False Claims Act.

Government investigations of clinical laboratories have been ongoing for a number of years and are expected to continue in the future. Written “corporate compliance” programs to actively monitor compliance with fraud laws and other regulatory requirements are recommended by the Department of Health and Human Services’ Office of the Inspector General and we have a program following the guidelines in place.

Our laboratory services are subject to extensive federal and state regulation, and our failure to comply with such regulations could result in penalties or suspension of Medicare payments and/or loss of our licenses, certificates or accreditation.

The clinical laboratory testing industry is subject to extensive regulation, and many of these statutes and regulations have not been interpreted by the courts. The Clinical Laboratory Improvement Amendments of 1988 (“CLIA”) established quality standards for all laboratory testing to ensure the accuracy, reliability and timeliness of patient test results regardless of where the test was performed. Laboratories covered under CLIA are those which perform laboratory testing on specimens derived from humans for the purpose of providing information for the diagnosis, prevention, treatment of disease and other factors. The Centers for Medicare and Medicaid Services is charged with the implementation of CLIA, including registration, surveys, enforcement and approvals of the use of private accreditation agencies. For certification under CLIA, laboratories such as ours must meet various requirements, including requirements relating to quality assurance, quality control and personnel standards. Since we will be performing patient testing from all states, our laboratory will also be subject to strict regulation by California, New York and various other states. State laws may require that laboratory personnel meet certain qualifications, specify certain quality controls or require maintenance of certain records, and we will be required to obtain state regulatory licenses to offer the professional and technical components of laboratory services. If we are unable to secure our state regulatory license in a timely manner, our plans to expand into laboratory services could be compromised. We will also seek to be accredited by the College of American Pathologists, a private accrediting agency, and therefore will be subject to their requirements and evaluation. Our

failure to comply with CLIA, state or other applicable requirements could result in various penalties, including restrictions on tests which the laboratory may perform, substantial civil monetary penalties, imposition of specific corrective action plans, suspension of Medicare payments and/or loss of licensure, certification or accreditation. Such penalties could result in our being unable to continue performing laboratory testing. Compliance with such standards is verified by periodic inspections and requires participation in proficiency testing programs.

We are subject to significant environmental, health and safety regulation.

We are subject to licensing and regulation under federal, state and local laws and regulations relating to the protection of the environment and human health and safety, including laws and regulations relating to the handling, transportation and disposal of medical specimens, infectious and hazardous waste and radioactive materials as well as to the safety and health of laboratory employees. In addition, the federal Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for health care employers, including clinical laboratories, whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis B virus. These regulations, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to, and transmission of, blood-borne pathogens. In addition, the federally-enacted Needlestick Safety and Prevention Act requires, among other things, that we include in our safety programs the evaluation and use of engineering controls such as safety needles if found to be effective at reducing the risk of needlestick injuries in the workplace.

We are subject to federal and state laws governing the financial relationship among healthcare providers, including Medicare and Medicaid laws, and our failure to comply with these laws could result in significant penalties and other adverse consequences.

Existing federal laws governing Medicare and Medicaid and other similar state laws impose a variety of broadly described restrictions on financial relationships among healthcare providers, including clinical laboratories. These laws include the federal anti-kickback law which prohibits individuals or entities, including clinical laboratories, from, among other things, making any payments or furnishing other benefits intended to induce or influence the referral of patients for tests billed to Medicare, Medicaid or certain other federally funded programs. Several courts have interpreted the statute’s intent requirement to mean that if any one purpose of an arrangement involving remuneration is to induce referrals of federal healthcare covered business, the statute has been violated. Penalties for violations include criminal penalties and civil sanctions such as fines, imprisonment and possible exclusion from Medicare, Medicaid and other federal healthcare programs. In addition, some kickback allegations have been claimed to violate the Federal False Claims Act (discussed above). In addition, many states have adopted laws similar to the federal anti-kickback law. Some of these state prohibitions apply to referral of patients for healthcare items or services reimbursed by any source, not only the Medicare and Medicaid programs. Many of the federal and state anti-fraud statutes and regulations, including their application to joint ventures and collaborative agreements, are vague or indefinite and have not been interpreted by the courts.

In addition, these laws also include self-referral prohibitions which prevent us from accepting referrals from physicians who have non-exempt ownership or compensation relationships with us as well as anti-markup and direct billing rules that may apply to our relationships with our customers. Specifically, the federal anti-”self-referral” law, commonly known as the “Stark” law, prohibits, with certain exceptions, Medicare payments for laboratory tests referred by physicians who have, personally or through a family member, an investment interest in, or a compensation arrangement with, the testing laboratory. A person who engages in a scheme to circumvent the Stark Law’s prohibitions may be fined up to $100,000 for each such arrangement or scheme. In addition, anyone who presents or causes to be presented a claim to the Medicare program in violation of the Stark Law is subject to monetary penalties of up to $15,000 per claim submitted, an assessment of several times the amount claimed, and possible exclusion from participation in federal healthcare programs. In addition, claims submitted in violation of the Stark Law may be alleged to be subject to liability under the federal False Claims Act and its whistleblower provisions.

Several states in which we operate have enacted legislation that prohibits physician self-referral arrangements and/or requires physicians to disclose any financial interest they may have with a healthcare provider to their patients when referring patients to that provider. Some of these statutes cover all patients and are not limited to Medicare or Medicaid beneficiaries. Possible sanctions for violating state physician self-referral laws vary, but may include loss of license and civil and criminal sanctions. State laws vary from jurisdiction to jurisdiction and, in a few states, are more restrictive than the federal Stark Law. Some states have indicated they will interpret their own self-referral statutes the same way that the U.S. Centers for Medicare and Medicaid Services (“CMS”) interprets the Stark Law, but it is possible the states will interpret their own laws differently in the future. The laws of many states prohibit physicians from sharing professional fees with non-physicians and prohibit non-physician entities, such as us, from practicing medicine and from employing physicians to practice medicine.

If we do not comply with existing or additional regulations, or if we incur penalties, it could increase our expenses, prevent us from increasing net revenue, or hinder our ability to conduct our business. In addition, changes in existing regulations or new regulations may delay or prevent us from marketing our products or cause us to reduce our pricing.

Our business is subject to stringent laws and regulations governing the confidentiality of medical information, and our failure to comply could subject us to criminal penalties and civil sanctions.

The use and disclosure of patient medical information is subject to substantial regulation by federal, state, and foreign governments. For example, the Health Insurance Portability and Accountability Act of 1996, known as HIPAA, was enacted among other things, to establish uniform standards governing the conduct of certain electronic health care transactions and to protect the security and privacy of individually identifiable health information maintained or transmitted by health care providers, health plans and health care clearinghouses. We are currently required to comply with two standards under HIPAA. We must comply with the Standards for Electronic Transactions, which establish standards for common health care transactions, such as claims information, plan eligibility, payment information and the use of electronic signatures; unique identifiers for providers, employers, health plans and individuals; security; privacy; and enforcement. We were required to comply with these Standards by October 16, 2003. We also must comply with the Standards for Privacy of Individually Identifiable Information, which restrict our use and disclosure of certain individually identifiable health information. We were required to comply with the Privacy Standards by April 14, 2003. We are also required to implement certain security measures to safeguard certain electronic health information. In addition, CMS recently published a final rule, which will require us to adopt a Unique Health Identifier for use in filing and processing health care claims and other transactions by May 23, 2007. While the government intended this legislation to reduce administrative expenses and burdens for the health care industry, our compliance with this law may entail significant and costly changes for us. If we fail to comply with these standards, we could be subject to criminal penalties and civil sanctions.

The Standards for Privacy of Individually Identifiable Information establish a “floor” and do not supersede state laws that are more stringent. Therefore, we are required to comply with both federal privacy regulations and varying state privacy laws. In addition, for health care data transfers from other countries relating to citizens of those countries, we must comply with the laws of those other countries.

Risks Related to Our Common Stock

We have never paid cash dividends on our common stock and do not anticipate paying dividends on our common stock, which may cause investors to rely on capital appreciation for a return on their investment.

We currently intend to retain future earnings for use in our business and do not anticipate paying cash dividends on our common stock in the foreseeable future. Any payment of cash dividends will also depend on our financial condition, results of operations, capital requirements and other factors and will be at the discretion of our board of directors. Accordingly, investors will have to rely on capital appreciation, if any, to earn a return on their investment in our common stock.

If we raise additional funds you may suffer dilution or subordination and we may grant rights in our technology or products to third parties.

If we raise additional funds by issuing equity securities, further dilution to our stockholders could result, and new investors could have rights superior to those of holders of the shares of our common stock. Any equity securities issued also may provide for rights, preferences or privileges senior to those of holders of our common stock. If we raise additional funds by issuing debt securities, these debt securities would have rights, preferences and privileges senior to those of holders of our common stock, and the terms of the debt securities issued could impose significant restrictions on our operations. If we raise additional funds through collaborations and licensing arrangements, we might be required to relinquish significant rights to our technologies or products, or grant licenses on terms that are not favorable to us. If adequate funds are not available, we may have to delay or may be unable to continue to develop our products.

Our stock price is likely to continue to be volatile, which could result in substantial losses for investors.

The market price of our common stock has in the past been, and in the future is likely to be, highly volatile. These fluctuations could result in substantial losses for investors. Our stock price may fluctuate for a number of reasons including:

• media reports and publications and announcements about cancer or diagnostic products or treatments or new innovations;

• developments in or disputes regarding patent or other proprietary rights;

• announcements regarding clinical trials or other technological or competitive developments by us and our competitors

• loss of a significant customer or group purchasing organization contract;

• the hiring and retention of key personnel;

• announcements concerning our competitors or the biotechnology industry in general;

• regulatory developments regarding us or our competitors;

• changes in reimbursement policies concerning our products or competitors’ products;

• changes in the current structure of the healthcare financing and payment systems;

• stock market price and volume fluctuations, which have particularly affected the market prices for medical products and high technology companies and which have often been unrelated to the operating performance of such companies; and

• general economic, political and market conditions.

In addition, stock markets have from time to time experienced extreme price and volume fluctuations. The market prices for medical device and laboratory service affected by these market fluctuations and such effects have often been unrelated to the operating performance of such companies. These broad market fluctuations may cause a decline in the market price of our common stock.

Securities class action litigation is often brought against a company after a period of volatility in the market price of its stock. This type of litigation could be brought against us in the future, which could result in substantial expense and damage awards and divert management’s attention from running our business.

With the advent of the Internet, new avenues have been created for the dissemination of information. We do not have control over the information that is distributed and discussed on electronic bulletin boards and investment chat rooms. The motives of the people or organizations that distribute such information may not be in our best interest or in the interest of our shareholders. This, in addition to other forms of investment information, including newsletters and research publications, could result in a significant decline in the market price of our common stock.

Future sales of shares by existing stockholders could result in a decline in the market price of the stock.

Some of our current stockholders hold a substantial number of shares which they are currently able to sell in the public market, and our employees hold options to purchase a significant number of shares and/or have been issued shares of restricted stock that are covered by registration statements on Form S-8. If our common stockholders sell substantial amounts of common stock in the public market, or the market perceives that such sales may occur, the market price of our common stock could fall. Safeguard Scientifics, Inc., which owns a majority of our outstanding common stock, has rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or other stockholders. Furthermore, if we were to include in a Company-initiated registration statement shares held by Safeguard pursuant to the exercise of its registrations rights, the sale of those shares could impair our ability to raise needed capital by depressing the price at which we could sell our common stock.

We are controlled by a single existing stockholder, whose interests may differ from other stockholders’ interests and may adversely affect the trading price of our common stock.

Safeguard Scientifics, Inc. beneficially owns a majority of the outstanding shares of our common stock. Safeguard Scientifics, Inc. currently beneficially owns a majority of our common stock. As a result, Safeguard Scientifics, Inc. will have significant influence in determining the outcome of any corporate transaction or other matter submitted to the stockholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets. In addition, Safeguard Scientifics, Inc. will have the ability to elect all of our directors and they could, as a result, dictate the management of our business and affairs. The interests of this stockholder may differ from other stockholders’ interests. In addition, this concentration of ownership may delay, prevent, or deter a change in control and could deprive other stockholders of an opportunity to receive a premium for their common stock as part of a sale of our business. This significant concentration of share ownership may adversely affect the trading price of our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders.

We have adopted a stockholder rights plan and other arrangements which could inhibit a change in control and prevent a stockholder from receiving a favorable price for his or her shares.

Our board of directors has adopted a stockholders’ rights plan providing for discounted purchase rights to its stockholders upon specified acquisitions of our common stock. The exercise of these rights is intended to inhibit specific changes of control of our company.

In addition, Section 203 of the Delaware General Corporation Law limits business combination transactions with 15% stockholders that have not been approved by our board of directors. These provisions and others could make it difficult for a third party to acquire us, or for members of our board of directors to be replaced, even if doing so would be beneficial to our stockholders. Because our board of directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt to replace the current management team. If a change of control or change in management is delayed or prevented, you may lose an opportunity to realize a premium on your shares of common stock or the market price of our common stock could decline.

Our shares of common stock currently trade on the NASDAQ SmallCap Market which results in a number of legal and other consequences that may negatively affect our business and the liquidity and price of our common stock.

Effective August 15, 2003, a Nasdaq Qualifications Panel terminated our Nasdaq National Market Listing and transferred our securities to the Nasdaq SmallCap Market. With our securities listed on the Nasdaq SmallCap Market, we face a variety of legal and other consequences that may negatively affect our business including, without limitation, the following:

• future issuances of our securities may require time-consuming and costly registration statements and qualifications because state securities law exemptions available to us are more limited;

• securities analysts may decrease or cease coverage of Clarient; and

• we may lose current or potential investors.

In addition, we are required to satisfy various listing maintenance standards for our common stock to be quoted on the Nasdaq SmallCap Market. If we fail to meet such standards, our common stock would likely be delisted from the Nasdaq SmallCap Market and trade on the over-the-counter bulletin board, commonly referred to as the “pink sheets.” This alternative is generally considered to be a less efficient market and would seriously impair the liquidity of our common stock and limit our potential to raise future capital through the sale of our common stock, which could materially harm our business, results of operations, cash flows and financial position.

Recently enacted and proposed changes in securities laws and regulations will increase our costs.

The Sarbanes-Oxley Act of 2002 along with other recent and proposed rules from the Securities and Exchange Commission and Nasdaq require changes in our corporate governance, public disclosure and compliance practices. Many of these new requirements will increase our legal and financial compliance costs, and make some corporate actions more difficult, such as proposing new or amendments to stock option plans, which now require shareholder approval. These developments could make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments also could make it more difficult for us to attract and retain qualified executive officers and qualified members of our board of directors, particularly to serve on our audit committee.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Historically, we have invested excess cash in short-term debt securities that are intended to be held to maturity. These short-term investments typically have various maturity dates which do not exceed one year. We had no short-term investments as of September 30, 2005.

Two of the main risks associated with these investments are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of debt securities. Fluctuations in interest rates would not have a material effect on our financial statements because of the short-term nature of the securities in which we invest and our intention to hold the securities to maturity. Credit risk refers to the possibility that the issuer of the debt securities will not be able to make principal and interest payments. We have limited our investments to investment grade or comparable securities and have not experienced any losses on our investments to date due to credit risk.

Changes in foreign exchange rates, and in particular a strengthening of the U.S. dollar, may negatively affect our consolidated sales and gross margins as expressed in U.S. dollars. To date, we have not entered into any foreign exchange contracts to hedge our exposure to foreign exchange rate fluctuations. However, as our international operations grow, we may enter into such arrangements in the future. Effective January 1, 2002, our foreign sales were denominated in Euros. Foreign currency-denominated sales have not been significant.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that we would meet our disclosure obligations.

During 2005, our diagnostic laboratory services business has become an increasingly significant component of our operations. As a result, in the ordinary course we have reviewed and continue to review our system of internal control over financial reporting for the laboratory operations, and we have implemented changes based on our ongoing review that are designed to improve and increase the efficiency of our internal controls while maintaining an effective control environment. For example, during the third quarter of 2005, we created process documentation for evaluation and testing of our internal controls relating to our laboratory operations. In addition, during the third quarter of 2005, we began evaluating the automation of various processes relating to our laboratory services to replace certain processes that are currently conducted manually. Except for the foregoing, there has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

The Company is not a party to any legal proceedings, the adverse outcome of which, individually or in the aggregate, management believes would have a material adverse effect on the business, financial condition or results of operations of the business.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

On August 1, 2005, the Company issued a warrant to purchase 50,000 shares of common stock for an exercise price of $2.00 per share to Safeguard as a portion of the consideration paid to Safeguard in exchange for Safeguard’s guarantee of a $3.0 million increase in the Company’s borrowing limit under the Company’s working capital loan facility with Comerica Bank. The warrant was issued in reliance upon the exemption from the registration requirements of the Securities Act of 1933 provided by Section 4(2) of the Securities Act.

On November 8, 2005, the Company entered into a securities purchase agreement with a limited number of accredited investors pursuant to which the Company has agreed to issue approximately 15,000,000 shares of common stock, together with warrants to purchase an additional 2,250,000 shares of common stock, for an aggregate purchase price of $15,000,000. The securities being issued in the private placement are being issued in reliance upon the exemption from the registration requirements of the Securities Act of 1933 provided by Section 4(2) of the Securities Act. The terms of this private placement are described in more detail in Note 13 to our unaudited financial statements included in Part I of this quarterly report on Form 10-Q.

Item 5. Other Events

On November 8, 2005, the Company entered into a securities purchase agreement with a limited number of accredited investors pursuant to which the Company has agreed to issue approximately 15,000,000 shares of common stock, together with warrants to purchase an additional 2,250,000 shares of common stock, for an aggregate purchase price of $15,000,000. The terms of this private placement are described in more detail in Note 13 to our unaudited financial statements included in Part I of this quarterly report on Form 10-Q.

Item 6. Exhibits and Reports on Form 10-Q

(a) Exhibits

Exhibit Number		Description
10.1		Distribution and Development Agreement dated July 18, 2005 between the Company and DakoCytomation Denmark A/S (a)†
10.2		Facility lease between the Company and 31 Columbia, Inc. dated July 20, 2005 (a)
10.3		Waiver and Fifth Amendment to Loan Agreement dated August 1, 2005 by and between the Company and Clarient, Inc. (b)
10.4		Second Amended and Restated Unconditional Guaranty dated August 1,2005 , to Comerica Bank provided by Safeguard Delaware, Inc. and Safeguard Scientifics (Delaware), Inc (b)
10.5		Reimbursement and Indemnity Agreement dated August 1, 2005 , by Clarient, Inc. in favor of Safeguard Delaware, Inc and Safeguard Scientifics (Delaware), Inc (b)
10.6		Warrant to Purchase 50,000 Shares of Common Stock dated August 1, 2005 issued to Safeguard Scientifics (Delaware), Inc. (b)
10.7		Separation Agreement dated August 23, 2005 between the Company and Kenneth D. Bauer, Ph.D.(c)
10.8		Securities Purchase Agreement dated November 8, 2005, by and among the Company and the investors named therein. (d)
10.9		Registration Rights Agreement, dated November 8, 2005, by and among the Company and the investors named therein. (d)
10.10		Form of Common Stock Purchase Warrant to be issued pursuant to Securities Purchase Agreement dated November 8, 2005 (d)
31.1		Certifications pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a) for Ronald A. Andrews. (*)
31.2		Certifications pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a) for Stephen T. D. Dixon. (*)
32.1		Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for Ronald A. Andrews. (*)
32.2		Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for Stephen T. D. Dixon. (*)

(*)		Filed herewith.

(a)		Filed on August 8, 2005 as an exhibit to the Company’s Quarterly Report on Form 10-Q and incorporated by reference.
†		Confidential treatment requested as to certain portions, which portions have been filed separately with the Securities and Exchange Commission

(b)		Filed on August 4, 2005 as an exhibit to the Company’s Current Report on Form 8-K and incorporated by reference.

(c)		Filed on August 29, 2005 as an exhibit to the Company’s Current Report on Form 8-K and incorporated by reference.

(d)		Filed on November 9, 2005 as an exhibit to the Company’s Current Report on Form 8-K and incorporated by reference.

CLARIENT, INC.
(Exact name of registrant as specified in its charter)

DELAWARE		75-2649072
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)

33171 PASEO CERVEZA
SAN JUAN CAPISTRANO, CA		92675
(Address of principal executive offices)		(Zip code)

	CLARIENT, INC.

DATE: November 9, 2005	BY:	/s/ Ronald A. Andrews
		Ronald A. Andrews President and Chief Executive Officer


DATE: November 9, 2005	BY:	/s/ Stephen T. D. Dixon
		Stephen T.D. Dixon Executive Vice President and Chief Financial Officer

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For The Quarterly Period Ended September 30, 2005

OR

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

For the Transition Period from to

COMMISSION FILE NUMBER 000-22677

CLARIENT, INC.

(Exact name of registrant as specified in its charter)

DELAWARE

75-2649072

(State or other jurisdiction of incorporation or
organization)

(IRS Employer Identification Number)

33171 PASEO CERVEZA

SAN JUAN CAPISTRANO, CA

92675

(Address of principal executive offices)

(Zip code)

(949) 443-3355

(Registrant’s telephone number, including area code)

CHROMAVISION MEDICAL SYSTEMS, INC.

(Former name, former address and former fiscal year, if changed since last report)

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, and (2) has been subject to such filing requirements for the past 90 days.

Yes ý No o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

SIGNATURES

PART I - FINANCIAL INFORMATION

Item 1.

Condensed Consolidated Statements of Cash Flows

Stock Options

(8) Recent Accounting Pronouncements

(9) Stock Transactions

Overview and Outlook

Critical Accounting Policies and Estimates

RISK FACTORS

SIGNATURES

PART I		FINANCIAL INFORMATION

	Item 1	Financial Statements

		Condensed Consolidated Balance Sheets as of September 30, 2005 (unaudited) and December 31, 2004

		Condensed Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2005 and 2004

		Condensed Consolidated Statements of Cash Flows (unaudited) for the three and nine months ended September 30, 2005 and 2004

		Notes to Condensed Consolidated Financial Statements

	Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations

	Item 3	Quantitative and Qualitative Disclosures About Market Risk

	Item 4	Controls and Procedures

PART II		OTHER INFORMATION

	Item 1	Legal Proceedings

	Item 6	Exhibits

SIGNATURES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For The Quarterly Period Ended September 30, 2005

OR

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

For the Transition Period from to

COMMISSION FILE NUMBER 000-22677

CLARIENT, INC.

(Exact name of registrant as specified in its charter)

DELAWARE

75-2649072

(State or other jurisdiction of incorporation or organization)

(IRS Employer Identification Number)

33171 PASEO CERVEZA

SAN JUAN CAPISTRANO, CA

92675

(Address of principal executive offices)

(Zip code)

(949) 443-3355

(Registrant’s telephone number, including area code)

CHROMAVISION MEDICAL SYSTEMS, INC.

(Former name, former address and former fiscal year, if changed since last report)

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, and (2) has been subject to such filing requirements for the past 90 days.

Yes ý No o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

SIGNATURES

PART I - FINANCIAL INFORMATION

Item 1.

Condensed Consolidated Statements of Cash Flows

Stock Options

(8) Recent Accounting Pronouncements

(9) Stock Transactions

Overview and Outlook

Critical Accounting Policies and Estimates

RISK FACTORS

SIGNATURES

(State or other jurisdiction of incorporation or
organization)