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See "Risk Factors - Lack ofSales and Earnings" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." DIVIDEND POLICY The Company has not paid any dividends on its Common Stock and intends for the foreseeable future to follow a policy of retaining earnings, if any, for use in connection with the commencement of its operations and expansion of its business. DILUTION For purposes of the following discussion, no value has been assigned to the Warrants included in the Units being offered hereby and purchasers of the Units are considered to have paid 56.50 per share of Common Stock. At March 31, 1984, the net tangible book value of the Company's Common Stock was S 197,436, or S.034 per shm, after giving effect to the acquisition of the assets subject to the liabilities of NCC Group, Ltd. "Net tangible book value" represents the amount of the Company's tangible assets (which excludes the Company's patent rights) less the amount of its liabilities. Without giving effect to any other changes in such book value after March 31, 1984, but giving effect to the sale by the Company of the Units offered by it hereby (kss estimated expenses and underwriting discounts and commissions), the pro forma net tangible book value of the Company at March 31, 1984 would have been S 1.06 per share. This represents an immediate dilution to new investors purchasing Units in the offering of 55.44 per share from the -initial--public- ofl'crine_prisx _per _Unit,_ _as -illustrated in _the- following_ t-a_ble._ Neither_ the_ foregoing calculations nor the tables give effect to the exercise of (i) the Warrants included in the Units, or (ii) the 100,000 Unit purchase warrants to be purchased by the Representative of the Underwriters, which if exercised may result in additional dilution. Public offering price .................................................................................. 56.50 Net tangible book value before offering .................................................... S.034 Increase attributable to payments by new investors .................................. 1.026 Pro forma net tangible book value after offering ....................................... 1.06 Dilution of net tangible book value per share to new investors ................. 55.44 The following table compares the share ownership and cash contribution to the Company (including its predecessors) thcrefor by the Company's existing shareholders, including shareholders receiving shares in connection with the acquisition of the assets of NCC Group, Ltd. and the above private placement, with the share ownership and effective cash contribution to the Company therefor by persons purchasing Units in the offering described herein. Perccnt of Percent Total o f Cons{d- Shares Total Coasident3oo tradoa Purchaied Shue. Paid Pald Existing shareholders .................................. 5,737,600 82.1% $1,156,675 12.5% Purchasers in offering ................................. 1,250,000 17.9% $8,125,000 87.5% The Company's shareholders other than purchasers of the Units have agreed with the State Securities Commissioner of Texas to deposit in escrow an aggregate of 3,000,000 of such shareholders' shares, subject to release only upon the satisfaction of certain conditions. Such shareholders have also agrecd not to sell any of their shares in the public market except in compliance with the holding period, volume limitations and other requirements of Rule 144 under the Securities Act of 1933. The shares held by such shareholders would not become available for such sales until the period commencing in September, 1985 through the second anniversary of this offering. See "Risk Factors - Possible Release From Escrow and Rule 144 Sales" and "Management - Certain Transactions." Il

CAPITALIZATION The following table sets forth the actual shareholders' equity and capitalization of the Company as of March 31, 1984, on a pro forma basis as of such date giving effect to the acquisition of the net assets of NCC Group, Ltd. and as adjusted to give effect to the sale of the Units (exclusive of the 187,500 Units subject to the Underwriters' over-allotment option). Marcb 31, 1984 Outstandins Pro Forma Combined As Adjusted (Unaudited) Debt ................................................................ - - - Shareholders' equity: Preferred stock, $100.00 par value; authorized, 500,000 shares; none issued .... - - - Common stock, 5.01 par value; authorized, 30,000,000 shares; issued and outstanding, 1,067,908 shares, 5,737,600 shares pro forma and 6,987,600 shares as adjusted(1) ................. 10,679 57,376 69,876 Paid-in capital .............................................. 238,705 1,076,059 8,197,934 Deficit .......................................................... (27,146 ) (462,722) (462,722) Total shareholders' equity ........................... $222,238 S 670,713 $7,805,088 (1) Excludes 163,600 shares of Common Stock covered by outstanding options, 310,000 shares of Common Stock reserved for issuance upon exercise of options that may be granted under the Company's incentive stock option plan, and 150,000 shares of Common Stock issuable upon exercise of Unit purchase warrants to be purchased by the Representative ofthe Underwriters and upon exercise of Warrants included in the Units covered by such Unit purchase warrants. See "Management - Stock Option Plan" and "Underwriting." 12

SELECTED FINANCUIL INFORMATION The following tables set forth certain historical selected financial information for the Company, on a prolorma basis giving effect to thc'aoquisition of the net assets of NCC Group, Ltd., and as adjusted to give cffect to the sale of Units (exclusive of the 187,500 Units subject to the Underwriters' over-allotment option). The following selected financial information has been derived from historical audited and historical unaudited financial statements, and u.nauditod pro forma financial statements included elsewhere in this Prospectus, and should be read in conjunction therewith. The historical financial statements of the Company and NCC for the periods to December 31, 1983 have been examined by Dcloitte Haskins & Sells, certified public accountants, whose report thereon, together with such financial statements and notes thereto, appear elscwhar in this Prospectus. The following pro forma condensed operating data is not necessarily indicative of the future results of operations of the combined Company. THE COMPANY AND PRO FORMA - THE COMPANY AND NCC GROUP, LTD. COMBINED December 31, Marrb 31, 1984 1983 Pro Forma As Hktorka! H{storkal Combtoed(l) Adjusted Balance Sheet DAta: Working capital .......................................... $ 2,125 $127,461 $195,598 57,329,973 Total assets ................................................. 29,668 279,734 703,691 7,838,066 Total liabilities ........................................... 16,284 57,496 32,978 32,978 Total shareholders' equity .......................... 13,384 222,238 670,713 7,805,088 ANgust, 1982 7hrK MontW (Date of Year Ended tscepti00) LO Eaded March 31, December 31, December 31, 1982 1983(1) 1983 1981 Operating Data(1): Advanced Tobacco Product~ Inc.: Revenues - interest ................................ $ S 2,762 Total expenses ......................................... 16,000 13,908 Net loss .................................................... S(1 6,000) S(11,146) Net loss per share ..................................... M.OJ4 S(.01) Pro Forma Combined - Advancod Tobacco Products, Inc. and NCC Group, Ltd. Revenues - interest ................................ $ 17,117 $ 28,459 $ 7,177 S 3,946 Total expenses ......................................... 178,598 263,173 37,842 70,473 Net loss .................................................... S(161,481) S 234 714 S 3( 0,665) S 6( 6,527) Net loss per share ..................................... S(.OS) S-O l) (1) Includes only the operations of the Company from April, 1983 (date of inception) through December 31, 1983. 13

MANAGEMEN-I'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND R£SULT'S OF OPERATIONS Liquidity and Capital Resources During the past five years the Company's activities have consisted of product development, clinical and consumer testing and the development ofpromotional and advertising plans. Since the commencement of operations of NCC Group, Ltd. in August, 1982, through March 31, 1984, the NCC Group, Ltd. had an accumulated net loss of 5435,756. During the period from inception in April, 1983 through March 31, 1984 the Company had an accumulated net loss of 527,146. The Company has not yet commenced retail sales or commercial scale manufacturing of its Smokeless Cigarette. The Company expects to introduce the Smokeless Cigarette in Austin and San Antonio, Texas, commencing approximately one year after this offering, and in Dallas and Houston during the second year after this offering. Depending on the results of initial marketing and the Company's manufacturing, marketing and financial capacity, the Company presently anticipates that it will introduce the Smokeless Cigarette nationally in the second or third year after this offering. The Company's only source of capital to date has been the net proceeds from the sale in 1981 of 5500,000 of units of limited partnership interest in its predecessor NCC Group, Ltd., and from the sale of 55,000 shares of Common Stock in a private placement in January, 1984 for $220,000. Until the commercial introduction of its Smokeless Cigarette, the Company's only anticipated source of cash, other than income from the short term investment of its cash on hand, will be the net proceeds from the sale of the Units. Upon the completion of this offering the Company will have net cash resources of approximately $7,200,000, of which approximately S 1,850,000 will be used during the six-month period following the completion of this offering to purchase, modify and refurbish manufacturing equipment and to make leasehold improvements to its initial manufacturing facility. During the two-year period following completion of this offering the Company plans to apply approximately 54,700,000 to advertising and promotional costs and market research, but the Company's advertising and promotion expenditures could increase substantially during the second year of such two-year period if the Company commences its national expansion during such second year. Approximately 5700,000 will be required to finance the production of the Company's initial inventory of Smokeless Cigarettes believed to be necessary to commence commercial operations. As a result of the foregoing and other anticipated expenditures, the Company anticipates that approximately S 1,300,000 of the Company's cash on hand and net proceeds of this offering will be available to finance the Company's other cash expenditures until positive cash flow from operations, if any, is achieved. See "Use of Proceeds." As indicated above, the Company anticipates the initial commercial introduction of its Smokeless Cigarette and the receipt of initial revenues from operations no earlier than the first anniversary of the completion of this offering. Accordingly, the Company expects that its operations will continue to result in operating losses for at least twelve months after this offering. Furthermore, the Company anticipates that its operations will result in decreases in its working capital for at least 24 months after this offering because initial retail sales are not expected until approximately twelve months after this offering and because a significant amount of working capital is expected to be used as inventory and accounts receivable increase prior to and after the commencement of initial retail sales. Nevertheless, assuming no internally generated revenues other than income from short-term investment of available cash, and the anticipated addition of employees consistent with the Company's current business plan, the Company anticipates that its cash on hand, together with the net proceeds of this offering, will be sufficient to meet its anticipated cash requirements for at least the twelve-month period following completion of this offering. There can be no assurance, however, that the Company's actual losses will not be greater than anticipated or that its available cash will in fact be sufficient to meet its cash requirements. In any event, if the Company commences its national expansion during the second year after this offering, the Company anticipates that the costs and expenses associated with such expansion would cause its anticipated operating losses to continue and its anticipated cash requirements to exceed its available cash 14

during such second year. To the extent that the Company's available cash is insufficient, for any reason, to meet the Company's cash requirements, the Company may attempt to raise additional capital through bank borrowings, additional sales of equity or other securities, or other means, but has not made any arrangements with any third parties with respect thereto. Certain Factors Bearing on Results of Future Operations Anticipated Unit Manufacturing Costs and Revenues. The Company plans to market its Smokeless Cigarettes in packs of six, which packs are intended to have a nicotine delivery capacity sufficient to satisfy the average smoker of conventional cigarettes for an entire day, for a factory selling price of approximately 60 cents per pack. The Company believes that such price is the approximate average factory selling price for packs of 20 conventional cigarettes and that the retail price per pack of six Smokeless Cigarettes will be approximately the same as, or slightly less than, the average price per pack of 20 conventional cigarettes. The Company anticipates that the manufacturing cost, including manufacturing overhead, of the Smokeless Cigarette will be approximately 22 cents per pack of six at the commencement of commercial scale production, assuming the manufacturing of approximately 200,000 Smokeless Cigarettes per eight hour shift and one production line, decreasing to approximately 16 cents assuming the manufacturing of 800,000 Smokeless Cigarettes per eight hour shift and four production lines, which the Company anticipates will be its approximate maximum output per shift. The foregoing unit manufacturing costs do not include operating costs not directly or indirectly related to manufacturing, which costs (particularly for advertising, promotional and other marketing costs) are expected to be substantial. There can be no assurance that the demand for the Smokeless Cigarette will be sufficient to justify the manufacturing of 800,000 Smokeless Cigarettes per eight hour shift. Furthermore, there can be no assurance that the anticipated substantial marketing costs and the increased per unit manufacturing costs that could arise if demand is insufficient to justify the production ofat least 200,000 Smokeless Cigarettes per eight hour shift and one production line would not have an adverse effect on the Company's results of operations. See "Business - Manufacturing." Selling. Distribution and Marketing Costs. The Company expects to incur significant selling, distribution and marketing costs to introduce, and to expand and maintain sales of, the Smokeless Cigarette. The Company's region-by-region marketing strategy is designed to control such costs, but such costs are expected to exceed manufacturing costs for the foreseeable future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and "Business - Marketing and Markets." Effect ojFederal Cigarette Excise Tax. The Company believes its Smokeless Cigarette will not be subject to current federal excise taxes applicable to conventional cigarettes. See "Business - Governmental Regulation and Taxation - Taxation ofCigarettes Under the Internal Revenue Code." Because the amount of the current federal cigarette excise tax is calculated by the use of a flat tax rate per thousand cigarettes manufactured, each pack of six Smokeless Cigarettes manufactured would result in approximately 30% of the tax imposed on a pack of 20 conventional Class A cigarettes. Therefore, in the event the Smokeless Cigarettes were taxed under the Internal Revenue Code on the same basis as conventional Class A cigarettes, each pack of six Smokeless Cigarettes would bear a tax of 4.8 cents. The federal cigarette excise tax was doubled on January 1, 1983. There can be no assuranet that if the tax is determined to be applicable to the Smokeless Cigarette, the Smokeless Cigarette would not be subject to similar future increases. IS

BUSINESS Introduction The Company believes that the Surgeon General's determination that cigarette smoking is dangerous to smokers' health and the legal and social trend toward the protection of non-smokers from the effects of cigarette smoke have created a market for a product that delivers nicotine in a form and manner similar to that enjoyed by smokers of conventional cigarettes while avoiding the principal negative effects of ciprette smoking. The number of conventional cigarette smokers who will purchase and use the Smokeless Cigarette on a sustained basis, however, cannot be reliably estimated. Nevertheless, the Company believes that its profitability does not require a large percentage penetration of the conventional cigarette market .because an independent study indicates that in 1982 there were approximately 56 million American smokers smoking approximately 633 billion conventional cigarettes at a retail cost of approximately S23.4 billion (and that in 1981 more than four trillion conventional cigarettes were manufactured worldwide). Although the Surgeon General and other medical researchers have concluded that many of the products of the combustion of tobacco known popularly as "tar" (including aza-arenes, turmorigenic hydrocarbons, arsinious oxide and radioactive polonium compounds) are carcinogens, nicotine is not known to the Company to have ever been shown to be a cause ofcanoer or lung disease. In the November 17, 1983, prepublication release of the Surgeon General's report entitled The Health Consequences ofSmoking: Cardiovascular Disease ("the 1983 Surgeon General's Report"), the Surgeon General indicates that the increased risk of heart disease is even a greater hazard to smokers of conventional cigarettes than the increased risk of cancer. The 1983 Surgeon General's Report and other medical literature believed by the Company to be responsible suggest that the carbon monoxide resulting from burning tobacco may increase smokers' risk of cardiovascular disease. Although noting that use of nicotine may negatively effect the operation of the cardiovascular system, the Surgeon General indicates that the exact mechanisms whereby nicotine might influence cardiovascular events are unknown. Furthermore, the Surgeon General and many other medical commentators have not shown nicotine to be a primary contributor to the hazards of inhaling cigarette smoke and there is a significant body of scientific opinion to the effect that cigarette smokers experience pleasurable, though not therapeutic, pharmacological effects from inhaling nicotine and that these pleasurable effecu may be the primary reason many individuals continue cigarette smoking in spite of health warnings and negative social consequences. The 1983 Surgeon General's ~eport states that: "One should not ignore the proportion of the population that continues to smoke, nor should one accept unchallenged the concept of a`safe' cigarette. The main objective is to reduce the harmful constituents present in tobacco smoke. It is probable that promotion of ultra-low-yield products will not suffice, since compensatory mechanisms may be triggered by sensory needs for taste as well as for nicotine. . "A cigarette considered less harmful for cancer etiology might not reduce the risk for coronary disease. It appears to be a formidable task to develop a product that satisfies the smoker and does not increase disease risk through exposure to carbon monoxide, cyanide, nitrous oxide, or still unknown agents." The Company believes that the Smokeless Cigarette does not contain the harmful constituents referred to in the Surgeon General's Report, but responds to conventional cigarette smokers' sensory needs for taste and nicotine. However, the Smokeless Cigmtte was not tested by or on behalf of the Surgeon General and the 1983 Surgeon General's Report concluded that it is unlikely that a "safe cigarette" can be developed that will reduce the risk of cardiovascular disease. The 1983 Surgeon General's Report states the following with regard to the effect of nicotine as delivered by conventional cigarettes: "Nicotine exerts an effect on danglionic cells, producing transient excitation. The pharmacological effects are small, but are reinforced several times daily in habitual smokers. 16

The exact mechanisms whereby nicotine might influence cardiovascular events are unknown, but a lowering of the ventricular fibrillation threshold is closely related to nicotine levels." Because the Company believes that the Smokeless Cigarette delivers an amount of nicotine within a range of amounts delivered by conventional cigarettes, the Company believes that the Surgeon General's statements with regard to the effect of nicotine as delivered to conventional cigarette smokers would also be applicable in the case of the Smokeless Cigarette. The conventional cigarette industry has responded to the public's health concerns relating to cigarette smoking primarily with two general innovations: filtered cigarettes and low tar cigarettes. Most low tar and filtered cigarettes are designed to reduce the tar content of cigarette smoke in a manner which also reduces nicotine delivery. Consequently, the Surgeon General has indicated that smokers of low tar and filtered cigarettes may smoke more low tar or filtered cigarettes per day in order to maintain their accustomed daily intake of nicotine than do many smokers of other conventional cigarettes. Non-tobacco industry responses to the problems of cigarette smokers have included attempts to simulate cigarette smoking through the use of substances not including nicotine or the removal of nicotine from cigarette smoke by filtration, and alternative means of nicotine delivery such as NicoretteO, chewing gum recently introduced by Dow Chemical Company. Unlike the foregoing alternatives, the Company's product is intended to offer cigarette smokers the alternative of continuing their nicotine consumption in a manner similar to smoking conventional cigarettes, but free of other products of tobacco combustion suspected to be harmful. The Company is not aware of any currently available product which provides the conventional cigarette smoker with a means of enjoying the inhalation of nicotine in circumstances in which conventional cigarette smoking is illegal or socially unacceptable. Consequently, the Company believes that its Smokeless Cigarette is a unique ahernative for conventional cigarette smokers who desire nicotine inhalation pleasure with reduced health concerns and without negative social consequences or legal restrictions. The Company intends to market the Smokeless Cigarette as a pleasurable nicotine product and not as a product intended to deter or reduce smoking or to have therapeutic benefits. The Smokeless Cigarette The Smokeless Cigarette consists essentially of an active surface containing a nicotine solution blended with carriers, flavorants and pH buffers inserted within a small tube having the shape, weight and size of a conventional cigarette. Whed the user draws air through the Smokeless Cigarette a small amount of nicotine vapor is emitted into the air inhaled by the user. In order to appeal to the perceived preferences of the conventional cigarette smoker, the Company, has designed its Smokeless Cigarette in order to have substantially the same appearance, weight and feel, and to provide a similar sensation, as a conventional cigarette. The Smokeless Cigarette includes cigarette filter rod segments overwrapped with a paper laminate and commonly used cork-like tipping paper, and can be manufactured in standard cigarette lengths. The nicotine solution used in the Smokeless Cigarette is blended with flavorants for the purpose of approximating the flavors of leading brands of "regular," "menthol" and "light" conventional cigarettes. These flavorants are available to the Company from suppliers of flavorants to the conventional cigarette industry. The Company intends to offer the Smokeless Cigarettes in packs of six at a retail price approximately the same as, or slightly less than, a pack of twenty conventional cigarettes. Each pack of six Smokeless Cigarettes will have a nicotine delivery capacity intended to satisfy the average smoker of conventional cigarettes for an entire day. Because the nicotine delivery capacity of a Smokeless Cigarette is determined primarily by the amount of nicotine it contains, a single Smokeless Cigarette can be manufactured with the nicotine delivery capacity of several cigars or conventional cigarettes. However, because the Smokeless Cigarette is more efficient as a means of nicotine delivery than are cigars and conventional cigarettes, a Smokeless Cigarette can be manufactured to deliver an amount of nicotine equivalent to several conventional cigarettes or cigars while containing only an amount of nicotine comparable to that contained in a single cigarette of some brands of conventional cigarettes and less than is contained in most cigars. 17

The Company expccts initially to manufacture the Smokeless Cigarette in a form such that each normal •'puf}r" on a Smokeless Cigarette will deliver an amount of vaporized nicotine, which the Company believes • is within a range of amounts of nicotine delivered by a normal puff on many conventional cigarettes. See "The Company." Nicotine is an alkaloid with two properties not found among commonly~used alkaloids, such as, for example, caffeine, quinine, and codeine, which enable the Smokeless Cigarette to deliver nicotine to its user in substantially the same form and quantity per inhalation as many conventional cigarettes without the nceessity for tobacco combustion. First, the quantity of nicotine required to produce the effect on the nervous system to which most cigarette smokers are accustomed is small relative to the amounts of other alkaloids regularly consumed by typical users. This characteristic is important because nicotine is a toxic substance and, if consumed in a manner different than inhalation of the amount delivered by conventional cigarettes or through the Smokeless Cigarette, can be highly dangerous. See "Risk Factors - Possible Products Liability Claims." Second, nicotine when extracted from tobacco and properly distilled is a colorless, transparent liquid which vaporizes easily. Market and Marketing The Company believes that most users of the Smokeless Cigarette will be current smokers of conventional cigarettes who wish to reduce their health concerns or to enjoy nicotine in environments where smoking is forbidden or when others may be offended by conventional cigarette smoke and odor. According to an independent study, in 1982 approximately 56 million Americans smoked 633 billion conventional cigarettes purchased at retail for 523.4 billion, and in 1981 more than 4 trillion conventional cigarettes were manufactured world wide. The Company intends to market the Smokeless Cigarette initially in Austin and San Antonio, Texas beginning no earlier than the first anniversary of the completion of the public offering, and in Dallas and Houston during the second year after this offering, and to expand its market throughout the United States and selected foreign countries thereafter on a region by region basis based on and subject to the results of initial marketing and the Company's manufacturing, marketing and financing capacity. The Company anticipates two significant marketing advantages not enjoyed by its conventional cigarette competitors. Fim, the Company anticipates the availability of television advertising of its Smokeless Cigarettes which the Company believes is the most cost-effective means of mass consumer advertising. Second, the Company believes that the introduction of its Smokeless Cigarette will require less promotion and advertising than is the case'with the introduction of new conventional cigarette brands or smokeless tobacco products because the Smokeless Cigarette is a novel form of nicotine delivery and therefore more likely to benefit from consumer curiosity and word-of-mouth publicity. The Company believes that such publicity is likely to occur due to the continuing publicity regarding the health risks of smoking and legal restrictions on smoking in public places, publicity surrounding the recent introduction by Dow Chemical Company of its NicoretteO' nicotine chewing gum, and publicity normally associated with newly introduced novel consumer products. The Company's strategy of region by region introduction of the Smokeless Cigarette is intended to help control its advertising and promotional cost by allowing the Company to concentrate its initial advertising in a single region in order to initiate its anticipated word-of-mouth advantage. However, there can be no assurance that the Company's anticipation of the availability of television advertising and of consumer curiosity regarding the Smokeless Cigarette will be accurate or that any such initial curiosity will result in positive word-of-mouth publicity. The amount of advertising and promotional activity to be financed by the net proceeds of this offering is far less than that normally necessary for a successful nationwide introduction of a new conventional cigarette brand or smokeless tobacco product. See "Risk Factors - Potential FDA Regulation; Other Governmental Regulation and Taxation," "Management's Discussion and Analysis - Selling, Distribution and Marketing Costs" and "Business - Governmental Regulation and Taxation - The Federal Cigarette Labeling and Advertising Act." 18

The Company plans to introduce its Smokeless Cigarette through a regional multi-media advertising program emphasizing television advertising, but also including magazine, newspaper and outdoor billboard advertising. To the extent that television advertising is not available to the Company, the Company intends to rely primarily on such latter forms of advertising. This program has been developed by the Company with the assistance of its advertising agency, The Richards Group, Inc. of Dallas. The Company's strategy will be to distribute its Smokeless Cigarettes through the same retail outlets through which conventional cigarettes are sold. The Company anticipates selling directly to supermarkets through food brokers and to drug stores and tobacco wholesalers through manufacturers representatives. The Company expects that tobacco wholesalers will re-distribute the Smokeless Cigarettes to restaurants, newsstands and other retailers of tobacco products. No commitments or other arrang.ements have been made with any such distributors because the Company believes that it is customary in introducing new consumer products for the manufacturer to arrange distribution relationships approximately three months prior to the commercial introduction of the product and to arrange retail relationships when commercial quantities of the product are in warehouse inventory. The Company does not anticipate any significant delays or difficulties in establishing satisfactory distribution relationships because the Company believes, based on management's experience with the introduction of other consumer products, that demand by food brokers and tobacco wholesalers for new consumer products is sufficient to facilitate the wholesale and retail distribution of the anticipated quantities of the Smokeless Cigarette. The Company intends to market its Smokeless Cigarette under the trademark "FAVOR" which the Company believes signifies the benefits of the Smokeless Cigarette to its user and to others who would otherwise be subjected to tobacco smoke had the user not chosen a Smokeless Cigarette. See "Business - Patents and Trademarks." Competition The Company believes that its principal competitors will be manufacturers of conventional cigarettes, most, if not all, of which have financial, promotional, advertising, manufacturing and other resources substantially in excess of the Company's. The Company's ability to finance promotional activities is small when compared with such large and experienced competitors. However, because the Smokeless Cigarette is a novel concept in the delivery of nicotine satisfaction, the Company believes that the promotional and advertising costs required to introduce its product will be substantially less than the costs normally incurred in the introduction of a conventional cigarette brand into the highly competitive conventional cigarette market. The Company believes the use of television advertising would also provide the Company with a competitive advantage over conventional cigarette manufacturers who are prohibited by the Federal Cigarette Labeling and Advertising Act from advertising conventional cigarette products on television. Further, since the Company anticipates that the direct manufacturing costs of a pack of Smokeless Cigarettes will be no greater than a pack of conventional cigarettes with less nicotine delivery capacity, the Company anticipates that it will be able to offer a substantial cost per unit advantage to the consumer, if necessary for competitive purposes, because of the heavy tax component of the retail price of conventional cigarettes. The Company intends, however, initially to sell packs of six Smokeless Cigarettes at approximately the same factory price as most packs of 20 conventional cigarettes. See "Risk Factors - Uncertain Market and Competition" and "- Potential FDA Regulation; Other Governmental Regulation and Taxation," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business Markets and Marketing." In addition to other factors, the Company anticipates that it will enjoy a direct manufacturing cost advantage over manufacturers of conventional cigarettes because the Company's manufacturing equipment will be less complicated, resulting in a smaller percentage of skilled labor among manufacturing personnel and because costly handling and storage of tobacco will not be required. The Company believes that the Smokeless Cigarette is competitive with conventional cigarettes because the Smokeless Cigarette can often be used in situations in which smoking conventional cigarettes is undesirable or prohibited. In addition, although the Company does not claim that the Smokeless Cigarette possesses any therapeutic benefits, the public may perceive the Smokeless Cigarette to be less harmful than conventional cigarettes. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business - Markets and Marketing," "- Manufacturing." 19

In addition to manufacturers of conventional cigarettes, the Company will be competing with manufacturers of conventional smokeless tobacco products such as chewing tobacco and snuff, and of alternative nicotine delivery products such as Dow Chemical Company's Nicorette' nicotine chewing gum, many, if not all, of which also have financial, promotional, advertising, manufacturing and other resources far greater than those of the Company. The Company may also experience substantial competition from manufacturers of future nicotine delivery products similar to the Smokeless Cigarette unless the Company is able successfully to assert patent infringement actions with respect to such products. See "Risk Factors - Untested Patent Protection" and "Business - Patents and Trademarks." Manufacturing While the Smokeless Cigarette resembles a conventional cigarette, it consists of two filter rods of a type commonly used by manufacturers of filter tipped conventional cigarettes, wrapped with a paper laminate and commonly used tipping paper. One of the filter rods constitutes the part of the Smokeless Cigarette into which the nicotine is introduced and the other rod is the tip which is placed in the user's mouth. The Smokeless Cigarette can be manufactured by modified versions of machines in common use by manufacturers of filter tipped conventional cigarettes. The manufacture of the Smokeless Cigarette will involve substantially the same steps as the manufacture of conventional filter tipped cigarettes except that the difficult tasks of dealing with thin cigarette paper and maintaining proper packed tobacco density will not be involved. The two types of filter rods used in the product will be fed into a combiner machine which will cut the filter rods into desired lengths and wrap them in alternating order with a laminated paper. The combiner will then cut the alternating filter rod assembly into lengths constituting two cigarettes each. These double length assemblies will then be fed into a tipping machine which will wrap commonly available tipping paper around the center of each assembly and then cut it at the center point, resulting in two tipped Smokeless Cigarettes. • The Smokeless Cigarettes will then be injected with a small amount of a nicotine solution by the use of a needle load injector commonly used by the felt-tip pen industry. Nicotine solution in volumes sufficient to meet the Company's foreseeable needs is available from a number of sources outside of the conventional cigarette and smokeless tobacco product industry. The finished Smokeless Cigarettes will then be fed into packing and wrapping machines commonly used in the conventional cigarette industry. The Company has obtained a commitment from a supplier to provide, modify and refurbish four dual rod combiners at a price of $50,000 each ($200,000 total), four tipping machines at $25,000 each (S 100,000 total), four packers at S 150,000 each (5600,000 total), four wrappers at S27,500 each (S 110,000 total) and four needle load injectors at 530,000 each (S 120,000 total). The Company believes that these t::achines,x,ilt, ,, ., ~~.,;~ir.~.,.~.,;~ir.~i....r.it.with four man>~ctt~ing lines with a combined sustained manufacturing capability of approximately one million Smokeless Cigarettes per eight-hour shift. Operation of these four manufacturing lines will require approximately 7,500 square feet of floor space and approximately 30 production personnel per shift. The Company has obtained a commitment for the lease of a 20,000 square foot facility, on a 40 acre tract, to be constructed in the San Antonio metropolitan area in which to establish its initial four line manufacturing facility. The lease will provide for a three year initial term and two successive five year renewal terms, at a rental rate of 5.93 per square foot (depending on final construction costs) plus cost of living adjustments during the renewal terms. The Company's cost analysis indicates that its manufacturing cost of a pack of six Smokeless Cigarettes with a nicotine delivery capacity approximately equivalent to a twenty cigarette pack of conventional cigarettes will be approximately 16 cents, assuming the manufacturing of 800,000 Smokeless Cigarettes per eight hour shift using the manufacturing equipment described above. The Company anticipates that its maximum output per eight hour shift in its contemplated manufacturing facility will be approximately 800,000 Smokeless Cigarettes There can be no assurance that the demand for the Smokeless Cigarette will be sufficient to justify the manufacturing of 800,000 Smokeless Cigarettes per shift and the Company anticipates that its unit manufacturing costs will be higher at lower levels of production. See "Management's Discussion and Analysis of Financial Condition and Results of Operation - Certain Factors Bearing on Results of Operations." 20