INHALE THERAPEUTIC SYSTEMS INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549
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FORM 10-K

/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER
31, 1999 OR

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

COMMISSION FILE NO. 0-23556
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INHALE THERAPEUTIC SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

DELAWARE 94-3134940
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

150 INDUSTRIAL ROAD, SAN CARLOS, CA 94070
(Address of principal executive offices and zip code)

(650) 631-3100
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act: NONE

Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK,
$0.0001 PAR VALUE

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /

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

The approximate aggregate market value of voting stock held by
non-affiliates of the Registrant, based upon the last sale price of the Common
Stock on March 1, 2000 as reported by Nasdaq National Market was approximately
$1,860,035,885. Determination of affiliate status for this purpose is not a
determination of affiliate status for any other purpose.

20,588,388

(Number of shares of common stock outstanding as of March 1, 2000)
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DOCUMENTS INCORPORATED BY REFERENCE

Portions of Registrant's definitive Proxy Statement to be filed for its 2000
Annual Meeting of Shareholders are incorporated by reference into Part III
hereof.

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INHALE THERAPEUTIC SYSTEMS, INC.
1999 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

PAGE
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PART I
Item 1. Business.......................................... 1
Item 2. Properties........................................ 26
Item 3. Legal Proceedings................................. 27
Item 4. Submission of Matters to a Vote of Security
Holders................................................. 27
PART II
Item 5. Market for Registrant's Common Equity and Related
Shareholder Matters..................................... 27
Item 6. Selected Financial Data........................... 30
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations..................... 31
Item 7A. Quantitative and Qualitative Disclosures about
Market Risk............................................. 35
Item 8. Financial Statements and Supplementary Data....... 35
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure..................... 35
PART III
Item 10. Directors and Executive Officers of the
Registrant.............................................. 36
Item 11. Executive Compensation........................... 39
Item 12. Security Ownership of Certain Beneficial Owners
and Management.......................................... 39
Item 13. Certain Relationships and Related Transactions... 39
PART IV
Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K..................................... 40
SIGNATURES.................................................. 43

PART I

ITEM 1. BUSINESS

OVERVIEW

Inhale Therapeutic Systems, Inc. ("Inhale") is creating a drug delivery
system to easily and painlessly deliver a wide range of drugs, including
peptides, proteins, nucleic acids and other molecules, by inhalation to the deep
lung for treatment of systemic and respiratory diseases. Inhale is using this
system principally to enable non-invasive delivery of protein drugs currently
administered by injection. Inhale's most advanced program, which is sponsored by
Pfizer Inc. ("Pfizer"), is inhaleable insulin. Pfizer commenced dosing for its
Phase III clinical trials in June 1999. In addition to its insulin program with
Pfizer, Inhale has development collaborations with Biogen, Inc., Aventis Behring
L.L.C. (formerly Centeon L.L.C., a joint venture of Hoechst AG and Rhone-Poulenc
S.A., which have now merged to form Aventis S.A.), and Eli Lilly & Co. Inhale
also has early stage feasibility and research collaborations with several other
companies and has tested seven drugs in clinical trials.

Currently there are approximately 35 macromolecule drugs marketed in the
United States and about 120 other such drugs in clinical trials. Sales of the
top 15 genetically engineered protein drugs (a subset of macromolecule drugs)
were estimated at $14 billion worldwide in 1997. Most of these drugs are
currently delivered by injection. Injections are undesirable for numerous
reasons including patient discomfort, inconvenience and risk of infection. Poor
patient acceptance of, and compliance with, injectable therapies can lead to
increased incidence of medical complications and higher disease management
costs. Alternatives to injection such as oral, transdermal and nasal delivery
have to date been commercially unattractive due to low natural
bioavailability--the amount of drug absorbed from the delivery site into the
bloodstream relative to injection. As an alternative to the invasiveness of
injection, Inhale believes a deep lung inhalation delivery system could expand
the market for protein drug therapies by increasing patient acceptance and
improving compliance and may enable new therapeutic uses of certain protein
drugs.

Inhale is creating a proprietary platform integrating customized
formulation, dry powder processing and packaging with a proprietary inhalation
device to enable efficient, reproducible delivery of drugs for systemic and
local lung indications. For specific drug products, Inhale formulates and
processes bulk drugs supplied by collaborative partners into dry powders which
are packaged into individual dosing units referred to as blisters. The blisters
are designed to be loaded into Inhale's device, which patients then activate to
inhale the aerosolized drugs. Inhale has developed an inhalation device that is
being used several times per day for several months in outpatient trials for
insulin. In addition, Inhale has demonstrated room temperature stability of a
year or more for a number of protein drugs, and has scaled-up its powder
processing and packaging for late stage clinical trials and small scale
production for certain drugs.

As an alternative to invasive delivery techniques, Inhale believes that a
deep lung delivery system could potentially expand the market for protein drug
therapies by increasing patient acceptance and improving compliance, which in
turn could decrease medical complications and the associated costs of disease
management. Additionally, deep lung delivery may enable new therapeutic uses of
certain protein drugs. Inhale is focusing development efforts on applying its
pulmonary delivery system primarily to drugs for systemic and local lung
diseases that either have proven efficacy and are approved for delivery by
injection or are in late stage clinical trials.

A cornerstone of Inhale's business strategy is to work with collaborative
partners to develop and commercialize drugs for deep lung delivery. In a typical
collaboration, Inhale's partner will support the application of Inhale's
technology to a particular drug by providing the drug, funding clinical
development, and marketing the resulting commercial product. Inhale typically
will supply the delivery system and receive research and development and
progress payments during development, and receive revenues from powder
manufacturing, device supply, and royalties from sales of any commercial
products.

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In addition to Pfizer's sponsorship of the inhaleable insulin program,
Inhale has active development programs with several other corporate partners.
Inhale's most recent collaboration is with Biogen for pulmonary delivery of
Interferon-Beta-1a, sold under the trade name AVONEX-Registered Trademark-, the
leading drug worldwide for the treatment of Multiple Sclerosis. Inhale is also
engaged in development collaborations with Aventis Behring on alpha-1 proteinase
inhibitor for genetic emphysema, and with Lilly for an undisclosed protein drug.
Inhale is also engaged in early stage feasibility and research programs with
respect to other compounds. Inhale anticipates that any product that may be
developed would be commercialized with a collaborative partner and believes its
partnering strategy will enable it to reduce the investment required to develop
a large and diversified potential product portfolio.

In late 1999, Inhale completed the sale of approximately $108.5 million
aggregate principal amount of 6 3/4% Convertible Subordinated Debentures due
October 13, 2006. In early 2000, the Company entered into agreements with
certain holders of these outstanding debentures to convert their debentures into
common stock in exchange for a cash payment. To date, the Company has agreed to
make cash payments of approximately $16.2 million in the aggregate in connection
with agreements that provide for the conversion of approximately $94.2 million
aggregate principal amount of outstanding debentures into approximately
2.9 million shares of common stock. Such amounts will be reflected as a charge
to interest expense in the first quarter of 2000.

In February 2000, Inhale received approximately $222.4 million in net
proceeds from the issuance of $230.0 million aggregate principal amount of
convertible subordinated notes to certain qualified institutional buyers under
Rule 144A of the Securities Act of 1933, as amended. Interest on the notes will
accrue at a rate of 5.0% per year, subject to adjustment in certain
circumstances. The notes will mature in 2007 and are convertible into shares of
Inhale's common stock at a conversion price of $76.71 per share, subject to
adjustment in certain circumstances.

Upon completion of the issuance of the February 2007 notes and the exchange
of the October 2006 debentures, the Company expects to net approximately
$206.2 million cash.

OPPORTUNITY FOR PULMONARY DRUG DELIVERY

MACROMOLECULES

Innovations in biotechnology and recombinant techniques have led to a large
increase in the number of macromolecule drugs over the last several years. These
drugs, which are identical or similar to the body's natural molecules, are
enabling new therapies for many previously untreated or poorly treated diseases.
Currently, approximately 35 biotechnology drugs are approved for marketing in
the United States and approximately 120 additional biotechnology drugs are in
clinical trials, many for chronic and subchronic diseases. Sales of genetically
engineered protein drugs were estimated at $14 billion worldwide in 1997.

There are five typical routes of administration of drugs, four natural and
one which bypasses natural barriers to entry of molecules into the body. The
four natural routes are through the digestive tract (oral), the skin
(transdermal), the mucosal surfaces (nasal and sublingual), and the lung
(inhalation). Penetration of the skin by injection (subcutaneous, intramuscular,
or intravenous) bypasses the major natural barrier to prevent molecules from
entering the body.

Oral delivery is a common method of delivery for many small molecule drugs.
However, macromolecules are typically extremely vulnerable to digestion and
therefore are very poorly delivered by an oral route. In addition, Inhale
believes that dosage reproducibility for oral delivery of macromolecules may be
very poor because of their low oral bioavailability. While several companies are
working on oral delivery for macromolecule drugs, no commercially viable system
is currently being marketed.

The size of most macromolecules makes penetration of the skin inefficient or
ineffective. Passive transdermal delivery using "patch" technology has not been
successful to date since the skin is less

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naturally permeable to macromolecules than the gastrointestinal tract. No
macromolecule drugs have been approved for marketing in the United States
utilizing patch technology. Certain peptides and proteins can be transported
across the skin barrier into the bloodstream using high pressure "needle-less"
injection devices. The devices, which inject proteins like insulin through the
skin into the body, have been available for many years. However, Inhale believes
these devices have not been well accepted due to patient discomfort and
relatively high cost.

The nasal route of drug administration has been limited by low and variable
bioavailability for proteins and peptides. As a result of these limitations,
penetration enhancers are often used with nasal delivery to achieve higher
bioavailability. These enhancers may cause local irritation to the nasal tissue
and result in safety concerns with long-term use. Only a limited number of
peptides have been approved for marketing in the United States utilizing nasal
delivery. Inhale believes these same obstacles will affect sublingual drug
delivery, which also relies on the penetration of similar tissue in the mouth.

The principal practical and efficient route of administration of
macromolecules, particularly recombinant proteins, has been injections.. Drug
injections administered in hospitals or doctors' offices can be expensive and
inconvenient to patients. Many patients find self-injectable therapies
unpleasant. As a result, such therapies for many chronic and subchronic diseases
meet with varying degrees of patient acceptance and compliance with the
prescribed regimens. Poor acceptance and compliance can lead to increased
incidence of medical complications and potentially higher disease management
costs. In addition, some elderly, infirm or pediatric patients cannot administer
their own injections and require assistance, thereby increasing both
inconvenience to these patients and the cost of therapy.

Delivery of drugs to the lungs via inhalation (pulmonary delivery) has the
potential to be a much more effective route of administration of macromolecules,
with a relatively higher absorption into the bloodstream (bioavailability) than
all alternative routes except injection. As an alternative to the invasiveness
of injection, Inhale believes a deep lung inhalation delivery system could
increase patient acceptance and improve compliance and may enable new
therapeutic uses of certain macromolecule drugs. Pulmonary delivery is already
in use for a variety of small molecule drugs.

Existing pulmonary drug delivery systems such as metered-dose inhalers
("MDIs"), dry powder inhalers and nebulizers, are used primarily to deliver
drugs to the upper airways of the lung for lung diseases. Approximately 35 drugs
are approved for marketing by the FDA for delivery into the respiratory tract,
but none of these pulmonary drug delivery devices were designed to optimize drug
delivery to the deep lung for absorption into the bloodstream. MDIs, dry powder
inhalers and nebulizers typically deliver only a fraction of the drug to the
deep lung, with most of the drug being lost in the delivery device or in the
mouth and throat. Consequently, Inhale believes that the total efficiency of
such systems is generally not high enough to be commercially feasible for
systemic delivery of most macromolecule drugs.

In addition, pulmonary drug delivery devices currently do not provide the
dosage reproducibility and formulation stability generally needed for
commercially viable systemic macromolecule drug delivery. Inhale believes that
many MDI and dry powder systems do not provide the deep lung dosage
reproducibility necessary for many systemic applications because the patient
must coordinate the breathing maneuver with the generation of the aerosol.
Further, Inhale believes that many macromolecules currently cannot be formulated
for use in MDI systems, since macromolecule drugs could be denatured by the MDI
formulating ingredients. In addition, Inhale believes that some macromolecules
may be inactivated by nebulization and that many dry powder systems do not
provide the protection needed for long-term stability that may be needed for
macromolecule formulations.

Inhale believes that an efficient and reproducible deep lung delivery system
for systemic macromolecule drugs used in the treatment of chronic and subchronic
diseases represents a significant commercial opportunity. Such a system could
improve patient acceptance of systemic macromolecule drug therapy and compliance
with prescribed regimens, thereby improving therapeutic outcomes and reducing

3

the costs of administration and treatment of disease. Additionally, pulmonary
delivery may enable new therapeutic uses of certain macromolecule drugs.

Inhale also believes that opportunities for a deep lung delivery system
exist in the delivery of macromolecules for local lung diseases due to the
limitations of current pulmonary devices. Biotechnology and pharmaceutical
companies are developing new macromolecule drugs for pulmonary diseases such as
asthma, cystic fibrosis, emphysema, lung cancer, pneumonia and bronchitis.
Pulmonary delivery is the preferred route for treating most lung diseases since
application of the drug directly to the site of action (lung) requires much less
drug than systemic administration, thereby potentially reducing systemic side
effects.

OTHER MOLECULES

In addition to developing a deep lung delivery system for macromolecules,
Inhale is investigating opportunities for leveraging its technology for
application to small molecules where there is a clear, demonstrable need for an
alternative drug delivery system and where Inhale's existing technology can be
applied without significant modification. Examples include molecules that
require rapid systemic absorption for efficacy (i.e., analgesics and
antiemetics), molecules that undergo massive first pass metabolism by the oral
route or molecules used for local lung delivery for diseases such as asthma that
are currently delivered by sub-optimal aerosol systems.

MDIs, existing dry powder inhalers and nebulizers have been used primarily
to deliver drugs to the upper airways of the lung for local lung applications.
Some of the problems associated with traditional small molecule aerosol delivery
systems include poor reproducibility, low efficiency, low drug payload per puff,
poor moisture barrier and, in the case of wet systems, long dosing time and
potential for microbial growth.

Inhale believes that its technology could be used to address these problems
by providing efficient dispersion of the drug into the lungs resulting in the
reproducible delivery of a consistent amount of drug into the bloodstream.
Inhale further believes its technology could potentially be applied economically
in market segments where it is essential that significant drug doses reach the
lung. Large amounts of drugs taken orally or through inefficient inhalers can
result in side effects which could be avoided or reduced through more efficient
and better targeted pulmonary delivery.

STRATEGY

Inhale's goal is to become the leading drug delivery company in the field of
pulmonary delivery of macromolecules. In addition, Inhale is leveraging its
technology base for other applications where its system can provide significant
market advantages. Inhale's strategy incorporates the following principal
elements:

- DEVELOP A BROADLY APPLICABLE PULMONARY DELIVERY SYSTEM. Inhale is
developing its non-invasive deep lung drug delivery system to be
applicable to a wide range of peptides, proteins and other molecules
currently delivered by injection or poorly delivered by inhalation or
other routes. Inhale intends to develop effective non-invasive delivery
alternatives that can: (1) expand market penetration for existing
therapeutics currently delivered by injection, infusion or other routes;
(2) commercialize new indications by using deep lung delivery as a new
route of administration; and (3) extend existing patents or seek new
patents to gain important competitive advantages for Inhale and its
partners.

- BUILD COMPETITIVE ADVANTAGE THROUGH AN INTEGRATED SYSTEMS APPROACH. Inhale
is developing a commercially viable deep lung delivery system through an
integrated systems solution. Inhale combines its expertise in pulmonary
physiology and biology, aerosol science, powder science, chemical
engineering, mechanical engineering and product design, protein
formulation, fine powder processing and filling to build a proprietary,
fully-integrated system for pulmonary delivery of therapeutic

4

drugs. Inhale believes that building expertise in technology across
several disciplines provides it with a significant competitive advantage.

- PARTNER WITH PHARMACEUTICAL AND BIOTECHNOLOGY COMPANIES.Inhale's strategy
is to market its proposed products through collaborative partners. Inhale
is seeking to work with partners that have significant clinical
development and marketing resources, and currently has collaborations with
several large pharmaceutical and biotechnology companies. For patented
drug products, Inhale intends to partner with owners or licensees from the
outset of the project. For drugs that are off-patent or licensed-in,
Inhale may perform initial feasibility screening work, formulations
development and early stage clinical trials before entering into a partner
relationship for further development. Inhale believes this partnering
strategy enables it to reduce its cash requirements while developing a
large and diversified potential product portfolio.

- FOCUS ON APPROVED OR LATE STAGE DRUGS. To date, Inhale has focused
primarily on drugs that either have proven efficacy and are approved for
marketing or are in late stage clinical trials. Inhale believes that
working primarily with drugs with demonstrated efficacy reduces the
technical risk of its projects. In the future, Inhale anticipates working
on drugs at earlier stages of development.

- EXPAND MANUFACTURING CAPABILITY. Inhale intends to formulate, manufacture
and package dry powders for most of its drugs and to subcontract
manufacturing of its device. Inhale believes that this strategy will
provide manufacturing economies of scale across a range of therapeutic
products and expand capacity for additional partnerships and commercial
scale production.

INHALE'S DEEP LUNG DRUG DELIVERY SYSTEM

Inhale believes that the following criteria are necessary for a commercially
viable non-invasive deep lung drug delivery system:

- SYSTEM EFFICIENCY/COST: The system must attain a certain minimum
efficiency in delivering a drug to the bloodstream as compared to
injection. Bioavailability (the percentage of drug absorbed into the
bloodstream from the lungs relative to that absorbed from injection) is
the most important element of system efficiency. Total system efficiency
is critical due to the high cost of macromolecule drugs. Total delivery
system efficiency is determined by the amount of drug loss during
manufacture, in the delivery device, in reaching the site of absorption,
and during absorption from that site into the bloodstream. Inhale believes
that for most systemic macromolecule drugs, a non-invasive delivery system
must show total delivery system efficiency of at least 5% to 25% compared
to injection for the system to be commercially viable.

- REPRODUCIBILITY: The system must deliver a consistent and predictable
amount of drug to the lung and into the bloodstream.

- FORMULATION STABILITY: Formulations used in the system must remain
physically and chemically stable over time and under a range of storage,
shipping and usage conditions.

- SAFETY: The system should not introduce local toxicity problems during
chronic or subchronic use by a wide population of patients.

- CONVENIENCE: The system must be convenient to the patient in terms of
comfort, ease of operation, transportability and required dosage time.

Inhale approaches pulmonary drug delivery with the objective of maximizing
overall delivery system efficiency while addressing commercial requirements for
reproducibility, formulation stability, safety and convenience. To achieve this
goal, Inhale's delivery system integrates customized drug formulations and
packaging with its proprietary inhalation device. Inhale combines an
understanding of lung biology, aerosol science, chemical engineering, mechanical
engineering and protein formulations in its system development efforts. Inhale
believes that this interdisciplinary capability provides an important
competitive advantage.

5

Inhale has chosen to base its deep lung delivery system on dry powders for
several reasons. Many proteins are more stable in dry powders than in liquids.
In addition, dry powder aerosols can carry approximately five times more drug in
a single breath than typical MDIs and, for many drugs, at least 25 times more
than currently marketed liquid or nebulizer systems. Inhale believes that a dry
powder system for drugs requiring higher doses, such as insulin and alpha-1
proteinase inhibitor, could decrease dosing time as compared with nebulizers.

Inhale takes bulk drugs supplied by partners and formulates and processes
them into fine powders that are then packaged into individual blisters. The
blisters are designed to be loaded into Inhale's device, which patients activate
to inhale the aerosolized drugs. Once inhaled, the aerosol particles are
deposited in the deep lung, dissolved in the alveolar fluid and absorbed into
the bloodstream. Although Inhale is in the advanced stages of developing its
system technologies, there can be no assurance that Inhale's products will ever
be successfully commercialized.

FORMULATIONS

Each macromolecule drug poses different formulation challenges due to
differing chemical and physical characteristics and dosing requirements. This
requires significant optimization work for each specific drug. Inhale has
assembled a team with expertise in protein formulation, powder science and
aerosol science and is applying this expertise to develop proprietary techniques
and methods that it believes will produce stable, fillable and dispersible dry
powder drug formulations. Inhale has developed several protein powders which
remain stable at room temperature in excess of one year. Through its work with
numerous macromolecules, Inhale is developing an extensive body of knowledge on
aerosol dry powder formulations, including knowledge relating to powder flow
characteristics and solubility within the lung, as well as physical and chemical
properties of various excipients. Inhale has filed and expects to continue to
file patent applications on several of its formulations and, through strategic
acquisitions, has acquired rights to certain U.S. and foreign patents and patent
applications relating to stabilization of macromolecule drugs in dry
formulations.

POWDER PROCESSING

Inhale is modifying standard powder processing equipment and developing
custom techniques to enable it to produce fine dry powders with particle aerosol
diameters of between one and five microns without degradation or significant
loss of expensive bulk drug. Inhale has scaled up powder processing to levels
sufficient for producing test powders for late stage clinical trials and small
volume marketed products. Inhale is in the process of further scaling up its
powder processing systems in order to produce quantities sufficient for
commercial production of products Inhale believes it will need to supply in high
volumes, such as insulin. However, there can be no assurance that Inhale will be
successful in further scaling up its powder processing on a timely basis or at a
reasonable cost, or that the powder processing system will be applicable for
every drug.

POWDER FILLING AND PACKAGING

Powders made up of fine particles that do not behave in a granularly flowing
way, are generally compressible, and hence require handling that is different
than for powders comprised of larger particles. Currently available commercial
filling and packaging systems are designed for filling powders of larger
particle size and therefore must be re-engineered to dispense finer powders
accurately and in the small quantities often required. Initially, during early
stages of development, powder filling was performed manually. Inhale has since
developed and qualified a proprietary automated filling system suitable for use
in production of clinical trial supplies and commercial quantities for certain
products. Inhale is further developing a high through-put system for use with
products whose market requirements dictate increased capacity.

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INHALATION DEVICE

Inhale's proprietary pulmonary delivery device is designed to provide deep
lung delivery of therapeutic powders in a reproducible, safe and efficient
manner. The first of a series of patents applied for covering the device was
granted in the United States in October 1995. To achieve its objectives, Inhale
has designed its pulmonary delivery device to perform the following:

- EFFECTIVELY DISPERSE FINE PARTICLES INTO AN AEROSOL CLOUD. Fine powders
have different dispersion requirements or characteristics than large
powders. Most current dry powder inhalers use larger powders and are not
efficient in dispersing powders with aerosol diameters of one to five
microns. Inhale has developed and is refining its dispersion system for
its device specifically for fine powders. Inhale's device has been
designed to efficiently remove powders from the packaging, effectively
break up the powder particles and create an aerosol cloud while
maintaining the integrity of the drug.

- EFFICIENTLY AND REPRODUCIBLY DELIVER THE AEROSOL CLOUD TO THE DEEP LUNG.
Inhale is developing a proprietary aerosol cloud handling system in its
device that is intended to facilitate deep lung powder deposition and
reproducible patient dosing. The handling system design is intended to
enable the aerosolized particles to be transported from the device to the
deep lung during a patient's breath, reducing losses in the throat and
upper airways. In addition, the aerosol cloud handling system, in
conjunction with the dispersion mechanism and materials used in the
device, is designed to reduce powder loss in the device itself.

- ELIMINATE THE USE OF PROPELLANTS TO AVOID ASSOCIATED ENVIRONMENTAL
CONCERNS AND FORMULATION DIFFICULTIES. Unlike MDIs, the Inhale device does
not use propellants. The oily surfactants required to stabilize propellant
formulations can cause aggregation of macromolecules. Current
chlorofluorocarbon propellants, which are used in most commercial MDI
systems, are being phased out in many countries due to environmental
concerns.

The success of Inhale's deep lung drug delivery system for any drug will
depend upon Inhale achieving sufficient formulation stability, safety dosage
reproducibility and total system efficiency (measured by the percentage of bulk
drug entering the manufacturing process that eventually is absorbed into the
bloodstream relative to injection for systemic indications, or the amount of
drug delivered to the lung tissue for local lung indications). The initial
screening determinant for the feasibility of pulmonary delivery of any systemic
drug is pulmonary bioavailability, which measures the percentage of the drug
absorbed into the bloodstream when delivered directly to the lungs. In addition,
a certain percentage of each drug dose may be lost at various stages of the
manufacturing process, (e.g., in drug formulation, dry powder processing, or
powder filling and packaging) and in moving the drug from a delivery device into
the lungs. Excessive drug loss at any one stage or cumulatively in the
manufacturing and delivery process would render a drug commercially unfeasible
for pulmonary delivery. Formulation stability (the physical and chemical
stability of the formulated drug over time and under various storage, shipping
and usage conditions) and safety will vary with each macromolecule and the type
and amount of excipients, that are used in the formulation. Dose reproducibility
(the ability to deliver a consistent and predictable amount of drug into the
bloodstream over time both for a single patient and across patient groups)
requires the development of an inhalation device that consistently delivers
predictable amounts of dry powder formulations to the deep lung, accurate unit
dose packaging of dry powder formulations and moisture resistant packaging.
There can be no assurance that Inhale will be able to successfully develop such
an inhalation device or overcome such other obstacles to reproducible dosing.

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CLINICAL STATUS SUMMARY

The following table sets forth, for both Inhale's partner development
programs and Inhale's programs available for partnering, the drug currently in
development, the indication(s) for the particular drug, its present stage of
clinical development and, with respect to Inhale's partner development programs,
the identity of Inhale's corporate partner for such drug.

PARTNER DEVELOPMENT PROGRAMS

DRUG INDICATION(S) CLINICAL STATUS(1) PARTNER
- ---- ------------------ ------------------ ---------------

Insulin................................. Type 1 and 2 Phase III Pfizer
Diabetes

Alpha-1 Proteinase Inhibitor............ Genetic Emphysema Phase I Aventis Behring

AVONEX-Registered Trademark-............ Multiple Sclerosis Preclinical Biogen

Undisclosed Protein..................... Not Released Preclinical Lilly

PTH..................................... Osteoporosis Phase I Lilly

PROGRAMS AVAILABLE OR EXPECTED TO BE AVAILABLE FOR PARTNERING

DRUG INDICATION(S) CLINICAL STATUS(1)
- ---- -------------------------------- ------------------

Calcitonin.................................... Osteoporosis, Bone Pain, Paget's Phase I
Disease

Interleukin-1 Receptor........................ Asthma Phase I/II

Undisclosed Non-Protein, Non-Peptide.......... Not Released Phase II

Undisclosed Non-Protein, Non-Peptide.......... Not Released Phase I

Undisclosed Non-Protein, Non-Peptide.......... Not Released Preclinical

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

(1) Clinical Status means:

Phase III - large-scale out-patient clinical trials conducted to obtain
information regarding specific patient groups conducted following encouraging
Phase II trial results.

Phase II - clinical trials to establish dosing and efficacy in patients

Phase I - clinical trials in healthy subjects to test safety, and for drugs with
systemic applications, to test bioavailability compared with injection.

Preclinical - formulation development and animal testing in preparation for
human trials

INHALE'S PARTNER DEVELOPMENT PROGRAMS

In general, Inhale's partnership arrangements provide funding for
development, payments upon the achievement of certain milestones and royalty and
manufacturing revenues upon the commencement of commercial sales. The
arrangements are cancelable by the partner at any time without significant
penalty.

INSULIN PROGRAM

Insulin is a protein hormone naturally secreted by the pancreas to induce
the removal of glucose from the blood. Diabetes, the inability of the body to
properly regulate blood glucose levels, is caused by insufficient production of
insulin by the pancreas or insufficient use of the insulin that is secreted.
Over

8

time, high blood glucose levels can lead to blindness, loss of circulation,
kidney failure, heart disease or stroke. Insulin is currently marketed only in
injectable form. Insulin is supplied by various manufacturers, including Lilly,
Novo-Nordisk A/S and Aventis.

According to the United States Centers for Disease Control and Prevention,
approximately 16 million people in the United States have diabetes
(10.3 million are diagnosed with diabetes; another 5.4 million have undiagnosed
diabetes) and 798,000 new cases are diagnosed each year. All Type 1 diabetics,
estimated at between 5% and 15% of all diabetics, require insulin therapy. Type
1 diabetics require both a baseline treatment of long-acting insulin and
multiple treatments of regular, or short acting, insulin throughout the day.
Type 2 diabetics, depending on the severity of their case, may or may not
require insulin therapy. Type 2 diabetics who use insulin are best treated with
regular insulin and sometimes require long-acting insulin as well. Because of
the inconvenience and unpleasantness of injections, many Type 2 patients who do
not require insulin to survive, despite the fact that they would benefit from
it, are reluctant to start treatment.

Regular insulin is generally administered 30 minutes before mealtimes and
generally is given only twice a day. A ten-year study by the National Institutes
of Health ("NIH"), however, demonstrated that the side effects of diabetes could
be significantly reduced by dosing more frequently. The NIH study recommended
dosing regular insulin three to four times per day, a regimen which would more
closely mirror the action of naturally produced insulin in non-diabetics.
Because of the risk of severe hypoglycemia, this course of treatment is not
recommended for children, older adults, people with heart disease or with a
history of frequent severe hypoglycemia. In addition, many patients are
reluctant to increase their number of daily doses because they find injections
unpleasant and inconvenient.

Pursuant to a collaborative agreement originally entered into in
January 1995, Inhale and Pfizer are developing an inhaled version of regular
insulin that can be administered in one to three blisters per dose using
Inhale's deep lung delivery system. Inhale believes that its delivery system
could provide increased user convenience and result in greater patient
compliance by eliminating some injections for Type 1 and Type 2 patients and all
injections for some Type 2 patients. In addition, Inhale believes that pulmonary
delivery could yield medical advantages by providing a more rapid acting insulin
than most currently marketed injectable products.

Through its collaboration with Inhale, Pfizer conducted Phase I and Phase
IIa clinical trials which indicated that pulmonary insulin was absorbed
systemically, reduced blood glucose levels and provided the same glycemic
control as injected insulin. In October 1996, Pfizer initiated a multi-site
Phase IIb outpatient trial to include up to 240 diabetes patients, the results
of which were announced in June 1998. In 70 Type 1 diabetics treated with either
inhaled or conventional injected insulin therapy for three months, blood levels
of hemoglobin A1c, the best index of blood glucose control, were statistically
equivalent. Virtually identical results were obtained in a group of Type 2
diabetics. In September 1998, Pfizer released additional Phase IIb data which
indicated that results from 56 to 69 patients in a three-month trial showed that
individuals with Type 2 diabetes can markedly improve their glycemic control
without insulin injections by combining Inhale's pulmonary insulin with oral
diabetes agents.

In November 1998, Pfizer and Aventis announced that they entered into
worldwide agreements to manufacture insulin and to co-develop and co-promote
inhaleable insulin. Under the terms of the agreement, Pfizer and Aventis agreed
to construct a jointly owned manufacturing plant in Frankfurt, Germany. Until
its completion, Pfizer will provide Inhale with biosynthetic recombinant insulin
for powder processing from Aventis's existing plant. Inhale will continue to
have responsibility for manufacturing powders and supplying devices and will
receive a royalty on inhaleable insulin products marketed jointly by Pfizer and
Aventis. In November 1998, Pfizer held a meeting for 117 Phase III sites of the
inhaleable insulin trials and in June 1999, Pfizer began dosing for the Phase
III clinical trials.

In January 1995 and October 1996, Pfizer made two $5 million equity
investments in Inhale at a 25% premium to the market price of Inhale stock at
the time of each investment.

9

ALPHA-1 PROTEINASE INHIBITOR PROGRAM

In January 1997, Inhale entered into a collaborative agreement with Aventis
Behring to develop a pulmonary formulation of alpha-1 proteinase inhibitor to
treat patients with alpha-1 antitrypsin deficiency, or genetic emphysema.
Alpha-1 proteinase inhibitor is approved in the United States and several
European countries for augmentation treatment of alpha-1 antitrypsin deficiency.
Current treatment is given by systemic intravenous infusion on a weekly basis.
This "replacement therapy" consists of a concentrated form of alpha-1 proteinase
inhibitor derived from human plasma. Under the terms of the collaboration,
Aventis Behring will receive commercialization rights worldwide excluding Japan
and Inhale will receive royalties on product sales, an up-front signing fee and
up to an estimated $15 million in research and development funding and milestone
payments.

The two companies have completed preclinical work that indicates Inhale's
dry powder formulation of Aventis Behring's alpha-1 proteinase inhibitor has the
potential to significantly improve the efficiency of delivery compared with
current infusion therapy. Inhale believes its pulmonary delivery system could
significantly reduce the amount of drug needed for genetic emphysema therapy
since alpha-1 proteinase inhibitor could be delivered directly to the lung.
Aventis Behring is currently negotiating to secure rights under patents that
have been granted in Europe directed to aerosol formulations for the treatment
of the lung containing serine protease inhibitors, including alpha-1 proteinase
inhibitor. In December 1999, patient dosing began for Phase I clinical trials.

AVONEX-REGISTERED TRADEMARK- PROGRAM

In February 1999, Inhale entered into a collaborative agreement with Biogen
to develop an inhaleable formulation of Biogen's proprietary Interferon-Beta-1a,
marketed as AVONEX-Registered Trademark-, for the treatment of Multiple
Sclerosis. Multiple Sclerosis is believed to be the most common chronic
neurological condition of young adults in North America and Europe. It is
estimated that over 250,000 people in the United States are currently affected
by Multiple Sclerosis and that approximately 10,000 new cases are diagnosed
annually in the United States. Under the terms of the agreement, Inhale will
receive royalties on product sales, an up-front signing fee, and up to an
estimated $25 million in research and development funding and potential progress
payments. Biogen will provide bulk AVONEX-Registered Trademark- to Inhale for
formulation into a dry powder which is stable at room temperature. Inhale will
manufacture and package the dry powder and supply inhalation devices. Biogen
will be responsible for clinical trials, marketing and commercialization.

PROPRIETARY MOLECULE PROGRAM WITH LILLY

In January 1998, Lilly and Inhale entered into a collaborative agreement to
develop an inhaleable formulaton for an undisclosed protein product based on
Inhale's deep lung drug delivery system. Under the terms of the agreement,
Inhale will receive funding of up to $20 million in research, development and
milestone payments. Lilly will receive global commercialization rights for the
pulmonary delivery of the products with Inhale receiving royalties on sales of
any marketed products. Inhale will manufacture packaged powders for, and supply
inhalation devices to, Lilly.

PTH PROGRAM

In January 1997, Inhale entered into a collaborative agreement with Lilly to
develop pulmonary delivery for parathyroid hormone (PTH 1-34) with the target
indication of treatment and prevention of osteoporosis. At this time,
osteoporosis was estimated to affect approximately 25 million Americans, mostly
women. If not prevented or left untreated, osteoporosis can progress painlessly
until a bone breaks. As many as 35,000 people die each year from a cause
associated with hip fractures, primarily due to complications that result from
surgery or from being confined to bed.

In late 1998, unexpected observations from a long-term test in rats of the
injectable version of this PTH 1-34 led Lilly to suspend further clinical
development of the injectable and pulmonary versions of this

10

drug pending further analysis. Inhale is maintaining a minimum development
effort in its pulmonary program pending further direction from Lilly. Depending
on the continued evaluations by Lilly, this inhalation program could be
re-initiated, suspended for an extended period, or possibly terminated. Inhale
does not currently believe that this program will be re-initiated by Lilly in
the near future, if at all.

INHALE'S PROGRAMS AVAILABLE OR EXPECTED TO BE AVAILABLE FOR PARTNERING

CALCITONIN PROGRAM

Inhale is funding a proprietary program to develop a pulmonary formulation
of calcitonin for the treatment of osteoporosis, bone pain and Paget's disease.
Calcitonin is a peptide hormone secreted by the thyroid gland that inhibits bone
resorption and lowers serum calcium. Calcitonin is available in two forms, fish
and human. Calcitonin is administered daily or every other day by injection in
the United States. In the United States, salmon calcitonin is approved for the
treatment of postmenopausal osteoporosis, Paget's disease, hypercalcemia of
cancer and bone pain. Human calcitonin is approved for Paget's disease and bone
pain. Paget's disease is a chronic disorder of the adult skeleton, in which
localized areas of bone become hyperactive and are replaced by a softened and
enlarged bone structure. About 3% of Caucasians in the United States over age 60
have Paget's disease. Hypercalcemia occurs as a result of excessive serum
calcium levels caused by hyperparathyroidism and malignancy. It occurs in
approximately 10-20% of cancer patients.

In April 1997, Inhale announced the successful completion of Phase I trials
to investigate the tolerability and bioavailability of pulmonary delivery of a
dry powder, aerosolized form of salmon calcitonin as a potential treatment for
osteoporosis, Paget's disease, hypercalcemia and other bone diseases. The
single-dose study conducted in the United Kingdom with a total of 36 fasted
healthy subjects indicated that the drug was systemically absorbed when
delivered by the pulmonary route with Inhale's system. Inhale is continuing work
on this program while it seeks a partner for further clinical development.

INTERLEUKIN-1 RECEPTOR PROGRAM

Interleukin-1 is a cytokine that helps initiate the inflammatory response to
foreign pathogens and is believed to be a causative factor for asthma. The
interleukin-1 receptor is a molecule which can block the inflammatory action of
Interleukin-1. Inhale collaborated with Immunex to develop a pulmonary
formulation of interleukin-1 receptor as a therapeutic product for asthma.
Initial formulation development and animal toxicology have been completed, and
the two companies successfully completed Phase I/II trials demonstrating
pulmonary delivery. This program is awaiting further work and/or licensing by
Immunex.

MOLECULE PROGRAMS FORMERLY PARTNERED WITH BAXTER

In March 1996, Inhale entered into a collaborative agreement with Baxter
International Inc. to use Inhale's dry powder pulmonary delivery system as a
technology platform for developing and launching therapeutic products. In
connection with the collaboration, Baxter made a $20 million equity investment
in Inhale at a 25% premium to the market price of Inhale stock at the time of
the investment. At that time, Baxter received worldwide commercialization rights
for four non-protein/peptide drugs in exchange for up to an estimated
$60 million in research and development funding and progress payments.

In April 1998, Inhale announced that the first two compounds from its
collaboration with Baxter had successfully completed Phase I and Phase II trials
respectively. In addition, it was announced that the program would focus on the
product that had completed Phase I as it was the product with the most
commercial potential. The technology from one of the three remaining products
was returned to Inhale, leaving the development of the other two compounds on
hold. In October 1998, Inhale announced that it had reached an agreement with
Baxter to amend their collaborative agreement to facilitate signing a new
corporate partner to fund further development and commercialization of the
undisclosed compound that

11

had been their focus since April 1998. Baxter's obligations under that amendment
expired in September 1999. As a result, rights to the compounds reverted to
Inhale and are now available for other partnering opportunities.

OTHER PROGRAMS

In addition to the above mentioned programs, Inhale has conducted and
continues to conduct feasibility studies with respect to additional drug
formulations both for its own account and in cooperation with potential
partners. Inhale will continue to pursue these and other feasibility programs to
determine the potential for collaborative development programs with respect to
these drugs. Included among such studies is initial research on a long-acting
inhaleable insulin. Some diabetic patients require a long-acting insulin to
maintain baseline insulin levels. A long-acting, inhaleable form of insulin
could be used by these patients as a supplement to short-acting, mealtime
inhaleable insulin. This program is part of a broader sustained release program
announced by Inhale in January 1999.

MANUFACTURING

Inhale generally plans to formulate, manufacture and package the powders for
its deep lung delivery products and to subcontract the manufacture of its
proprietary pulmonary delivery devices. Under its collaborative agreement with
Pfizer to develop inhaleable insulin, Inhale will manufacture insulin powders
and Pfizer will be primarily responsible for filling blisters. The terms of the
collaborative agreement with Pfizer provide that prior to the commercialization
of its first products, Inhale must build and have validated a powder processing
facility and must have validated a device manufacturer or manufacturers. Inhale
believes its manufacturing strategy will enable it to achieve the following:

- provide economies of scale by utilizing manufacturing capacity for
multiple products;

- improve its ability to retain any manufacturing know-how; and

- allow its customers to bring pulmonary delivery products to market faster.

Inhale has built a powder manufacturing and packaging facility in San
Carlos, California capable of producing powders in quantities sufficient for
clinical trial. This facility has been inspected and licensed by the State of
California and is used to manufacture and package powders under current good
manufacturing practices. Inhale is expanding its facility to meet its future
commercial manufacturing commitments.

Inhale is working to further scale-up its powder processing to a larger
production scale system and to further develop the necessary powder packaging
technologies. Fine particle powders and small quantity packaging (such as those
to be used in Inhale's delivery system) require special handling. Current
commercial packaging systems are designed for filling larger quantities of
larger particle powders and therefore must be modified to dispense finer
particles in the small quantities required by Inhale. Inhale has developed and
validated a proprietary prototype automated filling system which Inhale believes
is capable of supporting its requirements through Phase III trials and into
commercial production for some products. Inhale is developing a higher capacity
automated filling unit capable of filling blisters on a production scale for
moderate and large volume products. Inhale faces significant technical
challenges in developing an automated, commercial-scale filling system that can
accurately and economically handle the small dose and particle sizes of its
powders. There can be no assurance that Inhale will be able to develop or
acquire the technology necessary to develop successfully any such system in a
timely manner or at commercially reasonable cost. Any failure or delay in
developing such technology would delay product development or bar
commercialization of Inhale's products and would have a material adverse effect
on Inhale.

Inhale's proprietary inhalation device has been developed for commercial use
and is being used in the Phase III insulin and other trials in 2000. Inhale
plans to subcontract the manufacture of its pulmonary delivery device before
commercial production of its first product. Inhale has identified contract
manufacturers that it believes have the technical capabilities and production
capacity to manufacture its devices

12

and which can meet the requirements of current good manufacturing practices.
There can be no assurance that Inhale will be able to obtain and maintain
satisfactory contract manufacturing on commercially acceptable terms, if at all.
Inhale's dependence upon third parties for the manufacture of its inhalation
device may adversely affect Inhale's cost of goods and its ability to develop
and commercialize products on a timely and competitive basis.

GOVERNMENT REGULATION

The research and development, manufacture and marketing of pulmonary drug
delivery systems are subject to regulation by the FDA in the United States and
by comparable regulatory agencies in other countries. These national agencies
and other federal, state and local entities regulate, among other things,
research and development activities and the testing, manufacture, safety,
effectiveness, labeling, storage, record keeping, approval, advertising and
promotion of Inhale's products.

The process required by the FDA before a pulmonary drug delivery system may
be marketed in the United States depends on whether the compound has existing
approval for use in other dosage forms. If the drug is a new chemical entity
that has not been approved, the process includes the following:

- extensive preclinical laboratory and animal testing;

- submission of an Investigational New Drug application ("IND");

- adequate and well-controlled human clinical trials to establish the safety
and efficacy of the drug for the intended indication: and

- submission to the FDA for approval of a New Drug Application ("NDA") with
respect to drugs or a Biological License Application ("BLA") with respect
to biologics.

If the drug has been previously approved, the approval process is similar,
except that certain preclinical tests relating to systemic toxicity normally
required for the IND and NDA/BLA application may not be necessary.

Preclinical tests include laboratory evaluation of product chemistry and
animal studies to assess the potential safety and efficacy of the product and
its formulation. Pulmonary drug products must be formulated according to current
good manufacturing practices, and pre-clinical safety tests must be conducted by
laboratories that comply with FDA good laboratory practices regulations. The
results of the pre-clinical tests are submitted to the FDA as part of an IND
application and are reviewed by the FDA before clinical trials begin. Clinical
trials may begin 30 days after receipt of the IND by the FDA, unless the FDA
raises objections during that period.

Clinical trials involve the administration of the drug to healthy volunteers
or to patients under the supervision of a qualified medical investigator.
Clinical trials are conducted in accordance with protocols that detail the
objectives of the study, the parameters to be used to monitor participant safety
and efficacy or other criteria to be evaluated. Each protocol is submitted to
the FDA as part of the IND. Each clinical study is conducted under the auspices
of an independent Institutional Review Board ("IRB"). The IRB will consider,
among other things, ethical factors, the potential risks to subjects
participating in the trial and the possible liability of the institution.

Clinical trials are typically conducted in three sequential phases, but the
phases may overlap. In Phase I, the initial introduction of the drug into
healthy human subjects, the product generally is tested for tolerability,
pharmacokinetics, absorption, metabolism and excretion. Phase II involves
studies in a limited patient population to:

- determine the efficacy of the product for specific targeted indications;

- determine dosage tolerance and optimal dosage; and

- identify possible adverse effects and safety risks.

13

After Phase II trials demonstrate that administration of the drug by the
pulmonary route is effective and has an acceptable safety profile, Phase III
trials are undertaken to evaluate further clinical efficacy and safety within an
expanded patient population at geographically dispersed clinical study sites.
The FDA, the clinical trial sponsor, the investigators or the IRB may suspend
clinical trials at any time if any one of them believe that study participants
are being exposed to an unacceptable health risk.

The results of product development, pre-clinical studies and clinical
studies are submitted to the FDA as an NDA/BLA for approval of the marketing and
commercial shipment of the pulmonary drug product. The FDA may deny an NDA/BLA
if applicable regulatory criteria are not satisfied or may require additional
clinical testing. Even if such data are submitted, the FDA may ultimately decide
that the NDA/BLA does not satisfy the criteria for approval. Product approvals
may be withdrawn if compliance with regulatory standards are not maintained or
if safety concerns arise after the product reaches the market. The FDA may
require post marketing testing and surveillance programs to monitor the effect
of pulmonary drug products that have been commercialized, and has the power to
prevent or limit future marketing of the product based on the results of such
programs.

Each domestic drug product manufacturing establishment must be registered
with, and approved by, the FDA. Drug product manufacturing establishments
located in California also must be licensed by the State of California.
Establishments handling controlled substances must be licensed by the United
States Drug Enforcement Administration ("DEA"). Domestic manufacturing
establishments are subject to biennial inspections by the FDA for compliance
with current good manufacturing practices compliance. Inhale is also subject to
U.S. federal, state and local regulations regarding workplace safety,
environmental protection and hazardous and controlled substance controls, among
others.

Many of the drugs with which Inhale is working are already approved for
marketing by the FDA. Inhale believes that when working with approved drugs, the
approval process for delivery by pulmonary drug products may require less time
and fewer tests than for new chemical entities. However, Inhale expects that its
formulations often will use excipients not currently approved for pulmonary use.
Use of these excipients will require additional toxicological testing that may
increase the costs of, or lengthen the time in, gaining regulatory approval. In
addition, regulatory procedures applicable to Inhale's products may change as
regulators gain experience in the area of macromolecules, and any such changes
may delay or increase the cost of regulatory approval.

For the products currently under development, Inhale's device is considered
to be part of a drug/ device combination for deep lung delivery of each specific
molecule. Prior to submission of an IND, the FDA Center and division within the
FDA Center responsible for the review of the IND and NDA/BLA will be identified.
In the case of Inhale's products, either the Center for Drug Evaluation and
Research or the Center for Biologics Evaluation and Research, in consultation
with the Center for Devices and Radiological Health, could be involved in the
review. However, one Center is designated as the Center which has the lead
responsibility for regulating the product. The jurisdiction within the FDA is
based on the primary mode of action of the drug and is identified in the FDA's
intercenter agreement.

Inhale expects that its partners generally will be responsible for clinical
and regulatory approval procedures, but Inhale may participate in this process
by submitting to the FDA a drug master file developed and maintained by Inhale
which contains data concerning the manufacturing processes for the product. The
clinical and manufacuturing development and regulatory review process generally
takes a number of years and requires the expenditure of substantial resources.
Inhale's ability to manufacture and sell products developed under contract
depends upon the partner's completion of satisfactory clinical trials and
obtaining marketing approvals. Inhale may prepare and submit an IND application
and perform initial clinical studies before licensing the product to a partner.
Inhale's business strategy contemplates performing more of these studies in the
future.

14

Sales of Inhale's products outside the United States are subject to local
regulatory requirements governing clinical trials and marketing approval for
drugs and pulmonary delivery systems. Such requirements vary widely from country
to country.

Prior to marketing a new dosage form of any drug, including one developed
for use with Inhale's pulmonary drug delivery system, the product must undergo
rigorous preclinical and clinical testing and an extensive review process
mandated by the FDA and equivalent foreign authorities regardless of whether or
not such drug was already approved for marketing in another dosage form. These
processes generally take a number of years and require the expenditure of
substantial resources. None of Inhale's proposed products has been submitted to
the FDA for marketing approval. Inhale has no experience obtaining such
regulatory approval, does not have the expertise or other resources to do so and
intends to rely on its partners to fund clinical testing and to obtain product
approvals.

PATENTS AND PROPRIETARY RIGHTS

Inhale's policy is to apply for patent protection for the technology,
inventions and improvements deemed important to the development of its business.
Inhale also relies upon trade secrets, know-how, continuing technological
innovations and licensing opportunities to maintain and further develop its
competitive position. Inhale plans to defend aggressively its proprietary
technology and any issued patents.

Inhale expects that its integrated system for pulmonary delivery of both
large and small molecule drugs will yield innovations in dry powder
formulations, powder processing, powder packaging and device design. It is
Inhale's strategy to build proprietary positions in each of its technological
areas. Inhale's success will depend in part upon its ability to protect its
proprietary technology from infringement, misappropriation, duplication and
discovery. Inhale has filed patent applications covering certain aspects of its
device and powder processing technology and powder formulations and pulmonary
route of delivery for certain molecules, and plans to file additional patent
applications. There can be no assurance that any of the patents applied for by
Inhale will issue, or that any patents that issue will be valid and enforceable.
Even if such patents are enforceable, Inhale anticipates that any attempt to
enforce its patents could be time consuming and costly.

Inhale currently has 49 issued U.S. and foreign patents covering certain
aspects of its technology and has a number of patent applications pending. The
United States Patent and Trademark Office (the "PTO") has issued the following
patents to Inhale:

- Patent No. 5,458,135 (October 17, 1995) for certain claims covering the
use of its device in a method for delivering aerosolized (including
powder) formulations of drugs to the lung.

- Patent No. 5,607,915 (March 4, 1997) for pulmonary delivery of active
fragments of parathyroid hormone (PTH) 1-34.

- Patent No. 5,654,007 (August 5, 1997) for a system and methods for
processing fine dispersible powders for easier processing.

- Patent No. 5,740,794 (April 21, 1998) for a method and means to access a
packaged drug, to break up a dry powder drug into particles with
compressed air (aerosolize), and to transport the aerosolized drug into a
holding chamber.

- Patent No. 5,775,320 (July 7, 1998) for a method and means for dispersing
a dry-powder or liquid drug, and transferring the drug in its aerosolized
"cloud" form to a holding chamber where it is held until a patient is
ready to inhale, as well as a method and means to pull in atmospheric
"chase" air following the initial inhalation to help push the drug into
the deep lung.

- Patent No. 5,780,014 (July 14, 1998) for methods and means for pulmonary
delivery of dry powder alpha1-antitrypsin, a proteinase inhibitor, for
administration to a patient.

15

- Patent No. 5,785,049 (July 28, 1998) for approximately 50 claims directed
to methods and means for aerosolizing dry powders through use of a high
pressure gas stream to draw dry powder from a receptacle such as a blister
pack and for which Inhale utilizes the design described therein to achieve
efficient aerosolization of fine dry powders to enable deep lung delivery
for systemic absorption.

- Patent No. 5,814,607 (September 29, 1998) for pulmonary delivery of active
fragments of parathyroid hormone of between 34 and 38 amino acids in
length.

- Patent No. 5,826,633 (October 27, 1998) relating to Inhale's powder
handling technologies, including the process of transferring fine powder
particles into blister packs in an un-compacted state so that they can be
easily dispersed in Inhale's pulmonary delivery system.

- Patent No. 5,922,354 (July 13, 1999) for a method for preparing fine
particles by agglomeration.

- Patent No. 5,928,469 (July 27, 1999) for a method for preparing storage
stable compositions. In this method, a material to be stored and a glass
forming substance are spray-dried to form stable particles.

- Patent No. 5,976,574 (November 2, 1999) for a process for spray-drying
hydrophobic drugs in organic solvent suspensions.

- Patent No. 5,985,248 (November 16, 1999) for a process for spray-drying a
hydrophobic drug and a hydrophilic excipient in an organic solvent and
compositions formed by the process.

- Patent No. 5,993,783 (November 30, 1999) for a respirable
alpha-1-antitrypsin dry powder having an areodynamic diameter of less than
5 Microns.

- Patent No. 5,994,314 (November 30, 1999) for dry powder nucleic acid
compositions and methods for their preparation.

- Patent No. 5,997,848 (December 7, 1999) for pulmonary administration of
dry powder insulin which is rapidly absorbed through the alveoli into the
systemic circulation.

- Patent No. 6,001,336 (December 14, 1999) for a process for spray drying a
hydrophobic drug in an aqueous suspension with a hydrophilic component.

In November, 1999, Inhale acquired from Alliance Pharmaceutical Corp. its
PulmoSpheres-Registered Trademark- technology and other related assets for
particle formulation and powder processing, subject to the terms and conditions
of an asset purchase agreement. The PulmoSpheres-Registered Trademark-
technology utilizes an emulsification process to produce a powder having
characteristics that Inhale believes may improve efficiency and reproducibility
for drugs delivered to the lung through alternative technologies such as MDIs as
well as potentially improve drug delivery through Inhale's proprietary deep lung
drug delivery system. The assets acquired included Alliance's intellectual
property portfolio for PulmoSpheres-Registered Trademark- consisting of, among
other things, several patent applications. With respect to applications of the
PulmoSpheres-Registered Trademark- technology outside the respiratory field,
Inhale has licensed the technology back to Alliance. While Alliance has made
several representations in its agreement with Inhale regarding its ownership
rights of the PulmoSpheres-Registered Trademark- technology, it is possible that
third parties might assert claims challenging Alliance's rights, and thus
Inhale's rights. Even if Inhale can defend its rights successfully, the
uncertainty regarding the status of its rights during the time any such
litigation is pending may prevent Inhale from using the underlying technology.

In March 1998, Inhale and Initiatech Inc. signed an agreement under which
Inhale licensed technology, intellectual property, and patents for protecting
biologically active compounds in the dry state. Inhale intends to use this
technology to expand its current technology base in stabilizing dry powder
aerosol formulations for peptides, proteins, and other macromolecules at room
temperature. Inhale's license is exclusive for the fields of respiratory
delivery of pharmaceutical products and for any delivery form of insulin. The
license includes rights to two issued U.S. patents and a Canadian patent
covering the

16

protection of biological materials from degradation in the dry state. Initiatech
has licensed exclusive rights to this technology from the Boyce Thompson
Institute for Plant Research, Inc.

In June 1997, Inhale acquired the intellectual property portfolio of the
BioPreservation Division of Pafra. This portfolio includes issued U.S. and
foreign Letters Patent and pending applications relating to the stabilization of
macromolecule drugs in dry formulations. An application for reissue of the
original U.S. patent included in this portfolio is pending in the PTO. There can
be no assurance that Inhale will be successful in obtaining a reissued patent. A
second U.S. patent from this portfolio issued to Inhale on July 27, 1999 and is
noted above. A granted European patent included in this portfolio was the
subject of an opposition proceeding before the European Patent Office. The
opposition hearing was held on December 16, 1999. Inhale successfully defended
the patent and its method claims relating to glass stabilization technology
against four opposing parties. In addition, in late 1999, based on claims of
this granted European patent, Inhale filed an infringement action in the courts
of the United Kingdom against Quadrant Healthcare plc. There can be no assurance
that any of the other Pafra patent applications will be held to be valid and
enforceable. The inability to obtain or defend the Pafra patents could have a
material adverse effect on Inhale.

Inhale has obtained license rights to certain know-how and patent
applications owned by Genentech, Inc. covering formulations, powder processing
and pulmonary delivery of certain molecules, which it believes could be
important to the development of its business. These license rights are
worldwide, nonexclusive, sublicensable and royalty free. In 1997, Genentech
successfully defended an opposition proceeding involving a pending European
patent licensed to Inhale. Recently, this decision was upheld on appeal. The
pending patent covers the pulmonary delivery of cytokines and growth factors.

The patent positions of pharmaceutical, biotechnology and drug delivery
companies, including Inhale, are uncertain and involve complex legal and factual
issues. Additionally, the coverage claimed in a patent application can be
significantly reduced before the patent is issued. As a consequence, Inhale does
not know whether any of its patent applications will be granted with broad
coverage or whether the claims that eventually issue will be circumvented. Since
patent applications in the United States are maintained in secrecy until patents
issue, and since publication of discoveries in scientific or patent literature
often lag behind actual discoveries, Inhale cannot be certain that it was the
first inventor of inventions covered by its issued patents or pending patent
applications or that it was the first to file patent applications for such
inventions. Moreover, Inhale may have to participate in interference proceedings
declared by the PTO to determine priority of invention, which could result in
substantial cost to Inhale, even if the eventual outcome is favorable. An
adverse outcome could subject Inhale to significant liabilities to third
parties, require disputed rights to be licensed from or to third parties or
require Inhale to cease using the technology in dispute.

Inhale is aware of numerous pending and issued U.S. and foreign patent
rights and other proprietary rights owned by third parties that relate to
aerosol devices and delivery, pharmaceutical formulations, dry powder processing
technology and the pulmonary route of delivery for certain powder formulations
of macromolecules. Inhale cannot predict with any certainty which, if any,
patent references will be considered relevant to its technology by authorities
in the various jurisdictions where such rights exist, nor can Inhale predict
with certainty which, if any, of these rights will or may be asserted against it
by such third parties. There can be no assurance that Inhale can obtain any
license to any technology that it determines it needs, on reasonable terms, if
at all, or that Inhale could develop or otherwise obtain alternate technology.
The failure to obtain licenses if needed would have a material adverse effect on
Inhale.

Inhale also relies upon trade secret protection for its confidential and
proprietary information. No assurance can be given that others will not
independently develop substantially equivalent proprietary information and
techniques or otherwise gain access to Inhale's trade secrets or disclose such
technology, or that Inhale can meaningfully protect its trade secrets.

17

Third parties from time to time have asserted or may assert that Inhale is
infringing their proprietary rights based upon issued patents, trade secrets or
know-how that they believe cover Inhale's technology. In addition, future
patents may issue to third parties which Inhale's technology may infringe.
Inhale could incur substantial costs in defending itself and its partners
against any such claims. Furthermore, parties making such claims may be able to
obtain injunctive or other equitable relief which could effectively block
Inhale's ability to further develop or commercialize some or all of its products
in the United States and abroad, and could result in the award of substantial
damages. In the event of a claim of infringement, Inhale and its partners may be
required to obtain one or more licenses from third parties. There can be no
assurance that Inhale or its partners will be able to obtain such licenses at a
reasonable cost, if at all. Defense of any lawsuit or failure to obtain any such
required license could have a material adverse effect on Inhale.

Inhale's ability to develop and commercialize its technology will be
affected by its or its partners' access to the drugs which are to be formulated.
Many biopharmaceutical drugs, including some of those which are presently under
development by Inhale, are subject to issued and pending United States and
foreign patent rights which may be owned by competing entities. There are issued
patents and pending patent applications relating to the pulmonary delivery of
macromolecule drugs, including several for which Inhale is developing pulmonary
delivery formulations. Inhale intends generally to rely on the ability of its
partners to provide access to the drugs which are to be formulated for pulmonary
delivery. There can be no assurance, however, that Inhale's partners will be
able to provide access to drug candidates for formulation for pulmonary delivery
or that, if such access is provided, Inhale or its partners will not be accused
of, or determined to be, infringing a third party's rights and will not be
prohibited from working with the drug or be found liable for damages that may
not be subject to indemnification. Any such restriction on access or liability
for damages would have a material adverse effect on Inhale.

It is Inhale's policy to require its employees and consultants, outside
scientific collaborators, sponsored researchers and other advisors who receive
confidential information from Inhale to execute confidentiality agreements upon
the commencement of employment or consulting relationships with Inhale. These
agreements provide that all confidential information developed or made known to
the individual during the course of the individual's relationship with Inhale is
to be kept confidential and not disclosed to third parties except in specific
circumstances. The agreements provide that all inventions conceived by an
employee shall be the property of Inhale. There can be no assurance, however,
that these agreements will provide meaningful protection or adequate remedies
for Inhale's trade secrets in the event of unauthorized use or disclosure of
such information.

COMPETITION

Inhale believes that products developed using its technology will compete on
the basis of system efficiency, dosage reproducibility, safety, patient
convenience and cost. There is intense competition to develop a solution to the
non-invasive delivery of drugs from several drug delivery and pharmaceutical
companies, many of which are much larger and have far greater resources than
Inhale. These include companies working on developing systems for other
non-invasive routes of delivery, such as oral, transdermal, bucal, nasal, and
needle-less injections, as well as companies working on pulmonary delivery
systems. In addition, several companies are working on sustained release
injectable systems. While these latter systems involve injections, the lower
number of injections could be competitive with Inhale's pulmonary delivery
technology in certain applications. Inhale believes its technology and
integrated pulmonary delivery systems approach provides it with important
competitive advantages in the delivery of drugs compared with currently known
alternatives. However, new drugs or further developments in alternative drug
delivery methods may provide greater therapeutic benefits for a specific drug or
indication, or may offer comparable performance at lower cost than Inhale's
proprietary deep lung drug delivery system.

18

With respect to pulmonary delivery, several companies are marketing and
developing dry powder, MDI, liquid and nebulizer devices that could have
applications for drug delivery, including Dura Pharmaceuticals, Inc. and Aradigm
Corporation, which also have collaborative arrangements with corporate partners
for the development of pulmonary delivery systems for insulin. Several of these
companies may have or may be developing dry powder devices that could be used
for pulmonary delivery of proteins and other macromolecules. There can be no
assurance that competitors will not introduce products or processes competitive
with or superior to those of Inhale. Inhale intends to monitor competitive
device activities and continue to focus its activities on those products for
which Inhale believes it has and can maintain a competitive advantage. If a
device is developed that is superior to Inhale's for certain applications,
Inhale may seek to obtain a license to allow Inhale's partners to use such
device with Inhale-developed powders, although there can be no assurance that
Inhale would be able to do so.

Inhale's success depends upon maintaining a competitive advantage in the
development of products and technologies for pulmonary delivery of
pharmaceutical drugs. If a competing company were to develop or acquire rights
to a better system for efficiently and reproducibly delivering macromolecule
drugs to the deep lung, a non-invasive drug delivery system which is more
attractive for delivery drugs to the deep lung, a non-invasive delivery system
which is more attractive for the delivering of drugs than pulmonary delivery, or
an invasive delivery system which overcomes some of the drawbacks of current
invasive systems for chronic or subtonic indications (such as sustained release
systems), Inhale's business would be negatively impacted.

Inhale is in competition with pharmaceutical, biotechnology and drug
delivery companies, hospitals, research organizations, individual scientists and
nonprofit organizations engaged in the development of alternative drug delivery
systems or new drug research and testing, as well as with entities producing and
developing injectable drugs. Inhale is aware of a number of companies currently
seeking to develop new products and non-invasive alternatives to injectable drug
delivery, including oral delivery systems, intranasal delivery systems,
transdermal systems, bucal and colonic absorption systems. Several of these
companies may have developed or are developing dry powder devices that could be
used for pulmonary delivery of macromolecules. Many of these companies and
entities have greater research and development capabilities, experience,
manufacturing, marketing, financial and managerial resources than Inhale and
represent significant competition for Inhale. Acquisitions of competing drug
delivery companies by large pharmaceutical companies could enhance competitors'
financial, marketing and other resources. Accordingly, Inhale's competitors may
succeed in developing competing technologies, obtaining FDA approval for
products or gaining market acceptance more rapidly than Inhale. Developments by
others may render Inhale's products or technologies noncompetitive or obsolete.

EMPLOYEES AND CONSULTANTS

As of December 31, 1999, Inhale had 339 employees, of which 252 were engaged
in research and development (including manufacturing) activities and 87 in
general administration and business development. One hundred twenty-five of the
employees hold advanced degrees, of which 88 are Ph.D.s. Inhale employs
scientists and engineers with expertise in the areas of pulmonary biology,
aerosol science, powder technology, mechanical engineering, protein chemistry
and chemical engineering. None of Inhale's employees are covered by a collective
bargaining agreement and Inhale has experienced no work stoppages. Inhale
believes that it maintains good relations with its employees.

To complement its own expertise, Inhale utilizes specialists in regulatory
affairs, pulmonary toxicology, process engineering, manufacturing, quality
assurance, device design, clinical trial design and business development. These
individuals include certain of Inhale's scientific advisors as well as
independent consultants. See "Management."

19

RISK FACTORS

THE FOLLOWING RISK FACTORS SHOULD BE READ CAREFULLY IN CONNECTION WITH
EVALUATING INHALE'S BUSINESS. ANY OF THE FOLLOWING RISKS COULD MATERIALLY
ADVERSELY AFFECT INHALE'S BUSINESS AND OPERATING RESULTS OR FINANCIAL CONDITION.

WE DO NOT KNOW IF OUR DEEP LUNG DRUG DELIVERY SYSTEM IS COMMERCIALLY FEASIBLE.

We are in an early stage of development. There is a risk that our deep lung
drug delivery technology will not be commercially feasible. Even if our deep
lung delivery technology is commercially feasible, it may not be commercially
accepted across a range of large and small molecule drugs. We have tested seven
deep lung delivery formulations in humans, but many of our potential
formulations have not been tested in humans.

Many of the underlying drug compounds contained in our deep lung
formulations have been tested in humans by other companies using alternative
delivery routes. Our potential products require extensive research, development
and pre-clinical (animal) and clinical (human) testing. Our potential products
also may involve lengthy regulatory review before they can be sold. We do not
know if and cannot assure you that, any of our potential products will prove to
be safe and effective or meet regulatory standards. There is a risk that any of
our potential products will not be able to be produced in commercial quantities
at acceptable cost or marketed successfully. Our failure to achieve commercial
feasibility, demonstrate safety, achieve clinical efficacy, obtain regulatory
approval or, together with partners, successfully market products will
negatively impact our revenues and results of operations.

WE DO NOT KNOW IF OUR DEEP LUNG DRUG DELIVERY SYSTEM IS EFFICIENT.

We may not be able to achieve the total system efficiency needed to be
competitive with alternative routes of delivery. Total system efficiency is
determined by the amount of drug loss during manufacture, in the delivery
device, in reaching the site of absorption, and during absorption from that site
into the bloodstream. Deep lung bioavailability is the percentage of a drug that
is absorbed into the bloodstream when that drug is delivered directly to the
lungs as compared to when the drug is delivered by injection. Bioavailability is
the initial screen for whether deep lung delivery of any systemic drug is
commercially feasible. We would not consider a drug to be a good candidate for
development and commercialization if its drug loss is excessive at any one stage
or cumulatively in the manufacturing and delivery process or if its deep lung
bioavailability is too low.

WE DO NOT KNOW IF OUR DEEP LUNG DRUG FORMULATIONS ARE STABLE.

We may not be able to identify and produce powdered versions of drugs that
retain the physical and chemical properties needed to work with our delivery
device. Formulation stability is the physical and chemical stability of the drug
over time and under various storage, shipping and usage conditions. Formulation
stability will vary with each deep lung formulation and the type and amount of
ingredients that are used in the formulation. Problems with powdered drug
stability would negatively impact our ability to develop and market our
potential products or obtain regulatory approval.

WE DO NOT KNOW IF OUR DEEP LUNG DRUG DELIVERY SYSTEM IS SAFE.

We may not be able to prove potential products to be safe. Our products
require lengthy laboratory, animal and human testing. Most of our products are
in preclinical testing or the early stage of human testing. If we find that any
product is not safe, we will not be able to commercialize the product. The
safety of our deep lung formulations will vary with each drug and the
ingredients used in its formulation.

20

WE DO NOT KNOW IF OUR DEEP LUNG DRUG DELIVERY SYSTEM PROVIDES CONSISTENT DOSES
OF MEDICINE.

We may not be able to provide reproducible dosages of stable formulations
sufficient to achieve clinical success. Reproducible dosing is the ability to
deliver a consistent and predictable amount of drug into the bloodstream over
time both for a single patient and across patient groups. Reproducible dosing
requires the development of:

- an inhalation device that consistently delivers predictable amounts of dry
powder formulations to the deep lung;

- accurate unit dose packaging of dry powder formulations; and

- moisture resistant packaging.

We may not be able to develop reproducible dosing of any potential product.
The failure to do so means that we would not consider it a good candidate for
development and commercialization.

WE DEPEND ON PARTNERS FOR REGULATORY APPROVALS AND COMMERCIALIZATION OF OUR
PRODUCTS.

Because we are in the business of developing technology for delivering drugs
to the lungs and licensing this technology to companies that make and sell
drugs, we do not have the people and other resources to do the following things:

- make bulk drugs to be used as medicines;

- design and carry out large scale clinical studies;

- prepare and file documents necessary to obtain government approval to sell
a given drug product; and

- market and sell our products when and if they are approved.

When we sign a collaborative development agreement or license agreement to
develop a product with a drug company, the drug company agrees to do some or all
of the things described above. If our partner fails to do any of these things,
we cannot complete the development of the product.

WE MAY NOT OBTAIN REGULATORY APPROVAL FOR OUR PRODUCTS ON A TIMELY BASIS, OR AT
ALL.

There is a risk that we will not obtain regulatory approval for our products
on a timely basis, or at all. Our product must undergo rigorous animal and human
testing and an extensive review process mandated by the United States Food and
Drug Administration ("FDA") and equivalent foreign authorities. This process
generally takes a number of years and requires the expenditure of substantial
resources; although the time required for completing such testing and obtaining
such approvals is uncertain. We have not submitted any of our products to the
FDA for marketing approval. We have no experience obtaining such regulatory
approval.

In addition, we may encounter delays or rejections based upon changes in FDA
policy, including policy relating to good manufacturing practice compliance,
during the period of product development. We may encounter similar delays in
other countries.

Even if regulatory approval of a product is granted, the approval may limit
the indicated uses for which we may market our product. In addition, our
marketed product, our manufacturing facilities and Inhale, as the manufacturer,
will be subject to continual review and periodic inspections. Later discovery
from such review and inspection of previously unknown problems may result in
restrictions on our product or on us, including withdrawal of our product from
the market. The failure to obtain timely regulatory approval of our products,
any product marketing limitations or a product withdrawal would negatively
impact our revenues and results of operations.

21

WE DO NOT KNOW IF OUR TECHNOLOGIES CAN BE INTEGRATED SUCCESSFULLY TO BRING
PRODUCTS TO MARKET.

We may not be able to integrate all of the relevant technologies to provide
a deep lung drug delivery system. Our integrated approach to systems development
relies upon several different but related technologies:

- dry powder formulations;

- dry powder processing technology;

- dry powder packaging technology; and

- deep lung delivery devices.

At the same time we must:

- establish collaborations with partners;

- perform laboratory and clinical testing of potential products; and

- scale-up our manufacturing processes.

We must accomplish all of these steps without delaying any aspect of
technology development. Any delay in one component of product or business
development could delay our ability to develop, obtain approval of or market
therapeutic products using our deep lung delivery technology.

WE MAY NOT BE ABLE TO MANUFACTURE OUR PRODUCTS IN COMMERCIAL QUANTITIES.

POWDER PROCESSING. We have no experience manufacturing products for
commercial purposes. We have only performed powder processing on the small scale
needed for testing formulations and for early stage and larger clinical trials.
We may encounter manufacturing and control problems as we attempt to scale-up
powder processing facilities. We may not be able to achieve such scale-up in a
timely manner or at a commercially reasonable cost, if at all. Our failure to
solve any of these problems could delay or prevent late stage clinical testing
and commercialization of our products and could negatively impact our revenues
and results of operations.

To date, we have relied on one particular method of powder processing. There
is a risk that this technology will not work with all drugs or that the cost of
drug production will preclude the commercial viability of certain drugs.
Additionally, there is a risk that any alternative powder processing methods we
may pursue will not be commercially practical for aerosol drugs or that we will
not have, or be able to acquire the rights to use, such alternative methods.

POWDER PACKAGING. Our fine particle powders and small quantity packaging
require special handling. We have designed and qualified automated filling
equipment for small and moderate quantity packaging of fine powders. We face
significant technical challenges in scaling-up an automated filling system that
can handle the small dose and particle sizes of our powders in commercial
quantities. There is a risk that we will not be able to scale-up our automated
filling equipment in a timely manner or at commercially reasonable costs. Any
failure or delay in such scale-up would delay product development or bar
commercialization of our products and would negatively impact our revenues and
results of operations.

INHALATION DEVICE. We face many technical challenges in further developing
our inhalation device to work with a broad range of drugs, to produce such a
device in sufficient quantities and to adapt the device to different powder
formulations. In addition, we are attempting to develop a smaller inhalation
device, which presents particular technical challenges. There is a risk that we
will not successfully achieve any of these challenges. Our failure to overcome
any of these challenges would negatively impact our revenues and results of
operations.

22

For late stage clinical trials and initial commercial production, we intend
to use one or more contract manufacturers to produce our drug delivery device.
There is a risk that we will not be able to enter into or maintain arrangements
with any potential contract manufacturers or effectively scale-up production of
our drug delivery devices through contract manufacturers. Our failure to do so
would negatively impact our revenues and results of operations.

WE DEPEND ON SOLE OR EXCLUSIVE SUPPLIERS FOR OUR INHALATION DEVICE AND BULK
DRUGS.

We plan to subcontract the manufacture of our pulmonary delivery device
before commercial production of our first product. We have identified contract
manufacturers that we believe have the technical capabilities and production
capacity to manufacture our devices and which can meet the requirements of good
manufacturing practices. We cannot be assured that we will be able to obtain and
maintain satisfactory contract manufacturing on commercially acceptable terms,
if at all. Our dependence on third parties for the manufacture of our inhalation
device may negatively impact our cost of goods and our ability to develop and
commercialize products on a timely and competitive basis.

We obtain the bulk drugs we use to formulate and manufacture the dry powders
for our deep lung delivery system from sole or exclusive sources of supply. For
example, with respect to our source of bulk insulin, we have entered into a
collaborative agreement with Pfizer which has, in turn, entered into an
agreement with Aventis to manufacture biosynthetic recombinant insulin. Under
the terms of their agreement, Pfizer and Aventis agreed to construct a jointly
owned manufacturing plant in Frankfurt, Germany. Until its completion, Pfizer
will provide us with insulin from Aventis's existing plant. If our sole or
exclusive source suppliers fail to provide bulk drugs in sufficient quantities
when required, our revenues and results of operations will be negatively
impacted.

WE DO NOT KNOW IF THE MARKET WILL ACCEPT OUR DEEP LUNG DRUG DELIVERY SYSTEM.

The commercial success of our potential products depends upon market
acceptance by health care providers, third-party payors like health insurance
companies and Medicare, and patients. Our products under development use a new
method of drug delivery and there is a risk that our potential products will not
be accepted by the market. Market acceptance will depend on many factors,
including:

- the safety and efficacy of our clinical trials;

- favorable regulatory approval and product labeling;

- the frequency of product use;

- the availability of third-party reimbursement;

- the availability of alternative technologies; and

- the price of our products relative to alternative technologies.

There is a risk that health care providers, patients or third-party payors
will not accept our deep lung drug delivery system. If the market does not
accept our potential products, our revenues and results of operations would be
significantly and negatively impacted.

IF OUR PRODUCTS ARE NOT COST EFFECTIVE, GOVERNMENT AND PRIVATE INSURANCE PLANS
MAY NOT PAY FOR OUR PRODUCTS.

In both domestic and foreign markets, sales of our products under
development will depend in part upon the availability of reimbursement from
third-party payors, such as government health administration authorities,
managed care providers, private health insurers and other organizations. In
addition, such third-party payors are increasingly challenging the price and
cost effectiveness of medical products and services. Significant uncertainty
exists as to the reimbursement status of newly approved health care

23

products. Legislation and regulations affecting the pricing of pharmaceuticals
may change before our proposed products are approved for marketing. Adoption of
such legislation and regulations could further limit reimbursement for medical
products. A government or third-party payor decision to not provide adequate
coverage and reimbursements for our products would limit market acceptance of
such products.

WE EXPECT TO CONTINUE TO LOSE MONEY FOR THE NEXT SEVERAL YEARS.

We have never been profitable and, through December 31, 1999, we have an
accumulated deficit of approximately $94.5 million. We expect to continue to
incur substantial and increasing losses over at least the next several years as
we expand our research and development efforts, testing activities and
manufacturing operations, and as we further expand our late stage clinical and
early commercial production facility. All of our potential products are in
research or in the early stages of development except for our insulin
collaboration. We have generated no revenues from approved product sales. Our
revenues to date have consisted primarily of payments under short-term research
and feasibility agreements and development contracts. To achieve and sustain
profitable operations, we must, alone or with others, successfully develop,
obtain regulatory approval for, manufacture, introduce, market and sell products
using our deep lung drug delivery system. There is a risk that we will not
generate sufficient product or contract research revenue to become profitable or
to sustain profitability.

WE MAY NEED TO RAISE ADDITIONAL CAPITAL THAT MAY NOT BE AVAILABLE.

We anticipate that our existing capital resources will enable us to maintain
currently planned operations through at least the next 24 months. However, this
expectation is based on our current operating plan, which is expected to change
as a result of many factors, and we may need additional funding sooner than
anticipated. In addition, we may choose to raise additional capital due to
market conditions or strategic considerations, even if we believe we have
sufficient funds for our current or future operating plans. To the extent that
additional capital is raised through the sale of equity or convertible debt
securities, the issuance of such securities could result in dilution to our
stockholders.

We have no credit facility or other committed sources of capital. To the
extent operating and capital resources are insufficient to meet future
requirements, we will have to raise additional funds to continue the development
and commercialization of our technologies. Such funds may not be available on
favorable terms, or at all. In particular, our substantial leverage may limit
our ability to obtain additional financing. If adequate funds are not available
on reasonable terms, we may be required to curtail operations significantly or
to obtain funds by entering into financing, supply or collaboration agreements
on unattractive terms. Our inability to raise capital could negatively impact
our business.

OUR PATENTS MAY NOT PROTECT OUR PRODUCTS AND OUR PRODUCTS MAY INFRINGE ON
THIRD-PARTY PATENT RIGHTS.

We have filed patent applications covering certain aspects of our device,
powder processing technology, and powder formulations and deep lung route of
delivery for certain molecules, and we plan to file additional patent
applications. We currently have 49 issued U.S. and foreign patents that cover
certain aspects of our technology and we have a number of patent applications
pending. There is a risk that many of the patents applied for will not issue, or
that any patents that issue or have issued will not be valid and enforceable.
Enforcing our patent rights would be time consuming and costly.

Our access or our partners' access to the drugs to be formulated will affect
our ability to develop and commercialize our technology. Many drugs, including
powder formulations of certain drugs that are presently under development by us,
are subject to issued and pending U.S. and foreign patents that may be owned by
our competitors. We know that there are issued patents and pending patent
applications relating to the deep lung delivery of large molecule drugs,
including several for which we are developing deep lung delivery formulations.
This situation is highly complex, and the ability of any one company, including
Inhale, to commercialize a particular drug is unpredictable.

24

We intend generally to rely on the ability of our partners to provide access
to the drugs that are to be formulated by us for deep lung delivery. There is a
risk that our partners will not be able to provide access to such drug
candidates. Even if such access is provided, there is a risk that our partners
or we will be accused of, or determined to be, infringing a third-party's patent
rights and will be prohibited from working with the drug or be found liable for
damages that may not be subject to indemnification. Any such restriction on
access to drug candidates or liability for damages would negatively impact our
revenues and results of operations.

OUR COMPETITORS MAY DEVELOP AND SELL BETTER DRUG DELIVERY SYSTEMS.

We are aware of other companies engaged in developing and commercializing
pulmonary drug delivery systems and enhanced injectable drug delivery systems.
Many of these companies have greater research and development capabilities,
experience, manufacturing, marketing, financial and managerial resources than we
do and represent significant competition for us. Acquisitions of or
collaborations with competing drug delivery companies by large pharmaceutical
companies could enhance our competitors' financial, marketing and other
resources. Accordingly, our competitors may succeed in developing competing
technologies, obtaining regulatory approval for products or gaining market
acceptance before us. Developments by others could make our products or
technologies uncompetitive or obsolete. Our competitors may introduce products
or processes competitive with or superior to ours.

INVESTORS SHOULD BE AWARE OF INDUSTRY-WIDE RISKS.

In addition to the risks associated specifically with Inhale described
above, investors should also be aware of general risks associated with drug
development and the pharmaceutical industry. These include, but are not limited
to:

- changes in and compliance with government regulations;

- handling of hazardous materials;

- hiring and retaining qualified people; and

- insuring against product liability claims.

WE EXPECT OUR STOCK PRICE TO REMAIN VOLATILE.

Our stock price is volatile. In the last twelve months, based on closing
prices on the Nasdaq National Market, our stock price ranged from $23.00 to
$126.62. We expect it to remain volatile. A variety of factors may have a
significant effect on the market price of our common stock, including:

- fluctuations in our operating results;

- announcements of technological innovations or new therapeutic products;

- announcement or termination of collaborative relationships by Inhale or
our competitors;

- governmental regulation;

- clinical trial results or product development delays;

- developments in patent or other proprietary rights;

- public concern as to the safety of drug formulations developed by Inhale
or others; and

- general market conditions.

Any litigation brought against us as a result of this volatility could result in
substantial costs and a diversion of our management's attention and resources,
which could negatively impact our financial condition, revenues and results of
operations.

25

THE NOTES ARE SUBORDINATED TO ANY EXISTING AND FUTURE SENIOR DEBT.

The notes are contractually subordinated in right of payment to our existing
and future Senior Debt. As of December 31, 1999, we had approximately
$4.9 million of Senior Debt. Upon the closing of our sale of 6 3/4% Convertible
Subordinated Debentures in late 1999, we incurred additional indebtedness of
approximately $108.5 million. In early 2000, we entered into agreements with
certain holders of such debentures to reduce the principal amount of debentures
outstanding by approximately $94.2 million. The indenture does not limit the
creation of additional Senior Debt (or any other indebtedness). In connection
with the expansion of our facilities, we expect that we may significantly
increase our Senior Debt in the near future. Any significant additional Senior
Debt incurred may materially adversely impact our ability to service our debt,
including the notes. Due to the subordination provisions, in the event of our
insolvency, funds which we would otherwise use to pay the holders of the notes
will be used to pay the holders of Senior Debt to the extent necessary to pay
the Senior Debt in full. As a result of these payments, our general creditors
may recover less, ratably, than the holders of our Senior Debt and such general
creditors may recover more, ratably, than the holders of our notes or our other
subordinated indebtedness. In addition, the holders of our Senior Debt may,
under certain circumstances, restrict or prohibit us from making payments on the
notes.

OUR OUTSTANDING INDEBTEDNESS HAS INCREASED SUBSTANTIALLY WITH THE ISSUANCE OF
THE 5% CONVERTIBLE NOTES.

As of December 31, 1999, we had approximately $113.3 million in long-term
debt. Upon the closing of our sale of 5.0% convertible subordinated notes in
early 2000, we incurred additional long-term indebtedness of $230.0 million. In
early 2000, we entered into agreements with certain holders of the October 2006
debentures to reduce the principal amount of debentures outstanding by
approximately $94.2 million. Upon closing of the offering of the notes, our
long-term debt was approximately $249.2 million. This increased indebtedness has
and will continue to impact us by:

- significantly increasing our interest expense and related debt service
costs;

- making it more difficult to obtain additional financing; and

- constraining our ability to react quickly in an unfavorable economic
climate.

Currently, we are not generating sufficient cash flow to satisfy the annual
debt service payments that will be required as a result of the consummation of
sale of the notes. This may require us to use a portion of the proceeds from the
sales of the notes to pay interest or borrow additional funds or sell additional
equity to meet our debt service obligations. If we are unable to satisfy our
debt service requirements, substantial liquidity problems could result, which
would negatively impact our future prospects.

ITEM 2. PROPERTIES

Inhale currently leases approximately 156,000 square feet in San Carlos,
California, 20,000 square feet in Palo Alto, California and 8,000 square feet in
Belmont, California. The Palo Alto facility is used for research, development
and administration; the lease has a five-year term, and expires on May 31, 2003.
The Belmont facility is used for administration; the lease has a 30-month term
and expires on June 30, 2003.

The San Carlos facility is leased pursuant to a 15-year lease agreement. The
San Carlos facility serves as the Company's corporate headquarters and is used
for research, development, manufacturing and administration. The lease provides
Inhale with an option to lease approximately 69,000 additional square feet in
the same facility. This manufacturing facility operates under current good
manufacturing practices and has been approved and licensed by the State of
California to manufacture clinical supplies for use in clinical trials.

26

In October 1998, Inhale acquired 4.7 acres of land adjacent to its San
Carlos facility. Inhale intends to use this property to expand future
operations. In October 1999, Inhale commenced construction of an 85,000 square
foot facility on this site to expand its administrative offices and research and
development capacity.

ITEM 3. LEGAL PROCEEDINGS

Not applicable.

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

No matters were submitted to a vote of Inhale's shareholders in the quarter
ended December 31, 1999.

PART II

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

PRICE RANGE OF COMMON STOCK

Inhale's Common Stock trades on the Nasdaq National Market under the symbol
INHL. The table below sets forth the high and low closing sales prices for
Inhale's Common Stock (as reported on the Nasdaq National Market) during the
periods indicated.

PRICE RANGE OF
COMMON STOCK
-------------------
YEAR ENDED DECEMBER 31, 1998: HIGH LOW
- ----------------------------- -------- --------

1(st) Quarter............................................... $ 34.250 $25.250
2(nd) Quarter............................................... 34.000 23.125
3(rd) Quarter............................................... 29.875 21.750
4(th) Quarter............................................... 33.375 21.500

YEAR ENDED DECEMBER 31, 1999:
- ------------------------------------------------------------
1(st) Quarter............................................... $ 34.625 $23.875
2(nd) Quarter............................................... 29.688 23.000
3(rd) Quarter............................................... 34.875 23.625
4(th) Quarter............................................... 43.688 26.875

YEAR ENDED DECEMBER 31, 2000:
- ------------------------------------------------------------
1(st) Quarter (through March 9, 2000)....................... $126.625 $41.688

As of December 31, 1999, there were approximately 225 holders of record of
Inhale's Common Stock. Inhale has not paid any cash dividends since its
inception and does not intend to pay any cash dividends in the foreseeable
future.

27

RELATED STOCKHOLDER MATTERS

In February 2000 we issued $230,000,000 aggregate principal amount of
convertible subordinated notes, which are convertible at the option of the
holder, at any time on or prior to maturity into shares of our common stock. The
notes were sold only in the United States to certain qualified institutional
buyers under an exemption from registration provided by Rule 144A of the
Securities Act of 1933, as amended. The notes are convertible at a conversion
price of $76.71 per share, which is equal to a conversion rate of approximately
13.037 shares per $1,000 principal amount of notes, subject to adjustment.
Interest on the debentures will accrue at a rate of 5.0% per year subject to
adjustment in certain circumstances . We will pay interest on the notes on
February 8 and August 8 of each year, beginning August 8, 2000. The notes mature
on February 8, 2007. We may redeem some or all of the notes at any time before
February 8, 2003 at a redemption price of $1,000 per $1,000 principal amount of
notes, plus accrued and unpaid interest, if any, to the redemption date, if the
closing price of our common stock has exceeded 150% of the conversion price then
in effect for at least 20 trading days within a period of 30 consecutive trading
days ending on the trading day before the date of mailing of the provisional
redemption notice. We will make additional payment in cash with respect to the
notes, call for provisional redemption in an amount equal to $13.93 per $1,000
principal amount of notes, less the amount of any interest actually paid on the
notes before the call for redemption. We may redeem some or all of the notes at
any time after February 8, 2003. The notes are unsecured and subordinated to our
existing and future senior indebtedness. Merrill Lynch & Co. served as the sole
bookrunner for the offering and received approximately $7,187,500 in discounts
and commissions.

In October and November of 1999 we issued $108,450,000 aggregate principal
amount of convertible subordinated debentures, which are convertible at the
option of the holder, at any time on or prior to maturity into shares of our
common stock. The debentures were sold only in the United States to certain
qualified institutional buyers under an exemption from registration provided by
Rule 144A of the Securities Act of 1933, as amended. The debentures are
convertible at a conversion price of $32.0075 per share, which is equal to a
conversion rate of approximately 31.2427 shares per $1,000 principal amount of
notes, subject to adjustment. Interest on the debentures will accrue at a rate
of 6 3/4% per year subject to adjustment in certain circumstances . We will pay
interest on the notes on April 13 and October 13 of each year, beginning April
13, 2000. The debentures mature on October 13, 2006. We may redeem some or all
of the debentures after October 13, 2002 at the following prices (expressed in
percentage of the principal amount), together with accrued and unpaid interest
to, but excluding, the date fixed for redemption:

DURING THE TWELVE MONTHS COMMENCING REDEMPTION PRICE
- ----------------------------------- ----------------

October 13, 2002............................................ 103.375%
October 13, 2003............................................ 102.250%
October 13, 2004............................................ 101.125%
October 13, 2005............................................ 100.000%

The debentures are unsecured and subordinated to our existing and