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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

Commission File No. 0-23556

INHALE THERAPEUTIC SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

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)

        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 ý    No o

        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. o

        The approximate aggregate market value of voting stock held by non-affiliates of the Registrant, based upon the last sale price of the Company's Common Stock on March 1, 2002, as reported on the Nasdaq National Market was approximately $703,929,685. This calculation excludes approximately 958,902 shares held by directors and executive officers of the Company. Exclusion of these shares should not be construed to indicate that such person controls, is controlled by or is under common control with the Registrant. This calculation does not exclude shares held by organizations whose ownership exceeds 5% of the Registrant's outstanding Common Stock as of March 1, 2002 that have represented to the Company that they are registered investment advisers or investment companies registered under section 8 of the Investment Company Act of 1940. Determination of affiliate status for the purposes of this calculation is not necessarily a conclusive determination for any other purpose.

55,149,024
(Number of shares of common stock outstanding as of March 1, 2002)

INHALE THERAPEUTIC SYSTEMS, INC.
2001 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

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PART I

Item 1. Business

Overview

        We are working to become the world's leading drug delivery company by providing a portfolio of technologies and expertise that will enable our pharmaceutical partners to improve drug performance throughout the drug development process. Historically, drug delivery was focused on life cycle management of older products facing patent expiration, or seeking product line extensions. The advent of newer technologies, including high-throughput screening, combinatorial chemistry, genomics and proteomics, has led to an increase in the number of molecular leads. This has led pharmaceutical companies to focus earlier in development on molecular characteristics such as toxicity, solubility and immunogenicity to improve clinical safety and efficacy of drugs. It is now recognized that drug delivery spans the entire development process, with an earlier need to rescue or optimize drug candidates, and a premium on faster and more efficient drug development.

        In an effort to capitalize on what we believe is a growing market need for performance-enabling drug delivery technologies, we moved to expand our technology offerings by acquiring Shearwater Corporation and Bradford Particle Design Ltd. These acquisitions have added two additional technologies, advanced PEGylation and Solution Enhanced Dispersion by Supercritical Fluids ("SEDS™") to our portfolio. With these technologies, and our Inhance™ inhaleables technology, we are now positioned to address the development needs of molecules and improve drug characteristics to enable our partners to expand their pipelines.

        Our latest stage technology, advanced PEGylation, has been approved for use in three products. Advanced PEGylation is designed to enhance the efficacy and performance of most major drug classes, including macromolecules such as peptides and proteins, smaller sized molecular compounds, and other drugs. Our next most advanced technology, the Inhance™ inhaleable platform, enables inhalation for delivery of a range of drugs, including peptides, proteins and small molecules for treatment of systemic and respiratory diseases. Our latest-stage inhaleables product, Exubera™ inhaled insulin, is partnered with Pfizer Inc. and has completed initial Phase III trials. Our third platform, the SEDS™ technology uses a proprietary particle engineering method to develop drug formulations for multiple types of drug delivery and improvement. Overall, we currently have or are developing 19 therapeutic drugs and one compound used as a diagnostic agent incorporating our technologies that are either approved for use, in the process of being reviewed for approval by the appropriate regulatory agency, or in clinical trials. In addition, we have more than 50 projects underway in feasibility or preclinical development across the three platforms.

Opportunities for Improved Drug Delivery and Performance

        Innovations in biotechnology and the drug discovery process have led to a large increase in the number of protein therapeutics, other macromolecule and small molecule drugs over the last several years. With this increase in leads comes an increase in development issues facing drug developers. Delivery routes, dosing schedules, solubility issues, bioavailability, and stability issues are just a small number of the issues faced by drug developers. We believe there is an opportunity to apply new technologies to the development of new therapeutic compounds to increase efficacy, reduce toxicity and increase patient acceptance of drugs and address these issues.

        Currently, approximately 84 macromolecule drugs are approved for marketing in the United States and approximately 350 additional biotechnology macromolecule drugs are in human clinical trials, many for chronic and acute diseases. Sales of genetically engineered protein drugs were estimated to be at least $15.0 billion worldwide in 2000. In addition, advances in chemistry, such as combinatorial chemistry plus high-throughput screening have led to an increasing number of opportunities to develop small molecule therapeutic drugs, many of which have traditionally been difficult to formulate due to low solubility.

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        While a protein, macromolecule or other molecule's absorption into the bloodstream can be improved by optimizing the route of the drug's delivery, the effectiveness of the drug is still dependent on various factors including the amount of time it takes for an active molecule to be cleared through the bloodstream (i.e. its rate of circulation), the rate at which the protein or other molecule degrades and the ability of the body to produce an immune response.

        Unmodified proteins may be less effective if they are quickly cleared from the bloodstream or degraded by other enzymes in the body. In addition, the human body has a natural immune response to proteins that cause them to lose potency over time. Any one of these variables can cause a particular protein to be less effective or necessitate frequent dosing, thereby increasing the cost of the therapy and decreasing patient compliance. We believe there is a significant market opportunity to apply technology to the modification of therapeutic proteins and for addressing these variables and improving the overall therapeutic effect of these drugs. Likewise, other molecular compounds such as small molecules may be limited by poor solubility and rapid clearance from the body that could be improved by drug delivery.

        We believe that an application of advanced PEGylation technology to link PEG chains of higher molecular weight to active drug compounds represents a significant commercial opportunity. Such a system could enhance the efficacy of current therapeutic proteins and other molecular compounds while increasing patient acceptance of drug therapies and compliance with prescribed regimens through reduced dosing. Additionally, advanced PEGylation technology may result in the development of new therapeutic protein compounds that in unmodified forms are ineffective due to high toxicity, low solubility or significant immunogenicity.

        We also believe there is substantial opportunity for improving the efficacy and patient acceptance of protein therapeutics and macromolecule drugs by improving the method by which many of these drugs are introduced into the body. Drugs typically enter the body through one of five routes of delivery. The four natural routes are through the digestive tract (oral), the skin (transdermal), the mucosal surfaces (for example, nasal and sublingual), and the lung (inhalation). Drugs are also commonly delivered by injection (subcutaneous, intramuscular or intravenous), bypassing the natural barrier to entry provided by the skin.

        The principal route of administration of macromolecule drugs, particularly proteins, has been injections. Drug injections administered in hospitals or doctors' offices can be expensive and inconvenient to patients. Many patients find self-injectible therapies unpleasant. As a result, injected drugs for many chronic and subchronic diseases meet with varying degrees of patient acceptance and compliance with the prescribed regimens, which 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 the inconvenience to these patients and the cost of therapy.

        We believe 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 due to certain less efficient or effective alternative forms of delivery such as patches, oral delivery or nasal delivery. Such a system could improve patient acceptance of systemic macromolecule drug therapy and compliance with prescribed regimens, thereby improving therapeutic outcomes and reducing the costs of administration and treatment of disease. Additionally, pulmonary delivery may enable new therapeutic uses of certain macromolecule drugs.

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

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        We also believe a significant commercial opportunity exists for the application of technology to the engineering and formulation of drug particles to address particular development challenges. We believe that the use of our SEDS™ supercritical fluids technology to produce drug particles of uniform size, regular shape and smooth crystalline surfaces can significantly improve drug efficacy as these properties can be critical in controlling absorption and dissolution of the active drug compound into and within the bloodstream. Additionally, we believe a significant opportunity exists to apply our SEDS™ technology to the improved development of therapeutic drugs as our SEDS™ technology permits the production of multiple forms of drugs in a reproducible manner and may simplify the application of polymer chains, including PEG, to improve the solubility of drug compounds. Lastly, we believe that the use of our SEDS™ technology will benefit the manufacturing process. There has been little change in the past half-century to the traditional milling processes utilized in both conventional particle-formation and particle-size reduction. The traditional manufacturing process involves multiple stages of production in which proteins or other active drug compounds are exposed to multiple stresses such as variations in temperature. Consequently, the traditional manufacturing process provides only limited control over the particle size. In addition to the development issues SEDS™ can address, the technology can reduce the number of manufacturing steps required to produce particles.

Our Strategy

        Our goal is to become the pre-eminent provider of drug delivery solutions. While we initially focused on inhaleable macromolecules because of the need for non-invasive delivery of these drugs, our recent acquisitions of Shearwater Corporation and Bradford Particle Design have expanded our focus beyond the means of drug delivery to meet expanding drug development needs. Our growth strategy is to continue to build on our leadership position in these fields, while at the same time leveraging our strengths in inhalation, drug formulation, and powder and particle engineering technologies to enter large opportunity, non-commodity markets in these areas. Our approach is to pick technologies and markets where we can build leadership positions through developing or acquiring platform technologies with broad applications.

        Our strategy incorporates the following principal elements:

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Develop Broadly Applicable Drug Formulation Systems. We are developing our proprietary advanced PEGylation and SEDS™ technologies to improve the formulation of drug compounds so as to make them more effective through multiple delivery applications. We intend to focus our drug formulation technologies on drug compounds where we can substantially improve the performance of the active drug compound or improve the drug development or manufacturing process and to seek out additional formulation technology platforms that are consistent with this focus.



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Develop a Broadly Applicable Deep Lung Drug Delivery System. We are developing our 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. We intend 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 ourselves and our partners. In addition, we are expanding the use of our Inhance™ platform to apply to small molecules and for local lung disease applications.



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Build Competitive Advantage Through Expertise in Multiple Disciplines. In developing our PEGylation, SEDS™, and Inhance™ technology platforms, we have used and expanded our expertise in molecule engineering, chemistry, pulmonary physiology and biology, aerosol science, powder science, aerosol engineering, chemical engineering, mechanical engineering and product design, protein formulation, fine powder processing and filling. This expertise creates multiple

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barriers to entry and multiple opportunities in certain disciplines, such as drug formulation or powder science, to additional drug delivery applications.

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Partner with Pharmaceutical and Biotechnology Companies. Our strategy is to market our proposed products through collaborative partners. We are seeking to work with partners that have significant clinical development and marketing resources, and currently have collaborations with several large pharmaceutical and biotechnology companies. In a typical collaboration, our partner will provide the drug, fund clinical and formulation development and market the resulting commercial product. We will supply the drug delivery approach or drug formulation, and receive revenues from drug compound manufacturing and other manufacturing activities, as well as royalties from sales of most commercial products. In addition, for products using our Inhance™ inhaleables technology, we will receive revenues from the supply of our device for the product along with any applicable drug processing. Prior to commercialization, we receive revenues from our partners for research and development and progress payments upon achievement of certain developmental milestones. We also receive revenues from catalogue sales of certain advanced PEGylation products. More than 70% of our clinical pipeline involves molecules that are already approved by the FDA in another delivery form. In addition to the 19 therapeutic drugs and one compound used as a diagnostic agent incorporating our technologies that are in, or have completed, human trials, we have more than 70 drug projects using our various technologies that are in various stages of research, feasibility, and preclinical work, many of these in conjunction with partners. We believe this partnering strategy enables us to reduce our cash requirements while developing a large and diversified potential product portfolio.



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Utilize our Technology to Develop Proprietary Products with an Eye Toward Partnering. In addition to our partner-funded programs, we have started applying our technology independently toward initial proprietary product development efforts. We believe that there are many off-patent/near-term patent expiration compounds that would benefit from the application of our technology to improve their performance and delivery. For these programs, we may perform initial feasibility screening work, formulations development and early stage clinical trials before entering into a partner relationship for further development. It is our belief that we will be able to gain a greater share of product sales as a result of undertaking product development efforts.

Drug Delivery and Performance Technology Platforms

Advanced PEGylation Technology

        In June 2001, we completed the acquisition of Shearwater Corporation for which we paid consideration of approximately $72.5 million in cash and an aggregate of approximately 4.0 million shares and options to purchase our common stock. Through our acquisition of Shearwater Corporation we have extended our portfolio of technologies to include advanced PEGylation technology for enhancing the efficacy and performance of most major drug classes including macromolecules such as peptides and proteins and small molecules and other drugs. PEGylation is one of the leading methods for improving drug formulations through the modification of proteins and other molecular compounds accomplished through the attachment of polyethlene glycol ("PEG") to the active therapeutic molecule. The chemical attachment of PEG chains to a broad range of drug substances results in effectively increasing the drug's molecular weight. The advantages of PEGylation include improving drug solubility and stability, reducing immune responses, and in certain instances improving efficacy and/or safety of a molecule.

        PEG is a neutral, water soluble, non-toxic polymer that is one of the few synthetic polymers approved for internal use by the FDA in a variety of foods, cosmetics, personal care products and pharmaceuticals. When dissolved in water, the long chain-like PEG molecule is heavily "hydrated" (meaning water molecules are bound to it) and is put in a state of rapid motion. This rapid motion leads to the PEG molecule sweeping out a large volume and prevents the approach of other molecules. Although PEG is

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largely invisible to biological systems, due to its unique properties it can improve stability and solubility of the drug compound, reduce the natural immune response to proteins and degradation by other enzymes, and increase concentration and circulation of the active compound throughout the system. As a result, the effectiveness of the active drug compound may be increased and the dosing frequency of the drug may be decreased.

        First generation PEG chemistry has been generally restricted to the use of PEG chains with low molecular weight because of the poor solubility characteristics traditionally observed with PEG chains of higher molecular weight. The attachment of low molecular weight PEG chains to proteins has been limited by the inherently unstable linkages of PEG chains to the molecular compound. Attachment of low molecular weigh PEG chains can cause the modified compound to quickly degrade in a manner which may trigger an immune response to the active drug compound or otherwise hinder its effectiveness. The effectiveness of such PEG derivatives is also limited by the ability of the relatively small PEG to penetrate poorly accessible regions on the surface of a protein resulting in degradation of the active drug compound or undesired side effects.

Characteristics of our Advanced PEGylation Technology

        Our advanced PEGylation technologies are designed to improve the issues of first generation technology of therapeutic pharmaceutical products. The attachment of our activated PEG derivatives is designed to yield one or more of the following benefits:

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Improved solubility and stability of the active drug compound;



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Reduced immunogenicity and degradation of the drug compound;



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Slower clearance from the body; and



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Improved efficacy and/or safety.

        As a result of these benefits, less frequent dosing may be possible due to increased circulation time, more of the administered dose may be available to reach its intended target, and the efficacy of a particular dose may be improved due to increased concentration of the drug and longer dwell time at the site of action by the active drug compound.

        Our advanced PEGylation technology is also designed to optimize the efficacy of the attached therapeutic compounds and is characterized by the following features:

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Activated high-molecular weight PEGs that can be linked stably and site specifically to drugs, allowing prolonged performance of the drug in its PEGylated form;



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Stable linkage chemistry of the PEG to the drug compound to avoid problems associated with rapid degradation or clearance of the active drug compound;



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The availability of site-specific PEGylation in which the PEG is linked with the drug compound at a specific site on the compound to produce desired effects;



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Controlled release of the drug from the PEG-drug conjugated compound; and



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The availability of bi-functional PEG to facilitate targeting of the active drug compound.

        We believe these features are substantially superior to the characteristics associated with first-generation PEGylation chemistry and may significantly enhance the therapeutic value of new drugs or chemical entities already marketed by others and off-patent drugs with otherwise limited utility.

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Advanced PEGylation Applications

        We believe our advanced PEGylation technology can be of critical importance in facilitating a substantial number of emerging biopharmaceutical technologies, including the following:

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PEG-Proteins for Pharmaceutical Use. Our principal market strategy for our advanced PEGylation technology is to demonstrate and assist in developing drug compounds, particularly proteins that substantially enhance the therapeutic value of the active drug over unmodified forms. It has been demonstrated that the proteins with PEG attached remain active and have a greatly diminished or negligible immune response. As a result these PEG-proteins have substantially increased plasma lifetimes. In addition, active drugs attached to PEG result in making proteins or other compounds much larger and thus reduces their rate of clearance through the kidney, thereby allowing the active drug to remain active in the system for longer periods of time.



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PEG-Surfaces. In addition to molecular modifications, PEG can also be attached to surfaces to form protective, biocompatible coatings. A variety of applications may result, including PEG-coatings for arterial replacements, diagnostic apparatus and blood contacting devices. Similarly, capillary zone electrophoresis has emerged as an analytical technique in biochemistry, and PEG coatings on capillaries have been demonstrated to prevent absorption and provide critical control of electro-osmosis.



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PEG-Liposomes. Recent research has shown that incorporation of PEG into the outer coating of liposomes, which are particular membranes the biopharmaceutical industry is investigating as a means to provide controlled and specific delivery of drugs, can greatly increase serum lifetime, thereby potentially facilitating the use of liposomes for these purposes.



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Molecule-Molecule and Molecule-Surface Coupling. The nature of PEGs and their well-defined chemistry make them attractive for coupling or tethering molecules to molecules or molecules to surfaces. We believe this attribute could be critical to the next generation of drugs and biomaterials as developers seek to take advantage of unique properties resulting from binding particular molecules to other molecules or surfaces.



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Biological Purification. As biotechnology has continued to succeed in producing a variety of physiologically active proteins, a need has been created for improved methods for isolation of the proteins produced. We believe that PEG may provide a useful approach in this area by using its binding qualities to extract the desired protein in a method of purification that partitions in an aqueous two-phase system.



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Solubilization of Insoluble Materials. PEG is soluble in both water and many organic solvents and through PEG attachment water-insoluble materials may become water-soluble. This characteristic of PEGs may be critical to the effectiveness of pharmaceuticals as well as to include in various other products such as dyes, flavors, substrates for enzymes and cofactors.

Clinical Status Summary of our Advanced PEGylation Technology Applications

        As with our other drug delivery and drug formulation technologies, we typically develop new products using our advanced PEGylation technology through collaborations with corporate partners. We maintain a catalog of clinically proven PEG reagents for coupling to active pharmaceutical agents for use in our customers' internal drug development programs. More typically, however, our collaborative research personnel will work closely with our partners to choose the proper PEG derivative for the particular application and to optimize the PEG attachment. In a typical research collaboration, we derive revenue from milestone payments during research and development and will derive additional royalties on net sales of approved drugs or other PEG applications. We also derive revenue from manufacturing the PEG reagent.

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        We have also initiated internal development of several proprietary PEG drugs with the expectation that we will fund this activity through the early stages of clinical trials before establishing a collaborative effort to market the final product. We believe that, in certain circumstances, this process may result in higher royalty payments for marketed products than collaborations initiated at earlier stages of development.

        Our advanced PEGylation technology platform is currently being used in the manufacture and development of 15 drugs that are either currently in clinical trials or have either been approved or submitted for approval to the U.S. Food and Drug Administration. Three products using our advanced PEGylation technology, including two therapeutic drug compounds and one compound used as a diagnostic agent, have been approved for use by the FDA and two products have been submitted for approval to the FDA. In addition we have announced supply and/or collaboration agreements with an additional nine pharmaceutical companies with respect to products in various stages of research, feasibility, and development including collaborations with Regeneron Pharmaceuticals, Inc., Maxygen, Inc. and United Therapeutics Corporation.

        The following table summarizes our publicly announced partner development programs and the products currently in development using our advanced PEGylation technology, the indication(s) for the particular drug or other product, its present stage of clinical development and, with respect to our announced partner development programs, the identity of the corporate partner for such drug.

PARTNER DEVELOPMENT PROGRAMS (PEGylation)

(1)

Clinical Status means:

Approved—regulatory approval to market and sell product obtained.

NDA filed—clinical trials completed and new drug application filed with the FDA.

Phase III—large-scale clinical trials conducted to obtain regulatory approval to market and sell a drug; initiated following encouraging Phase II trial results.

Phase II—clinical trials to establish dosing and efficacy in patients.

Phase I—clinical trials typically in healthy subjects to test safety.

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Preclinical—formulation development and animal testing in preparation for human clinical trials.

(2)

This is Enzon's proprietary PEG manufactured by Shearwater. (See Patents and Proprietary Rights for Enzon agreement.)

        In general, our collaborative arrangements with respect to our advanced PEGylation technology provides funding for development, payments upon the achievement of certain milestones and royalty and manufacturing revenues upon the commencement of commercial sales.

Selected Partner Development Programs

PEG-INTRON™ Program (PEG Interferon Alpha)

        On February 1, 2000, Shearwater entered into a manufacturing agreement with Schering-Plough Corporation ("Schering-Plough") in connection with the PEG reagent used in PEG-INTRON™ (PEG-interferon alpha) for use in the treatment of the hepatitis C virus. Under the terms of this agreement, we manufacture the PEG reagent and Schering-Plough holds an exclusive worldwide license to PEG-INTRON, the first and only PEGylated interferon product approved for marketing in the United States and worldwide.

        PEG-INTRON is a recombinant interferon alpha-2b linked to a 12,000 Dalton PEG molecule and is a longer-acting form of INTRON A that uses proprietary PEG technology developed by Enzon. PEG-INTRON is approved for dosing according to patient body weight and is a once-weekly therapy designed to optimize the balance between antiviral activity and elimination of half-life.

        Chronic hepatitis C is estimated to affect some 10 million people in major world markets. The Centers for Disease Control and Prevention ("CDC") estimate that between 2.7 and 4 million Americans are chronically infected with the hepatitis C virus with 70 percent of infected patients going on to develop chronic liver disease. Hepatitis C infection contributes to the deaths of an estimated 8,000 to 10,000 Americans each year and this toll is expected to triple by the year 2010, according to the CDC.

Neulasta™ Program (PEG-G-CSF)

        On July 25, 1995, Shearwater announced that it had entered into a license, manufacturing and supply agreement with Amgen Inc. to supply its proprietary 20kDa PEG derivative, which is utilized in the manufacture of pegfilgrastim for Amgen's Neulasta™ product. Neulasta™ was approved for marketing in the United States by the FDA in late January 2002.

        Neulasta™ is indicated for decreasing the incidence of infection, as manifested by febrile neutropenia (fever associated with a severe drop in infection-fighting white blood cells) in patients with non-myeloid malignancies receiving myelosuppressive anti-cancer drugs. Neulasta™ is a protein that stimulates the production of infection-fighting white blood cells (neutrophils) that are depleted by cytotoxic chemotherapy. Amgen's first generation drug, NEUPOGEN® (Filgrastim), requires up to 2 weeks of daily injections following each cycle of chemotherapy due to the relatively short time it remains circulating in the blood. Almost half of chemotherapy patients who receive NEUPOGEN® require ten or more injections per chemotherapy cycle. With Neulasta™, a PEG unit is added to enlarge the Filgrastim molecule, thereby extending its half-life and causing it to be removed more slowly from the body. This allows for administration in a single dose per chemotherapy cycle. Self-regulation (neutrophil-mediated clearance) of Neulasta™ allows the drug to remain in the blood throughout the time during which a patient is neutropenic (when it is needed) and then be cleared rapidly when it is no longer needed (as neutrophils recover toward normal levels).

        Febrile neutropenia is a serious and common complication of many cancer chemotherapies. Up to half of cancer chemotherapy patients develop severe neutropenia, potentially placing them at risk for life-threatening infections. On average, less than 10% of these patients receive proactive protection from

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neutropenia and studies have shown that 30% to 40% of patients receiving certain types of chemotherapy who do not get a white blood cell booster will experience neutropenia with fever. Thousands of patients are hospitalized for neutropenia and its complications each year, in an age when most chemotherapy patients are treated in the outpatient setting.

PEGASYS™ Program (PEG Interferon Alpha)

        On November 9, 1998 Shearwater announced that it had entered into a license, manufacturing and supply agreement with F. Hoffmann-La Roche Ltd. ("Roche") whereby we license to Roche the PEG reagent used in Roche's PEGASYS™ product for the treatment of chronic hepatitis C. This agreement provides us with milestone payments, rights to manufacture the PEG reagent and a share of future revenues related to our PEGASYS™ product. On April 5, 1999, Shearwater entered into a subsequent agreement with Roche related to further collaborative work on PEGASYS™, a PEGylated interferon alpha-2a product.

        PEGASYS™ was filed for approval with the FDA for a hepatitis C indication on May 22, 2000. Under the terms of the collaborative arrangement with Roche, the FDA filing triggered a $1.0 million milestone payment to Shearwater by Roche. According to the CDC, chronic hepatitis C is estimated to affect some 10 million people in major world markets. Only a small percentage of the people estimated to be infected with hepatitis C now use interferon alpha because of its low success rate in treating the disease. In Phase III trials, the efficacy and safety of PEG modified interferon alpha-2a (PEGASYS) was compared with unmodified interferon alpha-2a (Roferon-A) for treatment of hepatitis-C in 531 patients. The results reported that sustained viral clearance was observed in 39% of patients receiving PEGASYS compared with 19% of patients receiving Roferon-A. In May 2001, Shearwater announced the latest clinical trial data from the first large efficacy and safety study to directly compare PEGASYS™ in combination with the antiviral drug ribavirin, against Rebetron™ (interferon alpha-2b plus rivavirin). The study results suggested that the combination of PEGASYS™ and ribavirin may yield significantly increased sustained virologic responses compared to combination therapy with Rebetron™.

        We are also developing a PEGASYS™ program to be used in the treatment of hepatitis B. A recently completed Phase II study for our PEG interferon alpha indication showed positive results at dosages of 180mg when compared to similar dosages of standard Roferon. Phase III studies in both antigen negative and positive hepatitis B have now begun with approximately 1,000 patients being treated. These trials will compare PEGASYS™ mono-therapy and PEGASYS™ combination therapy (with Lamivudine) vs. Lamivudine.

Somavert™ Program (PEG-hGHRa)

        On April 4, 2000, Shearwater entered into a license, manufacturing and supply agreement with Sensus Drug Development Corporation for the PEGylation of Sensus' Somavert™ (pegvisomant for injection), a human growth hormone receptor antagonist. The agreement provides us with milestone payments, rights to manufacture the PEG reagent and a share of future revenues. In March 2001, Sensus was acquired by Pharmacia Corp.

        Somavert™ is a genetically modified form of human growth hormone and an investigational drug designed to block the binding of growth hormone produced by the pituitary. Our patented PEG reagent is covalently bound to the molecule to increase the circulating life of the drug in the blood stream and potentially reduce the immune reaction to the drug. Pharmacia completed Phase III clinical trials for the use of Somavert™ in the treatment of acromegaly, a serious, debilitating disease that often requires lifelong therapy. Patients with acromegaly often suffer from headache, excessive sweating, soft-tissue swelling, joint disorders and a progressive coarsening of facial features and enlargement of the hands, feet and jaw. In acromegaly, excess production of growth hormone is usually caused by a pituitary tumor, affecting an estimated 40,000 patients in the U.S., Europe and Japan. Following the completion of

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Phase III clinical trials in 111 patients in the U.S. and Europe, an application to market Somavert™ in the U.S. and Europe was filed in February 2001 and is awaiting regulatory response.

SprayGel™ Program (PEG-hydrogel)

        On August 6, 1999, Shearwater entered into a license, supply and manufacturing agreement with Confluent Surgical, Inc. for Shearwater's PEG-hydrogel for use in the SprayGel™ adhesion barrier system. Under the terms of this arrangement, we manufacture and supply PEG components used in the SprayGel™ system and receive royalty payments and manufacturing supply fees from Confluent. SprayGel™ was approved for commercial distribution in Europe, receiving product certification by European regulatory authorities in November 2001.

        SprayGel™ is a bio-degradable, water-based, coating material designed to prevent post-operative adhesion formation. This material is formed from two water-based PEG solutions that mix at the site of an injury. The solutions are sprayed using an applicator that is designed for minimally invasive surgery. As internal wounds heal following surgery, a type of scar tissue or adhesion can form, connecting two organs or surfaces that are normally separate in the body. SprayGel™ is sprayed onto the internal surfaces most at risk for adhesions and creates a thin, flexible hydrogel coating that acts as an internal bandage as the wound heals.

        The sterile polymer kit manufactured and supplied to Confluent consists of two separate aqueous PEG-containing liquid precursors (clear and blue) that polymerize to form the hydrogel when mixed. The blue precursor also contains a small amount of methylene blue, a colorant added to facilitate visualization during hydrogel application. The hydrogel barrier is formulated to remain adherent to the site of application for 5-7 days during the critical window period when fibrin deposition, fibrinolysis and adhesion formation is believed to occur. It is then completely hydrolyzed, absorbed and excreted by the kidneys within 3-4 weeks.

        Adhesions can be responsible for severe pain and discomfort as well as small bowel obstructions and are the leading cause of infertility in women following gynecological surgery. Approximately 500,000 surgical procedures are performed annually to remove adhesions.

PEG-Aptamer Program

        On February 26, 2002, we announced a long-term commercial supply agreement with Eyetech Pharmaceuticals, Inc., a privately held biopharmaceutical company based in New York City. Eyetech is currently conducting a Phase II/III pivotal clinical trial to evaluate the safety and efficacy of EYE001, a PEGylated aptamer, for the treatment of age-related macular degeneration. .

        Under the agreement, we will provide Eyetech with PEGylation technology for use in the development of EYE001 and we will receive milestone payments, royalties and exclusive manufacturing of the PEGylated derivative.

        Age-related macular degeneration is a leading cause of blindness in the adult population. Studies suggest that Vascular Endothelial Growth Factor (VEGF) causes the abnormal blood vessel growth and/or leakage that lead to age-related macular degeneration. EYE001, an anti-VEGF aptamer, may inhibit the biological pathway that causes vision loss. Aptamers are chemically synthesized molecules created to either mimic or prevent specific molecules from binding to their receptors much like antibodies. If successful, Eyetech's compound may result in stabilized or improved vision and an enhanced quality of life for patients suffering from age-related macular degeneration, diabetic macular edema and other related retinal diseases.

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PEG CDP870 Program

        On February 26, 2002, we announced a collaboration with Pharmacia Corporation to provide proprietary PEGylation technology for Pharmacia's investigational new therapy for the treatment of rheumatoid arthritis, CDP870. This is a humanized antibody fragment that binds with high affinity to tumor necrosis factor-alpha, a key mediator responsible for the inflammation of rheumatoid arthritis. It is chemically modified to enable slow elimination from the body by coupling a branched PEG reagent to the antibody fragment. CDP870 has completed Phase II clinical testing.

        Shearwater entered into a license, manufacturing and supply agreement with Celltech Group plc in 2000 which was subsequently assigned to Pharmacia. Under the agreement, we receive milestone payments, royalties and PEG manufacturing revenues if the product is commercialized. Pharmacia will manage further clinical development and market the product for rheumatoid arthritis. CDP870 is also being assessed in Phase II studies as a treatment for Crohn's disease.

        Rheumatoid arthritis affects an estimated 2.1 million Americans. This systemic autoimmune disease is characterized by inflammation of the lining of the joint. Current therapies are directed at treating the symptoms of rheumatoid arthritis or at modifying the disease, or a combination of the two, requiring daily or weekly administration.

Cross Platform Strategic Alliance

        In January 2002, we announced a strategic alliance with Enzon, Inc. ("Enzon") that includes an agreement making us solely responsible for licensing Enzon's PEGylation patents, an option for Enzon to license our PEGylation patents, an agreement to explore the development of non-invasive delivery of single-chain antibody products via the pulmonary route and settlement of a patent infringement litigation originally filed by Enzon against Shearwater. We will have the option to license Enzon's PEG patents for use in our proprietary products. Enzon will receive a royalty or a share of profits on final product sales of any products that use Enzon's patented PEG technology, including branched PEG. As part of this broad alliance, we entered into a collaboration to develop three products using our Inhance™ inhaleables technology and/or SEDS™ technology. Under the terms of this collaboration, we will be responsible for the development of drug formulations for the agreed upon pharmaceutical agents as well as clinical and commercial manufacturing of the drug formulation and device combination. Enzon will be responsible for the clinical development and worldwide commercialization of such combination. We will receive research and development funding, milestone payments as the program progresses through further clinical testing, and royalty payments once the product is commercialized. As part of this alliance, Enzon made a $40.0 million equity investment in Inhale in the form of preferred convertible stock.

Inhance™ Inhaleables Technology

        Historically, we focused on the non-injectible delivery of peptides and proteins to the body through the lungs. Our inhaleables technology platform, known as Inhance™, would enable such non-invasive delivery of certain large sized molecular compounds now administered by injection. Currently there are approximately 84 of these macromolecule drugs marketed in the United States and about 350 other such drugs in clinical trials. Most of these drugs are currently delivered by frequent injection. Frequent injections are undesirable for numerous reasons including patient discomfort, inconvenience and risk of infection that can lead to non-compliance. The failure by patients to comply with current requirements for frequent injections can lead to increased incidence of medical complications and higher disease management costs. Alternatives to injection such as oral, nasal and transdermal, or "skinpatch," delivery approaches generally have been commercially unattractive for macromolecules due to the low natural amount of drug absorbed from the delivery site into the bloodstream relative to injection. As an alternative to the invasiveness of frequent injections, we believe our inhaleables technology could expand the market for macromolecule drug therapies and may enable new therapeutic uses of certain macromolecule drugs.

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Characteristics of Inhance™ Inhaleables Technology

        We believe 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 direct result 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 lost during manufacture, in the delivery device, in reaching the site of absorption, and during absorption from that site into the bloodstream. We believe 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.

        We approach 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, our deep lung drug delivery system integrates customized drug formulations and packaging with our proprietary inhalation device. We combine an understanding of lung biology, aerosol science, chemical engineering, mechanical engineering and protein formulations in our system development efforts. We believe that this interdisciplinary capability provides an important competitive advantage.

        We have chosen to base our 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 metered dose inhalers ("MDI") and, for many drugs, multiple times more than currently marketed liquid or nebulizer systems. We believe 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.

        We take bulk drugs supplied by our partners and then formulate and process them into fine powders that are packaged into individual unit doses, including blisters or capsules. The blisters or capsules are designed to be loaded into a 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 we are in the advanced stages of developing our system technologies, there can be no assurance that our products will ever be successfully commercialized.

Components of the Integrated Inhance™ Deep Lung Drug Delivery System

        The Inhance™ inhaleable platform integrates several technologies including customized formulation of drug compounds, dry powder processing and packaging along with proprietary inhalation devices to enable efficient and consistent delivery of both macromolecule and small molecule drugs for systemic and local lung diseases. For specific drug products, we formulate and process bulk drugs supplied by collaborative partners into dry powders, that are packaged into individual dosing units referred to as

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"blisters." The blisters are designed to be loaded into our device, which patients then activate to inhale the aerosolized drugs that have been formulated to a particle size that permits deep lung delivery.

        Dry Powder Formulations for Delivery to the Deep Lung.    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. We have assembled a team with expertise in protein formulation, powder science and aerosol science, and we are applying this expertise to develop proprietary techniques and methods that we believe will produce stable, fillable, shippable and dispersible dry powder drug formulations. We have developed several protein powders which remain stable at room temperature in excess of one year. Through our work with numerous macromolecules, we are developing an extensive body of knowledge on aerosol dry powder formulations, including knowledge relating to the physiochemical properties of particles that make up powders and the resulting characteristics such as flowability, dispersability and solubility within the lung, as well as the related properties and influences of various excipients. We have filed and expect to continue to file patent applications on several of our formulations and, through strategic acquisitions, have acquired rights to certain U.S. and foreign patents and patent applications relating to stabilization of macromolecule drugs in dry powder formulations.

        Powder Processing.    We are modifying standard powder processing equipment and developing custom techniques to enable us to produce fine dry powders with particle aerosol diameters of between one and five microns without significant drug degradation or significant loss. We have scaled up powder processing to levels sufficient for producing candidate powders for late stage clinical trials. It is expected that production at these levels will be more than sufficient to satisfy the needs of small volume commercial products. We are also in the process of further scaling up our powder processing systems in order to produce quantities sufficient for commercial production of products we believe we will need to supply in high volumes, such as insulin. However, there can be no assurance that we will be successful in further scaling up our 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 intended for inhalation typically require handling that is technically more challenging than for powders comprised of larger particles. Common practice in the pharmaceutical industry is to increase the powder's effective particle size by various agglomerative techniques such as pelletization, spheronization, or blending with an excipient of significantly larger particle size, in order to yield materials that handle more favorably in existing processing equipment such as tablet presses and capsule fillers. Thus, currently available commercial filling and packaging systems are generally designed for filling powders of larger particle size and mass, and are most commonly applied to oral dosage forms. Although applications of these capsule-filling approaches to aerosol products do exist, they typically can only deliver accurate and precise fills for much higher dose masses than required for deep lung delivery. Further still, by their method of operation they may overcompress or even damage the morphology of fine, low density powders, and may make them much more difficult to disperse than when in their uncompressed state. We have developed and internally qualified a proprietary automated filling system suitable for use in production of clinical trial supplies and, for certain products, commercial quantities. The system has been tested across a wide variety of powders encountered to date and its performance yields highly accurate and precise fills across a wide range of dose masses, down to the order of a single milligram. Subsequent aerosol performance observed with both active and passive devices is essentially equivalent to the powder's performance when filled by hand, where it is essentially uncompressed. This equipment is currently undergoing validation. The underlying technology is intended to allow its application to a broad variety of powder types, characteristics, and a wide range of target fill masses, but there can be no guarantee that our technology will work for any or all of the intended uses.

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        Inhalation Device.    Our 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 our objectives, we have designed our 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. We have developed and are refining the dispersion system for our device specifically for fine powders. Our 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. We are developing a proprietary aerosol cloud handling system in our 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. Our device does not use propellants. The oily surfactants required to stabilize propellant formulations used in many MDI formulations can cause aggregation of macromolecules. In addition, current chlorofluorocarbon propellants are being phased out in many countries due to environmental concerns.

        Leveraging our experience in aerosol physics, particle engineering, powder science formulation, device technology, and understanding of patient behavior, biological parameters, and product design, we are currently developing a device platform called Solo™ which we believe will lead to a pocket size inhaler. While preliminary results have been encouraging, there can no assurance that the system will work as intended, or that it will be manufacturable in the large volumes and at the cost levels required. In addition, review of any drug device system by regulatory authorities introduces many uncertainties, and there can be no guarantee of an approval for use.

Clinical Status Summary of our Inhance™ Inhaleables Technology

        The following table sets forth, for our partner development programs, the drugs currently in development using our Inhance™ inhaleables technology, the indication(s) for the particular drug, its present stage of clinical development and the identity of the corporate partner for such drug. We also have early stage feasibility and research collaborations involving our inhaleables technology with several other companies and have tested approximately 12 inhaleable drugs in clinical trials. We have also developed internal programs with respect to certain drugs or undertaken subsequent development with respect to certain drugs formerly the subject of particular collaborations. We are also developing next generation inhaleable powders and inhalation devices to further facilitate the delivery of small molecules and macromolecules both to, and through, the lung.

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PARTNER DEVELOPMENT PROGRAMS (Inhaleables)

(1)

Clinical Status means:

Phase III—large-scale clinical trials conducted to obtain regulatory approval to market and sell a drug; initiated following encouraging Phase II trial results.

Phase II—clinical trials to establish dosing and efficacy in patients.

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

(2)

Clinical activities on hold; on-going stability work.

        In general, our partnership arrangements with respect to our Inhance™ inhaleables technology 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.

Partner Development Programs

Insulin Program

        Insulin is a protein hormone naturally secreted by the pancreas to induce the removal of glucose from the blood into cells. Diabetes, the inability of the body to regulate properly blood glucose levels, is caused by insufficient production of insulin by the pancreas or resistance to the insulin produced. Over time, high blood glucose levels can lead to failure of the microvascular system, which may lead to blindness, loss of circulation, kidney failure, heart disease or stroke. Insulin, in its injectible form, is supplied by various manufacturers, including Lilly, Novo-Nordisk A/S and Aventis Pharma.

        According to the United States Centers for Disease Control and Prevention, approximately 16 million people in the United States have diabetes, 10.3 million of which are diagnosed with diabetes and another 5.4 million of which have undiagnosed diabetes. There are approximately 798,000 new cases of diabetes diagnosed each year. All Type 1 diabetics, estimated at between 5% and 15% of all diabetics, require insulin therapy. Type 1 diabetics require both basal insulin in the form 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 disease, may or may not require insulin therapy. 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.

        Insulin therapy in Type 2 patients is generally given twice daily and is a combination of a short and long acting insulin. A ten-year study by the National Institutes of Health, however, demonstrated that the side effects of diabetes could be significantly reduced by dosing more frequently. The NIH study

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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. Similar results were demonstrated in Type 2 patients in a UK trial.

        Pursuant to a collaborative agreement originally entered into in January 1995, Pfizer and we are developing an inhaled version of regular insulin that can be administered in one to three blisters per dose using our deep lung delivery system. We believe that our 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, we believe that because inhaleable insulin has a more rapid onset of action than injectible insulin, it offers simpler pre-meal dosing than the slower acting regular insulin.

        Phase I and Phase IIa clinical trials indicated that pulmonary insulin was absorbed systemically, reduced blood glucose levels and provided the same control of diabetes 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 Alc, or "HbAlc," 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 II data from a study of diabetics whose blood glucose was poorly controlled by oral agents alone. In that study, patients who were given inhaleable insulin in addition to their oral medications showed marked improvement in their blood glucose control.

        In November 1998, Pfizer and Aventis Pharma announced that they entered into a worldwide agreement to manufacture insulin and to co-develop and co-promote inhaleable insulin. Under the terms of the agreement, Pfizer and Aventis Pharma agreed to construct a jointly owned, state-of-the-art insulin manufacturing plant in Frankfurt, Germany. Pfizer and Aventis Pharma have reported plans to invest over $160 million in this new plant which is projected to be the largest of its kind worldwide and would employ approximately 200 people. We will continue to have responsibility for manufacturing powders and supplying delivery devices and will receive a royalty on inhaleable insulin products marketed jointly by Pfizer and Aventis Pharma.

        In June 1999, Pfizer began dosing in Phase III clinical trials. In June 2000, Pfizer reported new data on patients using inhaleable insulin therapy from a Phase II continuation, or extension, study being conducted by Pfizer and Aventis Pharma. The goal of the extension study was to determine if safety and efficacy results from previously reported short-term Phase II clinical trials could be maintained in the long term. These data showed that HbAlc, the long-term measurement of blood glucose control, remained stable in patients for up to 30 months of therapy. At the time that this data was compiled, 83 patients had completed 24 months of inhaleable therapy. Further data presented indicated similar results for patients who completed 30 months of therapy. Additionally, the results of four different lung function tests showed that lung function was sustained during the course of treatment.

        In June 2001, Pfizer reported on data released from Phase III studies showing that more patients with Type 2 diabetes who were treated with inhaled insulin achieved the recommended blood glucose levels than patients who received only insulin injections. In addition the frequency and nature of adverse events were comparable between groups. Patients who used inhaled insulin developed increased insulin antibody serum binding, but there did not appear to be any related clinical significance. Additional data released from these Phase III studies suggested that patients with Type 1 diabetes using inhale insulin multiple times a day with one bedtime long acting injection achieved comparable control of blood glucose to that seen in patients receiving multiple daily injections. An additional Phase III study indicated that Type 2

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diabetic patients who were poorly controlled on a combination of two oral diabetes therapies demonstrated improved glycemic control and greater overall satisfaction and acceptance of therapy when inhaled insulin was added to their treatment regimen or when it replaced oral therapies.

        In December 2001, Pfizer announced that it had decided to include an increased level of controlled, long-term safety data in its proposed NDA with respect to inhaled insulin and that it expected to complete this additional study in 2002.

        In January 1995 and October 1996, Pfizer made two $5.0 million equity investments in our company.

Alpha-1 Proteinase Inhibitor Program

        In January 1997, we 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 we will receive royalties on product sales, an up-front signing fee and research and development funding and milestone payments. Inhaled alpha-1 has received orphan drug status in the U.S. and Europe.

        We and Aventis Behring have completed preclinical work and Phase I clinical trials that indicate our dry powder formulation of Aventis Behring's alpha-1 proteinase inhibitor has the potential to improve significantly the efficiency of delivery compared with current infusion therapy. We believe our 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 where it acts. 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. Although originally planning to initiate pivotal clinical trials in the first half of 2002, Aventis Behring has not decided yet when they plan to conduct more advanced clinical trials based on their need to re-examine the type of endpoint measurement to be used.

Tobramycin Program

        In December 2001, we entered into a collaboration with Chiron Corporation to develop a next-generation inhaleable formulation of tobramycin for the treatment of Pseudomonas aeruginosa in cystic fibrosis patients and to explore the development of other inhaled antibiotics using our Inhance™ inhaleables technology. Cystic fibrosis is a hereditary disease that primarily affects people of Caucasian origin. About 30,000 people in the United States and about 70,000 people worldwide have cystic fibrosis. Cystic fibrosis is caused by genetic mutation that prevents cells from building a protein required for normal movement of sodium and chloride in and out of cells lining the lungs and other organs. Patients with cystic fibrosis typically suffer from chronic respiratory infections, digestive disorders, reduced male fertility and other problems. Chiron's existing tobramycin product, TOBI®, was introduced in 1998 as the first inhaled antibiotic approved for treating Pseudomonas aeruginosa lung infections in cystic fibrosis patients.

        Under the terms of the tobramycin collaboration, we will be responsible for the development of the next generation formulation of tobramycin as well as clinical and commercial manufacturing of the drug formulation and device combination. Chiron will be responsible for the clinical development and worldwide commercialization of the system. We will receive research and development funding, milestone payments as the program progresses through further clinical testing, and royalty payments once the product is commercialized. It is expected that the additional drug formulations to be investigated will also relate to antibiotic products for the treatment of lung infections.

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Fortéo™ Program

        In January 1997, we entered into a collaborative agreement with Eli Lilly and Company ("Lilly") to develop an inhaleable formulation of Fortéo™, a version of parathyroid hormone, PTH 1-34, used in the treatment of osteoporosis. Under the terms of the agreement we were to receive up to an estimated $20.0 million in research, development and milestone payments. Lilly was to receive global commercialization rights for the pulmonary delivery of the products and we were to receive royalties on any marketed products.

        In late 1998, unexpected observations from a long-term test in rats of the injectible version of this osteoporosis drug led Lilly to suspend further clinical development of the injectible and pulmonary versions of Fortéo™ pending further analysis. In September 2000, we announced the reinitiation of the Fortéo™ development program with Lilly. In October 2001, Lilly informed us that inhaled Fortéo™ would not be funded in 2002 and that other than on-going stability work, other activities were to be suspended. It was our understanding that this suspension is a result of Lilly's decision on funding priorities for the next year, not due to any technical issues.

Collaborations for other drug compounds

        In October 2001, we entered into a collaboration with the R.W. Johnson Pharmaceutical Research Institute and the Janssen Research Foundation, subsidiaries of Johnson & Johnson, for the development of multiple small molecule compounds using our inhaleables technology. Under the terms of the collaboration, we will be responsible for developing the formulations of inhaleable small molecule compounds up to proof-of-concept, and our partners will be responsible for the evaluation and clinical development of selected formulations. We will receive research and development funding, milestone payments based on progress in clinical trials and royalty payments if products are commercialized.

Marinol® Program

        In February 2002, we entered into a collaboration with Unimed Pharmaceuticals, Inc., a wholly owned subsidiary of Solvay Pharmaceuticals, Inc., ("Unimed") to develop an MDI of dronabinol (synthetic delta-9-tetrahydrocannabinol) to be used for multiple indications. Dronabinol is the active ingredient in Unimed's product MARINOL® Capsules. MARINOL® Capsules is synthetic delta-9-tetrahydrocannabinol. MARINOL® is approved in the U.S. and is indicated for the treatment of anorexia associated with weight loss in patients with AIDS and for the treatment of refractory nausea and vomiting associated with cancer chemotherapy.

        Under the terms of the collaboration, we will be responsible for development of the formulation, as well as clinical and commercial manufacturing of the drug formulation and inhaler combination. Unimed will be responsible for the clinical development and worldwide commercialization of the system. We will receive research and development funding, milestone payments as the program progresses through further clinical testing, and royalty payments and manufacturing revenues when the product is commercialized.

Avonex® Program

        In February 1999, we entered into a collaborative agreement with Biogen to develop an inhaleable formulation of Biogen's proprietary Interferon-Beta-la, marketed as Avonex®, for the treatment of multiple sclerosis. Under the terms of the collaboration agreement, Biogen was to provide us with bulk Avonex® for formulation into a dry powder for inhalation into the deep lung. We were to manufacture and package the dry powder and supply inhalation devices. Biogen was responsible for clinical development, commercialization and worldwide marketing of inhaleable Avonex®. In return for developing inhaleable Avonex®, we were to receive royalties on product sales, milestone payments and research and development funding.

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        Dosing for the Phase IA clinical trial of inhaleable Avonex® began in April 2000 and is now complete. In January 2002, Biogen announced that it does not plan to further develop inhaleable Avonex® for multiple sclerosis at this time, but is working with us to evaluate other opportunities for collaboration.

Feasibility Studies

        In addition to the active partners mentioned above and other development programs, we have conducted and continue to conduct feasibility studies of additional drug formulations both on our own account and in cooperation with potential partners. We will continue to pursue these and other feasibility programs to determine the potential for collaborative development programs with respect to these drugs.

Supplemental Agreement with Alliance Pharmaceutical Corp.

        In March 2002, we announced the expansion of our agreement with Alliance Pharmaceutical Corp. ("Alliance") regarding the PulmoSphere® particle and particle processing technology, aspects of which we initially acquired from Alliance in November, 1999. The PulmoSphere® technology is a particle formation method designed to enhance the performance of drugs delivered via the lung in propellant-based metered-dose inhalers and dry powder inhalers. As a result of the supplemental agreement, Inhale has paid to Alliance $5.25 million in exchange for rights beyond inhaleable applications and other considerations. Under the terms of the supplemental agreement, Inhale has the right to use the PulmoSphere® technology for alternative methods of delivery in addition to inhaleable applications. Further, Alliance assigned five new patent applications covering methods of producing microparticles to Inhale. Alliance retains the rights to use the technology on products to be instilled directly into the lung, and obtains the rights to commercialize up to four products administered with inhalers, two of which will be royalty-free. Inhale will pay Alliance future milestone or royalty payments on a reduced number of products developed by Inhale or its licensees utilizing the technology.

SEDS™ Technology

        In January 2001, we completed our acquisition of all the outstanding share capital of Bradford Particle Design for which we paid consideration of approximately $20.4 million in cash and an aggregate of approximately 3.75 million shares and options to purchase our common stock. Through this acquisition, we acquired additional technology and collaborations relating to the development of drug compounds using a technology known as Solution Enhanced Dispersion by Supercritical Fluids ("SEDS™"). This technique uses gases at elevated temperatures and pressures as alternative solvents and non-solvents in the formation of dry powder particles used in the manufacture of pharmaceuticals. Our SEDS™ technology is designed to reduce to a single step the current multi-stage powder manufacturing process for drug powders, while at the same time improving product purity and consistency. It offers an alternative to typical crystallization processes for many small molecules with the potential benefits of better control over particle size, form, structure and surface characteristics resulting in the potential for improved drug absorption, easier and more efficient formulation of drug compounds and lower manufacturing costs. We believe this technology can also be used in connection with technology designed for taste masking and controlled release of drug compounds.

        Over 80% of pharmaceutical products contain powder particles, either in the final form or at some point during the manufacturing process. Specific particle characteristics are fundamental to the effectiveness of drug delivery but precision and consistency in particle formation are difficult to achieve using conventional multi-stage methods of production. SEDS™ is designed to control the formation of powder particles in a wide variety of chemical substances. A supercritical fluid is any material held above a critical pressure and temperature. Supercritical fluids have attractive chemical properties for processing and preparing drug substances. Carbon dioxide is the widest commercially used supercritical fluid.

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        In the SEDS™ process, the supercritical fluid disperses and mixes a stream of drug solution while simultaneously extracting the organic solvent and rapidly forming dry particles. This is achieved by metering the solution and the supercritical fluid into a particle formation vessel held under controlled conditions of temperature and pressure above the critical point of the supercritical fluid-solvent mixture. Dry, solvent free particles are then recovered from the particle formation vessel.

        As a single-stage manufacturing process, SEDS™ provides greater control over batch to batch consistency, particle size, particle shape, powder flow, dissolution rate and residual solvent levels than traditional manufacturing methods. As a result, we believe that SEDS™ can deliver the following benefits:

•

Cost efficiency through greater consistency of product from batch to batch and simplicity in initial development of desired particle characteristics;



•

Lower risk of product recalls by ensuring stability, purity and consistent concentration of active ingredients; and



•

Reduced complexity and increased speed in drug development due to the reduced number of process standards and controls involved in single-stage manufacturing.

SEDS™ Applications

        We believe our SEDS™ technology can serve as a platform technology for a diverse range of therapeutic areas, including the following:

•

Polymorph Separation. The SEDS™ process offers the ability to prepare separate polymorphic forms of drugs in a manner that is easily reproducible.



•

Water Solubility. The SEDS™ process helps to provide enhanced dissolution of sparingly water-soluble drugs, by producing sub-micron sized particles or through coformulation with water soluble polymers.



•

Controlled Release. The SEDS™ process can support the application of a wide range of polymers and other materials to modify drug dissolution and release profiles.



•

Improved Powders for Inhaleable Drugs. We believe that particles designed with appropriate size and low cohesion deliver more drug to the deep lung from a range of dry powder inhalation devices. By allowing greater control over the formation of particles during manufacture, SEDS™ technology can assist in the development of dry powders with these preferred characteristics.



•

Taste Masking. We believe that the SEDS™ process can be used to minimize the taste of many oral drugs, particularly small organic molecules.



•

Biologicals. The typical method for particle formation of peptides, proteins, nucleic acids and other biologicals involves freeze-drying and spray-drying, which may lead to significant batch variation and problems in downstream processing and manufacture. We believe that SEDS™ offers a potentially valuable alternative to this method of particle formation for biologicals.

Clinical Status Summary of our SEDS™ Technology Applications

        We typically develop new products using our SEDS™ technology through collaborations with corporate partners. As with our other technologies, our collaborative research personnel will work closely with our partners in designing the preferred characteristics of the particle to be formulated and in applying the technology to achieve these characteristics consistently. In a typical research collaboration, we derive revenue from milestone payments and additional royalties on net sales of approved drugs. We will also derive revenue from the manufacturing of the drug powders.

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        We have 18 feasibility or collaboration agreements with biotechnology and pharmaceutical companies to apply our SEDS™ technology to approximately 25 drugs. Most of our collaborations with respect to our SEDS™ technology are in the preclinical feasibility stage with one product having been tested in humans.

        Almost all of our collaborations with corporate partners are at the feasibility stage and involve mostly new chemical entities. We are currently confidentially collaborating with eight pharmaceutical companies worldwide with respect to our SEDS™ technology. At this time, we have publicly announced partner development programs for the development of new products using our SEDS™ technology with the following corporate partners:

        AstraZeneca UK Limited has been carrying out feasibility studies on specific compounds using SEDS™ technology. AstraZeneca is continuing to evaluate our supercritical fluid technology and holds a license in certain of our patents.

        Bristol-Myers Squibb Company is funding a program of feasibility studies to evaluate the utility of supercritical fluid technology for a number of applications for its proprietary molecules. In 2000, Bradford Particle Design entered into a license agreement with Bristol-Myers Squibb to carry out further in-house research on our SEDS™ technology.

        GlaxoSmithKline plc is collaborating with Bradford Particle Design on supercritical fluid processes for particle formation. GlaxoSmithKline holds a license in this technology and continues to evaluate its potential.

Manufacturing

        We believe our manufacturing strategy will enable us to achieve the following:

•

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



•

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



•

allow our customers to bring products to market faster.

        With respect to products using our Inhance™ inhaleables technology we generally plan to formulate, manufacture and package the powders for our deep lung delivery products and to subcontract the manufacture of our proprietary pulmonary delivery devices. Our device is still in clinical testing and production scale-up work is underway. Further design and development work is underway to enable commercial manufacturing and additional work may be required to optimize the device for regulatory approval, field reliability or other issues that may