DURECT CORP - 10-K Annual Report

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period than 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 aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $167,900,871 as of March 15, 2002 based upon the closing sale price on the Nasdaq National Market reported for such date. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

We are pioneering the treatment of chronic diseases and conditions by developing and commercializing pharmaceutical systems to deliver the right drug to the right place in the right amount at the right time. Our pharmaceutical systems combine engineering innovations and delivery technology from the drug delivery and medical device industries with our proprietary pharmaceutical and biotechnology drug formulations. By integrating these technologies, we are able to control the rate and duration of drug administration as well as target the delivery of the drug to its intended site of action, allowing our pharmaceutical systems to meet the special challenges associated with treating chronic diseases or conditions. Our pharmaceutical systems can enable new drug therapies or optimize existing therapies based on a broad range of compounds, including small molecule pharmaceuticals as well as biotechnology molecules such as proteins, peptides and genes.

Our pharmaceutical systems are suitable for providing long-term drug therapy because they store highly concentrated, stabilized drugs in a small volume and can protect the drug from degradation by the body. This, in combination with our ability to continuously deliver precise and accurate doses of a drug, allows us to extend the therapeutic value of a wide variety of drugs, including those which would otherwise be ineffective, too unstable, too potent or cause adverse side effects. Delivering the drug directly to the intended site of action can also improve efficacy while minimizing unwanted side effects elsewhere in the body, which often limit the long-term use of many drugs. Our pharmaceutical systems can thus provide better therapy for chronic diseases or conditions by replacing multiple injection therapy or oral dosing, improving drug efficacy, reducing side effects and ensuring dosing compliance. Our pharmaceutical systems can improve patients’ quality of life by eliminating more repetitive treatments, reducing dependence on caregivers and allowing patients to lead more independent lives.

Our lead product, the CHRONOGESIC^™ (sufentanil) Pain Therapy System, intended for treatment of chronic pain, combines the DUROS^® technology with a proprietary formulation of sufentanil, a potent opioid currently used in hospitals as an analgesic. We completed an initial Phase I trial in November 1999. We commenced a Phase II clinical trial in December 2000. We completed the Phase II clinical trial, a pilot Phase III clinical trial and a pharmacokinetic trial in 2001, and we anticipate that we will commence pivotal Phase III trials in mid-2002. This product is aimed at the approximately $2 billion opioid market for the treatment of chronic pain and will compete with oral opioids, analgesic patches and external and implantable infusion pumps.

We are also currently researching and developing pharmaceutical systems in a variety of therapeutic areas, including chronic pain, local post-operative pain, central nervous system disorders, cardiovascular disease and cancer based on our proprietary SABER^™, DURIN^™ and MICRODUR^™ drug delivery platform technologies owned by our wholly owned subsidiary Southern BioSystems, Inc. (SBS), as well as based on the DUROS technology, a proven and patented drug delivery platform we licensed for specified fields of use from ALZA Corporation (ALZA), a subsidiary of Johnson and Johnson. Our SABER Delivery System is a patented controlled-release technology that can be formulated for systemic or local administration of active agents such as proteins and small molecules via the oral or parenteral (i.e., non-oral) route. The potential advantages of the SABER system over other available injectable controlled release technologies include less burst upon injection, higher drug loading and greater ease of administration and manufacturing. Our DURIN technology consists of a

NOTE: CHRONOGESIC^™, IntraEAR^® and ALZET^® are trademarks of DURECT Corporation. SABER^™, DURIN^™ and MICRODUR^™ are trademarks of Southern BioSystems, Inc., a wholly owned subsidiary of DURECT Corporation. DUROS^® is a trademark of ALZA Corporation. Other trademarks referred to belong to their respective owners.

biodegradeable implant that enables parenteral (i.e., non-oral) delivery of drugs from several weeks to six months or more. Our MICRODUR technology consists of a biodegradable microparticulate controlled release injectable which can provide sustained release of drug from a few days to many months. The DUROS technology is a miniature drug dispensing pump that releases minute quantities of concentrated drug formulations in a continuous, consistent flow over months or years using an osmotic engine. The miniature pump, made out of titanium, can be as small as a wooden matchstick and can be implanted under the skin. We intend to continue to develop and acquire additional pharmaceutical systems technologies consistent with our objective of delivering the right drug to the right place in the right amount at the right time.

Although the pharmaceutical, biotechnology and medical device industries have played key roles in increasing life expectancy and improving health, many chronic, debilitating diseases continue to be inadequately addressed with current drugs or medical devices. Cardiovascular disease, cancer, neurodegenerative diseases, diabetes, arthritis, epilepsy and other chronic diseases claim the lives of millions of Americans each year. These illnesses are prolonged, are rarely cured completely, and pose a significant societal burden in mortality, morbidity and cost. The Center for Disease Control estimates that the major chronic diseases are responsible for approximately 70% of all deaths in the U.S., and medical care costs for these conditions totaled more than $400 billion annually. Currently, more than 60% of total health care spending in the U.S. is devoted to the treatment of chronic diseases. Demographic trends suggest that, as the U.S. population ages, the cost of treating chronic disease as a proportion of total health care spending will increase.

Drugs are available to treat many chronic diseases, but harmful side effects can limit prolonged treatment. In addition, patients with chronic diseases commonly take multiple medications, often several times a day, for the remainder of their lives. If patients fail to take drugs as prescribed, they often do not receive the intended benefits or may experience side effects, which are harmful or decrease quality of life. These problems become more common as the number of drugs being taken increases, the regimen of dosing becomes more complicated, the patient ages or becomes cognitively impaired. It is estimated that only half of prescribed medicines are taken correctly.

The Pharmaceutical Industry. The pharmaceutical industry has traditionally focused on the chemical structure of small molecules to create drugs that can treat diseases and medical conditions. The ability to use these molecules as drugs is based on their potency, safety and efficacy. Therapeutic outcome and ultimately the suitability of a molecule as a drug depends to a large extent on how it gets into the body, distributes throughout the body, reacts with its intended site of action and is eliminated from the body. However, small molecules act at locations throughout the body and are often accompanied by unwanted side effects.

Most drugs require a minimum level in blood and tissues to have significant therapeutic effects. Above a maximum level, however, the drug becomes toxic or has some unwanted side effects. These two levels define the therapeutic range of the drug. With conventional oral dosing and injections, typically a large quantity of drug is administered to the patient at one time, which results in high blood levels of drug immediately after dosing. Because of these high levels, the patient can be over-medicated during the period immediately following dosing, resulting in wasted drug and possible side effects. Due to distribution processes and drug clearance, the blood level of drug falls as time elapses from the last dose. For some duration, the patient is within the desired therapeutic range of blood levels. Eventually, the blood level of drug falls sufficiently such that the patient becomes under-medicated and experiences little or no drug effect until the next dose is administered.

When drugs are administered orally, transdermally or by injection, they are absorbed into the systemic circulation and distributed throughout the body. Because the drug is dispersed throughout the body, relatively large quantities are necessary to create the desired effect at the intended site of action. In addition, systemic

The Biotechnology Industry. Over the past twenty years, the biotechnology revolution and the expanding field of genomics have led to the discovery of huge numbers of proteins and genes. Tremendous resources have been committed in the hope of developing drug therapies that would better mimic the body’s own processes and allow for greater therapeutic specificity than is possible with small molecule drugs. Unfortunately, this huge effort has led to only a limited number of therapeutic products. The proteins and genes identified by the biotechnology industry are large, complex, intricate molecules, and many are unsuitable as drugs. If these molecules are given orally, they are often digested before they can have an effect; if given by injection, they may be destroyed by the body’s natural processes before they can reach their intended sites of action. The body’s natural elimination processes require frequent, high dose injections that may result in unwanted side effects. As a result, the development of biotechnology molecules for the treatment of human diseases has been limited.

The Drug Delivery Industry. In the last thirty years, a multibillion dollar drug delivery industry has developed on the basis that medicine can be improved by delivering drugs to patients in a precise, controlled fashion. Several commercially successful oral controlled release products, transdermal controlled release patches, and injectable controlled release formulations have been developed. These products demonstrate that the delivery system can be as important to the ultimate therapeutic value of a pharmaceutical product as the drug itself. However, to date, most drug delivery products deliver drug systemically and do not target delivery to the intended site of action. In addition, drug delivery products are generally limited in duration and therefore may be less desirable for treating chronic diseases.

The Medical Device Industry. Advances in the field of medical device technology have dramatically improved device miniaturization and sophistication and allowed minimally invasive surgical access to remote locations within the body. For example, a coronary bypass patient can be treated with a stent in a procedure with a relatively short recovery, rather than with major surgery. Most devices, however, apply only mechanical solutions, rather than addressing chemical or biological mechanisms of disease.

We are pioneering the treatment of chronic diseases and conditions by developing and commercializing pharmaceutical systems that will deliver the right drug to the right place in the right amount at the right time. By integrating chemistry and engineering advancements, we can achieve what drugs or devices alone cannot. Our pharmaceutical systems enable optimized therapy for a given disease or patient population by controlling the rate and duration of drug administration as well as targeting the delivery of the drug to its intended site of action.

DURECT’s pharmaceutical systems combine technology innovations from the drug delivery and medical device industries with proprietary pharmaceutical and biotechnology drug formulations. These capabilities can enable new drug therapies or optimize existing therapies based on a broad range of compounds, including small molecule pharmaceuticals as well as biotechnology molecules such as proteins, peptides and genes. We currently have four major technology platforms:

The technological foundation of our initial products is the DUROS implant technology, coupled with proprietary catheter and drug formulation technology. The DUROS system is a miniature drug-dispensing pump made out of titanium which can be as small as a wooden matchstick. We have licensed the DUROS technology for specified fields of use from ALZA. The potential of the DUROS technology as a platform for providing drug therapy was demonstrated by the Food and Drug Administration’s approval in March 2000 of ALZA’s VIADUR product (leuprolide acetate implant), a once-yearly implant for the palliative treatment of prostate cancer, the first approved product to incorporate the DUROS implant technology. By leveraging this proven technology, we believe we can reduce our development risk and more rapidly introduce new products to the market.

The DUROS pump operates like a miniature syringe. Through osmosis, water from the body is slowly drawn through a semi-permeable membrane into the pump by salt residing in the engine compartment. This water fills the engine compartment and slowly and continuously pushes a piston to dispense minute amounts of drug formulation from the drug reservoir. The osmotic engine does not require batteries, switches or other electromechanical parts in order to operate. The amount of drug delivered by the system is regulated by the semi-permeable membrane’s control of the rate of body water entering the engine compartment and the concentration of the drug formulation.

The DUROS system has performance characteristics that cannot be matched by drug delivery pumps on the market today. First, the engine can generate sufficient pressure to deliver highly concentrated and viscous formulations. Second, the system can be engineered to deliver a drug formulation at the desired dosing rate with a high degree of precision, to less than 1/100th of a drop per day on a continuous basis. The titanium shell of the DUROS system protects the drug formulation from degradation by enzymes and clearance processes within the body. As a result, the DUROS system can store drugs for up to one year as they are being released into the body.

The DUROS system can be used for therapies requiring systemic or site-specific administration of drug. To deliver drugs systemically, the DUROS system is placed just under the skin, for example in the upper arm, in an outpatient procedure that is completed in just a few minutes using local anesthetic. Removal or replacement of the product is also a simple and quick procedure completed in the doctor’s office.

To deliver drug to a specific site, we are developing proprietary miniaturized catheter technology that can be attached to the DUROS system to direct the flow of drug directly to the target organ, tissue or synthetic medical structure, such as a graft. Site specific delivery enables a therapeutic concentration of a drug to be present at the desired target without exposing the entire body of the patient to a similar dose. The precision, size and performance characteristics of the DUROS system will allow for continuous site-specific delivery to a variety of precise locations within the body.

By concentrating drug in proprietary formulations, we can store enough drug in our pharmaceutical systems to dose a patient for extended periods of time, for up to one year. Our proprietary formulations of traditional small molecule drugs are much more concentrated than those currently available on the market. Concentrated formulations allow our pharmaceutical systems to be significantly smaller than alternative drug delivery systems available today. We also believe that we can keep these formulations chemically and physically stable for extended periods of time at body temperature. Our formulation expertise, combined with the protection provided by the reservoir of the DUROS system, may allow for the stable storage and delivery of proteins, peptides, and other large molecule agents in a long-term continuous fashion, thus enabling the full therapeutic potential of a wide range of biotechnology compounds.

The SABER system is a patented controlled-release technology that can be formulated for systemic or local administration of active agents via the parenteral (i.e., non-oral) or oral route. Through our subsidiary SBS, we are researching and developing a variety of controlled-release products based on the SABER technology. These include injectable controlled release products for systemic and local delivery and oral products.

We believe that our SABER system can provide the basis for the development of a state-of-the-art biodegradable, controlled-release injectable. The SABER system uses a high-viscosity base component, such as sucrose acetate isobutyrate (SAIB), to provide controlled release of active ingredients. When the high viscosity SAIB is formulated with drug, a biocompatible solvent and other additives, the resulting formulation is liquid enough to inject easily with standard syringes and needles. After injection of a SABER formulation, the solvent diffuses away, leaving a viscous deposit. We believe the SABER system can successfully deliver therapeutic levels of a wide spectrum of drugs from 1 day to 3 months from a single injection. Based on research and development work to date, our SABER technology has shown the following advantages:

SBS, we entered into an agreement with Cardinal Health Pharmaceutical Technologies and Services Center, Inc. to explore the feasibility of producing long acting soft gelatin based (i.e., gel-cap) oral products, using the SABER technology as core formulations. Cardinal Health is the major manufacturer of oral soft gelatin pharmaceutical products in the world through its subsidiary RP Scherer.

Our DURIN technology is a proprietary biodegradable implant that enables parenteral (i.e., non-oral) delivery of drugs from several weeks to six months or more. The DURIN technology can deliver a wide variety of drugs including small and large molecule compounds. Our proprietary implant design allows for a variety of possible delivery profiles including constant rate delivery. Because DURIN implants are biodegradable, at the end of its delivery life, what remains of the DURIN implant is absorbed by the body. Through SBS, DURECT is researching and developing products based on the DURIN technology for a variety of chronic disease applications.

Our MICRODUR technology is a patented biodegradable microparticulate depot injectable. Within our subsidiary, SBS, we have experience in microencapsulation of a broad spectrum of drugs using polymers and co-polymers of lactic and glycolic acid. In our MICRODUR process, both standard and proprietary polymers are used to entrap an active agent in solid matrices or capsules comprising particles generally between 10 and 125 microns in diameter. Through suitable choice of polymers and processing, sustained release from a few days to many months can be achieved. As with the DURIN technology, MICRODUR particles degrade fully in the body after the active agent is released. Our range of experience extends from manufacture of the polymer raw material to process and product development, scale up and cGMP manufacture.

Focus on Chronic Debilitating Medical Conditions. Many of the diseases that present the greatest challenges to medicine are chronic, debilitating diseases such as chronic pain, central nervous system disorders, cardiovascular disorders, cancer and degenerative neurological diseases. Our initial efforts will focus on using our versatile drug delivery platform technologies to develop products that address these diseases.

Minimize Product Development Risk and Speed Time-to-Market. Initially, we intend to minimize product development risk and speed time-to-market by using our drug delivery platform technologies to administer drugs for which medical data on efficacy and safety are available. This strategy reduces much of the development risk that is inherent in traditional pharmaceutical product discovery. We anticipate that we can expand the medical usefulness of existing well-characterized drugs in several ways:

Enable the Development of Pharmaceutical Systems Based on Biotechnology and Other New Compounds. We believe there is a significant opportunity for pharmaceutical systems to add value to therapeutic medicine by administering biotechnology products, such as proteins, peptides and genes. We believe our technologies will improve the specificity, potency, convenience and cost-effectiveness of proteins, genes and other newly discovered drugs. Our systems can enable these compounds to be effectively administered, thus allowing them to become viable medicines. We can address the stability and storage needs of these compounds through our advanced formulation technology and package them in a suitable pharmaceutical system for optimum delivery. Through continuous administration, the DUROS, SABER, MICRODUR and DURIN technology platforms may eliminate the need for multiple injections of these drugs. In addition, through the use of our proprietary miniature catheter technology or by precise placement of drug formulations comprising our biodegradable delivery technologies, proteins and genes can be delivered to specific tissues for extended periods of time, thus ensuring that large molecule agents are present at the desired site of action and minimizing the potential for adverse side effects elsewhere in the body.

Expand Our Technology Platforms. Beyond our four core technology platforms, we will continue to develop, license and acquire other technologies consistent with our objective of delivering the right drug to the right place in the right amount at the right time. For example, through our April 2001 acquisition of SBS, we acquired an experienced team of specialists and patented technologies in the field of controlled release injectables, implants, microspheres and biodegradable polymers. This acquisition, along with our internal development activities, has increased the breadth and depth of our technology platforms. We expect to continue to license or acquire technology that will complement our core capabilities.

Our pharmaceutical systems are designed to provide improved treatment efficacy with a high level of precision and quality. Our development efforts are focused on the application of our pharmaceutical systems technologies to potential products in four therapeutic franchise areas: pain, cardiovascular disease, CNS disorders and biotechnology. Ongoing product development efforts in these areas are set forth in the following table:

Potential Product/Area of Focus	Indication/Application	Drug	Franchise	System	Stage
CHRONOGESIC	• Chronic Pain	• Sufentanil	• Pain	• DUROS	• Expect to start Pivotal Phase III in mid-2002
SABER Oral	• Various	• Various Compounds	• Pain and others	• SABER	• Research Stage
SABER Injection	• Post Operative Pain	• Local Anesthetic	• Pain	• SABER	• Preclinical Stage
Spinal Delivery	• Chronic Pain	• Opiate	• Pain	• DUROS	• Preclinical Stage
Antipsychotic	• Psychotic Disorders	• Antipsychotic Agent	• CNS	• SABER	• Research Stage
Brain Tumor Local Delivery	• Brain Cancer	• Antitumor Agent	• CNS	• DUROS	• Preclinical Stage
Pericardial	• Coronary Disease	• Angiogenic Factors	• Cardiovascular	• DUROS	• Preclinical Stage
Biotechnology	• Various	• Various agents	• Biotechnology	• SABER	• Research Stage

nonmalignant pain affects as many as 34 million Americans annually. In addition, the National Cancer Institute estimates that 8.4 million Americans alive today have a history of cancer. About 1.2 million new cancer cases were expected to be diagnosed in 2000, and about 50%-70% of cancer patients experience chronic pain during the course of the disease. Sales of opioids for the treatment of chronic malignant and nonmalignant pain are approximately $2 billion.

Development Strategy. We are developing the CHRONOGESIC (sufentanil) Pain Therapy System, a subcutaneous, implantable DUROS-based system that delivers sufentanil systemically at a constant rate for 3 months. This product targets patients with chronic pain that is stable and opioid responsive and results from a variety of causes. Sufentanil is an off-patent, highly potent opioid that is currently used in hospitals as an analgesic. If approved for marketing and sale, this product will provide an alternative to current therapies for the treatment of chronic pain such as pills and patches, as well as ensuring improved patient compliance and convenience. We will develop a family of dosage strengths, tailored to meet market needs. As of December 31, 2001, we have completed an initial Phase I clinical trial, a Phase II clinical trial, a pilot Phase III clinical trial and a pharmacokinetic trial for our CHRONOGESIC product. We anticipate that we will begin pivotal Phase III trials on this product in mid-2002 which we expect will include at least 1,000 patients.

Market Opportunity. Infusion of opiates into the spinal fluid has become accepted medical therapy in patients who find high dose oral or transdermal opioids ineffective or who experience side effects that make systemic therapy unacceptable. This method of delivery increases analgesic potency and reduces side effects. Although there are many implantable infusion pumps on the market today, these pumps tend to be relatively large and require a costly surgical procedure to implant. A need exists for a minimally invasive, spinal infusion device that has improved cost benefit for patients with chronic pain.

Development Strategy. Our strategy is to develop an implantable DUROS-based system that can deliver an opioid into the spinal fluid via a catheter. Our proposed spinal opiate product will be considerably smaller and less invasive than currently available spinal infusion pumps. We are currently conducting preclinical studies on this product.

Market Opportunity. More than 60% of patients who undergo surgery experience moderate to extreme-post operative pain. In the United States, 25 million patients are afflicted with post surgical pain annually. The current standard of care for post surgical pain includes oral opiate and non-opiate analgesics, transdermal opiate patches and muscle relaxants. While oral analgesics can effectively control post surgical pain, they commonly cause side effects such as drowsiness, constipation and cognitive impairment. Effective pain management can be compromised if patients fail to adhere to recommended dosing regimens because they are sleeping or disoriented. The majority of post surgical pain can be localized to the incision site. Post surgical pain can be treated effectively with local anesthetics; however, the usefulness of these medications is limited by their short duration of action. In general, post operative pain is either undertreated or poorly treated.

Development Strategy. DURECT is developing a sustained-release formulation of a local anesthetic using our SABER delivery system for the treatment of post surgical pain. The physician would administer this product at the time of surgery. Placed in the tissues immediately adjacent to the surgical site, this formulation is designed to provide sustained regional analgesia from a single dose. We believe that by delivering effective amounts of a potent analgesic to the location from which the pain originates, adequate pain control can be achieved with minimal exposure to the remainder of the body, and hence minimal side effects. The duration of local delivery of the anesthetic by the product is expected to be a few days, which coincides with the typical timeline by which post surgical pain resolves in most patients. We are currently conducting preclinical studies on this product.

For example, it is expected that 180,000 new brain tumors will be diagnosed in the United States in 2001. During that same period, approximately 350,000 patients will be living with a primary brain tumor, of which, about 25% are malignant. Current treatments for CNS tumors include radiation, resection and chemotherapy. Treatment success rates vary by tumor type, but are generally low, and the risk of side effects or disability is high. It is generally recognized that improvements in treating primary metastatic brain tumors are needed, particularly for those which are inoperable.

Schizophrenia, a disease of the brain that manifests itself through multiple signs and symptoms involving thought, perception and behavior, is another CNS disorder estimated to affect about 2.5 million patients in the U.S.; worldwide, the incidence is about 250 million. Patients typically begin exhibiting symptoms early in life and the illness is usually severe and long lasting, requiring lifelong treatment. Adherence to prescribed drug regimens is recognized as a significant treatment obstacle in the schizophrenic population. Although it is estimated that 50% of patients in the U.S. are either untreated or under treated, the aggregated sales of antipyschotic medications in 2000 exceeded $5.7 billion. Opportunities exist to apply our pharmaceutical systems for treatment of these and other CNS disorders.

We currently have a collaboration with the Johns Hopkins University, Department of Neurology/Neurosurgery, exploring the feasibility of treating tumors of the brain stem by site specific delivery of a chemotherapeutic agent directly to the tumor via a DUROS system attached to a catheter. The program is currently in preclinical development studies in primates. We view this development program and our spinal opiate program as proof-of-concept applications of the DUROS and catheter technologies to CNS disorders. Once we have demonstrated proof-of-concept, our long-term plan is to use the DUROS platform with other therapeutic agents to develop products for a broader range of CNS disorders.

Market Opportunity. Cardiovascular disease, principally heart disease and stroke, accounts for 40% of all deaths, or 960,000 fatalities, annually in the U.S. About 58 million Americans, roughly 25% of the population, are currently living with some form of cardiovascular disease. The aggregate annual cost of cardiovascular disease in the U.S., including treatment and lost productivity, is estimated at $274 billion.

Ischemic heart disease, one of the major forms of cardiovascular disease, is the leading cause of death worldwide. Existing treatments for ischemia, or insufficient blood flow to the heart muscle, include cardiovascular bypass, angioplasty and the use of cardiovascular stents and similar medical devices. While effective, these treatments are invasive, and in roughly 40% of patients, ischemia returns within 2 years. There is a need for less invasive and more long lasting treatments for ischemic heart disease.

through continuous delivery of drugs to the pericardial sac of the heart, a thin membrane that envelops the heart. To date, our research in animal models suggests that ischemic heart disease may be treated by the induction of new blood vessel growth as a way of regenerating normal blood flow to the heart and thereby restoring function to the diseased heart. Our research data showed that the delivery of a proprietary angiogenic factor directly to the pericardial sac of a test animal resulted in the growth of new blood vessels and increased bloodflow in the heart. Should we choose to develop and commercialize a product using such proprietary angiogenic factor or other proprietary agent, we will be required to obtain a license to use such agent in our product. Any required licenses may not be available to us on acceptable terms, if at all. See “Factors that May Affect Future Results—We may be required to obtain rights to certain drugs.”

Drugs developed out of the biotechnology industry are today mainly administered by repeated, frequent injection. The desirability of dosage forms that can reliably administer proteins for long periods of time is readily acknowledged. We are currently researching various products utilizing our biodegradable platform technologies in combination with protein molecules having known efficacy against major diseases with a goal to develop products that require less frequent administration than products currently available on the market.

The ALZET product is a miniature, implantable osmotic pump used for experimental research in mice, rats and other laboratory animals. These pumps are not approved for use in humans, nor are they intended for such use. ALZET pumps continuously deliver drugs, hormones and other test agents at controlled rates from one day to four weeks without the need for external connections, frequent handling or repeated dosing. In laboratory research, these infusion pumps can be used for systemic administration when implanted under the skin or in the body. They can be attached to a catheter for intravenous, intracerebral, or intra-arterial infusion or for targeted delivery, where the effects of a drug or test agent are localized in a particular tissue or organ.

The Round Window (mu)-Cath and Round Window e-Cath products are dual-and triple-lumen micro-catheters of proprietary design which allow controlled fluid delivery to the round window membrane for treatment of ear disorders. These catheters feature a proprietary tip which is designed to allow the surgeon to secure the tip in the round window niche of the middle ear. When attached to a commercially available, external infusion pump, such as those manufactured by Disetronic Medical Systems, a variety of therapeutic fluids can be continuously delivered to the round window membrane to potentially treat ear disorders including Meniere’s disease, hearing loss and tinnitus. These catheters can be left in place for up to 29 days and can be connected to a syringe or pump for continuous delivery. The dual-lumen design allows the treating physician to add and remove fluid or flush the device without a build-up of air or fluid pressure. The e-Cath design incorporates an additional electrode to allow physicians to record electrical signals related to activities in the ear.

On April 30, 2001, we acquired SBS, a privately held Alabama corporation, which has since operated as a wholly owned subsidiary of DURECT. SBS owns three patented platform drug delivery technologies, the SABER delivery system, the DURIN bioerodable implants and the MICRODUR bioerodable microparticulates. SBS participates with us in researching and developing our pharmaceutical systems products based on these platform technologies. Additionally, SBS has on-going license and partnering agreements with pharmaceutical and life sciences companies for the research and development of products based on its platform technologies and will continue to pursue such license and partnering arrangements in the future.

Birmingham Polymers, Inc. (BPI) is a wholly-owned subsidiary of SBS. BPI designs, develops and manufactures for pharmaceutical clients a wide range of standard and custom polymers based on lactide, glycolide and caprolactone. These materials are manufactured and sold by BPI directly from its facility in Birmingham, Alabama and are used by SBS and other BPI customers for a variety of controlled-release and medical-device applications, including several FDA-approved commercial products.

In general, we intend to establish strategic distribution and marketing alliances for our pharmaceutical systems. We recognize that pharmaceutical companies have established sales organizations in markets we are targeting. We plan to leverage these sales organizations to achieve greater market penetration for our products than we could on our own. Because our first products combine drugs for which medical data on efficacy and safety are available with a proven technology platform, we believe we have the flexibility to enter into these alliances at a later stage of clinical development, when the product development risk is diminished, in order to retain greater economic participation. We may also establish our own sales force when strategically or economically advantageous.

We market our IntraEAR catheters for delivering fluids to the inner ear through a contract sales force in the United States. In addition, we sell our catheters through 12 distributors outside the U.S. We market and sell our ALZET product in the U.S. through a direct sales force, and we have a network of 10 distributors for this product outside of the U.S.

A substantial portion of our revenues are derived from sale of the ALZET product line. Until such time that we are able to bring our pharmaceutical systems to market, if at all, we expect this trend to continue. Since our acquisition of the ALZET product line in April 2000, one customer accounted for 11% and 14% of our 2001 and 2000 revenues, respectively.

The process for manufacturing our pharmaceutical systems is technically complex, requires special skill in aseptic processing, and must be performed in a qualified facility. For our CHRONOGESIC product, we subcontract to third-parties the manufacture of components of the DUROS system, which we then assemble. In 2001, we completed the construction of a flexible manufacturing facility to produce product for our Phase III clinical trial and market launch of our CHRONOGESIC product and to serve as a pilot facility for additional products under development. We expect to complete qualification and validation activities for this facility by mid-2002. In addition, we are evaluating alternative strategies to meet our long-term commercial manufacturing needs.

On April 21, 1998, we entered into a Development and Commercialization Agreement with ALZA Corporation (presently a subsidiary of Johnson and Johnson) which was amended and restated on April 28, 1999 and April 14, 2000. Pursuant to this agreement, ALZA granted to us exclusive, world-wide rights under ALZA intellectual property, including patents, trade secrets and know-how, to develop and commercialize products using the DUROS drug delivery technology in the fields of the delivery of drugs by catheter (except for the sufentanil product) to the central nervous system to treat selected central nervous system disorders, the delivery of drugs by catheter to the middle and inner ear, the delivery of drugs by catheter into the pericardial sac of the heart, the delivery of selected drugs by catheter into vascular grafts and the delivery of selected cancer antigens. We have the exclusive right to commercialize each product developed under the agreement for a period of 20 years from the first commercial sale of the product in the U.S., Canada, Japan, France, Germany, Italy or the United Kingdom. We can extend this commercialization period at our option on a year-by-year basis.

To maintain the rights granted to us in our licensed fields, we must meet annual minimum development spending requirements totaling $44.0 million through 2004 and fund development of a minimum number of products per year up to a total of eight products through 2004. We must also diligently procure required regulatory approvals and commercialize the products in each country in order to maintain commercialization rights for such product in that country. If we fail to meet the various diligence requirements, we may lose our rights to develop, commercialize and manufacture some of our DUROS-based pharmaceutical systems, lose rights to commercialize products in some or all countries, including the U.S., or lose rights in some fields of use, and these rights would revert to ALZA. If we develop or commercialize any drug delivery technology for use in a manner similar to the DUROS technology in a field covered in our license agreement with ALZA, then we may lose our exclusive rights to use the DUROS technology in such field as well as the right to develop new products using DUROS technology in such field.

Under this agreement, we initiate product development by sending ALZA a written notice containing a description of the proposed product and proposed target dates for key milestones. These target dates are subject to ALZA’s reasonable approval and may be adjusted from time to time by mutual agreement. We have the right to subcontract to third parties product development activities including development of components of the DUROS system, provided that design of the DUROS system and other development activities relating to the DUROS system must be performed by ourselves or ALZA unless ALZA permits us to subcontract out such development. We also have the right to partner with third parties to commercialize our products on a product-by-product basis, provided that ALZA has options to distribute our cancer antigen products which do not incorporate proprietary molecules owned by a third party throughout the world. We must allow ALZA an opportunity to negotiate in good faith for commercialization rights to our products developed under the agreement prior to granting these rights to a third party, other than products that are subject to ALZA’s option or products for which we have obtained funding or access to a proprietary drug from a third party to whom we have granted commercialization rights prior to commencement of human clinical trials.

We have the right to subcontract manufacturing activities relating to our products other than the assemblage of the components of the DUROS system itself. In the event of a change in our corporate control, including an acquisition of us, our right to develop and manufacture the DUROS system would terminate, and ALZA would have the right to develop and manufacture DUROS systems for us for so long as ALZA can meet our specification and supply requirements following such change in control. If ALZA elects to manufacture the DUROS system for us after such change in control, we will pay ALZA its manufacturing costs plus 25% of such costs. If ALZA elects to provide development services related to the DUROS system for us, we will pay ALZA its development costs, including research expenses (both direct and indirect, which are billed at a rate of 160% of direct research salaries), general and administrative expenses (at a rate of 80% of direct research salaries) and capital asset expenditures. In the years ended December 31, 1999, 2000 and 2001, we incurred development

expenses of $1,182,000, $666,000, and $98,000, respectively, for work performed by ALZA under the Development and Commercialization Agreement relating to our CHRONOGESIC and spinal opiate products. ALZA invoices us quarterly for development services performed, with payments due within 30 days of our receipt of the invoice. See “Factors That May Affect Future Results—Our agreement with ALZA limits our fields of operation for our DUROS-based pharmaceutical systems, requires us to spend significant funds on product development and gives ALZA a first right to distribute selected products for us.”

Any inventions and related intellectual property rights developed by us or ALZA under the agreement which relate to the DUROS system or its manufacture or to any combination of the DUROS system with other components, active agents, features or processes, shall be owned exclusively by ALZA. All other inventions and related intellectual property rights developed under the agreement, whether by us or ALZA, shall be owned exclusively by us. In addition, ALZA was granted a non-exclusive license to any proprietary technology we may develop relating to a means of connecting a catheter to the DUROS system. This license was granted in consideration for ALZA abiding by the terms of a market stand-off agreement under which, for a period of two years following the termination of any market stand-off or other similar agreement between ALZA and the underwriters of our initial public offering, ALZA may not dispose of 25% or more of the maximum number of all securities it has owned prior to our initial public offering in any six month period.

In consideration for the rights granted to us under this agreement, ALZA received 5,600,000 shares of our Series A-1 Preferred Stock pursuant to a Series A-1 and Series A-2 Preferred Stock Purchase Agreement dated as of June 19, 1998. As additional consideration, ALZA is entitled to receive a royalty on the net sales of products in an amount not less than 2.5% nor more than 5% of such net sales for so long as we sell the product. ALZA is also entitled to a percentage of any up-front license fees, milestone or any special fees, payments or other consideration we receive, excluding research and development funding, in an amount of 5% of such payment. In addition, commencing upon commercial sale of a product developed under the agreement, we are obligated to make minimum quarterly product payments at an annual rate of 1.5% of projected annual net product sales to ALZA based on our good faith projections for such net product sales, which minimum payments will be fully credited against the product royalty payments we must make to ALZA under the agreement. In connection with an amendment to the agreement made in April 2000, ALZA received 1,000,000 shares of our common stock and a warrant to purchase 1,000,000 shares of our common stock at an exercise price of $12 per share. The amendments to our development and commercialization agreement with ALZA included a reduction in product royalties and up front payments payable to ALZA by us under the agreement.

The term of our agreement with ALZA is for so long as we are obligated to make product payments to ALZA. Either party has the right to terminate the agreement in the event that the other party breaches a material obligation under the agreement and does not cure the breach in a timely manner. In addition, ALZA has the right to terminate the agreement if, at any time prior to July 2002, we solicit for employment or hire, without ALZA’s consent, a person who is or within the previous 180 days has been an employee of ALZA, or if at any time prior to July 2006, we solicit for employment or hire, without ALZA’s consent, a person who is or within the previous 180 days has been an employee of ALZA in the DUROS technology group. In the event that our rights terminate with respect to any product or country, or the agreement terminates or expires in its entirety (except for termination by us due to a breach by ALZA), ALZA will have the exclusive right to use all our data, rights and information relating to the products developed under the agreement as necessary for ALZA to commercialize products which rights have reverted to ALZA, subject to payment of a royalty to us based on the net sales of the products by ALZA. The agreement is assignable by either party to an acquiror of all or substantially all of such party’s business.

Our success depends in part on our ability to obtain patents, to protect trade secrets, to operate without infringing upon the proprietary rights of others and to prevent others from infringing on our proprietary rights. Our policy is to seek to protect our proprietary position by, among other methods, filing U.S. and foreign patent applications related to our proprietary technology, inventions and improvements that are important to the

development of our business. As of December 31, 2001, we held four issued U.S. patents and two issued foreign patents. Our patents expire at various dates starting in the year 2012. In addition, we have 24 pending U.S. patent applications and have filed 16 patent applications under the Patent Cooperation Treaty, from which 15 national phase applications are currently pending in Europe, Australia and Canada. As of December 31, 2001, our subsidiary SBS held 4 issued U.S. patents, 1 issued foreign patent and 5 pending U.S. patent applications and has filed 5 patent applications under the Patent Cooperation Treaty. These patents expire at various dates starting in the year 2015. In addition, pursuant to our agreement with ALZA, we have a license under a portfolio of pending, issued and future patents of ALZA which may cover our DUROS-based products depending on the attributes of such products.

Proprietary rights relating to our planned and potential products will be protected from unauthorized use by third parties only to the extent that they are covered by valid and enforceable patents or are effectively maintained as trade secrets. Patents owned by or licensed to us may not afford protection against competitors, and our pending patent applications now or hereafter filed by or licensed to us may not result in patents being issued. In addition, the laws of certain foreign countries may not protect our intellectual property rights to the same extent as do the laws of the U.S.

The patent positions of biopharmaceutical companies involve complex legal and factual questions and, therefore, their enforceability cannot be predicted with certainty. Our patents or patent applications, or those licensed to us, if issued, may be challenged, invalidated or circumvented, and the rights granted thereunder may not provide proprietary protection or competitive advantages to us against competitors with similar technology. Furthermore, our competitors may independently develop similar technologies or duplicate any technology developed by us. Because of the extensive time required for development, testing and regulatory review of a potential product, it is possible that, before any of our products can be commercialized, any related patent may expire or remain in existence for only a short period following commercialization, thus reducing any advantage of the patent, which could adversely affect our ability to protect future product development and, consequently, our operating results and financial position.

Because patent applications in the U.S. are maintained in secrecy for at least 18 months after filing and since publication of discoveries in the scientific or patent literature often lag behind actual discoveries, we cannot be certain that we were the first to make the inventions covered by each of our issued or pending patent applications or that we were the first to file for protection of inventions set forth in such patent applications. Our planned or potential products may be covered by third-party patents or other intellectual property rights, in which case we would need to obtain a license to continue developing or marketing these products.

Any required licenses may not be available to us on acceptable terms, if at all. If we do not obtain any required licenses, we could encounter delays in product introductions while we attempt to design around these patents, or could find that the development, manufacture or sale of products requiring such licenses is foreclosed. Litigation may be necessary to defend against or assert such claims of infringement, to enforce patents issued to us, to protect trade secrets or know-how owned by us, or to determine the scope and validity of the proprietary rights of others. In addition, interference proceedings declared by the U.S. Patent and Trademark Office may be necessary to determine the priority of inventions with respect to our patent applications. Litigation or interference proceedings could result in substantial costs to and diversion of effort by us, and could have a material adverse effect on our business, financial condition and results of operations. These efforts by us may not be successful.

We may rely, in certain circumstances, on trade secrets to protect our technology. However, trade secrets are difficult to protect. We seek to protect our proprietary technology and processes, in part, by confidentiality agreements with our employees and certain contractors. There can be no assurance that these agreements will not be breached, that we will have adequate remedies for any breach, or that our trade secrets will not otherwise become known or be independently discovered by competitors. To the extent that our employees, consultants or contractors use intellectual property owned by others in their work for us, disputes may also arise as to the rights in related or resulting know-how and inventions.

The FDA and comparable regulatory agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon the clinical development, manufacture and marketing of pharmaceutical products. These agencies and other federal, state and local entities regulate research and development activities and the testing, manufacture, quality control, safety, effectiveness, labeling, storage, record keeping, approval, advertising and promotion of our products. We believe that our initial products will be regulated as drugs by the FDA rather than as biologics or devices, whereas later products may be regulated as combination products with a device designation for all or some of the final product components.

Preclinical tests include laboratory evaluation of the product, its chemistry, formulation and stability, as well as animal studies to assess the potential safety and efficacy of the product. We then submit the results of the preclinical tests, together with manufacturing information and analytical data, to the FDA as part of an IND, which must become effective before we may begin human clinical trials. The IND automatically becomes effective 30 days after receipt by the FDA, unless the FDA, within the 30-day time period, raises concerns or questions about the conduct of the trials as outlined in the IND and imposes a clinical hold. In such a case, the IND sponsor and the FDA must resolve any outstanding concerns before clinical trials can begin. Our submission of an IND may not result in FDA authorization to commence clinical trials. Further, an independent Institutional Review Board at each medical center proposing to conduct the clinical trials must review and approve any clinical study.

In the case of products for severe diseases, such as chronic pain, or life-threatening diseases such as cancer, the initial human testing is often conducted in patients with disease rather than in healthy volunteers. Since these patients already have the target disease or condition, these studies may provide initial evidence of efficacy traditionally obtained in Phase II trials and thus these trials are frequently referred to as Phase I/II trials. We cannot be certain that we will successfully complete Phase I, Phase II or Phase III testing of our product candidates within any specific time period, if at all. Furthermore, the FDA or the Institutional Review Board or the sponsor may suspend clinical trials at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk.

The results of product development, preclinical studies and clinical studies are submitted to the FDA as part of a new drug application for approval of the marketing and commercial shipment of the product. The FDA may deny a new drug application if the applicable regulatory criteria are not satisfied or may require additional clinical data. Even if such data is submitted, the FDA may ultimately decide that the new drug application does not satisfy the criteria for approval. Once issued, the FDA may withdraw product approval if compliance with regulatory standards is not maintained or if safety problems occur after the product reaches the market. In addition, the FDA requires surveillance programs to monitor approved products which have been commercialized, and the agency has the power to require changes in labeling or to prevent further marketing of a product based on the results of these post-marketing programs.

In addition to the drug approval requirements applicable to our initial product for the treatment of chronic pain through the Center for Drug Evaluation and Research (CDER), the FDA may require an intercenter consultation review by the Center for Devices and Radiological Health (CDRH). This request for consultation may be based on the device-like nature of a number of aspects of the DUROS technology.

Satisfaction of the above FDA requirements or similar requirements of state, local and foreign regulatory agencies typically takes several years and the actual time required may vary substantially, based upon the type, complexity and novelty of the pharmaceutical product. Government regulation may delay or prevent marketing of potential products for a considerable period of time and impose costly procedures upon our activities. We cannot be certain that the FDA or any other regulatory agency will grant approval for any of our products under development on a timely basis, if at all. Success in preclinical or early stage clinical trials does not assure success in later stage clinical trials. Data obtained from preclinical and clinical activities is not always conclusive and may be susceptible to varying interpretations which could delay, limit or prevent regulatory approval. Even if a product receives regulatory approval, the approval may be significantly limited to specific indications. Further, even after regulatory approval is obtained, later discovery of previously unknown problems with a product may result in restrictions on the product or even complete withdrawal of the product from the market. Delays in obtaining, or failures to obtain regulatory approvals would have a material adverse effect on our business. Marketing our products abroad will require similar regulatory approvals and is subject to similar risks. In addition, we cannot predict what adverse governmental regulations may arise from future U.S. or foreign governmental action.

Any products manufactured or distributed by us pursuant to FDA clearances or approvals are subject to pervasive and continuing regulation by the FDA, including record-keeping requirements and reporting of adverse experiences with the drug. Drug manufacturers and their subcontractors are required to register their establishments with the FDA and state agencies, and are subject to periodic unannounced inspections by the FDA and state agencies for compliance with good manufacturing practices, which impose procedural and documentation requirements upon us and our third party manufacturers. We cannot be certain that we or our present or future suppliers will be able to comply with the GMP regulations and other FDA regulatory requirements.

The FDA regulates drug labeling and promotion activities. The FDA has actively enforced regulations prohibiting the marketing of products for unapproved uses. Under the FDA Modernization Act of 1997, the FDA will permit the promotion of a drug for an unapproved use in certain circumstances, but subject to very stringent requirements. We and our products are also subject to a variety of state laws and regulations in those states or localities where our products are or will be marketed. Any applicable state or local regulations may hinder our ability to market our products in those states or localities. We are also subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control, and disposal of hazardous or potentially hazardous substances. We may incur significant costs to comply with such laws and regulations now or in the future.

The FDA’s policies may change and additional government regulations may be enacted which could prevent or delay regulatory approval of our potential products. Moreover, increased attention to the containment of health care costs in the U.S. and in foreign markets could result in new government regulations that could have a

We may face competition from other companies in numerous industries including pharmaceuticals, medical devices and drug delivery. Our CHRONOGESIC product, if approved, will compete with oral opioids, transdermal opioid patches, and implantable and external infusion pumps which can be used for infusion of opioids. Products of these types are marketed by Purdue Pharma, Knoll, Janssen, Medtronic, AstraZeneca, Arrow International, Tricumed and others. Our spinal opioid product, if developed and approved, will compete with implantable and external infusion pumps marketed by Medtronic, Arrow International, Tricumed, Abbott, Deltec, Advanced Neuromodulation Systems and others. Numerous companies are applying significant resources and expertise to the problems of drug delivery and several of these are focusing or may focus on delivery of drugs to the intended site of action, including Alkermes, Atrix, Genetronics, The Liposome Company, Focal, Matrix Pharmaceuticals and others. Although we have exclusivity with respect to our license of the DUROS technology in specific fields of therapy, ALZA is also a potential competitor with technologies other than DUROS.

Some of these competitors may be addressing the same therapeutic areas or indications as we are. Our current and potential competitors may succeed in obtaining patent protection or commercializing products before us. Any products we develop using our pharmaceutical systems technologies will compete in highly competitive markets. Many of our potential competitors in these markets have greater development, financial, manufacturing, marketing, and sales resources than we do and we cannot be certain that they will not succeed in developing products or technologies which will render our technologies and products obsolete or noncompetitive. In addition, many of those potential competitors have significantly greater experience than we do in their respective fields.

As of March 15, 2002, including SBS, we had 150 employees, including 88 in research and development, 21 in manufacturing and 41 in sales, general and administrative. From time to time, we also employ independent contractors to support our research, development and administrative organizations. None of our employees are represented by a collective bargaining unit and we have never experienced a work stoppage. We consider our relations with our employees to be good.

We are headquartered in Cupertino, California, where we lease approximately 30,000 square feet of space under a lease expiring in January 2004 with options to extend for up to an additional ten years. This facility contains both office and laboratory space and is also the site of the manufacturing facility we have constructed. In June 2001, we leased approximately 20,000 square feet of additional corporate office space in Cupertino, California, under a lease expiring in May 2006 with options to extend for up to an additional eight years. We also lease approximately 7,800 square feet of space in Vacaville, California, which contains manufacturing space for the ALZET product. Our lease of this facility expires in August 2003 with an option to extend for two years. Pursuant to our acquisition of SBS, we assumed leases for approximately 23,000 square feet of office and laboratory space in Birmingham, Alabama, which expire in May 2003, with options to extend for up to an additional ten years. We believe that our existing and planned facilities are adequate to meet our current and foreseeable requirements or that suitable additional or substitute space will be available as needed.

Delaware		94-3297098
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

Name	Age	Position
Felix Theeuwes, D.Sc.	64	Chairman, Chief Scientific Officer and Director
James E. Brown, D.V.M.	45	President, Chief Executive Officer and Director
Thomas A. Schreck