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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

(Mark One)

For the fiscal year ended December 31, 2003

OR

For the transition period from              to             .

Commission File No. 000-31135

INSPIRE PHARMACEUTICALS, INC.

(Exact Name of Registrant as Specified in Its Charter)

(919) 941-9777

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.001 par value

(Title of Class)

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

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

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

Yes  x    No  ¨

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $291,533,919.

Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of January 31, 2004.

Documents incorporated by reference

None.

Item 1. Business.

Overview

We are a biopharmaceutical company dedicated to discovering, developing and commercializing prescription products in disease areas with significant commercial markets and unmet medical needs. Our primary focus is in the ophthalmic and respiratory therapeutic areas where we have significant expertise. Our ophthalmic products and product candidates are concentrated in the allergic conjunctivitis, dry eye disease and retinal disease indications. We are working on respiratory product candidates for the treatment of cystic fibrosis and upper respiratory disorders. Our portfolio of products and product candidates include:

We have acquired the rights to market Elestat^™ and Restasis® in the United States under co-promotion agreements with Allergan, Inc., or Allergan, and we receive royalty payments based upon net sales of these products. We have five product candidates in various stages of clinical development and one product candidate identified in preclinical development for which we expect to file an Investigational New Drug Application, or IND. Our product candidates in clinical trials are based on proprietary technology relating to specific receptors known as P2 receptors. Our lead product candidates are P2Y₂ receptor agonists that target ophthalmology, allergy and respiratory conditions and diseases where current treatments are not adequate. We have begun to apply our expertise to other applications of P2 receptor subtypes as well as advancing several non-P2Y programs.

We were incorporated in October 1993 and commenced operations in March 1995 following our first substantial financing and licensing of the initial technology from The University of North Carolina at Chapel Hill, or UNC. Since that time, we have been engaged in the discovery and development of novel pharmaceutical products, and more recently, in the co-promotion of products. We are located in Durham, North Carolina, adjacent to the Research Triangle Park.

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Our Strategy

Our business objective is to become a leading biopharmaceutical company focused on discovering, developing and commercializing new treatments for diseases primarily in the ophthalmic and respiratory areas. We intend to advance multiple product candidates in areas where we have expertise through drug discovery, clinical trials, strategic alliances and in-licensing, and to be involved in the marketing and sale of our products. A key element of our strategy is to build a sustainable pipeline of innovative new treatments based upon our expertise in certain therapeutic areas. All of our current clinical programs represent P2Y₂ receptor-based technology targeting ophthalmic and respiratory indications. We are also expanding into other clinical areas, such as P2Y₁₂ receptor blockers for a platelet aggregation inhibitor indication. Our strategy is to:

COMMERCIAL PRODUCTS

Elestat^™

Overview. In December 2003, we entered into an agreement with Allergan to co-promote Elestat^™ (epinastine HCl ophthalmic solution 0.05%) to ophthalmologists, optometrists and allergists in the United States. Elestat^™ was approved by the U.S. Food and Drug Administration, or FDA, in October 2003 for the prevention of itching associated with allergic conjunctivitis. We launched and began promoting Elestat^™ in the United States in February 2004 within the eye care and allergy area.

Elestat^™, a topical antihistamine with mast cell stabilizing and anti-inflammatory activity, was developed by Allergan for the relief of ocular itching associated with ocular allergies. Its multi-action effects inhibit binding to both H₁ and H₂ receptors, while preventing recruitment and activation of pro-inflammatory mediators that can trigger and exacerbate the allergic response. Elestat^™ has a rapid onset of action, and in pivotal clinical trials was well tolerated by patients and demonstrated a favorable safety profile.

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Market Opportunity. Allergies affect more than 40 million people in the United States annually, including 20% to 30% of adults and up to 40% of children. Allergic conjunctivitis may occur in up to 90% of those patients suffering from allergies. The annual United States market for ocular allergy prescriptions is approximately $425 million, with a strong growth rate of 17% over 2002. In terms of dollars, this market has shown double-digit growth over the past six years. Elestat^™ is indicated for adults and children at least 3 years old.

Co-Promotion Agreement. We have the primary responsibility for selling, promotional and marketing activities of Elestat^™ in the United States and will be responsible for the associated costs. We work with Allergan collaboratively on overall product strategy and management in the United States. Allergan records Elestat^™ sales and remains responsible for all other product costs. Allergan also retains the licensing rights relating to promotion of Elestat^™ to prescribers other than ophthalmologists, optometrists and allergists; but we have a right of first refusal to obtain such rights in the event Allergan decides to engage a third party to undertake such activities. Under the terms of the agreement, we paid Allergan an up-front payment and Allergan will pay a royalty to us on United States Elestat^™ net sales; except in the event that a third party is engaged by Allergan to promote Elestat^™ to prescribers outside of our field, in which case we will be paid a proportionate share of United States Elestat^™ net sales based upon filled prescriptions written by ophthalmologists, optometrists and allergists. Allergan also retains rights to all international sales and marketing activities relating to the drug. See “—Corporate Collaborations.”

Restasis®

Overview. In June 2001, we entered into a joint license, development and marketing agreement with Allergan to develop and commercialize diquafosol tetrasodium (INS365) which included the right to co-promote Allergan’s Restasis® (cyclosporine ophthalmic emulsion) 0.05%, each for the treatment of dry eye disease, in the United States. In December 2002, Restasis® was approved for sale by the FDA and Allergan launched Restasis® in the United States in April 2003. In January 2004, we began co-promotion of Restasis® in the United States and will receive a royalty on Restasis® net sales beginning April 2004.

Restasis® is the first approved pharmacologically active therapy for patients in the United States with keratoconjunctivitis sicca, or dry eye disease, whose tear production is presumed to be suppressed due to ocular inflammation. Dry eye disease is a painful, burning and irritating condition involving abnormalities and deficiencies in the tear film due to a variety of causes. Restasis® has been shown to improve tear production which leads to significant improvement in ocular surface integrity which, in turn, resolves dry eye symptoms and returns the surface of the eye to a more normal state while providing relief of the symptoms associated with dry eye disease.

Market Opportunity. Other than Restasis®, the current treatments for dry eye disease in the major markets consist of artificial tear solutions and lubricant eye drops. In some cases, small plugs are inserted by physicians in the tear duct to slow tear drainage. Artificial tears, which are available as over-the-counter and, in some countries, as prescription products, provide temporary relief of symptoms, but can also wash out the natural proteins and other components that keep an eye healthy. We estimate, based on an extrapolation from United States data, that moderate to severe dry eye disease affects approximately thirty million people in the eight major international prescription pharmaceutical markets and ten million are in North America. Dry eye disease can be caused by eye stress, aging, environmental factors, autoimmune disorders and various medications. Because dry eye disease is more prevalent among the elderly and post-menopausal women, this market is expected to grow as populations age. We estimate that, in the eight major international prescription pharmaceutical markets, sales of prescription and over-the-counter pharmaceutical products for dry eye disease treatments exceed $500 million annually. Allergan recorded $38.3 million of Restasis® revenue in the United States for the April to December 2003 time period, its first nine months as a commercial product. Allergan has projected 2004 Restasis® revenue of $75-95 million.

Collaborative Agreement. In the third quarter of 2003, we exercised our right to co-promote Restasis® under the joint license, development and marketing agreement with Allergan. In December 2003, at the time we entered into the co-promotion agreement relating to Elestat^™, we amended the joint license, development and marketing agreement to reduce the royalty rates that we would receive upon the sale of Restasis®. We began promoting Restasis® in January 2004 and we will receive royalty payments from Allergan on net sales of Restasis® beginning April 2004. See “—Corporate Collaborations.”

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HIGHER PRIORITY PRODUCTS IN CLINICAL DEVELOPMENT

Diquafosol tetrasodium (INS365) for the treatment of dry eye disease.

Overview. Diquafosol is an ophthalmic product candidate designed to treat dry eye disease and is expected to complement Restasis®, if and when it receives regulatory approval. The abnormalities responsible for dry eye disease are typically characterized by a decrease in tear production, an increase in tear evaporation or the improper mixture of the eye’s tear film components. If left untreated, dry eye disease can result in permanent corneal damage and visual impairment.

Diquafosol is a P2Y₂ receptor agonist that activates the P2Y₂ receptors on the surface of the eye and inner lining of the eyelid to stimulate the release of water, salt, mucin and lipids—the key components of natural tears. Mucin is made in specialized cells and acts to lubricate surfaces. Lipids in the eye are oily substances that form the outer-most layer of the tear film and are responsible for the prevention of excessive tear fluid evaporation. We are developing diquafosol as an eye drop for dry eye disease. We believe that diquafosol can be the second FDA approved pharmacologically active agents to treat dry eye disease, and the first one with this mechanism of action. In preclinical testing, our product increased the secretions of natural tear components, which we believe can help restore a natural tear film, reduce dry eye disease symptoms, help prevent long-term corneal damage, and improve ocular surface health in dry eye disease sufferers. Because diquafosol and Restasis® have different mechanisms of action, we consider them complementary products and believe the commercial opportunity of these products to be significant.

Development Status. On June 27, 2003, we submitted a New Drug Application, or NDA, to the FDA, and we were notified that our NDA was granted a “priority review” on July 31, 2003. On December 19, 2003, we received an approvable letter from the FDA. In January 2004, we met with the FDA to discuss the additional clinical study which they requested. Based upon this discussion, we now have a clear understanding of the FDA’s additional requirement for the regulatory approval of diquafosol and are working closely with them to develop a protocol for a new Phase III clinical study. We intend to initiate and begin enrollment in a confirmatory Phase III trial in early 2004. In addition, we are assisting Allergan in a European regulatory submission that will seek approval of the right to commercialize diquafosol for dry eye disease in the European Union. Submission of this application is expected in the second half of 2004.

Collaborative Agreement. Under the joint license, development and marketing agreement with Allergan, we have continued our efforts to develop and commercialize diquafosol. Under this agreement, we have received up-front and milestone payments of $11 million and may receive up to an additional $28 million in milestone payments assuming the successful completion of all remaining diquafosol milestones. We will also receive royalty payments from Allergan on net sales, if any, of diquafosol worldwide, excluding most larger Asian markets. In the third quarter of 2003, we exercised our right under the Allergan agreement to co-promote diquafosol with Allergan in the United States and expect to begin promoting this product if and when we receive FDA approval and the product is launched. Our partner, Santen Pharmaceutical Co., Ltd., or Santen, is developing diquafosol in Japan and nine other Asian countries. Diquafosol is currently in Phase II clinical trials in Japan. See “—Corporate Collaborations.”

INS37217 Respiratory (denufosol tetrasodium) for the treatment of cystic fibrosis.

Overview. We are developing INS37217 Respiratory (denufosol tetrasodium) as an inhaled product for the treatment of cystic fibrosis. We believe our product may become the first FDA approved product that mitigates the underlying ion-transport defect in the airways of patients with cystic fibrosis. This product has been granted orphan drug status by the FDA and is also on fast-track review status for its approval.

INS37217 Respiratory is designed to enhance the lung’s innate mucosal hydration and mucociliary clearance mechanisms, which in cystic fibrosis patients are impaired by a genetic defect. By hydrating airways and stimulating mucociliary clearance through stimulation of the P2Y₂ receptor, we expect that INS37217 Respiratory will help keep the lungs of cystic fibrosis patients clear of thickened mucus, reducing infections and the damage that occurs as a consequence of the retention of thick and tacky infected secretions. We further believe that these effects may result in reduced frequency and length of hospitalizations, reduced need for antibiotics and other medications, reduced deterioration of lung function, and improved respiratory symptoms and health status. In addition, this product is expected to be complementary with the two approved products, Pulmozyme® and TOBI®, neither of which affects the underlying ion-transport defects in cystic fibrosis airways.

Cystic fibrosis is a life-threatening disease involving a genetic mutation that disrupts the cystic fibrosis transmembrane regulator protein, an ion channel. In cystic fibrosis patients, a defect in this ion channel leads to poorly hydrated lungs and severely impaired mucociliary clearance. Chronic secondary infections invariably occur, resulting in progressive lung dysfunction and deterioration. Respiratory infections and complications account for more than 95% of the morbidity and mortality associated with this disease. According to the United States Cystic Fibrosis Foundation, the median life expectancy for patients is 33 years.

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Development Status. We completed all necessary preclinical studies for initial clinical testing and in the fall of 2000 filed an IND in the United States. We initiated and completed a Phase I clinical trial in late 2000 and a Phase I/II clinical trial for INS37217 Respiratory for cystic fibrosis in 2002. A multi-center Phase II study was initiated in collaboration with the Cystic Fibrosis Foundation Therapeutics, Inc., or the CFFT, in 2003. Enrollment of 90 patients has been completed and top-line results from the Phase II study are expected in the second quarter of 2004. This study is funded largely through a study funding arrangement established with the CFFT in October 2002. See “—Corporate Collaborations.”

Market Opportunity. The current therapeutic approaches to address cystic fibrosis mainly treat the symptoms, but do not cure the disease, and are aimed at reducing respiratory infections and breaking up thickened mucous secretions that cause airflow obstruction and harbor bacteria. For example, TOBI® is an inhaled antibiotic that treats the infection, and Pulmozyme® is an inhaled protein that breaks up excessive DNA in cystic fibrosis mucus that reduces the thickness and tackiness of the respiratory secretions. While both products are approved for the treatment of cystic fibrosis, neither product is designed to address the underlying ion-transport defect, which results in dehydrated mucus and severely impaired mucociliary clearance.

There are approximately 30,000 diagnosed cystic fibrosis patients in the United States and approximately 75,000 in the eight major international prescription pharmaceutical markets. The average annual cost of medicine to treat a cystic fibrosis patient in the United States exceeds $35,000, and the annual healthcare cost for patients in the United States is over $1 billion. We estimate that in the United States sales of prescription pharmaceutical products to treat cystic fibrosis currently are in excess of $200 million annually.

Collaborative Agreement. In October 2002, we entered into a study funding agreement with the CFFT in which they agreed to fund the majority of the external costs of a Phase II trial for the treatment of cystic fibrosis in exchange for milestone payments upon FDA approval, and the possibility of a sales milestone upon the commercialization and the achievement of a certain aggregate sales volume in the first five years following product approval. In the event of FDA approval, we are obligated to pay to the CFFT, over a period of five years, an amount equal to a multiple of the trial costs incurred by the CFFT as a development milestone payment, which could exceed $10 million. Additionally, in the event aggregate sales of the product exceed a certain level, we are obligated to pay the CFFT an additional $4 million sales milestone, payable over two years. See “—Corporate Collaborations.”

INS37217 Ophthalmic (denufosol tetrasodium) for the treatment of retinal disease.

Overview. INS37217 Ophthalmic (denufosol tetrasodium) is an investigative new drug under evaluation for the treatment of retinal diseases associated with pathological sub-retinal or intra-retinal accumulation of fluid. These sight-threatening retinal diseases are associated with retinal detachment (where fluid accumulates in the sub-retinal space between the retina and the underlying retinal pigment epithelium) and macular edema (where fluid accumulates in the central retina). Restoration of vision is contingent in part on the removal of the pathological fluid accumulation. INS37217 Ophthalmic has been shown in experimental models of retinal detachment to stimulate retinal re-attachment by reabsorbing (i.e., draining) extraneous sub-retinal fluid across the retinal pigment epithelium, or RPE, a layer of cells involved in controlling proper hydration of the retina and sub-retinal space. The retina is a thin layer of sensory tissue that captures and processes visual information, and normally remains attached to the underlying RPE. In the most common cause of retinal detachment, breaks or holes in the retina result in the influx of fluid from the vitreous into the sub-retinal space between the retina and RPE, thereby creating rhegmatogenous retinal detachment, or RRD. RRD results in acute loss of vision that may progress over a period of hours to days or weeks. Delayed treatment of this condition can lead to permanent loss of vision and ultimately detachment of the entire retina. RRD progresses when the rate of fluid influx into the sub-retinal space primarily through the retinal break(s) exceeds that of fluid reabsorption across the RPE, thereby enlarging the retinal detachment.

We are developing INS37217 Ophthalmic as an intravitreal injection initially for RRD. In RRD, fluid accumulates in the sub-retinal space between the retina and the underlying RPE and successful retinal re-attachment is contingent upon the reabsorption of this fluid across the RPE. We believe that INS37217 Ophthalmic may become the first FDA approved product to be administered as first-line therapy to enable retinal reattachment in some RRD patients without the need for surgery. Because of its ability to stimulate fluid reabsorption across the RPE, INS37217 Ophthalmic may be useful to treat other retinal diseases also associated with pathological accumulation of sub-retinal or intra-retinal fluid, including diabetic and non-diabetic macular edema.

Development Status. In 2001 we initiated a dose-escalating, randomized, double-masked, placebo-controlled Phase I/II clinical study of INS37217 Ophthalmic, given as a single intravitreal injection, in patients with RRD. The study was designed to evaluate the safety, tolerability, and pharmacological activity of INS37217 Ophthalmic in facilitating retinal re-attachment. Phase I/II results demonstrated that when compared with placebo the drug was well-tolerated and showed pharmacological activity in terms of reducing the extent of retinal detachment. In January 2004, we met with the FDA and were given guidance on the planning of a well-controlled Phase II study designed to advance this program. This Phase II study is expected to begin in the first half of 2004.

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Market Opportunity. There are currently no pharmaceutical products approved for RRD. While surgical techniques used to reattach the retina have relatively high single-operation success rates of 60-95%, patients frequently suffer from post-surgical problems, including diminished visual acuity, loss of eye motility, misaligned eyes, protracted periods of convalescence, and post-operative pain and discomfort. By stimulating fluid reabsorption across the RPE, INS37217 Ophthalmic may reverse the progression of RRD and stimulate retinal re-attachment in some RRD patients without the need for surgery. Approximately 50,000 retinal detachments occur each year in the United States.

INS50589 Cardiovascular

P2Y₁₂ receptor antagonists as inhibitors of platelet aggregation.

Overview. We are developing potent, selective and reversible inhibitors of platelet aggregation for the use in the treatment of acute cardiovascular diseases. Platelets, small disk-shaped blood cells, are responsible for initiating and maintaining blood clots. These cells have P2 receptors, including the P2Y₁₂ receptor, on their surface which respond to a soluble clotting factor called adenosine 5’-diphosphate (ADP). It has been demonstrated that pharmacological intervention to inhibit platelet aggregation has potential benefit on a number of debilitating acute and chronic diseases such as myocardial infarction, unstable angina, stroke and peripheral arterial disease. Inhibition of platelet P2Y₁₂ receptors in particular reduces the relative risk of atherosclerotic events such as myocardial infarction, stroke and cardiovascular death.

Development status. We have taken advantage of our expertise in nucleotide receptor chemistry and pharmacology and developed a new proprietary class of potent and selective P2Y₁₂ antagonists for use in the treatment of acute cardiovascular or cerebrovascular indications. Our molecules are novel platelet aggregation inhibitors that have a rapid onset and offset mechanism of action and are intended for intravenous administration. In preclinical studies it has been shown that our compounds produce dose-dependent and sustained inhibition of platelet aggregation during the administration of the drug, and protect against mortality resulting from systemic intravascular thromboembolism. We believe that the fast offset pharmacokinetic properties of our compounds, coupled with their ability to inhibit both platelet aggregation and degranulation/secretion, are key differentiating characteristics from other approved anti-platelet agents, such as aspirin, clopidogrel, ticlopidine, abciximab, tirofiban, and eptifibatide. Based on extensive structure-activity, pharmacological and safety information, we have identified a product candidate, INS50589 Cardiovascular for advancement into clinical studies in this program. We intend to file an IND application for INS50589 Cardiovascular pending completion of successful preclinical evaluation in the second half of 2004.

LOWER PRIORITY PRODUCTS IN CLINICAL DEVELOPMENT

INS37217 Intranasal (denufosol tetrasodium) for upper respiratory disorders.

Overview. We are developing INS37217 Intranasal (denufosol tetrasodium) as a nasal spray treatment for upper respiratory disorders in which mucociliary clearance is impaired, such as allergic rhinitis, rhinosinusitis, and common cold. These disorders affect millions of people and result in significant morbidity and several million office visits to doctors. To date we have completed four studies of INS37217 Intranasal in healthy volunteers, patients with allergic rhinitis, and individuals with common cold. Although the drug has been well-tolerated, in a recent 630 patient study of allergic rhinitis, INS37217 Intranasal was not superior to placebo. We have discussed the results from the program with several medical experts in the field and are currently considering our future development plans.

INS316 Diagnostic (uridine 5’-triphosphate) to aid in the diagnosis of lung cancer and lung infection.

Overview. INS316 Diagnostic (uridine 5’-triphosphate), a P2Y₂ agonist with a short duration of action, is being developed as an acute-use inhaled solution to stimulate enhanced clearance of mucus from the lungs to produce a sputum specimen to aid in the diagnosis of lung cancer. INS316 Diagnostic has been studied in a number of clinical trials and has been shown to increase the amount of sputum produced. In May 2001, we initiated a Phase III clinical trial. Enrollment has been slow and it appears likely that an additional trial will be required for regulatory approval. Therefore enrollment was stopped at approximately 700 of the original enrollment target of 800 patients and the results will be analyzed in the first half of 2004. It is unlikely we will progress further development of this program; however our partner Kirin Brewery Co, Ltd. or Kirin, may continue development. See “—Corporate Collaborations.”

Additional discussion of the costs and expenses associated with all of our research and development programs is discussed below in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Years Ended December 31, 2003, 2002 and 2001—Costs and Expenses.”

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Corporate Collaborations

Allergan, Inc.—Elestat^™

In December 2003, we entered into an agreement with Allergan to co-promote Elestat^™ to ophthalmologists, optometrists and allergists in the United States. Elestat^™ was approved by the FDA in October 2003 for the prevention of itching associated with allergic conjunctivitis. We will have the primary responsibility for selling, promotional and marketing activities of Elestat^™ in the United States and will be responsible for the associated costs. We work with Allergan collaboratively on overall product strategy and management in the United States. Allergan records Elestat^™ sales and remains responsible for all other product costs, as well as retaining responsibility for all international marketing and selling activities. Allergan also retains the licensing rights relating to promotion of Elestat^™ to prescribers other than ophthalmologists, optometrists and allergists; but we have a right of first refusal to obtain such rights in the event Allergan decides to engage a third party to undertake such activities. We have established a joint commercialization committee with Allergan to coordinate and oversee the broad strategies and promotion and manage the relationship. Allergan is responsible for supply chain management, managed healthcare, customer order processing and regulatory compliance. Under the terms of the agreement, we paid Allergan an up-front payment and Allergan will pay a royalty to us on United States Elestat^™ net sales; except in the event that a third party is engaged by Allergan to promote Elestat^™ to prescribers outside of our field, in which case we will be paid a proportionate share of United States Elestat^™ net sales based upon filled prescriptions written by ophthalmologists, optometrists and allergists. Under the terms of the agreement, we are required to achieve certain performance minimums to receive some or all of the royalty initially contemplated.

The agreement will be in effect until the earlier of: (i) the approval and launch of the first generic epinastine product; or (ii) the approval and launch of the first over-the-counter epinastine product; in each case after expiration of Elestat’s^™ listing in the FDA’s publication “Approved Drug Products with Therapeutic Equivalence Evaluations” (generally known as the “Orange Book”). Either Allergan or we may terminate the agreement in the event of a material breach of the agreement by the other or in the event of the other’s insolvency. Allergan can terminate the agreement if we fail to meet a defined minimum of net sales in any given year, or upon a change of control where we become an affiliate of a direct competitor of Allergan’s as that term is defined in the agreement. We can terminate the agreement in the event that Elestat^™ is withdrawn from the market for more than ninety days.

Allergan, Inc. – Restasis® and diquafosol

In June 2001, we entered into a joint license, development and marketing agreement with Allergan to develop and commercialize diquafosol which included the right to co-promote Restasis® in the United States. In December 2003, at the time we entered into the co-promotion agreement relating to Elestat^™, we amended the joint license, development and marketing agreement to reduce the royalty rates that we would receive upon the sale of Restasis®.

Under the terms of the amended agreement, Allergan obtained an exclusive license to develop and commercialize diquafosol worldwide, with the exception of Japan and nine other Asian countries covered by our agreement with Santen. In return, we will receive royalty payments from Allergan on diquafosol and Restasis® net sales, if any, worldwide, excluding most larger Asian markets. In December 2002, Restasis® was approved for sale by the FDA and Allergan launched Restasis® in the United States in April 2003. We will be entitled to receive royalties on net sales of Restasis® beginning April 2004, and have already received milestone payments under this agreement. In the third quarter of 2003, we exercised our right under the Allergan agreement to co-promote diquafosol and Restasis® with Allergan and began promoting Restasis® in January 2004 and will promote diquafosol if and when we receive FDA approval.

We have established a joint development committee with Allergan to oversee the joint development program and a joint commercial committee to establish the brand strategies and manage the relationship. Under the terms of the agreement, we provide bulk active drug substance while diquafosol is in development and Allergan is responsible for obtaining or manufacturing all of its bulk active drug substance requirements and for commercial supply of product.

We are responsible for conducting, in collaboration with Allergan, the Phase III clinical trials for diquafosol for dry eye disease and for United States NDA filing and approval. Allergan is responsible for all other development activities under the agreement, including all development outside the United States and in its territories, and for ex-United States regulatory submissions, filings, and approvals relating to products. Allergan is responsible for all commercial costs except for the cost of our sales force in the United States. Allergan is required to use commercially reasonable efforts to conduct development, seek regulatory approvals and market and sell the products.

The agreement will be in effect until all patents licensed under the agreement have expired. Either Allergan or we may terminate the agreement in the event of a material breach of the agreement. In addition, we have the right to terminate the agreement if we determine, subject to the joint commercialization or committee’s review and arbitration, that Allergan has not made reasonably sufficient progress in the commercialization of our product by giving 180 days prior notice. If Allergan

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breaches the agreement, becomes insolvent or we terminate for failure to make progress with the commercialization of our product, Allergan’s license will terminate and Allergan must provide us with all data and information relating to our product and must assign or permit us to cross-reference all regulatory filings and approvals.

Santen Pharmaceutical Co., Ltd.

In December 1998, we entered into a Development, License and Supply Agreement with Santen for the development of diquafosol for the therapeutic treatment of ocular surface diseases, such as dry eye disease, in Asia. Under the agreement, we granted Santen an exclusive license to market diquafosol for ocular surface diseases in Japan, China, South Korea, the Philippines, Thailand, Vietnam, Taiwan, Singapore, Malaysia and Indonesia.

We established a coordinating committee to review and evaluate Santen’s progress in the development and commercialization of products. Santen is responsible for all development, regulatory submissions, filings and approvals, and all marketing of products. We are obligated to supply Santen with its requirements of diquafosol in bulk drug substance form for all preclinical studies, clinical trials and commercial requirements at agreed-upon prices.

Under the terms of the agreement, we received an up-front equity investment of $1.5 million for shares of our preferred stock in December 1998, that were subsequently converted into shares of our common stock. During 2000, we received a milestone payment under the Santen Agreement of $500,000 based on achievement of a regulatory milestone by Santen. In addition, depending on whether all milestones are met, we could receive additional payments of up to $4.25 million, as well as royalties on net sales of licensed products.

The agreement will terminate when all patents licensed under the agreement have expired. Either Santen or we may terminate the agreement if the other materially breaches the agreement. In addition, we have the right to terminate the agreement at any time if we determine, subject to the coordinating committee’s review and arbitration, that Santen has not made reasonably sufficient progress in the development or commercialization of products. If Santen breaches the agreement, or if we terminate the agreement because Santen has not made sufficient progress, Santen’s license will terminate. Santen will provide us with all data and information relating to our products, and will assign or permit us to cross-reference all regulatory filings and approvals.

Cystic Fibrosis Foundation Therapeutics, Inc.

In October 2002, we entered into a study funding agreement with the CFFT, a non-profit drug development affiliate of the Cystic Fibrosis Foundation, for the funding of a Phase II study in INS37217 Respiratory for the treatment of cystic fibrosis. Under the agreement, the CFFT will provide the majority of funding of external costs for a Phase II trial of INS37217 Respiratory in exchange for post-commercialization development and sales milestone payments. The trial is a Phase II proof-of-concept study whereby predetermined success criteria have been defined. If the success criteria are achieved clinical development will continue, either directly by us or through a mutually acceptable licensee. If the product candidate ultimately receives FDA approval, we would be obligated to pay a development milestone to the CFFT, calculated as a multiple of the trial costs incurred by the CFFT. In addition, we would be obligated to pay a sales milestone if the product candidate achieves a certain aggregate sales volume in the first five years following product approval. The development milestone could exceed $10 million, payable over five years and the sales milestone would be an additional $4 million, payable over two years.

The trial was designed in collaboration with the CFFT and the Therapeutics Development Network. We are working with the Therapeutics Development Network and its coordinating center in conducting the study. The agreement will terminate no later than the expiration of all payment obligations under the agreement. Either the CFFT or we may terminate the agreement if the other materially breaches the agreement.

Kirin Brewery Co., Ltd. Pharmaceutical Division

In September 2000, we entered into a License Agreement with Kirin for the development and commercialization of INS316 Diagnostic. Under the agreement we granted Kirin an exclusive license to commercialize INS316 Diagnostic in 21 Asian countries and regions, including Japan.

We established a coordinating committee to review and evaluate Kirin’s progress in the development and commercialization of the product and to provide input and recommendations regarding development of the product. Kirin is responsible for all development, regulatory submissions, filings and approvals, and all marketing of the product. We are responsible for providing Kirin copies of preclinical and clinical data relating to the development and commercialization of the product within 30 days after any such information becomes available. Under the terms of the agreement, we received an up-front payment in cash and will receive milestone payments based on clinical success and approval.

The agreement will terminate on the later of the 10th anniversary of the first commercial sale of the product or the date on which the sale of the product ceases to be covered by a valid claim of any licensed patent under the agreement. Either Kirin or we may terminate the agreement if the other materially breaches the agreement. In addition, Kirin has the right, by giving us 180 days prior notice, to terminate the agreement at any time.

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Research and Development

Discovery

Our scientists have specific expertise and proprietary knowledge relating to the design and synthesis of P2 receptor agonists and antagonists, including P2Y₂ agonists, P2Y₁₂ antagonists and P2X antagonists. We have invested in state-of-the-art equipment and laboratory space for performing synthetic chemistry, determination of compound structure and receptor location and function identification. Our discovery effort is focused on conducting studies using cell-based scientific tests that measure biological activities caused by stimulation or blocking of P2 receptors, to identify new compounds that specifically and selectively bind to members of the P2 receptor family. These tests enable us to identify agonists and antagonists that act at specific receptor subtypes and demonstrate a level of specificity and activity that merits further investigation. We use data from these tests to design and synthesize compounds specific to each P2 receptor subtype that can be advanced to clinical trials.

By screening against several P2 receptor subtypes, we have been able to identify agonists and/or antagonists that interact preferentially with a specific receptor subtype. Several proprietary discovery compounds, including new chemical entities, with promising stability and metabolic profiles are being actively explored. We intend to conduct further preclinical development studies to advance such proprietary compounds to project status, if appropriate. These compounds will then be targeted to the treatment of new disease areas, as identified through our strategic planning process.

Additionally, we signed a fee-for-service agreement with Discovery Partners International in August 2002 in our P2 receptor antagonist program. This collaboration allows for efficient and cost-effective synthesis of compounds that may be important in the treatment of various diseases.

We obtain access to chemical libraries through our own proprietary chemistry, commercial sources and corporate agreements. The chemicals are screened for both agonist and antagonist activity. Our chemistry department also assists in the development of analytical protocols used by contract service organizations for analysis of a drug substance, clinical trial material and drug stability studies which will be incorporated into IND and NDA filings.

We use sponsored research agreements to investigate specific biological processes to augment our technology platform. We have sponsored research agreements at major universities. We use contract research organizations for all toxicology and most in vivo studies (studies involving live mammals) required for regulatory submissions, such as IND applications.

Development

After a molecule is determined to be an appropriate product candidate based upon our business strategy, it moves into the development phase of our organization, where extensive testing of both the characteristics of the actual product and the effects it has on humans are conducted. The progression of products through the various stages of development is overseen by the Portfolio Review Committee, a group comprised of the company officers and selected senior staff from the Development and Discovery departments. Our Development function is divided into four functional areas, Pharmaceutical Development, Regulatory Affairs, Clinical Research, and Biostatistics and Data Management

Generally, when a product is judged as ready for human testing, an IND is filed with the FDA allowing us to embark on human testing in the United States. Since 1997, we have filed six INDs for products that were subsequently evaluated in humans. Some of these products have progressed to later phases of development, most notably diquafosol eye drops for dry eye disease, for which an NDA was filed in June 2003. In addition to internal resources, we have many collaborations that allow us to perform development activities with a limited number of staff.

See “Management’s Discussion and Analysis of Financial Conditions and Results of Operations – Research and Development Expenses.”

Sales and Marketing

To fulfill our role in selling and promoting Elestat^™ and Restasis® and launching future products, we hired 64 highly experienced territory managers and 6 regional sales directors to provide us with national sales coverage for our ophthalmic products. Our small, specialty commercial organization will focus its promotional efforts on ophthalmologists, optometrists and allergists. We believe our focused marketing organization and a specialty sales force can effectively address these audiences and effectively co-promote these products. Eye care professionals account for the majority of the dry eye disease prescriptions, and combined with the allergists these specialties prescribe approximately half of the ocular allergies prescriptions. Targeting these

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medical specialties is an excellent strategic fit for Elestat^™ and our dry eye disease products, diquafosol (currently under FDA review) and Restasis®. In addition to our direct field efforts, we intend to heighten the awareness of our products through advertisements in professional journals, targeted direct mail and seminars designed to educate eye care professionals and allergists on the therapeutic areas in which we promote. We expect to experience seasonality in the sale of Elestat^™, with a large increase in sales in the spring and a lesser increase during the summer and fall.

In the United States, we are co-promoting Elestat^™ and Restasis® and intend to co-promote diquafosol if and when that product candidate receives FDA approval. We co-promote Restasis® in the United States with Allergan, but have primary United States sales and marketing responsibilities for Elestat^™. Outside of the United States, we expect diquafosol and any other product candidates that we successfully develop to be commercialized through arrangements or collaborations with third parties, as we do not intend to develop international operations outside of North America. We have not developed commercial plans for our product candidates beyond Elestat^™, Restasis® and diquafosol as these plans will be dependent in large part on their market potential and our financial resources. We intend to establish corporate partnering, licensing or other arrangements for the marketing and sale of these products, especially outside of the United States. Accordingly, third parties may have significant control or influence over important aspects of the commercialization of our product candidates, including market identification, marketing methods, pricing, composition and magnitude of sales force and promotional activities. We may have limited control over the amount and timing of resources that a third party devotes to our products.

We feel the establishment of commercial operations provides us with the opportunity and flexibility to market and sell other products we are developing, or products that we may in-license or otherwise acquire and to maximize their commercial value in the United States.

Compliance

We are committed to conducting our business fairly, honestly, ethically and lawfully. We act responsibly and with integrity in our relationships with patients, health care professionals, providers, governments, regulatory entities, customers, suppliers, and vendors.

We have designated a Corporate Compliance Officer who reports to the Chief Executive Officer and Chairman of the Audit Committee of the Board of Directors. The Corporate Compliance Officer is responsible for evaluating potential compliance risks within the company and designing control procedures. This is achieved by conducting audits consistent with implementation of codes, policies and other controls. Areas of control include, but are not limited to, compliance with current Federal and State law, such as Sarbanes-Oxley Act of 2002, U.S. Foreign Corrupt Practices Act of 1977, NASDAQ and National Association of Securities Dealers listing requirements and Securities and Exchange Commission, FDA, and Office of Inspector General regulations. Codes and policies that have been implemented include, but are not limited to, “Code Of Ethics and Conduct Relating to Financial Affairs,” “Code of Business Ethics,” “Whistleblower Policy” and “Code of Conduct: Promotional Interactions with Health Care Professionals.” The Corporate Compliance Officer provides frequent updates to senior management, the Audit Committee of the Board of Directors and to the full Board of Directors.

Manufacturing and Supply

We do not currently engage in, nor do we expect to engage in, the manufacture of bulk active pharmaceutical ingredients, or APIs, for preclinical, clinical or commercial purposes. We rely on a contract manufacturing supply arrangement with a single manufacturer, Yamasa Corporation located in Choshi, Japan, for the development stage production of INS316 Diagnostic, diquafosol and INS37217. We expect that Yamasa will ultimately supply commercial quantities of INS316 Diagnostic, diquafosol and INS37217 for both respiratory and ophthalmic applications. We have already obtained clinical trial grade batches of these compounds from Yamasa and, in addition, they have completed the validation of the manufacturing process for diquafosol. Although we have identified alternative sources for product candidates, we presently depend on Yamasa as the sole manufacturer of our supply of APIs for our product candidates. See “Risk Factors— Reliance on a single party to manufacture and supply either finished product or the bulk APIs for a product or product candidates could adversely affect us.”

In addition to the bulk APIs, our products incorporate pharmacopeial grade excipients such as sodium chloride, sodium hydroxide and hydrochloric acid, all of which are readily available from numerous sources. Many of our clinical trial materials are packaged in unit-dose form-fill-seal vials, which are manufactured by Cardinal Health Pharmaceutical Technologies & Services—Automatic Liquid Packaging of Woodstock, Illinois, but similar vials are also available from other commercial filling and packing companies. In addition to unit-dose vial packaging, we also administer our products as metered-dose nasal sprays and intravitreal injections. The metered-dose nasal pump delivery system is comprised of a plastic bottle manufactured by Createchnic AG of Nuerensdorf, Switzerland and a nasal spray pump manufactured by Pfeiffer GmbH of Radolfzell, Germany. The intravitreal injections have been manufactured by Cardinal Health Pharmaceutical Technologies & Services — SP Pharmaceuticals of Albuquerque, NM and Formatech of Andover, MA using standard glass vials and rubber stoppers. In the case of both the nasal spray and intravitreal injection products, alternate sources of both components and manufacturing sites are available.

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We have established a Corporate Quality Assurance and Regulatory Compliance Division to conduct qualification and routine audits of our contract manufacturers. These contract manufacturers are identified in our regulatory agency filings, such as with the FDA, and are subject to Regulatory Agency Inspections. We also attempt to stay informed on the financial condition of contract manufacturers and their status with regulatory agencies. We also maintain an inventory of drug product in order to minimize the risk of material shortage. A prolonged interruption in supply could adversely disrupt our manufacturing plans.

The manufacture of our products and product candidates is based in part on technology that we believe to be proprietary to our contract manufacturers or our collaborative partners. Such manufacturers may not abide by the limitations or confidentiality restrictions in agreements with us. In addition, any such manufacturer may develop process technology related to the manufacture of our compounds that such supplier owns either independently or jointly with us. This would increase our reliance on such manufacturer or require us to obtain a license from such manufacturer in order to have our products manufactured.

Patents and Proprietary Rights

We believe that the proprietary protection of our product candidates, processes and know-how is important to the success of our business. We aggressively file and prosecute patents covering our proprietary technology, and, if warranted, will defend our patents and proprietary technology. As of January 31, 2004, we owned or licensed patent rights consisting of 39 issued United States patents, none of which expire before 2011, and numerous pending applications in the United States and corresponding patents and patent applications in foreign jurisdictions. We seek patent protection for our proprietary technology and products in the United States and Canada and in key commercial European and Asia/Pacific countries and other major commercial sectors of the world, as appropriate. We intend to seek trademark protection in the United States and foreign countries, as appropriate. We also rely upon trade secrets, know-how, continuing technological innovation and licensing opportunities to develop and maintain our competitive position.

In March 1995, September 1998, and January 2002, we entered into three separate agreements with UNC granting us exclusive worldwide licenses to develop, make, use and sell products based on UNC patented technology relating to the use of P2Y receptor agonists and antagonists for respiratory therapeutics, such as INS365 Respiratory; respiratory diagnostics, such as INS316 Diagnostic; and prevention of platelet aggregation. The term of each of the UNC exclusive licenses is based upon the duration of the patents covered by each of these agreements. The United States government may have limited rights in some of this UNC patented technology. We also entered into a fourth agreement that granted us a non-exclusive worldwide license to use other UNC patented technology as a research tool to identify agonists and antagonists for P2Y receptors. The agreements require us to pay licensing fees upon the attainment of development milestones and royalties on net sales or a share of sublicensing income on products covered by the patents. We are also required to meet due diligence milestones and UNC may terminate the licenses if we fail to do so. In connection with the licenses, we issued to UNC an aggregate of 326,286 shares of our common stock, of which 128,610 shares have been transferred to the inventors of the licensed UNC patented technology. We also entered into consulting agreements with some of the inventors of these technologies, all of whom are from UNC, including Dr. Richard C. Boucher, one of our founders and an Emeritus Board Observer, Dr. M. Jackson Stutts, Dr. Kendall Harden and Dr. Michael Knowles, in which they agreed to consult with us regarding their respective fields of knowledge.

Additional patent applications have since been filed on discoveries made in support of such technologies, from research conducted at UNC or in our own laboratories. Our sponsored research agreements, material transfer agreements, and other collaborations have the potential to result in license agreements with universities, institutes and businesses. We believe that our patents and licensed patents provide a substantial proprietary base that will allow us, and our collaborative partners, to exclude others from conducting our business as described in this report and as encompassed by our issued patents and issued patents licensed to us. We cannot be sure, however, that pending or future applications will issue, that the claims of any patents which do issue will provide any significant protection of our technology or that our directed discovery research will yield compounds and products of therapeutic and commercial value.

Our competitors or potential competitors may have filed for, or have received, United States and foreign patents and may obtain additional patents and proprietary rights relating to compounds, uses and/or processes which may compete with our product candidates. Accordingly, there can be no assurance that our patent applications will result in patents being issued or that, if issued, the claims of the patents will afford protection against competitors with similar technology, nor can we be sure that others will not obtain patents that we would need to license or circumvent in order to practice our inventions.

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Competition

Many pharmaceutical companies engage in research and development to commercialize products to treat allergic conjunctivitis, dry eye disease, cystic fibrosis, allergic rhinitis and other diseases that we are researching. We compete with these companies for funding, access to licenses, personnel, third party collaborators and product development. Almost all of these companies have substantially greater financial, marketing, sales, distribution and technical resources and more experience in research and development, clinical trials and regulatory matters, than we do. We are aware of existing palliative treatments that will compete with our products.

We believe that several major pharmaceutical companies have initiated research programs to design P2Y receptor agonists or antagonists. However, we are not aware of any competing P2Y₂ receptor agonists that have entered clinical testing. If successfully developed and commercialized, our products will compete with existing therapeutics and any new treatments developed by competitors.

Although we believe that none of the therapeutic approaches described above address the underlying problem of excessive retained mucus and impaired mucociliary clearance, drugs based on other therapeutic mechanisms may be efficacious in treating respiratory diseases. The development by others of treatments that are not related to our mucociliary clearance approach could render our product candidates non-competitive or obsolete.

There are multiple therapies available to treat or prevent allergic conjunctivitis. The primary brands that Elestat^™ will compete with are the antihistamine and mast cell stabilizers and include: Patanol®, Zaditor® and Optivar®. Patanol® currently has the majority of the prescriptions in the allergic conjunctivitis market.

The current prescription and non-prescription treatments for dry eye disease include artificial tear replacement therapy or lubricant eye drops. The FDA approved Restasis® in December of 2002 for patients with dry eye disease whose tear production is presumed to be suppressed due to ocular inflammation. We are aware of the following dye eye disease products in clinical development: 15HETE, by Alcon, Inc.; OPC-12759 (rebamipide), by Otsuka Pharmaceuticals; ProGraf/FK-506, by Fujisawa Healthcare, Inc.; and Androgen Tears, by Allergan.

There are two products approved in the United States specifically for the treatment of cystic fibrosis: Pulmozyme^®, an agent designed to break up thickened airway secretions, and TOBI^®, an inhaled antibiotic. At least one study has been completed that demonstrated clinical benefit with Zithromax^®, an oral antibiotic. Although Zithromax^® has not been officially approved for use in cystic fibrosis, it has been added to the treatment regimen in patients with evidence of airway infection.

We are not aware of any other pharmaceuticals treatments available for retinal detachment.

Plavix® is an approved platelet aggregation inhibitor that irreversibly inhibits the P2Y₁₂ receptor on platelets. There are two P2Y₁₂ receptor antagonists in clinical development as platelet aggregation inhibitors. Cangrelor (The Medicines Company) has finished Phase II clinical testing using intravenous administration. AZD6140 (AstraZeneca) is in Phase II clinical testing and is an oral formulation.

The introduction of new products or the development of new processes by competitors or new information about existing products may result in price reductions or product replacements, even for products protected by patents. However, we believe our competitive position is enhanced by our commitment to research leading to the discovery and development of new products. Other factors that may help us meet competition include the quality and breadth of our technology platform, the skill of our employees and our ability to recruit and retain skilled employees, our aggressive program of seeking patent protection and our capabilities for early stage research and drug discovery. However, many large pharmaceutical and biotechnology companies have significantly larger intellectual property estates than we do, more substantial capital resources than we have and greater capabilities and experience than we do in preclinical and clinical development, sales, marketing, manufacturing and regulatory affairs.

Governmental Regulation

The research, development, testing, manufacture, promotion, marketing and distribution of human therapeutic and diagnostic products are extensively regulated by governmental authorities in the United States and other countries. In the United States, the FDA regulates drugs and diagnostic products and similar regulatory bodies exist in other countries. The steps ordinarily required before a new drug may be marketed in the United States, which are similar to steps required in most other countries, include:

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Preclinical tests include laboratory evaluation of product toxicity and formulation, as well as animal studies. The results of preclinical testing are submitted to the FDA as part of an IND. A 30-day waiting period after the filing of each IND is required before the commencement of clinical testing in humans. At any time during this 30-day period or later, the FDA may halt proposed or ongoing clinical trials until the FDA authorizes trials under specified terms. The IND process may be extremely costly and substantially delay development of our products. Moreover, positive results of preclinical tests will not necessarily indicate positive results in clinical trials.

Clinical trials to support NDAs are typically conducted in three sequential phases, but the phases may overlap. During Phase I, the initial introduction of the drug into healthy human subjects or patients, the drug is tested to assess metabolism, pharmacokinetics and pharmacological actions and safety, including side effects associated with increasing doses. Phase II usually involves studies in a limited patient population to:

If a compound is found to be potentially effective and to have an acceptable safety profile in Phase II evaluations, Phase III trials, also called pivotal studies, major studies or advanced clinical trials, are undertaken to further demonstrate clinical efficacy and to further test for safety within an expanded patient population at geographically dispersed clinical study sites.

After successful completion of the required clinical testing, generally a NDA is submitted. The FDA may request additional information before accepting a NDA for filing, in which case the application must be resubmitted with the additional information. Once the submission has been accepted for filing, the FDA has 180 days to review the application and respond to the applicant. The review process is often significantly extended by FDA requests for additional information or clarification. The FDA may refer the NDA to an appropriate advisory committee for review, evaluation and recommendation as to whether the application should be approved, but the FDA is not bound by the recommendation of an advisory committee.