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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
 
                                   FORM 10-K
                 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
                     OF THE SECURITIES EXCHANGE ACT OF 1934
 
                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
 
                          COMMISSION FILE NO. 0-22788
 
                           AXYS PHARMACEUTICALS, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
<S>                                                    <C>
                      DELAWARE                                              22-2969941
           (STATE OF OTHER JURISDICTION OF                               (I.R.S. EMPLOYER
           INCORPORATION OR ORGANIZATION)                               IDENTIFICATION NO.)
</TABLE>
 
             180 KIMBALL WAY, SOUTH SAN FRANCISCO, CALIFORNIA 94080
          (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
 
       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (650) 829-1000
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
                                      NONE
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
                          COMMON STOCK $.001 PAR VALUE
                        PREFERRED SHARE PURCHASE RIGHTS
                                (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 (Section 229.405 of this chapter) is not contained herein,
and will not be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K.  [ ]
 
     The approximate aggregate market value of the voting stock held by
nonaffiliates of the Registrant as of February 26, 1999, based upon the last
trade price of the Common Stock reported on the Nasdaq National Market on
February 26, 1999, was $138,399,938.*
 
     The number of shares of Common Stock outstanding as of February 26, 1999
was 30,362,601.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
     Portions of the Registrant's Proxy Statement which will be filed with the
Commission pursuant to Section 14a in connection with the 1999 annual meeting of
stockholders are incorporated herein by reference in Part III of this report.
 
     *Excludes approximately 438,290 of the Registrant's outstanding Common
Stock held by directors and officers of the Registrant at February 26, 1999.
Exclusion of shares held by any person should not be construed to indicate that
such person possesses the power, direct or indirect, to direct or cause the
direction of the management or policies of the Registrant, or that such person
is controlled by or under common control with the Registrant.
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<PAGE>   2
 
                                    PART I.
 
ITEM 1. BUSINESS
 
  Introduction
 
     This section discusses the business of Axys Pharmaceuticals, Inc. Our
objective has been to describe our business in plain English. In this section we
sometimes refer to Axys Pharmaceuticals, Inc. as Axys or the company.
 
     You should be aware that the following discussion of the company contains
both historical information and forward-looking statements. Forward-looking
statements are statements made about future events and include projections and
other statements about what may or could happen in the future. You should be
aware that forward-looking statements involve risks and uncertainties. Our
actual results could differ significantly from those you might expect based on
our forward-looking statements. There are a number of reasons that this might
occur. To understand what those reasons are, you should review the section below
entitled "What Factors Could Cause Our Results To Differ Materially From Those
You Might Expect?" and you should also consider the additional risk factors
described in the section entitled "Item 7. Management's Discussion and Analysis
of Financial Condition and Results of Operations."
 
     On January 8, 1998, the company acquired Sequana Therapeutics Inc., a
genomics company based in La Jolla, California. At the conclusion of the
acquisition, we changed our name from Arris Pharmaceutical Corporation to Axys
Pharmaceuticals, Inc. You will find elsewhere in this Form 10-K our financial
statements and a discussion of our financial results for the twelve-month period
ended December 31, 1998. For the periods prior to 1998, our financial statements
reflect Arris Pharmaceutical Corporation only and do not include any information
for Sequana Therapeutics, Inc. However, the discussion contained in this section
reflects the combined company, Axys, and does not distinguish between what was
formerly Arris' business and what was formerly Sequana's business.
 
  Business Overview
 
     Axys is a leader in the integration of life science technologies with a
focus on transforming gene discoveries into drugs. We seek to build shareholder
value through
 
     - a broad and diversified pipeline of drug discovery and development
       programs partnered with world-class pharmaceutical companies,
 
     - expansion of a non-partnered research and development franchise in
       oncology, and
 
     - the spin out of affiliated businesses in combinatorial chemistry,
       pharmacogenomics and agricultural biotechnology that leverage the
       company's technologies and are intended to provide capital for Axys' drug
       discovery and development programs. Our ADVANCED TECHNOLOGIES DIVISION
       runs the combinatorial chemistry business. Our subsidiary PPGX, INC. runs
       the pharmacogenomics business. And our other subsidiary XYRIS CORPORATION
       runs the agricultural biotechnology business.
 
     See Note 12 of "Notes to Consolidated Financial Statements" for Segment
Information.
 
WHAT ARE THE LIFE SCIENCE TECHNOLOGIES THAT WE HAVE INTEGRATED TO ALLOW US TO
TRANSFORM GENE DISCOVERIES INTO DRUGS?
 
     In recent years, the advent of new drug discovery technologies, including
genomics, bioinformatics, computational sciences, structure-based drug design,
combinatorial chemistry, high throughput screening and pharmacogenomics, has
offered great potential for streamlining the lengthy and expensive process of
drug discovery. Axys has assembled a premier platform for drug discovery by
combining and integrating these new technologies with the traditional
pharmaceutical sciences, including medicinal chemistry and pharmacology. We are
using these integrated technologies to identify more quickly and efficiently
both novel molecular
 
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targets associated with disease and small molecule compounds (important for oral
delivery) that can be used as drugs against these targets.
 
     Drug discovery can be viewed as a step-wise process from the identification
of a gene linked to a particular disease to finding a treatment for that
disease, although drugs are not necessarily discovered by moving from the first
step to the final step of the process. While it may in some cases be preferable
to understand the entire disease progression process from gene to disease, it is
not necessary to understand each step in this process in order to develop new
and better drugs. Since we are focused on developing small molecule compounds,
we can take advantage of discoveries we make at any of the various points along
the drug discovery process to advance our development of new drugs.
 
     The entire drug discovery process runs from gene identification to the
determination of gene function to lead identification to preclinical development
to clinical development. The following sections describe each part of this
process and the technologies that Axys employs in drug discovery.
 
GENE IDENTIFICATION
 
     The human genome is the collection of all the genetic information needed to
define a human being. This information is subsequently passed along to a
person's children. Scientifically defined, the human genome consists of 23 pairs
of chromosomes that contain the 100,000 or so genes that define every human's
make-up. A gene is the smallest unit of an organism that is capable of passing
along genetic information. These genes are made up of DNA (deoxyribonucleic
acid). In humans, a DNA molecule resembles a twisted ladder and consists of two
strands -- a double helix -- whose carbohydrate-like sides are connected by
pairs of nitrogen-containing chemicals called bases which form the rungs of the
ladder. There are four different bases which appear at each end of a rung, known
by the initials A, T, C and G. The particular order of the bases is called the
DNA sequence. In total, there are approximately 3 billion base pairs of DNA
comprising all of the chromosomes in the human genome. However, scientists
estimate that individuals differ in only about 0.1% of the 3 billion base pairs.
 
     Much effort has been devoted by various governments, research institutions
and companies to mapping out the exact location of each gene on each chromosome
and to determine the complete DNA sequence of the 3 billion DNA bases. To date,
much of the mapping of the genes on the chromosomes has been completed.
Sequencing the 3 billion DNA base pairs of the chromosomes is a much bigger
task. There are two basic approaches to this task: random sequencing and
positional cloning.
 
     Generally, random sequencing uses rapid gene sequencing techniques
(including the use of silicon DNA chips and massive parallel processing with
computers) with various samples, regardless of what role the gene plays or its
medical importance. Rather than randomly sequencing large numbers of genes with
unknown and perhaps irrelevant functions, the focus of our gene identification
process is on the identification and characterization of specific genes
associated with common diseases. This is known as positional cloning and it is a
technique in which Axys was a pioneer. Positional cloning begins with the
collection of DNA (usually blood samples) from families or groups that have a
high incidence of a particular disease. By comparing the DNA samples from
healthy people and people who have a particular disease, we can pinpoint the
region on a particular chromosome or chromosomes that may contain the gene or
genes involved in a particular disease.
 
     As a pioneer in positional cloning, Axys developed a network of academic
researchers, clinicians and health care providers all over the world. Axys has
obtained exclusive access to certain DNA samples from population groups in
isolated geographic regions who have higher incidence rates of diseases, such as
asthma and cancer. To support our gene discovery programs, the company currently
has access to approximately 45,000 DNA samples.
 
     We believe that we employ some of the best gene identification technologies
available. However, we continue to evaluate whether it makes sense from a cost
and efficiency standpoint to redesign and improve our systems, analytical
techniques and tools.
 
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GENE FUNCTION
 
     Finding and sequencing a gene is not enough. We also need to know what
biological processes that gene plays a role in. The term "functional genomics"
refers to a variety of scientific disciplines that examine gene function and
identify disease pathways resulting from a gene or genes that are not
functioning properly. A great deal of work may have to be done to arrive at a
final conclusion about the role of a particular gene in protein production and
any associated disease process. The job of determining the functions of a
gene -- and its protein products -- requires testing in systems that approximate
human systems. We use many such systems at Axys, including the C. elegans
(nematode worm) system, the Drosophila (fruit fly) system and a DNA gene array
system.
 
     Axys is a leader in the use of C. elegans, a microscopic multicellular
round worm, as a tool to determine gene function. This nematode is the most
thoroughly understood multicellular animal in terms of cellular development,
anatomy and genetic content. In fact, its DNA has been completely sequenced. C.
elegans is quite useful as a research tool because as many as 70% of the
currently known human disease genes possess a highly significant homolog (sister
gene) in the nematode. Nematode genetic studies have led to major advances in
the understanding of several disease pathways. By using our nematode technology,
we are able to study the function of nematode genes as a model system for a
number of important human diseases. In addition to nematodes, we also use other
model systems such as fruit flies, yeast and mice to test the function of genes.
 
     Rounding out our functional genomics technologies is the use of gene
"microarray" technology. Using technology licensed from Molecular
Dynamics-Amersham, very small arrays are built on glass slides to study the
expression levels of thousands of genes at the same time. Gene expression is the
extent to which a gene causes a protein to be emitted from a cell. With the
information generated from these arrays, we can compare differences in gene
expression between normal and diseased or genetically manipulated cells. This is
known as gene expression profiling and is a valuable tool for identifying the
levels of genetic messages that change in a disease state. By combining gene
expression data with information about genetic relationships gained from model
systems and studying human populations, we are better able to identify points in
biological pathways that may be the best route for therapeutic intervention.
 
     In the course of our gene function research, we have identified several
target disease genes and are currently attempting to identify the corresponding
mutations responsible for the applicable diseases. Among other gene discoveries,
Axys, together with the National Cancer Institute, identified a gene and a
corresponding mutation associated with hereditary melanoma in January 1996. In
addition, the company, in collaboration with The Jackson Laboratory, discovered
TULP 1, a gene associated with obesity in mice, in early 1996. Subsequently, the
company was issued a patent covering the full length sequence of the TULP1 gene
(tubby) and its protein product.
 
LEAD IDENTIFICATION
 
     Once we have identified the gene and its function in a disease, we need to
find a way to chemically regulate the protein product of that gene. The first
step in that process is to find lead chemical compounds which may be further
developed later if they pass certain tests. Lead candidates in our drug
discovery programs are identified using a broad range of technologies, including
crystallography, structural biology, medicinal chemistry, combinatorial
chemistry and high-throughput screening. Where molecular structures of protein
targets can be determined, we can utilize our computational science
capabilities; where structural information is limited, we can utilize our
combinatorial chemistry and high-throughput screening to identify lead
candidates.
 
     Axys uses a broad range of scientific capabilities to study the basic
structure of molecules (X-ray crystallography) and advanced chemistry that uses
the knowledge gained from crystallography and structural biology. These
technologies can speed research by enabling an understanding of the precise
structure of a target molecule associated with a disease. Using these
technologies, we have the ability to determine the exact three-dimensional
structure of a protein molecule. Then, we bring additional computational science
capabilities into play. Axys has its own software program that is a rapid,
flexible molecular docking model that can be
 
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used to test compounds for binding without actually doing the work in the
chemistry lab. This software allows us to look for a natural or synthetic
"inhibitor" that can bind to the molecule and change the way it will perform in
the body. By using structure-based design, we have the ability to rapidly create
lead compounds that are less likely to cause side effects, be toxic or result in
lengthy delays in drug development due to failed safety studies. The X-ray
crystallography and structural biology efforts at Axys have produced significant
results by identifying many important structures.
 
     Medicinal chemistry is an important part of our lead identification
efforts. We have approximately 50 medicinal chemists at Axys, many of whom are
involved in lead identification. Using the information gathered from X-ray
crystallography and structural biology, medicinal chemists make custom drug-like
compounds and then are able to fine tune them using data from various tests.
 
     Traditional medicinal development has been described as carefully selecting
one bullet at a time and carrying out extensive laboratory experiments to
fine-tune the capability of the bullet to hit the target. In contrast,
combinatorial chemistry is more like shooting thousands of bullets at a target
all at once and then finding the bullets that hit the target. The combinatorial
chemists in our Advanced Technologies Division are able to rapidly create
libraries of drug-like compounds, consisting of large collections of different
compounds.
 
     To screen these libraries, Axys uses automated robotics systems. These
robots test the binding activity of thousands of compounds against a disease
target, usually a protein. This binding activity is a measure of the compound's
ability to inhibit or potentiate the activity of the protein. The primary role
of the technology is to detect active compounds and supply directions for their
optimization using other techniques. Given the variety and size of chemical
libraries available today, and the need to compare the results from multiple
screenings, data collection and management of information are critical elements
of high throughput screening. Axys maintains data bases of structures, assays
performed, screening results and other similar information in relational data
bases, which can be queried from any number of research parameters.
 
     Many of the leads being pursued by the company are protease inhibitors.
Proteases are enzymes which play a critical role in virtually every biological
process, and their over or under regulation is often associated with a disease.
The company believes the ability to develop inhibitors of proteases is therefore
important. Axys also has a number of other early research programs aimed at
identifying potential biological targets among serine and cysteine proteases,
two classes of proteases. Using sophisticated genetic mapping techniques, the
company believes it is able to gain proprietary knowledge about how proteases
contribute to key biological events, in particular, those that play a role in
physiological disorders, such as cancer and inflammatory diseases.
 
PRECLINICAL AND CLINICAL DEVELOPMENT
 
     Once a drug compound succeeds in winning out against tens of thousands of
competing compounds in a series of critical tests, whether it was developed
through structure-based drug design or was the product of our combinatorial or
medicinal chemistry efforts, we must still refine it to meet rigorous safety and
clinical criteria before it can be tested in humans. This is also where
traditional medicinal chemistry comes into play.
 
     We believe we are unique in having an in-house medicinal chemistry group of
the size and scope usually found in large pharmaceutical companies. We use our
medicinal chemistry capabilities to fine-tune, or optimize, the drug-like
compounds to become lead candidates and potential new drugs. Medicinal chemistry
is a process used to improve the potency, selectivity (won't bind to wrong
target), oral bioavailability (compound can be absorbed by the body when taken
orally as a pill), metabolic stability (how rapidly the body breaks down the
compound), and biological half-life (how long the effects of the drug will last)
of a drug candidate. Among our own medicinal chemistry tools is our patented
Delta Technology, which enhances the ability of lead compounds to act against
some proteases implicated in a broad range of diseases. In December 1997, the
United States Patent and Trademark Office issued a patent providing broad
protection of the company's Delta Technology. The patent pertains to technology
useful in research for the discovery of unique protease inhibitors. Delta
Technology enables researchers to take a common element that is always in the
blood -- zinc -- and use it to increase the binding potency of a drug candidate.
Many of the company's collaborations use the Delta Technology.
 
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     Before qualifying for evaluation in human trials, compounds must pass
extensive safety and effectiveness tests. In further tests, Axys uses models of
human disease to provide important information on how long the drug effects last
or the duration of action of a potential drug, as well as how it is absorbed by
the body or metabolized. On-site studies take advantage of advanced
technologies, such as mass spectrometry (a sensitive analytical method to
identify a compound and the products into which it is broken down), to evaluate
hundreds of samples, indicating not only drug concentrations but also the
pharmacodynamic (what the drug does to the body) and the pharmacokinetic (what
the body does to the drug) characteristics of compounds nearing human clinical
trials.
 
     In addition, we are using our genomics-derived assets and capabilities in
the field of pharmacogenomics in our preclinical and clinical development
efforts. Pharmacogenomics is the use of genetic and genomic information to
predict the response of individual patients and patient populations to drugs.
Through our PPGx subsidiary we have developed and are continuing to develop our
bioinformatics platform and computer-based tools to link genetic data from drug
development and medical practice with worldwide genomic databases. These tools
allow us to better determine which patients will respond to the compounds being
tested, as well as eliminate those who may be at risk of adverse reactions. We
believe that pharmacogenomics will revolutionize clinical trials, improve the
success rate of clinical development and reduce development time and cost.
 
     Finally, while some of our collaborative partners provide clinical
development expertise, we also have an in-house clinical development group. With
extensive prior experience in managing clinical trials, satisfying regulatory
requirements, ensuring manufacturing quality control and quality assurance, this
group is taking our products forward into human testing.
 
WHAT DRUG DISCOVERY PARTNERSHIPS WITH WORLD-CLASS PHARMACEUTICAL PARTNERS DOES
AXYS HAVE?
 
                               PARTNERED PIPELINE
 
<TABLE>
<CAPTION>
                                                    GENE          GENE          LEAD
                                               IDENTIFICATION   FUNCTION   IDENTIFICATION   PRECLINICAL   CLINICAL
                                               --------------   --------   --------------   -----------   --------
<S>                                            <C>              <C>        <C>              <C>           <C>
Bayer -- Asthma........................................................................................       X
       -- Psoriasis....................................................................................       X
       -- IBD..........................................................................................       X
Merck -- Osteoporosis....................................................................         X
Bristol-Myers Squibb -- Hepatitis C......................................................         X
Rhone-Poulnec Rorer -- Inflammation......................................................         X
Pharmacia & Upjohn (to be repartnered) -- Factor Xa......................................         X
Amgen -- Hematology.....................................................          X
Pharmacia & Upjohn -- Endocrinology.....................................          X
Roche Bioscience -- CNS disorder.............................       X
Parke-Davis -- Schizophrenia/Bipolar.........         X
Boehringer Ingelheim -- Asthma...............         X
</TABLE>
 
  Bayer AG (Tryptase Inhibitors/Asthma/Clinical Phase)
 
     In 1994 we entered into an agreement with Bayer AG for the research and
development of tryptase inhibitors for the treatment of asthma. Tryptase is a
serine protease that has been shown to regulate inflammation. Tryptase is
released by mast cells as part of an immune response to allergens such as
pollen, mold or grasses and contributes to several biological events which
result in inflammation. Axys' tryptase inhibitors are designed to slow or halt
the inflammatory process at an early stage, in an attempt to provide safe and
effective therapies for the treatment of the underlying cause of disease, rather
than the symptoms.
 
     Asthma is characterized by generalized airway inflammation and tightness in
the lungs (bronchoconstriction) which makes breathing difficult. Five percent of
the United States population, or approximately 13 million people, are estimated
to suffer from some form of asthma. The exact causes of asthma are not well
 
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understood, and current treatments for asthma are limited to controlling
inflammation through the use of inhaled steroids or treating airway constriction
through the use of bronchodilators.
 
     In our collaboration with Bayer, we have established (in previous Phase II
clinical studies) that inhibiting tryptase resulted in improved breathing
(reduction in late airway response) in asthmatics. In December 1998, Bayer
selected an oral tryptase inhibitor compound for clinical development and is now
moving forward with the development of that compound.
 
  Bayer AG (Tryptase Inhibitors/Psoriasis/Clinical Phase)
 
     In July 1997, we modified our 1994 research and development agreement with
Bayer to re-acquire the rights to develop tryptase inhibitors for the treatment
of psoriasis, which, like asthma, is a mast cell regulated inflammatory disease.
 
     Psoriasis is a skin disorder characterized by excessive skin cell
reproduction. The disease has several different clinical presentations that are
most often characterized by raised, inflamed sores covered with a scaly white
buildup of dead skin cells. Nearly seven million people in the U.S. suffer from
various forms of psoriasis, however, none of the current treatments, including
topical steroids or systemic chemotherapeutics, offer consistent relief.
 
     In the second half of 1997, we started preclinical development of a
tryptase inhibitor (APC 2059) as a potential treatment for this disease. APC
2059 is a compound developed by Axys and is a member of a class of compounds
designed to inhibit tryptase. In December 1998 we started Phase Ia safety
clinical studies on a topical cream formulation of APC 2059 for the treatment of
psoriasis. We successfully completed that Phase Ia (single dose per subject)
clinical study and in February 1999 started a Phase Ib (multiple doses per
subject) clinical study of APC-2059 as a topical cream formulation for the
treatment of psoriasis. Upon the conclusion of Phase II (studying the effects of
varying doses of a drug to establish that it works in patients) clinical studies
for this indication, Bayer has the ability to reacquire from Axys the rights to
further develop APC 2059 for this indication. If Bayer decides to re-acquire
this compound, Bayer would reimburse Axys for development expenses incurred to
date and make other additional payments to Axys.
 
  Bayer AG (Tryptase Inhibitors/Inflammatory Bowel Disease/Clinical Phase)
 
     In July 1997, we also modified our 1994 research and development agreement
with Bayer to re-acquire the rights to develop tryptase inhibitors for the
treatment of inflammatory bowel disease, which, like asthma, is a another mast
cell regulated inflammatory disease.
 
     Inflammatory bowel disease generally refers to two diseases: Crohn's
disease and ulcerative colitis. Over 500,000 people in the U.S. suffer from
inflammatory bowel disease. Current therapies, which include the use of
corticosteroids and immunosuppressants such as cyclosporine and methotrexate,
expose patients to significant side effects.
 
     In the second half of 1997, we also initiated preclinical development of
the same Axys-developed compound, APC 2059 (in a different formulation), as a
potential treatment for this disease. In December 1998 we commenced Phase Ia
safety clinical studies on an injectable formulation of APC 2059 for the
treatment of inflammatory bowel disease. We successfully completed that Phase Ia
clinical study and in February 1999 we initiated a Phase Ib clinical study of an
injectable formulation of APC-2059 for the treatment of inflammatory bowel
disease. Upon the conclusion of Phase II clinical studies for this indication,
Bayer has the ability to reacquire from Axys the rights to further develop APC
2059 for this indication. If Bayer does decide to re-acquire this compound,
Bayer would reimburse Axys for development expenses incurred to date and make
other additional payments to Axys.
 
  Merck (Cathepsin K Inhibitors/Osteoporosis/Preclinical)
 
     In November 1996 we entered into a research and development collaboration
with Merck & Co. to develop small molecule inhibitors of cathepsin K for the
treatment of osteoporosis. Osteoporosis is a disease of
 
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the bones that results in weakened bones which leads to more bone breaks. This
condition mainly affects elderly women.
 
     Cathepsin K belongs to a class of enzymes called cysteine proteases. It is
known to be secreted in excessive amounts by osteoclasts. In the healthy human
body, osteoblast cells are responsible for bone-building while osteoclasts are
responsible for bone degradation. By maintaining a careful balance in each type
of cell's activity, normal bone remodeling and skeletal integrity is achieved.
However, when the rate at which bone is destroyed by the osteoclasts exceeds the
rate at which new bone is produced by osteoblasts, the result is excessive bone
degradation (bone resorption) -- a condition that results in brittle bones and
is characteristic of osteoporosis.
 
     In February 1997, we announced the first ever solution of the
three-dimensional crystal structure of cathepsin K. Although the research and
development relationship was originally schedule to end after two years, we
agreed with Merck in December 1998 to extend this collaboration for an
additional year until early November, 1999.
 
  Bristol-Myers Squibb (Protease Inhibitors/Hepatitis C/Preclinical)
 
     In December 1997, the company entered into an agreement with Bristol-Myers
Squibb to develop protease inhibitors to prevent the growth and spread of the
hepatitis C virus, also known as HCV. In relation to this agreement, both Axys
and Bristol-Myers Squibb entered into agreements with Chiron Corporation to
obtain non-exclusive licenses under its hepatitis C virus patents for protease
inhibitor research. These licenses allow both companies to collaborate in their
research under Chiron's patents with respect to the use of HCV NS3 protease in
protease inhibitor research activities.
 
     As many as seven viruses are known to cause hepatitis, which is
characterized by the damage of liver cells, and is a leading cause of liver
disease. Different types of hepatitis cause acute as well as chronic infection,
in addition to cirrhosis of the liver and jaundice. Differentiated by letters of
the alphabet, the viruses which cause hepatitis are transmitted through various
modes and have varying degrees of severity. In the 1960's, the first viral agent
was identified which causes hepatitis (hepatitis B). Hepatitis A was isolated in
1973. Despite these early discoveries, chronic and severe cases of hepatitis
spread with no known cause. These cases were referred to as Non-A, Non-B
hepatitis. Hepatitis C, the major cause of Non-A and Non-B hepatitis, was
finally discovered in 1987.
 
     As many as four million Americans and 60 million people worldwide are
infected with hepatitis C virus. HCV infection is more serious than hepatitis A
or B, and is more likely to result in chronic liver disease. Liver damage due to
HCV is the leading reason for liver transplants in the U.S. The virus may be
sexually transmitted or acquired through I.V. drug use or by blood transfusions
prior to 1990.
 
     In September 1998 we announced the receipt of a milestone payment from
Bristol-Myers Squibb in this collaboration based on the attainment of certain
drug discovery goals making use of our chemistry. Research under this
collaboration is on-going and the research program extends through December
2000.
 
  Rhone-Poulenc Rorer (Cathepsin S inhibitors/Inflammatory Diseases/Preclinical)
 
     In December 1998 we entered into a collaborative research and development
agreement with Rhone-Poulenc Rorer (RPR). The objective of the collaboration is
the discovery and development of small molecule therapeutics that inhibit
cathepsin S, a human cysteine protease associated with certain inflammatory
diseases. The collaboration is for two years and may be extended by RPR for two
additional one-year periods.
 
     Cathepsin S is a cysteine protease found in antigen-presenting cells of the
immune system. Unlike many other proteases, it is rarely found in other types of
cells. Cathepsin S is believed to function in a pathway that regulates the
body's ability to fight off these foreign antigens, leading to an inflammatory
reaction. As a result, it may be possible to use inhibitors of cathepsin S to
block the pathway and consequently protect the body from certain inflammatory
diseases and perhaps autoimmune disorders. Our researchers were the first to
solve the three-dimensional X-ray crystal structure of cathepsin S, as reported
in June 1998 in Protein Science.
 
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<PAGE>   9
 
     Cathepsin S is associated with some inflammatory diseases, including
arthritis, asthma, atherosclerosis and a variety of autoimmune diseases. Under
the terms of the agreement, RPR has exclusive development and marketing rights
to cathepsin S protease inhibitors for respiratory diseases, atherosclerosis and
related conditions and rheumatoid arthritis. Rheumatoid arthritis affects
approximately 2.5 million Americans. Coronary heart disease is caused by the
atherosclerotic narrowing of the coronary arteries and is the number one cause
of death in United States with approximately 500,000 deaths occurring annually.
Stroke is the third leading cause of death in the United States, with
approximately 160,000 deaths occurring annually.
 
  Pharmacia & Upjohn (Factors Xa & VIIa & Thrombin Inhibitors/Blood Clotting
Disorders/Preclinical)
 
     In September 1995, we signed a collaboration agreement with the company
that is now known as Pharmacia & Upjohn, Inc. to develop oral therapeutics for
blood clotting disorders, such as deep vein thrombosis, stroke, and myocardial
infarction. More specifically, we have been using our Delta technology and other
technologies to discover inhibitors of Factors Xa and VIIa and thrombin, all of
which are serine proteases. In July 1998 the research support for this
collaboration ended and in February 1999 we formally agreed to end this
collaboration. We are, however, continuing our research efforts and are actively
seeking a new partner for this program.
 
     Factor Xa, factor VIIa and thrombin are three enzymes involved in the blood
clotting process. All three are serine proteases that have been acknowledged as
targets for a host of disorders related to abnormal clotting. Annually, more
than 2 million people are hospitalized in the United States for deep vein
Thombosis, acute myocardial infarction and unstable angina.
 
     In 1996 and 1997, we designed and tested a variety of compounds based on
our Delta technology and, with our partner, Pharmacia & Upjohn, we identified
six families of Delta compounds for study in clotting and pharmacokinetic (what
the body does to the drug) tests. Throughout 1998, we continued to work on the
development of compounds which could be nominated as a clinical candidates.
 
  Amgen (EPO Mimetics/Hematology/Lead Identification)
 
     In May 1993 we entered into an agreement with Amgen to develop synthetic,
small molecule mimetics of erthropoietin (EPO). The collaboration funding ended
in February 1997 and all research activities were then transferred to Amgen.
Amgen is obligated to continue further research in this area.
 
     In October 1998 joint team of researchers from Axys and Amgen published the
three dimensional X-ray crystal structure of EPO bound to its receptor. The
structure as determined offers important insight into how human EPO is involved
in stem cell growth and red blood cell production.
 
  Pharmacia & Upjohn (Endocrinology/hGH/Lead Identification)
 
     In March, 1993, we entered into a research and development agreement with
Pharmacia & Upjohn to develop synthetic, small molecule mimetics of human growth
factor, initially focusing on human growth hormone. The collaboration funding
concluded at the end of 1997 and all research activities were transferred to
P&U. P&U is obligated to continue further research in this area. Concurrent with
the signing of the initial agreement, P&U made a $5.4 million equity investment
in Axys. Axys received research funding during the term of the research
collaboration, will receive benchmark payments if mutually agreed upon
milestones are reached, and royalties upon P&U's sales of any licensed products.
 
  Roche Bioscience (Nematode Research/CNS Disorders/Gene Function)
 
     In June 1998 we entered into an agreement with Roche Bioscience to
establish a partnership based on the functional genomics capabilities of Axys.
The alliance is focusing on evaluating the function of genes provided by Roche
Bioscience that may serve as drug targets in the development of therapies for
pain and other conditions involving peripheral nervous system disorders. Roche
Bioscience is providing us with a set of unique genes to which we are applying
our functional genomic technologies involving the nematode. The initial research
term is 15 months. Roche Bioscience may, however, extend the agreement through
June 2000.
 
                                        8
<PAGE>   10
 
  Parke-Davis (Gene Research/Schizophrenia & Bipolar Disorder/Gene
Identification)
 
     In November 1997, the Company entered into a broad-based genomics alliance
with the Parke-Davis Pharmaceutical Research Division of Warner-Lambert Company
to develop unique therapeutic products for the treatment of schizophrenia and
bipolar disorder. The alliance combines our capabilities in gene discovery,
functional genomics, bioinformatics, screening with Parke-Davis' research,
development and clinical expertise in the central nervous systems area. The
research term of the alliance is five years, but may be extended in one-year
increments to a period of eight years with additional increases in research
funding.
 
     By October 1998 we had achieved two milestones in this research
collaboration. One research milestone was achieved by making significant
progress in our psychiatric genomics research. Another was reached by completing
certain technology development on our own bioinformatics platform and
transferring that technology to Parke-Davis.
 
  Boehringer Ingelheim (Gene Research/Asthma/Gene Identification)
 
     In June 1995, we entered into a five-year collaborative research agreement
with Boehringer Ingelheim aimed at identifying genetic causes of asthma and
developing new therapeutics based on those findings. In May 1997, we agreed to
expand the program with a doubling of the research support for the
collaboration. Also in May 1997 we announced the discovery of a gene related to
asthma and the receipt of an associated milestone payment. Effective January 1,
1999, we agreed to reduce the number of funded researchers in this program and
we are continuing to have discussions with Boehringer Ingelheim about the future
direction of this collaboration.
 
OTHER AGREEMENTS/RELATIONSHIPS
 
  Memorial Sloan-Kettering (Gene Research/Oncology/Gene Identification)
 
     In January 1997, the company and Memorial Sloan-Kettering Cancer Center
formed a joint venture known as Genos Biosciences, Inc. Genos' focus is the
identification of genes and related genetic information that will be of value in
the prognosis, diagnosis and possible treatment of three of the most common
cancers, specifically, prostate, breast, and colon cancer, which collectively
account for a significant percentage of all new cancer cases. These types of
cancer are usually caused by "somatic" mutations -- non-hereditary changes
occurring in the genes of certain cells that increase the risk for developing
cancer.
 
  Perkin-Elmer (Gene Sequencing/Liver Cancer/Gene Identification)
 
     In 1997 the company entered into an agreement with PE Applied Biosystems, a
division of The Perkin-Elmer Corporation, to form a broad-based DNA-sequencing
joint venture in Shanghai, China called GeneCore. In October 1997, the joint
venture was expanded to include SiniWest Holdings, Inc. (a 5% equity holder). In
October 1997, the joint venture was awarded a research contract from China's
State Science & Technology Commission to sequence human genes involved in liver
cancer. Under the contract, GeneCore is applying high throughput genomic
sequencing and related technologies to a targeted region of the human genome
believed to contain a gene responsible for the disease. Identification and
isolation of this gene is expected to provide potential new targets for improved
diagnostic and therapeutic products.
 
  Corange International (Osteoporosis)
 
     In May 1995, we entered into a strategic alliance with Corange
International, Ltd., the parent company of Boehringer Mannheim ("Corange"), to
identify the genes involved in osteoporosis. The goal of the program was to
identify specific genetic regions linked to bone metabolism within the human
genome, as a successor to the work already done with primates. In March 1998, we
agreed to expand the resources devoted to the program in order to accelerate the
research. However, when research priorities were changed following Roche Group's
acquisition of Corange, Corange exercised its right to end this research program
as of February 1999. We are seeking to partner this research.
 
                                        9
<PAGE>   11
 
  Glaxo-Wellcome (Type II Diabetes)
 
     In July 1994 we entered into a strategic partnership with Glaxo-Wellcome to
discover genes associated with type II diabetes or non-insulin dependent
diabetes mellitus (NIDDM). In February 1996, Glaxo expanded its strategic
alliance with the company in the area of type II diabetes to include the study
of human obesity. In September 1997, as a result of this study which involved
genetic analyses of more than 5,000 individuals from diabetic families, the
company and Glaxo identified specific regions of DNA which we both believe
contain genes associated with NIDDM, for which we received a milestone payment
from Glaxo. In January 1997, Axys announced the signing of an agreement between
NemaPharm and Glaxo to apply Axys' nematode technology to evaluate the function
of certain genes provided by Glaxo and identify targets for the discovery of
novel therapeutics.
 
     In May 1998, following a review of our relationship, we agreed to
discontinue the collaboration on type II diabetes and obesity. Under the terms
of the dissolution agreement, we received exclusive rights to all obesity family
samples and data and non-exclusive rights to some type II diabetes samples and
data. In addition, the nematode research has been concluded and the rights to
the information and technology developed during the collaboration have been
divided between the company and Glaxo. We are seeking to partner this research.
 
  Additional Program
 
     In February 1998 we announced the discovery we made with the Jackson
Laboratory of a human gene related to the mouse obesity gene known as "tubby"
which is responsible for a form of an inherited blindness disorder, commonly
known as retinitis pigmentosa (RP). The U.S. Patent and Trademark Office has
issued to Axys a patent relating to TULP2, a second tubby-like protein sequence
identified by the Axys/Jackson Laboratory team and linked to ocular disease. We
are seeking to partner this research.
 
     For additional information about the terms of the agreements discussed
above, we refer you to Item 7 of this Form 10-K entitled "MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and
the subsection entitled "Overview in Item 7."
 
WHAT DOES AXYS' NON-PARTNERED RESEARCH AND DEVELOPMENT FRANCHISE IN ONCOLOGY
LOOK LIKE?
 
                        PROPRIETARY PIPELINE -- ONCOLOGY
 
<TABLE>
<CAPTION>
                                            GENE          GENE          LEAD
                                       IDENTIFICATION   FUNCTION   IDENTIFICATION   PRECLINICAL   CLINICAL
                                       --------------   --------   --------------   -----------   --------
<S>                                    <C>              <C>        <C>              <C>           <C>
Urokinase -- Agiogenesis.........................................................             X
Cathepsin B -- Solid Tumor Metastasis...........................                X
Prostate Specific Antigen -- Prostate Cancer....................                X
Axys Serine Protease (ASP) 05 -- Insulin-like Growth Factor
  (IGF) pathway.................................................                X
Cathepsin U, V, W, Axys Serine Protease (ASP) 07 --
  various cancers....................................          X
Hypoxia, Metastasis, Angiogenesis....               X
Prostate, Breast, Colon cancers......               X
</TABLE>
 
     In early 1999 we announced our strategy to focus our unpartnered resources
on the development of small molecule therapeutics for the treatment of cancer.
We believe that there is a significant market opportunity to meet current and
future medical needs associated with many different types of cancer. The
worldwide market for cancer therapeutics was estimated at $4.8 billion in 1996.
That market is projected to grow to $13.3 billion by 2005 and $18.8 billion by
2010. One of the factors contributing to this growth is the aging of the world's
population. As people live longer, cancer becomes more prevalent.
 
     Our decision to focus our resources on cancer therapeutics was also partly
based on the improving regulatory environment for approval of cancer
therapeutics. In recent years the FDA has established a
 
                                       10
<PAGE>   12
 
regulatory "fast track" for some cancer therapeutics reviews. In addition,
surrogate markers such as tumor shrinkage have been increasingly accepted as
research endpoints. The use of surrogate markers substantially shortens the
length of the necessary clinical research studies.
 
     Further, there are a number of emerging treatment methods which we believe
we can or may be able to use our technologies on, such as protease inhibition,
to develop small molecule therapeutics (essential for oral delivery). These
include antiangiogenesis and metastasis inhibition. Angiogenesis is the process
by which blood vessels are formed. Blood vessel formation and growth is
necessary for tumor growth. Antiangiogenesis drugs are believed to be able to
cut off blood vessel growth and thereby reduce the size of tumors and
potentially maintain them in a non-growth state. Metastasis is the process by
which cancer spreads. Drugs which discourage metastasis are believed to be able
to stop cancer from spreading throughout the body.
 
     A final reason for this decision is that we were already actively
participating in cancer research. We have had research programs underway that
range from a preclincial program in angiogenesis to lead identification programs
in solid tumor metastasis, prostate cancer and the insulin growth factor (IGF)
pathway to cancer gene function and identification research programs.
 
     Our most advanced cancer program today is our urokinase research program.
Urokinase is believed to play a role in angiogenesis and tumor metastasis and we
believe it is involved in cancer progression at a relatively early stage of the
cancer process. We are focused on the development of urokinase inhibitors for
use in combination with other cancer therapies. Our Delta Technology is being
used in the development of potent and selective inhibitors of urokinase. We
anticipate we will select an urokinase inhibitor compound to move forward into
clinical development in the latter half of 1999.
 
     To enhance our cancer research efforts, we reallocated our research
personnel in January 1999, increasing the number of cancer researchers from
approximately 50 scientists to approximately 120 scientists. In addition, we are
actively seeking to license cancer treatment compounds from other biotechnology
or pharmaceutical companies with an emphasis on the pre-clinical and early stage
clinical product opportunities.
 
WHY AND HOW HAVE WE LEVERAGED OUR TECHNOLOGY PLATFORM?
 
     In looking to the future we recognize that we will need additional capital
in order to continue our research and development efforts. One way we believe we
can raise additional capital is through the leveraging our existing technology
assets. To accomplish this, we have created two new businesses (one in
agricultural biotechnology and the other in pharmacogenomics) and have
structured our combinatorial chemistry business to be spun out. At the same
time, we are retaining the intellectual property and assets that these
businesses also make use of for our own drug discovery and development purposes.
In spinning out these businesses, our business model contemplates that each
business should have
 
     - ACCESS TO AND OWNERSHIP (IF NECESSARY) OF OUR RELEVANT TECHNOLOGIES, so
       that they can continue to pursue their respective businesses
       independently,
 
     - INDEPENDENT MANAGEMENT focused on their business, rather than on Axys'
       drug discovery business, and
 
     - FUNDING FROM THIRD PARTIES so that we do not have to divert our own
       capital from drug discovery.
 
     While the third parties who provide capital for these businesses acquire an
equity ownership position in the businesses, we would also retain a sizeable
equity ownership position. Having set up these businesses, secured financing for
them and provided additional business support as necessary, we have positioned
ourselves to eventually ease our capital formation needs by selling some or all
of our equity position in each of these businesses. This could happen in the
following ways:
 
     - through a sale of our equity interest in the business in the course of a
       public offering of securities for that business,
 
     - through the sale of our equity interest in the business to a third party
       or
 
     - a sale of the business to the third party who has provided it with
       funding or to some other company.
 
     While we believe we will be successful in realizing meaningful value from
these affiliated businesses, our ability to do so will depend on the success of
these businesses in executing their business strategies. There can,
 
                                       11
<PAGE>   13
 
however, be no assurance that these affiliated business will be successful or
that we will have the ability to sell all or a portion of our equity ownership
in these businesses. In addition, there can be no assurance that the amount we
may receive upon selling our equity ownership interest will provide significant
funding so as to postpone for a meaningful time period the need to engage in
other capital formation activities.
 
HOW AND WHEN WERE THESE AFFILIATED BUSINESSES SET UP?
 
     The first affiliated business we set up in early 1998 (but have not yet
spun out) was our combinatorial chemistry business which is called the Advanced
Technologies Division. It has its own divisional management and handles the
sales and marketing and production of its products, including combinatorial
chemistry libraries and related technology. The Division is reviewed internally
on a separate stand alone basis except for certain overhead allocations to the
Division. In 1998 the Division was a positive contributor to our cash flows. We
have not sought third party funding for the Division but are seeking other ways
in which the Division would help to fund our drug discovery business.
 
     The second affiliated business, incorporated separately as Xyris
Corporation, was formed in the second quarter of 1998. Xyris is applying our
genomics, combinatorial chemistry and small molecule discovery technologies in
the agricultural biotechnology field. Xyris is being run by Dr. Jerry Caulder,
the former Chairman and CEO of Mycogen, a diversified agribusiness and
biotechnology company. During his 14-years at Mycogen, Dr. Caulder guided
Mycogen from a start-up venture to a leadership position in the agbiotech
market. Prior to joining Mycogen, he spent over 15 years with Monsanto Company,
where he managed various aspects of both the international and domestic business
of Monsanto Agricultural Products Company. A San Francisco-based merchant bank
and advisory partnership has provided the initial capital for the business in
exchange for a minority ownership position. We currently own more than a
majority of the outstanding shares of Xyris.
 
     The third affiliated business, incorporated separately as PPGx, Inc., was
formed in the first quarter of 1999. PPGx is a provider of a comprehensive
package of products and services to provide solutions to pharmacogenomic
problems. We believe that PPGx's pharmacogenomics products and services will be
of significant interest to those performing clinical trials. PPGx is being run
by Dr. Jean Warner, our Vice President of Medical Affairs. Dr. Warner formerly
has been involved with clinical trials for over 18 years, working with us since
1996 and with Khepri Pharmaceuticals, Syntex, Merck, Sharpe and Dohme Research
Laboratories prior to then. The funding for PPGx is being initially provided by
and through our minority partner, PPD, Inc. We currently own more than a
majority of the outstanding shares of PPGx. In addition to funding PPGx, PPD
contributed its former subsidiaries Intek Labs, Inc. and Intek Labs Ltd. to
PPGx's operations. In connection with the formation of PPGx, PPD received the
right to handle the marketing and sales of PPGx's pharmacogenomics products and
services on an exclusive basis.
 
WHAT DO THESE AFFILIATED BUSINESSES DO?
 
  Advanced Technologies Division
 
     The Advanced Technologies Division conceives, produces and sells large
numbers of diverse combinatorial chemistry libraries of drug-like compounds, as
well as more focused libraries which are more focused around a specific
structure. In addition, the Advanced Technologies Division sells the protocols
which provide the basis for making the libraries that are produced and also
provide the basis to make other similar drug-like compounds. The customers of
the Advanced Technologies Division, including the company, screen these
drug-like compounds against biological targets of interest in an effort to
identify lead compounds for their drug discovery programs.
 
     The Advanced Technologies Division has entered into and is performing a
number of contracts, including contracts with Pharmacia & Upjohn, Parke-Davis
and Rhone-Poulenc Rorer, as well as contracts with biotechnology companies such
as Signal Pharmaceuticals and Protein Design Labs. In most cases, these
contracts provide for the sale of libraries hundreds of thousands of
non-exclusive or co-exclusive drug-like compounds over several years. In some
cases the sale of these libraries is accompanied by the sale of the applicable
protocols which describe how to remake the libraries. In addition, the Advanced
Technologies
 
                                       12
<PAGE>   14
 
Division also offers a program that provides access to our combinatorial
chemistry software tools and that teaches a company how to establish its own
combinatorial chemistry program.
 
  Xyris Corporation
 
     Xyris is focusing its business on the creation of products for crop
protection, crop improvements and animal health, as well as the development of
technology for the seed industry and human nutrition. Since Xyris was created in
mid-1998, it has built its staff. Towards that end, Xyris has hired as Chief
Technical Officer Dr. Leo Kim, the former executive vice president and chief
technical officer at Mycogen Corporation where he was responsible for Mycogen's
worldwide research strategy and implementation. Xyris has also successfully
assembled its Scientific Advisory Board. Xyris is now in the process of
participating in our technology transfer and is also determining the initial
optimal uses for our gene finding, functional genomics, bioinformatics,
structural biology and combinatorial chemistry technologies.
 
  PPGx, Inc.
 
     PPGx is the first company offering a full range of products and services in
pharmacogenomics. PPGx has done this by combining laboratory services, such as
DNA extraction and archiving, genotyping and assay development, with genetic
research capabilities, including physical mapping, gene sequencing, polymorphism
identification and expression analysis, and a comprehensive informatics platform
with genetic and clinical data storage, data mining and analysis capabilities.
 
     PPGx maintains laboratory facilities in the United States and the United
Kingdom to provide genotyping and phenotyping services to its customers.
Currently over 300 assays in 90 genes of pharmaceutical relevance are available.
PPGx uses state of the art high throughput genotyping methods in a Good
Laboratory Practices environment. PPGx has the capability to rapidly develop new
assays in a variety of formats. Phenotyping services are also available for a
number of drug metabolism enzymes. PPGx also maintains genetic research
laboratories with a complete range of genetic and genomic capabilities to
provide services in those cases where the genetic variant that influences drug
effects is not known. These capabilities include use of microarray expression
technologies, as well as physical mapping and gene sequencing technologies.
 
     In addition, PPGx is further developing its informatics platform which
includes a large database containing pharmacogenomic data. Details about
polymorphisms and their effects, as well as the assay methodologies and clinical
data are also contained in the database. In addition, the informatics platform
includes other software programs for data management and other uses in
connection with clinical trials. While PPGx has developed its informatics
platform for its own uses, PPGx also has the capability to customize and
integrate its informatics platform in its customers' environment.
 
WHAT FACTORS COULD CAUSE OUR RESULTS TO DIFFER SIGNIFICANTLY FROM THOSE YOU
MIGHT EXPECT?
 
  THE DEVELOPMENT OF OUR PRODUCTS WILL TAKE SEVERAL YEARS, AND WE MAY NOT BE
  SUCCESSFUL IN DEVELOPING COMMERCIAL PRODUCTS.
 
     All of our potential products are in stages of research and development
that require a great deal of additional research and development efforts before
the drugs could be sold. These efforts include extensive preclinical and
clinical testing and lengthy regulatory review and approval by the United States
Food and Drug Administration. The development of new pharmaceutical products is
highly uncertain and subject to a number of significant risks. Products that
appear to be promising at early stages of development may not reach the market
for a number of reasons, including the following:
 
     - We or our collaborators may not successfully complete any research and
       development efforts
 
     - We may not achieve necessary research milestones
 
     - Our current research may not result in the identification of disease
       genes
 
     - Disease genes that we identify may not lead to the development of
       products
 
                                       13
<PAGE>   15
 
     - Any products we develop may be found to be ineffective or cause harmful
       side effects during preclinical testing or clinical trials
 
     - Any products we develop may be prevented from being commercialized due to
       proprietary rights of third parties
 
     - Required regulatory clearance for any products we develop may not be
       obtained
 
     - We may be unable to manufacture enough of any potential products at an
       acceptable cost and with appropriate quality
 
     - We may be unable to successfully market approved products
 
     - Consumers may not accept any of our approved products.
 
We do not expect any of our products to be commercially availability for a
number of years.
 
  WE HAVE DEPENDED HISTORICALLY ON OUR COLLABORATIVE RELATIONSHIPS, AND WE MAY
  HAVE TO ESTABLISH ADDITIONAL COLLABORATIONS IN THE FUTURE.
 
     Our strategy for the development, clinical testing, manufacturing and
commercialization of certain of our products has in many instances included
entering into collaborations with corporate partners, licensors, licensees and
others. We rely on the activities of our collaborators with respect to the
commercialization of potential products. In addition, a large portion of our
revenues have resulted from these collaborations. If we fail to meet our
contractual obligations under these arrangements, development of our products
may be delayed. If we fail to extend or enter into additional collaborative
relationships, we will have to consider other sources of revenue, including the
need to secure additional financing. See the discussion below entitled "We may
need to secure additional financing."
 
     To date we have entered into collaborations with a number of different
partners, including Amgen, Bayer, Boehringer Ingelheim, Bristol-Myers Squibb,
Corange International, Glaxo Wellcome, Merck, Parke-Davis, Perkin-Elmer,
Pharmacia & Upjohn, Roche Bioscience, Smith-Kline Beecham and Rhone-Poulenc
Rorer.
 
     The amount and timing of resources to be devoted to research, development,
eventual clinical trials and commercialization activities by our collaborators
are not within our control. We cannot guarantee that our partners will perform
their obligations as expected. In addition, we cannot be certain that we will
gain additional revenue from these arrangements beyond the minimum contractual
commitments.
 
     All of our collaboration agreements may be canceled under certain
circumstances. In addition, the research funding phase of several of the
company's collaborations will come to an end in the next few years unless
continued or extended by agreement with our collaborators. If any of our
collaborators break or elect to cancel their agreements or otherwise fail to
conduct their collaborative activities in a timely manner, the development or
commercialization of potential products or research programs may be delayed. In
that case, we may be required to devote additional resources to product
development and commercialization or we may cancel certain development programs.
 
     In addition, we have entered into a number of agreements with hospitals and
academic institutions in which they provide human tissue samples to the company.
Some of these agreements are material to our research. If we are unable to
maintain or renew these agreements, it could have a material adverse effect on
our business, financial condition and results of operation.
 
     Disputes may arise in the future with regards to the ownership of rights to
any technology developed with collaborators. These and other possible
disagreements with collaborators, or tissue sample providers, could lead to
delays in the achievement of milestones or receipt of payments or in
collaborative research, development and commercialization of certain potential
products. In addition, these disputes could require or result in lawsuits or
arbitration. Lawsuits and arbitration are time-consuming and expensive. Even if
we win, the cost of these proceedings could adversely affect our business,
financial condition and results of operations. Furthermore, these proceedings
could adversely affect our stock price or our business reputation and may make
the process of entering into additional collaborative relationships more
difficult.
 
                                       14
<PAGE>   16
 
     In some cases our collaborators are developing products that may compete
with our potential products. In addition, some of our collaborators have well
established products from which they receive substantial revenue. Some of these
products will compete with those being developed under collaborations. As a
result, collaborators may pursue their existing or alternative technologies in
preference to diagnostic or therapeutic products being developed in
collaboration with us. In addition, our collaborators may not develop and market
any potential products under the collaborations.
 
  WE MAY BE UNABLE TO SATISFY FDA REGULATORY REQUIREMENTS FOR CLINICAL TRIALS.
 
     Either we or our collaborators must show through preclinical studies and
clinical trials that each potential product is safe and beneficial in humans for
each target indication before getting regulatory clearance from the FDA for the
commercial sale of the product. The failure to adequately show the safety and
effectiveness of a potential product could delay or prevent regulatory approval
of that potential product. The results from preclinical studies and early
clinical trials are often different than the results that will be obtained in
large-scale testing. We cannot be certain that we will show sufficient safety
and effectiveness in our clinical trials that would allow us to obtain the
needed regulatory approval. A number of companies in the pharmaceutical
industry, including biotechnology companies, have suffered significant setbacks
in advanced clinical trials, even after promising results in earlier trials.
 
     Before starting clinical trials in humans, our collaborators or we must
submit to and receive approval from the FDA of an investigational new drug
application (IND). Submission of an IND does not guarantee FDA authorization to
start clinical trials. Clinical testing must meet requirements for institutional
review board oversight, informed consent and good clinical practice requirements
and is subject to continuing FDA monitoring. We do not have extensive experience
in conducting and managing the clinical testing necessary to obtain regulatory
approval.
 
     Any drug is likely to produce some level of toxicity or undesirable side
effects in animals and in humans when administered at sufficiently high doses
and/or for a long period of time. Unacceptable toxicities or side effects may
occur in the course of toxicity studies or of clinical trials of our potential
products. If we observe unacceptable toxicities or side effects in toxicology
studies or in clinical trials, we, our collaborators or regulatory authorities
may interrupt, limit, delay or halt the development of the potential product. In
addition, these unacceptable toxicities or side effects could prevent clearance
by the FDA or foreign regulatory authorities for any or all targeted
indications.
 
     We currently have one compound, APC 2059, in clinical trials and another
compound is moving forward to clinical trails. Clinical trials are being
performed to establish the safety and effectiveness of two different
formulations of APC 2059 for the treatment of inflammatory bowel disease and
psoriasis. There can be no assurance that we will be able to complete the
clinical trials of APC 2059 successfully for either or both indications or at
all. Our collaboration partner Bayer is moving forward with clinical development
of a compound for the treatment of asthma that would be taken as a pill.
Clinical trials are being planned to establish the safety and effectiveness of
that compound in the treatment of asthma. There can be no assurance that the
clinical trials of this compound will be completed successfully or at all.
Finally, we cannot be certain that any other drug candidates entering clinical
trials will successfully complete these trials or that we will be able to show
the safety and effectiveness of such drug candidates.
 
  WE MAY BE UNABLE TO OBTAIN NECESSARY REGULATORY APPROVALS RELATED TO THE
  DEVELOPMENT OF DRUGS.
 
     The research, testing, manufacture and marketing of drug products are
subject to extensive regulation by numerous regulatory authorities in the United
States and other countries. Failure to comply with the FDA or other relevant
regulatory requirements may subject us to administrative or legally imposed
restrictions. These include:
 
     - warning letters
 
     - civil penalties
 
     - injunctions
 
                                       15
<PAGE>   17
 
     - product seizure or detention
 
     - product recalls
 
     - total or partial suspension of production
 
     - FDA refusal to approve pending New Drug Applications NDAs or supplements
       to approved NDAs.
 
     We have not applied for or received regulatory approval in the United
States or any foreign country for the commercial sale of any of our products. We
cannot guarantee that the FDA will approve any of our products under
development. The process of obtaining FDA and other required regulatory
approvals, including foreign approvals, often takes many years and can vary a
great deal based upon the type, complexity and novelty of the products involved.
Furthermore, the approval process is extremely expensive and uncertainties are
often involved. Delays or rejections may be encountered based upon additional
government regulation from future legislation or administrative action or
changes in FDA policy during the period of product development, clinical trials
and FDA regulatory review. Similar delays also may be encountered in foreign
countries. Even if regulatory approval of a product is granted, we cannot be
certain that we will be able to obtain the labeling claims necessary or
desirable for the promotion of those products.
 
     Even if we obtain regulatory approval, we may be required to continue
clinical studies even after the product has been marketed. In addition,
identification of certain side effects after a drug is on the market or the
occurrence of manufacturing problems could cause subsequent withdrawal of
approval, reformulation of the drug, additional preclinical testing or clinical
trials and changes in labeling of the product.
 
     If regulatory approval is obtained, we will also be subject to ongoing FDA
obligations and continued regulatory review. In particular, we or any third
party that we use to manufacturer the drug or collaborators will be required to
adhere to regulations setting forth current good manufacturing practices. The
regulations require that we manufacture our products and maintain our records in
a particular way with respect to manufacturing, testing and quality control
activities. Furthermore, we or our third party manufacturers or our
collaborators must pass a preapproval inspection of its manufacturing facilities
by the FDA before obtaining marketing approval. See the section below entitled
"Government Regulation."
 
THIS IS A HIGHLY COMPETITIVE BUSINESS AND MANY OF OUR COMPETITORS HAVE
SUBSTANTIALLY GREATER RESOURCES THAN WE HAVE.
 
     The pharmaceutical industry is intensely competitive. Many companies,
including biotechnology, chemical and pharmaceutical companies, are actively
involved in the research and development of new or improved drugs to meet the
same medical needs we are seeking to meet. Many of these companies have
substantially greater financial, scientific, regulatory and marketing) resources
than we have. In addition, some of these companies have considerably more
experience in preclinical testing, clinical trials and other regulatory approval
procedures than we have.
 
     Additionally, certain colleges and universities, governmental agencies and
other research organizations are conducting research in the same areas in which
we are working. These institutions are becoming increasingly aware of the
commercial value of their findings and are becoming more active in seeking
patent protection and licensing arrangements to collect royalties for the use of
technology that they have developed. These institutions also may market
competitive commercial products on their own or through joint ventures.
Currently, they compete with us in recruiting highly qualified scientific
personnel.
 
     We are pursuing areas of product development in which there is a potential
for significant technological innovation in relatively short periods of time. At
the present time Bayer is proceeding with the clinical development of an oral
compound for the treatment of asthma. Currently, Schering-Plough Corporation,
Astra AB and Glaxo, among others, produce therapeutics for the treatment of
asthma. We are proceeding with the clinical development of APC 2059 for the
treatment of psoriasis and inflammatory bowel disease for which there are many
competitive products from other pharmaceutical companies. Our competitors may
succeed in developing technologies or products that are more effective than
those we develop. Rapid technology changes or developments by others may result
in our technology or potential products becoming obsolete or
 
                                       16
<PAGE>   18
 
noncompetitive. There can be no assurance that our competitors will not develop
more effective or more affordable products, or achieve earlier product
development completion, patent protection, regulatory approval or product
commercialization than we will.
 
  WE MAY BE UNABLE TO EFFECTIVELY PROTECT OUR INTELLECTUAL PROPERTY.
 
     Our success depends in large part on our ability to obtain patents,
maintain trade secrets and operate without infringing the rights of others, both
in the United States and in other countries. See the section below entitled
"Patents and Proprietary Rights."
 
     Our ability to obtain patent protection on genes that we identify, or
products based on such genes, is uncertain. Patents may not issue from any of
our pending or future applications. Patent applications in the United States are
maintained in secrecy until the patent issues. As a result, we cannot be certain
that others have not filed patent applications for technology covered by our
pending patent applications or that we were the first to invent the technology.
In addition, an issued patent may be challenged, invalidated or maneuvered
around or it may otherwise not be sufficient to protect our technology. The
patent positions of biotechnology and pharmaceutical companies can be highly
uncertain and involve complex legal and factual questions. As a result, it is
difficult to predict the broadness of claims allowed in biotechnology and
pharmaceutical patents or their enforceability. Moreover, there is substantial
uncertainty regarding the patentability of gene fragments or genes without known
function.
 
     Our commercial success also depends, in part, on not infringing patents
issued to others and not breaching the technology licenses upon which any of our
potential products are based. Competitors may have filed applications for, or
may have received patents and may obtain additional patents and rights relating
to, genes, products or processes that block or compete with ours. A number of
third parties have filed patent applications or received patents in the areas of
our programs. Some of these applications or patents may limit or hinder our
patent applications, or conflict in certain ways with claims made under our
issued patents. Furthermore, in the past we have been, and we may from time to
time in the future be, notified of claims that we are infringing patents or
other intellectual property rights owned by third parties.
 
     We may have to participate in interference proceedings declared by the U.S.
Patent and Trademark Office. These proceedings determine the priority of
invention and the right to a patent for the technology in the U.S. In addition,
lawsuits may be necessary to enforce any patents issued to us or to determine
the scope and validity of the rights of third parties. Lawsuits and interference
proceedings, even if they are successful, are expensive to pursue, and we could
use a substantial amount of our limited financial resources in either case. An
adverse outcome could subject us to significant liabilities to third parties and
require us to license disputed rights from third parties or to cease using such
technology.
 
     We also rely on trade secrets to protect our technology, especially where
patent protection is not believed to be appropriate or obtainable. We protect
our own technology and processes, in part, by confidentiality agreements with
our employees, consultants and certain contractors. However, these agreements
may be disregarded or breached, and we may not have adequate remedies for any
breach. In addition, it is possible that our trade secrets will otherwise become
known or be independently discovered by competitors.
 
 WE MAY BE UNABLE TO REALIZE SIGNIFICANT COMMERCIAL VALUE FOR OUR GENE
 DISCOVERIES.
 
     Our gene discovery programs currently target complex polygenic diseases.
Polygenic diseases are those caused by a defect in more than one gene. We cannot
be certain that our positional cloning technology and approach to gene discovery
will enable us to successfully identify and characterize the specific genes that
cause or predispose individuals to these diseases.
 
     Even if we successfully identify specific genes, our gene discoveries may
not lead to the development of commercial products. Once we identify specific
genes, we may rely upon others to complete characterization of the genes. In
addition, we plan to rely on others to develop and commercialize products based
upon such genes. The resources and efforts of third parties in this regard may
be outside our control. These third parties may not rigorously pursue gene
characterization or product development and commercialization efforts.
 
                                       17
<PAGE>   19
 
     Our success depends, in part, upon our ability to focus research efforts on
genes which may be identified and characterized through the use of positional
cloning techniques. These genes should also be suitable candidates for
gene-based diagnostic and therapeutic products. However, we believe the
polygenic diseases that we are targeting are caused by a number of genetic as
well as environmental factors. As a result, we cannot be certain that these
diseases can be successfully addressed through gene-based diagnostic or
therapeutic products.
 
 WE DO NOT HAVE MANUFACTURING FACILITIES OR COMMERCIAL MANUFACTURING EXPERIENCE.
 WE COULD EXPERIENCE MANUFACTURING DELAYS OR PROBLEMS THAT HURT OUR PRODUCT
 SALES.
 
     We have no manufacturing facilities for our proposed drug products, and our
potential products have never been commercially manufactured. We must rely on
our collaborators, including Bayer, Merck, Bristol-Myers Squibb and
Rhone-Poulenc Rorer, to manufacture products created by our collaborations. We
believe that our collaborators or contract manufacturers or we will be able to
manufacture our compounds at a cost and in quantities necessary to make them
commercially acceptable. However, we cannot be certain that this will be the
case. If we or our collaborators are unable to manufacture or contract with
others for a sufficient supply of our compounds on acceptable terms, we may have
to delay any of the following:
 
     - our preclinical and clinical testing schedule,
 
     - our submission of products for regulatory approval
 
     - the market introduction and subsequent sales of products
 
     Any of these delays would adversely affect our financial condition and
results of operations. In addition, we could face the same delays as a result of
delays or difficulties in our relationships with third party manufacturers.
 
     In addition to us, our collaborators and contract manufacturers must adhere
to current Good Manufacturing Practices regulations enforced by the FDA through
its facilities inspection program. If these facilities cannot pass a
pre-approval plant inspection, FDA approval of our products will not be granted
or will be delayed.
 
     With respect to our Advanced Technologies Division, we are developing new
manufacturing processes to meet the expanding demand for our combinatorial
chemistry libraries. We have never had to manufacture the quantities of
libraries we are committed to delivering in 1999. We have occasionally
experienced problems in manufacturing in the past that have delayed some
shipments of libraries and we may experience manufacturing problems in the
future as we expand our manufacturing capabilities. Problems in manufacturing
could delay shipments of combinatorial chemistry compounds and such delays could
have a material adverse effect on our business and our financial results.
 
 WE DO NOT HAVE MARKETING EXPERIENCE OR CAPABILITIES. THIS COULD PUT OUR
 PRODUCTS AT A COMPETITIVE DISADVANTAGE.
 
     We currently have no sales, marketing or distribution capability. We will
rely on our collaborative relationships, including those with Bayer, Merck,
Bristol Myers Squibb and Rhone-Poulenc Rorer, to market certain potential
products. In addition, we may enter into future collaborations in which we rely
on our pharmaceutical partner to market our products. We cannot be certain that
collaborators will devote sufficient resources to the marketing and sale of our
products or those third parties efforts will otherwise be successful. Revenues
received under existing and future collaborations will depend on the ability of
our collaborators to market our products.
 
     We may also decide to market other potential products by ourselves. To
market any potential products ourselves, we must develop a marketing and sales
force with technical expertise and the necessary supporting distribution
capability. If we are unable to develop a market and sales force, sale of any
products could be adversely affected. We do not know whether we will desire to
or be able to establish our own sales and distribution capabilities or whether
we will be able to enter into the necessary relationships with third parties.
 
                                       18
<PAGE>   20
 
 WE MAY BE UNABLE TO SUCCESSFULLY PRICE OUR PRODUCTS OR OBTAIN ADEQUATE
 REIMBURSEMENT.
 
     The business and financial condition of pharmaceutical and biotechnology
companies will continue to be affected by the efforts of outside parties such as
governments and third party payors (i.e. government health administrators,
private health insurance companies, HMOs, etc.) to contain or reduce the cost of
health care. In some foreign markets, pricing or profitability of prescription
pharmaceuticals is subject to governmental control. In the United States, there
have been, and we expect that there will continue to be, a number of federal and
state proposals to install similar governmental control. In addition, an
increasing emphasis on managed care in the United States has and will continue
to increase the pressure on price of prescription drugs. The announcement of
these proposals or efforts could adversely affect our ability to raise capital
and our stock price. In addition, if these proposals or efforts adversely affect
other pharmaceutical companies that are prospective collaborators with Axys, our
ability to establish or maintain strategic alliances may be adversely affected.
 
     In both domestic and foreign markets, sales of our potential products will
depend in part on the availability of reimbursement from third-party payors,
such as government health administration authorities, private health insurers
and other organizations. Third-party payors are increasingly challenging the
price and cost-effectiveness of medical products and services. Significant
uncertainty exists as to the reimbursement status of newly approved health care
products. We cannot be certain that any of our potential products will be
considered cost-effective or that adequate third-party reimbursement will be
available.
 
  PHYSICIANS AND INSURERS MAY NOT ACCEPT OUR PRODUCTS.
 
     Even if any of our products are cleared for marketing, we are not certain
that physicians, health insurance companies or patients will accept them. The
degree of market acceptance will depend upon a number of factors, including
getting regulatory approvals, showing proof in the medical community of the
clinical effectiveness and safety of our product candidates and their potential
advantages over existing treatment methods and reimbursement policies of
government and third-party payors. There is no assurance that physicians,
patients, payors or the medical community in general will accept and use any
products that may be developed by the company.
 
  WE MAY BE UNABLE TO ATTRACT AND RETAIN PROFESSIONAL STAFF.
 
     We are highly dependent on the senior members of our scientific and
management staff. Retaining and attracting qualified personnel, consultants and
advisors is critical to our success. We face intense competition for qualified
individuals from numerous pharmaceutical and biotechnology companies,
universities and other research institutions. We are currently seeking, to hire
additional qualified scientific personnel to perform research and development.
In addition, we expect that we will need to add management personnel and develop
additional expertise by existing management personnel in order to expand product
development and clinical testing. We cannot be certain that we will be able to
attract and retain such individuals on acceptable terms or at all.
 
     In addition, our academic collaborators are not our employees. As a result,
we have limited control over their activities and can expect that only limited
amounts of their time will be dedicated to our activities. These academic
collaborators may also have relationships with other commercial entities, some
of which could compete with Axys.
 
  WE EXPECT TO CONTINUE TO OPERATE AT A LOSS AND MAY NEVER ACHIEVE
PROFITABILITY.
 
     We may never achieve and sustain profitability. We have experienced
significant operating losses since the company started. We have not generated
any product revenue. As of December 31, 1998, we had an accumulated deficit of
approximately $230 million. We expect that we will continue to incur significant
operating losses over at least the next several years as our research and
development efforts and preclinical and clinical testing activities expand.
 
                                       19
<PAGE>   21
 
  WE MAY NEED TO SECURE ADDITIONAL FINANCING.
 
     The development of our technology and potential products will require
substantially more money than the company currently has. That means substantial
funds will need to be committed to the company in order to conduct the costly
and time-consuming research and preclinical and clinical testing activities
necessary to develop products.
 
     We plan to be able to meet some of our needs for money through the sale of
our interests in our affiliated businesses. However, those businesses are still
in relatively early stages of development. There can be no assurance that these
businesses will prove to be financially successful or that we will be able to
sell our interest in these businesses for a substantial amount of money or at
all.
 
     Whether we are successful in getting money for our interests in these
affiliated businesses, we believe we will still need to pursue other sources of
money to fund our research and development. Our future money needs will depend
on many factors, including the following:
 
     - scientific progress in the research and development of our technology and
       drug development programs
 
     - the size and complexity of these programs
 
     - the timing, range and results of preclinical studies and clinical trials
 
     - our ability to establish new and maintain existing collaborations
 
     - our ability to achieve any milestones under such collaborations
 
     - the time and costs involved in getting regulatory approvals or in filing,
       enforcing or prosecuting patents
 
     We expect that our existing money resources, including research and
development revenues from existing collaborations, will enable us to maintain
current and planned operations for at least the next two years. However, we
expect to raise substantial additional money to fund operations before the end
of this period. In addition, we will need to continue to raise money until we
achieve substantial product or royalty revenues, which may take a number of
years to happen.
 
     We expect that we will seek additional funding through new collaborations,
the extension of existing collaborations, through sale of our interests in our
affiliated businesses, or through public or private equity or debt financings.
Furthermore, we may obtain funds through arrangements with collaborative
partners or others that require us to give up rights to technologies or products
that we would otherwise seek to develop or commercialize ourselves. We cannot be
certain that additional funding will be available or that the terms will be
acceptable. Existing stockholders will experience dilution of their investment
if additional funds are raised by a follow-on stock offering. If adequate funds
are not available, we may delay, reduce or eliminate any of our research or
development programs.
 
  OUR STOCK MAY EXPERIENCE SUBSTANTIAL PRICE AND VOLUME FLUCTUATIONS.
 
     Stock prices and trading volumes for biotechnology companies often
fluctuate widely for reasons which may be unrelated to their businesses. Our
stock price could decline as a result of many factors, including:
 
     - announcements of technological innovations or new products by Axys or our
       competitors
 
     - developments or disputes concerning patents or other rights
 
     - publicity regarding actual or potential medical results from products
       under development by Axys or our competitors
 
     - regulatory developments in both the United States and foreign countries
 
     - public concern regarding the safety of biopharmaceutical products
 
     - any shortfall in our revenues or net income from that expected by
       securities analysts
 
                                       20
<PAGE>   22
 
     - changes in analyst's estimates of our financial performance, the
       financial performance or our competitors or the financial performance of
       biotechnology companies in general
 
     - sales of large blocks of our common stock
 
     - conditions in the financial markets or economy in general or the
       biotechnology industry in particular
 
 BECAUSE WE ARE DEVELOPING DRUG PRODUCTS, WE MAY ENCOUNTER PRODUCT LIABILITY
 CLAIMS.
 
     We may be exposed to liability claims resulting from the use of our
products in clinical trials, or the manufacturing, marketing and the sale of any
approved products. These claims may be made directly by consumers,
pharmaceutical companies or others. We maintain product liability insurance
coverage for claims arising from the use of our products which are still in the
developmental phase. However, this insurance coverage is becoming increasingly
expensive. We and our collaborative partners may not be able to obtain and
maintain commercially reasonable product liability insurance. Furthermore, even
if we maintain insurance, the amount may not be enough to protect us against
losses due to a lawsuit. A successful product liability claim against Axys or
series of claims in excess of our insurance could adversely affect our results
of operations and our need for additional financing.
 
 DELAWARE LAW AND OUR CHARTER COULD MAKE AN ACQUISITION OF AXYS MORE DIFFICULT.
 
     In 1998 we adopted a shareholder rights plan, which may have the effect of
delaying or preventing an unsolicited takeover of the company. Our Certificate
of Incorporation and Bylaws states that any action of this nature taken by
stockholders must be conducted at an annual or special meeting of stockholders
and may not be conducted by written consent. Only the Board of Directors, the
Chairman of the Board or the President may call special meetings of the
stockholders. These and other charter provisions may discourage certain types of
transactions involving an actual or potential change in control of Axys. In
fact, these provisions may discourage transactions in which the stockholders
might otherwise receive a premium for their shares over then current prices, and
may limit the stockholders' ability to approve transactions that they think are
in their best interests.
 
WHAT OTHER MATTERS SHOULD STOCKHOLDERS CONSIDER WITH RESPECT TO THE COMPANY?
 
  Patents And Proprietary Rights
 
     We hold a number of issued United States patents relating to compositions
of matter, methods of treating disease, combinatorial chemistry and
computational technologies. These patents expire at various dates up to the year
2016. In addition, we have filed and there are now pending patent applications
relating to compositions of matter, methods of treating disease, combinatorial
chemistry, assay techniques, transgenic animal models, computational
technologies and novel technology for the discovery of novel protease
inhibitors. We intend to file additional patent applications, when appropriate,
relating to our technology and to specific products we develop.
 
     We strategically file selected patent applications to protect technology,
inventions and improvements that are important to the development of our
business. That is our policy, as well as our practice. We also rely upon trade
secrets, know-how, continuing technological innovations and licensing
opportunities to develop and maintain our competitive position.
 
     The patent positions of pharmaceutical and biotechnology firms, including
Axys, are uncertain and involve complex legal and factual questions. In
addition, the scope of the claims in a patent application can be significantly
modified before the issued patent is issued. As a result, we do not know whether
any of our applications will result in the issuance of patents, or if any of our
issued patents will provide significant protection. We also do not know whether
any of our issued patents will be invalidated. Since patent applications in the
United States are maintained in secrecy until patents issue, and since
publication of discoveries in the scientific or patent literature often lag
behind actual discoveries, we cannot even be certain that we were the first
creator of inventions covered by our pending patent applications or that we were
the first to file patent applications for such inventions.
 
                                       21
<PAGE>   23
 
     In addition, we may have to participate in interference proceedings
declared by the United States Patent and Trademark Office (PTO) to determine
priority of invention. These proceedings determine the priority of invention and
the right to a patent for the technology in the U.S. Such proceedings could
result in substantial costs to us, even if we win.
 
     There can be no assurance that our pending patent applications, if issued,
or our existing patents, will not be invalidated. An adverse outcome could
subject the company to significant liabilities to third parties, require
disputed rights to be licensed from third parties or require the company to stop
or modify its use of such technology.
 
     The development of therapeutic products for applications in the product
fields we are pursuing is intensely competitive. A number of pharmaceutical
companies, biotechnology companies, universities and research institutions have
filed patent applications or received patents in the areas in which we are
conducting research. In addition, patent applications filed by others relating
to our potential products or technologies may currently be pending. Some of
these applications or patents may limit or hinder our freedom to practice and
could result in a significant reduction of the coverage of our patents, or
potential patents. We are aware of pending patent applications that have been
filed by other companies that may pertain to certain of our technologies. If
patents are issued to these or other companies containing incompatible or
conflicting claims, and such claims are ultimately determined to be valid, we
may be required to obtain licenses to these patents or to develop or obtain
alternative technology.
 
     Furthermore, we have in the past been, and may again be, notified of claims
that we may be infringing patents or other intellectual property rights owned by
third parties. We have obtained licenses under several patents held by third
parties. If necessary or desirable, we may seek additional licenses under other
patents or intellectual property rights. There can be no assurance, however,
that we will be able to obtain a license we seek on reasonable terms or even at
all. As an alternative, we could decide to resort to litigation to challenge a
patent or patents. Such challenges can be extremely expensive and time
consuming. Consequently, they can have a material adverse effect on our
business, financial condition and results of operations.
 
     Much of the unpatentable know-how important to our technology and many of
its processes depends upon the knowledge, experience and skills of key
scientific and technical personnel. To protect our rights to this know-how and
technology, all employees, consultants, advisors and collaborators are required
to enter into confidentiality agreements with the company that prohibits the
disclosure of confidential information to any third party and requires
disclosure to the company of ideas, developments, discoveries and inventions
made by these individuals. There can be no assurance that these agreements will
effectively prevent disclosure of our confidential information or that these
agreements will provide meaningful protection for our confidential information
if there is unauthorized use or disclosure. Our business could be adversely
affected by competitors who develop substantially equivalent technology.
 
     In connection with certain research, we entered into sponsored research
agreements with various researchers and universities. Generally, under these
agreements we fund the research of investigators in exchange for the right or an
option to a license to any patentable inventions that may result in designated
areas. We are obligated to make certain payments during the terms of certain of
the agreements, to pay royalties on net sales of any licensed products and, in
some cases, to negotiate in good faith the business terms of any license
executed upon exercise of licensing options. There can be no assurance that
these agreements will not be breached or that we would have adequate remedies
for any breach.
 
  Government Regulation
 
     The manufacturing and marketing of our proposed products and our research
and development activities are subject to regulation for safety, effectiveness
and quality by many governmental authorities in the United States and other
countries. In the United States, drugs are subject to stringent regulation by
the United States Food and Drug Administration (FDA). The Federal Food, Drug and
Cosmetic Act and FDA regulations, as well as other federal and state laws and
regulations, govern, the testing, manufacture, safety, effectiveness, package
labeling, storage, record keeping, approval, advertising and promotion of our
proposed products. Product development and approval takes a long time and
involves the expenditure of a lot of money. If we fail
 
                                       22
<PAGE>   24
 
to comply with certain regulatory requirements, we could be subject to
sanctions, such as warning letters, penalties, criminal prosecution,
injunctions, product seizure, product recalls, total or partial suspension of
production, and FDA refusal to approve pending New Drug Applications (NDA) or
costly supplements to approved applications.
 
     The steps required before a drug may be marketed in the United States
include (i) preclinical laboratory tests, in vivo (animal model) preclinical
studies and formulation studies, (ii) the submission to the FDA of an
application for human clinical testing, known as an Investigational New Drug
Application (IND), which must be accepted by the FDA before human clinical
trials are started, (iii) adequate and well-controlled human clinical trials to
establish the safety and effectiveness of the drug, (iv) the submission of an
NDA to the FDA, and (v) FDA approval of the NDA prior to any commercial sale or
shipment of the drug. In addition to obtaining FDA approval for each product,
each domestic drug manufacturing establishment must be registered with the FDA.
Domestic drug manufacturing establishments are subject to inspections twice a
year by the FDA and must comply with Good Manufacturing Practices. To supply
products for use in the United States, foreign manufacturers must comply with
Good Manufacturing Practices and are subject to periodic inspection by the FDA
or by corresponding regulatory agencies in their country. Drug product
manufacturers located in California also must be licensed by the State of
California.
 
     Preclinical tests include laboratory evaluation of what is in the product
and how it was made, as well as animal studies to assess the potential safety
and effectiveness of the product. Preclinical safety tests must be conducted by
laboratories that comply with FDA regulations regarding Good Laboratory
Practices. The results of the preclinical tests are submitted to the FDA as part
of an IND and reviewed by the FDA prior to the start of human clinical trials.
Unless the FDA objects, the IND will become effective 30 days following its
receipt by the FDA. There can be no assurance that submission of an IND will
result in FDA authorization to start clinical trials. Clinical trials involve
the giving the investigational new drug to healthy volunteers and to patients,
under the supervision of a qualified investigators. Clinical trials are
conducted in agreement with Good Clinical Practices under instructions that
detail the objectives of the study, the limits to be used to monitor safety and
the effectiveness criteria to be evaluated. Instructions must be submitted to
the FDA as part of the IND. Further, each clinical study must be conducted under
the power of an independent Institutional Review Board ("IRB") at the site where
the study will be conducted. The IRB will consider, among other things, ethical
factors, the safety of human subjects and the possible liability of the site.
 
     Clinical trials are typically conducted in three phases that go in order,
but the phases may overlap. In Phase I, in which we usually give the drug to
healthy subjects, the drug is tested to determine its metabolism (how the drug
is absorbed by the body), pharmacokinetics (what the body does to the drug) and
pharmacological actions (biological effects) in humans, the side effects
associated with increasing doses and early evidence of how effective the drug
is, if possible. Phase II involves studies in a limited patient population to
(i) determine the effectiveness of the drug for specific, targeted indications,
(ii) determine what amount of the drug works best and how much of the drug can
be tolerated, and (iii) identify possible adverse effects and safety risks. If a
compound is found to be effective and to have an acceptable safety profile in
Phase II evaluations, Phase III trials further evaluate the effectiveness of the
drug and further test for safety in a larger group of people at many different
locations.
 
     There can be no assurance that Phase I, Phase II or Phase III testing will
be completed successfully within any specific time period, if at all, for any of
our proposed products. Furthermore, the FDA or we may suspend or cancel clinical
trials at any time if it is felt that the patients are being exposed to an
unacceptable health risk or the FDA finds errors or incorrect information in the
IND or due to the conduct of the investigation. Further, FDA regulations state
that sponsors of clinical investigations must meet numerous regulatory
requirements, including, selection of qualified investigators, proper monitoring
of the investigations, recordkeeping and record retention, and ensuring that FDA
and all investigators are promptly informed of significant new adverse effects
or risks with respect to the drug.
 
     The results of the drug development, preclinical studies and clinical
studies are submitted to the FDA in the form of an NDA, which, if accepted,
would clear the way for marketing and commercial shipment of the drug. There can
be no assurance that any approval will be granted by the FDA at all or, if
granted, will be
 
                                       23
<PAGE>   25
 
granted on a timely basis. The FDA may deny an NDA if certain regulatory
criteria are not satisfied, may require additional testing or information, or
may require post-marketing testing and surveillance to monitor the safety of our
products if the FDA does not view the NDA as containing enough evidence of the
safety and effectiveness of the drug. Even if the company submits additional
data, the FDA may still decide that the application does not satisfy its
regulatory criteria for approval. In addition, even if regulatory clearance of a
drug is granted, such approval may limit the uses for which it may be marketed.
Finally, product approvals may be taken away if regulatory standards are not
maintained or if problems occur following initial marketing.
 
     Among the typical conditions for NDA approval is the requirement that the
proposed manufacturer's quality control and manufacturing procedures conform to
Good Manufacturing Practices, which must be followed at all times. To comply
with these standards, we will have to spend a large amount of time, money and
effort in the area of production and quality control to ensure full technical
compliance.
 
     In addition to regulations enforced by the FDA, we will also be subject to
regulation under the Occupational Safety and Health Act, the Environmental
Protection Act, the Toxic Substances Control Act, the Resource Conservation and
Recovery Act and other present and potential future federal, state or local
regulations. Our research and development involves the controlled use of
hazardous materials, chemicals and various radioactive compounds, all of which
are regulated. Although we believe that our safety procedures for handling and
disposing of these materials comply with the standards set by state and federal
regulations, the risk of accidental contamination or injury from these materials
is possible. In the event of an accident, the company could be held sued for any
damages that result and any such lawsuit could exceed the insurance and
resources of the company.
 
     For clinical investigation and marketing outside the United States, we are
also subject to foreign regulatory requirements governing human clinical trials
and marketing approval for drugs. These requirements governing the conduct of
clinical trials, product licensing, pricing and reimbursement vary widely for
European countries both within, and outside, the European Union (EU). We plan to
comply with the European regulatory process by identifying and using clinical
investigators in the member states of the EU and other European countries to
conduct clinical studies. Further, we intend to design our studies to meet FDA,
EU and other European countries' standards.
 
     Within the EU, while marketing authorizations must be supported by clinical
trial data of a type and to the extent set out by EU directives and guidelines,
the approval process for the commencement of clinical trials is not currently
harmonized by EU law and varies from country to country. As far as possible, we
intend to design our studies so as to develop a regulatory package sufficient
for multi-country approval in our European target markets, without the need to
duplicate studies for individual country approvals.
 
     Outside the United States, our ability to market a product is based upon
receiving a marketing authorization from the appropriate regulatory authority.
Currently, foreign marketing authorizations are applied for at a national level,
although within the EU certain registration procedures are available to
companies wishing to market the product in more than one EU member state. If the
regulatory authority is satisfied that enough evidence of safety, quality and
effectiveness has been presented, a marketing authorization will be granted. The
system for obtaining marketing authorizations within the EU changed on January
1, 1995. The current EU registration system is a dual one in which certain
products, such as biotechnology and high technology products and those
containing new active substances, will have access to a central regulatory
system that provides registration throughout the entire EU. Other products will
be registered by national authorities in individual EU member states, operating
on a principle of mutual recognition. This foreign regulatory approval process
includes all of the same risks involved in the FDA approval process described
above.
 
  Employees
 
     As of December 31, 1998, Axys employed 427 individuals, of whom 138 hold
Ph.D. or M.D. degrees and 140 hold other advanced degrees. Approximately 345
employees are involved in research and development activities, including a
variety of disciplines within the areas of molecular biology and other
biological sciences, medicinal chemistry, genomics and genetics, bioinformatics,
computer sciences and clinical development.
 
                                       24
<PAGE>   26
 
Approximately 82 employees are employed in finance, corporate development and
general administrative activities. In January 1999, as part of our reallocation
of resources to our oncology programs, we reduced our work force by
approximately 34 employees. None of the company's employees is covered by
collective bargaining agreements, and management considers relations with its
employees to be good. Axys also enters into part-time consulting arrangements
with experienced, professional scientists and managers to supplement our work
force.
 
ITEM 2. PROPERTIES
 
     Axys currently occupies approximately 265,000 square feet of leased
laboratory, support and administrative space in South San Francisco and La
Jolla, California and Cambridge, Massachusetts, of which the Company's Advanced
Technologies Division occupies approximately 40,000 square feet in South San
Francisco. Leases expire on these facilities to October 15, 1999 with respect to
approximately 12,150 square feet, December 31, 2002 with respect to the
approximately 108,000 square feet, July 31, 2005 with respect to 32,700 square
feet, and August 4, 2006 for the remainder of the Company's facilities. Most of
these leases have additional options for extensions. In addition to the above
listed facilities, the Company is subleasing approximately 39,000 square feet
under two sublease agreements to unrelated third parties, with the leases and
subleases expiring on July 14, 1999 and July 31, 2005. The Company's existing
and planned facilities are believed to be adequate to meet its present
requirements, and the Company currently believes that suitable additional space
will be available to it, when needed, on commercially reasonable terms.
 
ITEM 3. LEGAL PROCEEDINGS
 
     From time to time the Company is subject to legal proceedings or claims
arising in the ordinary course of its business. While the outcome of any such
proceedings or claims cannot be predicted with certainty, management does not
believe that the outcome of any of these legal matters will have a material
adverse effect on the Company's consolidated results of operations or
consolidated financial position.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     During the fourth quarter of 1998, no matters were submitted to a vote of
the stockholders.
 
                                       25
<PAGE>   27
 
                      EXECUTIVE OFFICERS OF THE REGISTRANT
 
     Listed below is biographical information on executive officers of Axys as
of February 28, 1999.
 
<TABLE>
<CAPTION>
           NAME             AGE               POSITION WITH AXYS
           ----             ---               ------------------
<S>                         <C>   <C>
John P. Walker............  50    Chairman, Chief Executive Officer and
                                  Director
Daniel H. Petree, J.D. ...  43    President, Chief Operating Officer
Frederick J. Ruegsegger...  43    Senior Vice President, Finance and
                                  Corporate Development and Chief Financial
                                  Officer
Michael C. Venuti,          45    Senior Vice President, Preclinical
  Ph.D. ..................        Development, Chief Technical Officer
William J. Newell,          41    Vice President, General Counsel and
  J.D. ...................        Secretary
Natalie J. Warner,          51    Vice President, Medical Affairs
  M.D. ...................
</TABLE>
 
JOHN P. WALKER
 
     Mr. Walker has been Chief Executive Officer and a director of the company
since 1993 and was appointed Chairman of the Board in January 1998. From 1993 to
January 1998, he was also President of the company. Prior to joining Axys, Mr.
Walker was the Chairman and Chief Executive Officer of Vitaphore Corporation, a
medical device company which was sold to Union Carbide in 1990, and for a period
of 15 years was an executive with American Hospital Supply Corporation, most
recently serving as President of the Hospital Company. Mr. Walker also serves as
Chairman of Signal Pharmaceuticals, Inc. and Microcide Corporation and is on the
board of directors of Geron Corporation and the Biotechnology Industry
Organization. Mr. Walker received a B.A. degree from the State University of New
York at Buffalo and conducted graduate business studies at Northwestern
University Institute of Management.
 
DANIEL H. PETREE, J.D.
 
     Mr. Petree has been President and Chief Operating Officer of the company
since January 1998. From June 1996 until January 1998, he served as Executive
Vice President, Corporate Development of the company. From August 1993 until
June 1996, Mr. Petree served as the company's Vice President, Corporate
Development. Mr. Petree also served as Chief Financial Officer of the company
from August 1993 until December 1996. From 1992 to 1993, he was Vice President,
Business Development of TSI Corporation, a biotechnology service company. Prior
to that time, he was with Montgomery Securities, an investment bank, from 1987
to 1992, ultimately serving as Vice President, Health Care Group in Montgomery's
corporate finance division. Mr. Petree received a J.D. degree from the
University of Michigan Law School and holds a B.A. degree from Stanford
University.
 
FREDERICK J. RUEGSEGGER
 
     Mr. Ruegsegger has been the company's Senior Vice President, Finance and
Corporate Development and Chief Financial Officer since January 1998. Prior to
that he served as Vice President, Finance and Administration and Chief Financial
Officer of the company from December 1996 until January 1998. From 1993 to 1996,
he was President and Chief Executive Officer of EyeSys Technologies, Inc., a
medical instrument and software company. Mr. Ruegsegger served as Chief
Financial Officer, from 1986 to 1993, and President, from 1991 to 1993, of
Vitaphore Corporation, a medical device company. Mr. Ruegsegger also serves as a
director of SteriGenics International, Inc. Mr. Ruegsegger received a B.S.
degree in Economics from the University of Illinois and a Master of Management
from Northwestern University's Kellogg Graduate School of Management.
 
MICHAEL C. VENUTI, PH.D.
 
     Dr. Venuti has been the company's Senior Vice President, Research and
Preclinical Development since November 1998, and had previously served as Senior
Vice President, Research, South San Francisco, Vice President, Research and
Chief Technical Officer since January 1998, February 1997 and July 1996,
 
                                       26
<PAGE>   28
 
respectively. Dr. Venuti joined the company in November 1994 as Director of
Chemistry and was promoted to Vice President of Chemistry in July 1995, where he
served until February 1997. From 1993 until he joined the company, he was at
Parnassus Pharmaceuticals, a start-up biotechnology company that initiated
insolvency proceedings in October 1994, where he was Vice President, Chief
Scientific Officer and a founder. From 1988 to 1993, Dr. Venuti was at
Genentech, Inc., a biotechnology company, where he was Director of Bioorganic
Chemistry, a program that he helped establish. Dr. Venuti received an A.B. in
chemistry from Dartmouth College, a Ph.D. in organic chemistry from the
Massachusetts Institute of Technology and was a postdoctoral fellow at the
Syntex Institute of Organic Chemistry.
 
WILLIAM J. NEWELL, J.D.
 
     Mr. Newell joined Axys as Vice President and General Counsel and Secretary
in July 1998. From October 1983 to July 1998, Mr. Newell practiced at the firm
of McCutchen, Doyle, Brown & Enersen, LLP (Palo Alto Office) where he had been a
partner since 1990. He received his J.D. from the University of Michigan Law
School and holds an A.B. from Dartmouth College.
 
NATALIE J. WARNER, M.D.
 
     Dr. Warner has been the company's Vice President, Medical Affairs since
January 1996 when she joined the company in connection with its acquisition of
Khepri Pharmaceuticals, Inc., a pharmaceutical research and development company.
Dr. Warner has also been Chief Executive Officer of PPGx since its inception in
February 1999. From January 1993 to December 1995, she was Vice President of
Medical Affairs and Drug Development at Khepri Pharmaceuticals. From 1988 to
1993, Dr. Warner worked at Syntex Corporation, a pharmaceutical products and
medical diagnostic systems company, where she held a number of positions,
including Vice President of Clinical Research and Vice President, Worldwide
Safety, Surveillance and Reporting. Prior to joining Syntex, Dr. Warner was
Director of Clinical Research at Merck, Sharp & Dohme Research Laboratories. She
received a B.A. from Swarthmore College, an M.D. from Cornell Medical College
and completed her fellowship and residency at Columbia University.
 
                                    PART II.
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
 
     Axys' Common Stock began trading on the Nasdaq National Market under the
symbol "ARRS" on November 19, 1993. Prior to that date, there was no public
market for the Company's Common Stock. On January 12, 1998, when the company
acquired Sequana Therapeutics, Inc., the company changed its name to Axys
Pharmaceuticals, Inc. and changed its ticker symbol to "AXPH". The following
table sets forth, for the periods indicated, the high and low sales prices of
the Common Stock reported on the Nasdaq National Market. These over-the-counter
quotations reflect inter-dealer prices, without retail markup, markdown or
commission, and may not necessarily represent the sales prices in actual
transactions.
 
<TABLE>
<CAPTION>
                                                              HIGH      LOW
                                                             ------    ------
<S>                                                          <C>       <C>
1997
First Quarter..............................................  $15.88    $12.13
Second Quarter.............................................   14.00      9.50
Third Quarter..............................................   15.63     11.38
Fourth Quarter.............................................   14.00      7.50
 
1998
First Quarter..............................................  $10.75    $ 7.66
Second Quarter.............................................    8.75      6.50
Third Quarter..............................................    7.75      3.38
Fourth Quarter.............................................    7.06      3.69
</TABLE>
 
                                       27
<PAGE>   29
 
     On March 19, 1999, the last sale price reported on the Nasdaq National
Market for the Company's Common Stock was $4.13 per share.
 
HOLDERS
 
     As of February 26, 1999 there were approximately 663 stockholders of record
of the Company's Common Stock.
 
DIVIDENDS
 
     The Company has not paid dividends on its Common Stock and currently does
not plan to pay any cash dividends in the foreseeable future.
 
RECENT SALES OF UNREGISTERED SECURITIES
 
     On December 30, 1998, Axys issued 878 shares of Common Stock, valued at
approximately $4,100 to MMC/GATX Partnership No. 1, in connection with the net
issuance exercise of a warrant.
 
     On December 17, 1998, Axys issued 23,700 shares of Common Stock, valued at
$155,282, to 52nd Street Associates, in connection with a consulting agreement
dated November 23, 1998 between Axys and McKinsey & Company, Inc.
 
     The issuance and sale of such shares was intended to be exempt from
registration and prospectus delivery requirements under the Securities Act of
1933, as amended (the "Securities Act"), by virtue of Section 4(2) thereof due
to, among other things, (i) the limited number of persons to whom the shares
were issued, (ii) the distribution of disclosure documents to the investor,
(iii) the fact that such person represented and warranted to the Company, among
other things, that such person was acquiring the shares for investment only and
not with a view to the resale or distribution thereof, and (iv) the fact that
certificates representing the shares were issued with a legend to the effect
that such shares had not been registered under the Securities Act or any state
securities laws and could not be sold or transferred in the absence of such
registration or an exemption therefrom.
 
                                       28
<PAGE>   30
 
ITEM 6. SELECTED FINANCIAL DATA
 
                           AXYS PHARMACEUTICALS, INC.
 
     The data should be read in conjunction with "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
"Item 8. Financial Statements and Supplementary Data" which is included
elsewhere in this Annual Report on Form 10-K.
 
<TABLE>
<CAPTION>
                                                      YEAR ENDED DECEMBER 31,
                                     ---------------------------------------------------------
                                       1994      1995(1)       1996        1997       1998(2)
                                     --------    --------    --------    --------    ---------
                                             (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                  <C>         <C>         <C>         <C>         <C>
Consolidated Statements of
  Operations:
Revenues...........................  $  8,304    $ 16,727    $ 21,560    $ 24,814    $  47,422
Operating costs and expenses:
  Cost of goods sold...............        --          --          --       1,010        2,058
  Research and development.........    13,155      14,689      24,319      30,040       62,176
  General and administrative.......     4,010       4,247       5,409       7,153       14,460
  Acquired in-process research and
     development...................        --      22,514         230          --      124,888
                                     --------    --------    --------    --------    ---------
Total operating costs and
  expenses.........................    17,165      41,450      29,958      38,203      203,582
                                     --------    --------    --------    --------    ---------
Operating loss.....................    (8,861)    (24,723)     (8,398)    (13,389)    (156,160)
Interest income (expense), net.....       522         990       2,470       2,422        3,812
Equity interest in loss of joint
  venture..........................        --          --          --          --       (2,281)
                                     --------    --------    --------    --------    ---------
Net loss...........................  $ (8,339)   $(23,733)   $ (5,928)   $(10,967)   $(156,124)
                                     ========    ========    ========    ========    =========
Net loss per share, basic and
  diluted..........................  $  (0.97)   $  (2.71)   $  (0.45)   $  (0.73)   $   (5.25)
Weighted average number of shares
  used in computing basic and
  undiluted outstanding............     8,570       8,745      13,177      15,025       29,758
</TABLE>
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                     ---------------------------------------------------------
                                       1994        1995        1996        1997        1998
                                     --------    --------    --------    --------    ---------
                                                          (IN THOUSANDS)
<S>                                  <C>         <C>         <C>         <C>         <C>
Consolidated Balance Sheet Data:
Cash, cash equivalents and
  marketable investments...........  $ 30,070    $ 31,105    $ 66,720    $ 53,408    $  72,717
Total assets.......................    34,786      40,293      80,832      73,584      107,262
Long-term obligations..............     7,645      16,490      10,676      15,331       16,816
Accumulated deficit................   (33,298)    (56,876)    (62,804)    (73,771)    (229,895)
Total stockholders' equity.........    13,425       7,278      52,900      43,890       60,512
</TABLE>
 
---------------
(1) Includes the results of operations of Khepri Pharmaceuticals, Inc. from
    December 22, 1995 through December 31, 1995, including a one-time charge for
    acquired in-process research and development. Excluding such one-time
    charge, net loss and net loss per share would have been $1,219,000 and $0.14
    per share, respectively.
 
(2) Includes the results of operations of Sequana Therapeutics, Inc. from
    January 8, 1998 through December 31, 1998, including a one-time charge for
    acquired in-process research and development. Excluding such one-time
    charge, net loss and net loss per share would have been $31,236,000 and
    $1.05 per share, respectively.
 
                                       29
<PAGE>   31
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
 
     The following discussion contains both historical information and
forward-looking statements that involve risks and uncertainties. Forward-looking
statements include projections and other statements of events that may occur at
some point in the future. The company's actual results could differ
significantly from those described in the forward-looking statements. Factors
that could cause or contribute to such differences include, but are not limited
to, those discussed in this section as well as under "Item 1. Business,"
including, "What Factors Could Cause Our Results To Differ Significantly From
Those You Might Expect".
 
  Overview
 
     Since the company's founding in 1989, Axys has devoted most of its
resources to research and development programs. To date, the company's revenues
have resulted from its collaborative research programs with pharmaceutical
companies as part of its drug discovery business and more recently from sales of
chemical compound libraries as part of its Advanced Technologies Division
("ATD") combinatorial chemistry business.
 
     The company's collaborative research programs generally contain one or more
of the following sources of revenue to the company:
 
     - Research Support: Payments which are generally based on the number of
       researchers Axys is committing to a particular program. These revenues
       are recorded when earned by the company.
 
     - License Fees: Payments generally made when a collaboration agreement is
       signed. These revenues are recorded when the agreement is signed.
 
     - Commitment Fees: Payments made in conjunction with the company's
       commitment to perform certain funded research. These revenues are
       recorded in equal periodic amounts over the course of the research
       efforts.
 
     - Milestone Payments: Payments which are based on the company or its
       partner achieving certain technical or regulatory milestones in the
       collaboration. These revenues are recorded upon the achievement of
       mutually agreed milestones.
 
     - Royalties: Upon commercialization of products resulting from a
       collaboration, the company may earn royalties based on a percentage of
       the revenue earned by the collaboration partner. These revenues would be
       recorded when product sales result from the company's collaborations.
 
     The company's sales of chemical compound libraries contain one or more of
the following sources of revenue to the company:
 
     - Product Sales: As chemical compound libraries are shipped to customers of
       the ATD, the Company records revenue based on the contracted price per
       compound.
 
     - License Fees: Payments made when compound supply or technology license
       agreements are signed. These revenues are recorded when the agreement is
       signed.
 
     - Commitment Fees: Payments made in conjunction with the ATD's commitment
       to perform certain obligations under compound supply or technology
       license agreements. These revenues are recorded in equal periodic amounts
       over the course of the relevant agreement.
 
     Although not generally a source of revenue, the collaborative research
programs occasionally include the sale of stock by the Company to the
pharmaceutical company sponsoring the research. These sales may involve the
recognition of revenue by the Company if they are made at a premium to the
prevailing price of the Company's common stock at the time of the sale. In that
case, the amount of the premium is recognized as revenue at the time of the
stock purchase.
 
                                       30
<PAGE>   32
 
     A summary of the company's significant collaborative research agreements,
including those of Sequana Therapeutics, Inc., since inception follows:
 
<TABLE>
<CAPTION>
                            TERM OF
       COMPANY           RESEARCH PHASE                 SUBJECT OF COLLABORATION
       -------           --------------                 ------------------------
<S>                     <C>                <C>
Bayer AG ("Bayer")      November 1994 to   Development of inhibitors of the regulatory enzymes
                        November 1997      tryptase and chymase for the treatment of asthma
                                           and other inflammatory and auto-immune diseases. As
                                           of November 1997, the Company completed its
                                           obligations under the research phase of this
                                           agreement. In July 1997, the company reacquired the
                                           rights (with Bayer retaining an option to reacquire
                                           rights again) to exploit tryptase inhibitors
                                           against psoriasis and inflammatory bowel disease,
                                           which were part of the original agreement.
Merck & Co.             November 1996 to   Development of small molecule inhibitors of
  ("Merck")             November 1999      proteases involved in osteoporosis. In November
                                           1998, Merck elected to extend the research phase to
                                           November 1999.
Bristol-Myers Squibb    December 1997 to   Development of protease inhibitors to prevent the
  ("BMS")               December 2000      growth and spread of hepatitis C virus infection.
                                           The company's obligations under the research term
                                           extend to December 2000.
Rhone-Polenc Rorer      December 1998 to   Development of small molecule therapeutics that
  ("RPR")               December 2000      inhibit cathepsin S, a protease associated with
                                           certain inflammatory diseases. The initial research
                                           phase of this agreement extends through December
                                           2000. Rhone-Polenc Rorer has the option to extend
                                           the research phase to December 2002.
Pharmacia & Upjohn      August 1995 to     Development of inhibitors of Factor Xa, Factor VIIa
  ("P&U")               April 1998         and for the treatment of blood clotting disorders.
                                           As of April 1998 the Company completed its
                                           obligations under this agreement.
Amgen, Inc.             May 1993 to        Development of synthetic small molecule mimetics of
  ("Amgen")             February 1997      erythropoietin. As of February 1997 the Company
                                           completed its obligations under this agreement.
P&U                     March 1993 to      Development of certain human growth factor
                        December 1997      mimetics, initially focusing on human growth
                                           hormones. As of December 1997 the Company completed
                                           its obligations under this agreement.
Roche Bioscience        June 1998 to       To develop therapies for pain using functional
  ("RBS")               September 1999     genomics. The research phase may be extended to
                                           June 2000, at the option of RBS.
Parke-Davis             October 1997 to    Identification of genes important in the etiology
  Pharmaceutical        October 2002       of schizophrenia and bipolar disorder. The
  Research Division                        company's obligations under the research term
  of Warner-Lambert                        extend to October 2002.
  Company ("PD")
Boehringer Ingelheim    June 1995 to       Identification of genes important in the etiology
  International GmbH    June 2000          of asthma. As of January 1, 1999 the company agreed
  ("BI")                                   to reduce the number of researchers in this program
                                           and is continuing to have discussions with BI about
                                           the future direction of this collaboration. The
                                           company's current obligations under the research
                                           term extend to June 2000.
Corange                 June 1995 to       Identification of genes important in the etiology
  International, Ltd.   February 1999      of osteoporosis. The research phase of this
  ("Corange")                              collaboration terminated in February 1999.
Glaxo-Wellcome Inc.     July 1994 to       Genomics work in the area of type II diabetes and
  ("Glaxo")             February 1998      human obesity. As of February 1998 the Company
                                           completed its obligations under this agreement.
</TABLE>
 
     With respect to the company's product sales through the ATD, the company
has several outstanding agreements with pharmaceutical and biotechnology
companies for the production of combinatorial chemistry
 
                                       31
<PAGE>   33
 
compounds, of which the following are material to the ATD: Pharmacia & Upjohn,
dated March 1996, for the delivery of compounds through December 1999 and
Parke-Davis Pharmaceutical Research Division of Warner-Lambert Company, dated
May 1998, for the delivery of compounds over the next three years. Additionally,
in December 1998, the company entered into an agreement with Rhone-Polenc Rorer
for the delivery of compounds through December 2000.
 
                             RESULTS OF OPERATIONS
 
YEARS ENDED DECEMBER 31, 1998 AND 1997
 
     1998 Events Which Affected The Company's Operations: On January 8, 1998 the
company completed the acquisition of Sequana Therapeutics, Inc. ("Sequana"), a
genomics company of approximately 200 employees based in La Jolla, California.
The company acquired all of the outstanding stock of Sequana in exchange for
common stock of the company. The discussion below on "In Process Research and
Development" sets out in further detail a description of the research programs
at Sequana at the date of acquisition. In general, Sequana was a company of
similar size and complexity to Axys. Sequana's revenues were primarily derived
from collaborative research agreements with most of the same components as those
described above for Axys. Consequently, in comparing the operating results of
the company for the periods ended December 31, 1998 and 1997, Sequana
contributed in large part to the doubling of all of the line items on the
Statement of Operations, except "Product Revenues" and "Cost of Goods Sold,"
which were applicable to of Axys alone.
 
     In May 1998, the company formed a majority owned subsidiary, Xyris
Corporation ("Xyris"), which was established to leverage the company's existing
pharmaceutical technology in the agricultural biotechnology market. The company
owns 82 percent of the outstanding stock of Xyris as of December 31, 1998, and
the remaining 18 percent is owned in part by a third party and by the chief
executive officer of Xyris.
 
REVENUES
 
  Collaboration and licensing revenues
 
     The company's collaboration and licensing revenues increased to $38.9
million for the year ended December 31, 1998, from $22.5 million in 1997,
primarily due to the acquisition Sequana. If the acquisition had occurred prior
to 1997, revenues on a pro forma basis for 1997 would have been $42.1 million,
and would have therefore been $3.2 million lower in 1998. Collaboration and
licensing revenues for the year ended December 31, 1998 were attributable to the
material collaborative research agreements with: (i) Parke-Davis for the gene
identification program in schizophrenia and bipolar disorder, and includes
research funding; (ii) BI for the gene identification program in asthma, and
include research funding; (iii) BMS for the development of small molecule
inhibitors of proteases involved in hepatitis C virus infection and include
research funding, as well as a licensing fee; (iv) Merck for the development of
small molecule inhibitors of proteases involved in osteoporosis, and include
research funding and the amortization of an up-front licensing fee; and (v) RPR
for the development of small molecule therapeutics that inhibit cathepsin S,
associated with certain inflammatory diseases, and include a licensing fee.
Although some of these agreements were new, 1998 revenues decreased when
compared to 1997 on a pro forma basis because of lower revenues recognized under
the following agreements: (i) the end of research funding in July 1998 of the
P&U agreement for the development of inhibitors of Factor Xa; (ii) the end of
the research phase in November 1997 of the Bayer agreement to develop inhibitors
of the regulatory enzymes tryptase and chymase for the treatment of asthma;
(iii) the termination of the Glaxo agreement for the genomics work in the area
of type II diabetes and related conditions; and (iv) the end of the research
phase of the SB agreement in December 1997 for the inhibition of intracellular
viral proteases.
 
  Product revenues
 
     The company's product revenues increased to $8.5 million for the year ended
December 31, 1998, from $2.3 million in 1997. The increase was primarily due to
the overall increase in compound libraries shipped in
 
                                       32
<PAGE>   34
 
1998, when compared to 1997, in accordance with the terms of the combinatorial
chemistry agreements with P&U, PD and RPR described above.
 
  Cost of Goods Sold
 
     The company's cost of goods sold increased to $2.1 million for the year
ended December 31, 1998 from $1.0 million in 1997. The increase was primarily
due to more compound libraries being shipped in 1998 than 1997 under the three
agreements discussed above.
 
  Research and Development
 
     The company's research and development expenses increased to $62.2 million
for the year ended December 31, 1998, from $30.0 million in 1997, primarily due
to the acquisition of Sequana and additional costs associated with the clinical
trials of APC-366, prior to the termination of that program. If the acquisition
of Sequana had occurred prior to 1997, research and development expenses would
have been $59.9 million in 1997 on a pro forma basis. The increase on a pro
forma basis to $62.2 million in 1998 from $59.9 million in 1997 was due to the
increase in clinical trial costs discussed above, as well as the expanded
research efforts in drug discovery.
 
  General and Administrative
 
     The company's general and administrative expenses increased to $14.5
million for the year ended December 31, 1998, from $7.2 million in 1997,
primarily due to the Sequana acquisition and the planning of our strategic
initiative in oncology. Additionally, general and administrative expenses for
1998 included all of the expenses of the company's subsidiary, Xyris, due to the
company's 82% ownership at December 31, 1998. Further expansions in general and
administrative expenses took place in legal, finance and business development to
support the company's expanded research and development efforts. These increases
for 1998 were offset in part by the elimination of approximately $3.0 million of
outside service costs, executive management, and other administrative expense
from the combining of Arris (as the company was previously known) and Sequana.
If the acquisition of Sequana had occurred prior to 1997, pro forma basis
general and administrative expenses would have been $12.5 million in 1997. The
increase, on a pro forma basis to $14.5 million in 1998 from $12.5 million in
1997 was primarily due to one-time charges related to the integration of
Sequana, as well as the other administrative costs discussed above.
 
  Acquired In-Process Research and Development
 
     Acquired in-process research and development (IPR&D) expense increased to
$124.9 million for the year ended December 31, 1998 due to the company's
acquisition of Sequana Therapeutics on January 8, 1998. That acquisition was
accounted for using the purchase method of accounting and the $174.1 million
purchase price was allocated to the various tangible and intangible assets
acquired based on their respective estimated fair values. As a result, $124.9
million was allocated to acquired IPR&D. The $124.9 million was expensed as a
non-recurring charge on the acquisition date because the acquired in-process
technology had not yet reached technological feasibility, had no future
alternative uses, and all programs were still in the research phase. The
company's use of the acquired in-process technology is to pursue the discovery
of the genetic causes of diseases that can be used in the company's drug
discovery programs or in the fulfillment of contractual obligations with our
collaborators. The company anticipates that, utilizing the acquired in-process
technology, it will take many years to determine the genetic causes of certain
diseases and then introduce that information into the company's or our
collaborators' drug discovery programs. There can be no assurance that the
genetic causes of these diseases will be found, that pharmaceutical agents
developed using this genetic information can be discovered by the company or our
collaborators which can modulate those diseases, that any resulting
pharmaceutical agent will be approved for marketing by regulatory authorities,
or that any resulting pharmaceutical agent will be commercially successful.
 
     The nature of the acquired IPR&D as of the date of the acquisition relates
to projects associated with the study of the genetic causes of certain major
diseases, the development of software for use principally by the
 
                                       33
<PAGE>   35
 
Company in the study of genetic causes of diseases, and projects in the field of
pharmacogenomics (the emerging science of how genetic variation among
individuals affects drug safety and efficacy). The purchased research and
development was identified and valued through extensive interviews and
discussions with appropriate management and scientific personnel and the
analysis of data provided by Sequana concerning Sequana's development projects,
their respective stage of development, the time and resources needed to complete
them, their expected income generating ability, target markets and associated
risks. The following discussion outlines in detail the methods Axys used in
allocating the cost of acquired IPR&D.
 
     The determination of the genetic causes of diseases as practiced by Sequana
included the following four major processes, each of which involve technology
risks and uncertainties, with the further risk that the failure to successfully
complete any single process can prevent the project from reaching conclusion:
 
     1. TECHNOLOGY: Development of laboratory methods for DNA sample intake,
        automated DNA sample handling, automated DNA sample storage which
        includes data acquisition and retrieval systems, and robotics systems.
 
     2. DISEASE IDENTIFICATION: Identification of disease populations, which
        include inbreeding and background evaluations. This phase also includes
        the securing of contracts to obtain DNA samples and the tracing of
        patient information, which encompasses parental background, severity of
        disease, interviews, and physician participation.
 
     3. GENETIC MAPPING: The processing of DNA samples including genotyping, the
        development of proprietary genotype markers, high throughput sequencing,
        computer-based analysis, and candidate gene identification.
 
     4. GENE IDENTIFICATION AND VALIDATION: The refinement of genetic mapping to
        localize the gene to a single area of the genome including exact
        identification of the genetic sequence data, characterization of the
        function of the gene, localizing of gene function to certain tissues,
        and validation of the gene's function through manipulation to either
        induce or inhibit the creation of the product of the genetic sequence
        under study.
 
     Due to the nature of the scientific efforts required for each process, the
earlier phases, particularly the disease identification phase, involve a level
of complexity disproportionately greater than their cost or time to complete
relative to the other phases. While programs were at varying stages of
completion, all acquired programs were 45% complete in the aggregate.
 
     At the date of the acquisition, Sequana had ongoing programs in the
following areas:
 
     -  Asthma: The study of the genetic causes of Asthma in collaboration with
        Boehringer Ingelheim Int'l GmbH ("BI"): Sequana had received a milestone
        payment from BI and was pursuing the discovery of additional genes. The
        study of the additional genes had completed the first three processes
        outlined above.
 
     -  Osteoporosis: The study of the genetic causes of Osteoporosis in
        collaboration with Corange International, Ltd. ("Corange"): Sequana had
        completed the first three processes outlined above.
 
     -  Non-Insulin Dependent Diabetes Mellitus (NIDDM): The study of the
        genetic causes of NIDDM (or also Type II diabetes) in collaboration with
        Glaxo Wellcome, Inc. ("Glaxo"): Sequana had completed the first two
        processes outlined above.
 
     -  Schiz/Bipolar: The study of the genetic causes of Schizophrenia and
        Bipolar Disorder (manic depressive illness) in collaboration with
        Parke-Davis ("Parke-Davis"): Sequana was in middle of the first process
        outlined above.
 
     -  Obesity: This unpartnered program was set up to study the genetic causes
        of Obesity and had completed the four processes outlined above in an
        animal model. This program was also leading to early work in the genetic
        causes of certain visual disorders.
 
                                       34
<PAGE>   36
 
     - Alzheimer's: The study of the function of genes identified with
       Alzheimer's disease. Sequana's efforts were focused on phases three and
       four only, with phase three being completed.
 
     - Pharmacogenomics: A program generally involved in the development of
       patient data, software tools and processes in the pursuit of
       pharmacogenomics activities. Due to the nature of this aspect of the
       technology acquired, it does not lend itself to being defined in the
       context of the four processes discussed. The Company estimates that
       Sequana was 70% complete with respect to the initial development of this
       technology. The Company intends to continue the development of this
       technology beyond the initial scope as defined at the date of the
       acquisition.
 
     - Other: Smaller studies of the genetic causes of other diseases
       (Inflammatory Bowel Disease, Type I Diabetes, and diseases associated
       with genetic variations in certain biological signaling processes  --
       Potassium Channels) were also underway progressing in varying degrees
       through the first two processes outlined above.
 
     The value of Sequana's projects noted above was determined after estimating
the net cash flows from such projects, and discounting the net cash flows back
to their present value. The net cash flows were based on the Company's estimate
of revenue, research and development costs, general and administrative costs and
income taxes.
 
     At the acquisition date, the company estimated revenue for the Sequana
projects acquired would relate largely to research support and milestone
payments through 2005. The company currently expects that medicines which
utilize its proprietary developmental-stage technologies will obtain FDA
approval beginning at various times beginning in 2005 through 2016. If such
medicines are successfully marketed the Company will receive a royalty on the
product sales. Research support costs were estimated at 150% of revenues in
1998, declining to a stabilized level of 65% of revenues in 2002 and beyond. The
general and administrative costs were estimated to be approximately $6 million
in 1998 and were assumed to grow at 20% annually until 2005, then to stabilize
to 8% annual growth thereafter. The effective tax rate utilized was 40%. The
discount rate used to value Sequana's IPR&D was 30%. The discount rate considers
the company's weighted average cost of capital of 13% at the date of acquisition
and a risk premium to reflect the risk associated with the stage of development
the Sequana projects. The estimated cost and time needed to complete Sequana's
programs at of the date of acquisition was approximately $190 million through
2007.
 
     Subsequent to the date of acquisition, as part of the company's ongoing
assessment of allocating resources to projects, the Obesity and Alzheimers
programs were temporarily suspended. In addition, the partnered programs have
had the following changes: (i) Glaxo in the NIDDM program exercised their option
for early termination upon Sequana's change in control and terminated the
research funding in May 1998; (ii) Corange in the Osteoporosis program, changed
their priorities following Roche Group's acquisition of Corange, and exercised
its right to end this program in February 1999; and (iii) BI in the Asthma
program, reduced the amount of research support in January 1999, and is
currently in discussion with the company about the future of the program. If the
company is unable to find alternative partners for any of these partnered
programs, the company will have to further evaluate the future of these
programs.
 
  Interest Income and Interest Expense
 
     Interest income increased to $4.7 million for the year ended December 31,
1998, from $3.4 million in 1997. The increase was primarily due to the increase
in average cash and investment balances between the periods, as a result of the
acquisition of Sequana. Interest expense increased to $2.4 million for the year
ended December 31, 1998, from $1.0 in 1997. The increase was primarily due to
the higher debt balances from the company's two lines of credit and existing
leasing arrangements following the acquisition of Sequana. The company has
generally used draw-downs from its lending arrangements for capital equipment
leasehold improvements.
 
                                       35
<PAGE>   37
 
  Provision for income tax
 
     The Company incurred a net operating loss in 1998 and, accordingly, no
provision for federal or state income taxes was recorded. As of December 31,
1998, the Company had federal net operating tax loss carryforward of
approximately $75.5 million. The company's ability to utilize its net operating
loss carryforwards may be subject to an annual limitation in future periods
pursuant to the "change in ownership rules" under Section 382 of the Internal
Revenue Code of 1986, as amended.
 
  Equity Interest in Loss of Joint Venture
 
     Equity interest in loss of joint venture increased to $2.4 million for the
year ended December 31, 1998, and was due to the increase in the loss for Genos,
which was acquired as part of the company's acquisition of Sequana. This amount
represents the company's 50% portion of Genos' loss for 1998 based on its
percentage ownership.
 
  Minority Interest
 
     Minority interest represents another investor's share of a subsidiary's
operating income (loss), where the company owns 51% to 99% of that subsidiary.
Income reported by the company which is attributable to a minority interest
increased to $112,000 for the year ended December 1998, from none in 1997. This
amount is the result of the formation of the Company's majority owned
subsidiary, Xyris. Since we reports all of Xyris's expenses as our expenses (see
"General and Administrative" above), this one line allocates a portion of Xyris'
loss to the minority shareholders, and offsets our operating loss.
 
YEARS ENDED DECEMBER 31, 1997 AND 1996
 
  Revenues
 
     Collaboration and licensing revenues
 
     The company's collaboration and licensing revenues increased to $22.5
million for the year ended December 31, 1997 from $21.6 million in 1996. The
company's collaboration and licensing revenues for the year ended December 31,
1997 were attributable to collaborations with P&U, Amgen, Bayer, SB, Merck,
Abbott and BMS. The increase in 1997 was primarily due to (i) the inclusion of a
full year of research and development funding support under a collaboration with
Merck, which commenced in November 1996, to develop small molecule inhibitors of
proteases involved in osteoporosis; (ii) additional research funding under a
collaboration with PNU for the Xa project, which commenced in September 1995;
(iii) the commencement of the collaboration with BMS to develop small molecule
inhibitors of proteases involved in Hepatitis C virus infection; (iv) the
commencement of the collaboration with Abbott to transfer to Abbott specialized
drug discovery technologies for application by Abbott in an undisclosed
proprietary research program; and (v) the inclusion of a full year of research
and development funding support under a collaboration with SB, which commenced
in June 1996, to develop inhibitors using Axys' proprietary Delta technology
targeting intracellular viral proteases. The increases were partially offset by
lower revenues recognized under the erythropoietin collaboration with Amgen,
human growth hormone collaboration with P&U and the oral tryptase inhibitor
collaboration with Bayer, where the funded research portion of these agreements
ended during 1997.
 
  Product revenues
 
     Product revenues increased to $2.3 million for the year ended December 31,
1997 from none in 1996, primarily from the sale of combinatorial chemistry
compounds. The company first starting shipping small molecule synthetic organic
compounds in 1997 under an agreement with P&U, which commenced in March 1996 and
extends until December 1999.
 
                                       36
<PAGE>   38
 
  Cost of Goods Sold
 
     Cost of goods sold increased to $1.0 million for the year ended December
31, 1997, and was primarily due to the costs of producing combinatorial
chemistry libraries. These costs were specifically related to the agreement with
P&U for the compounds that were shipped during 1997.
 
  Research and Development
 
     The company's research and development expenses increased to $30.0 million
for the year ended December 31, 1997, from $24.3 million in 1996, primarily due
to the expansion of the company's research efforts in new and existing programs,
the expense of two phase IIa clinical trials of APC-366, and investments in
proprietary programs.
 
  General and Administrative
 
     The company's general and administrative expenses increased to $7.2 million
for the year ended December 31, 1997, from $5.4 million in 1996, primarily due
to increased support associated with the company's expanded research and
development efforts, and the expansion of the company's facilities and business
development activities.
 
  Interest income and interest expense
 
     Interest income increased to $3.4 million for the year ended December 31,
1997, from $3.1 million for the same period in 1996. The increase was primarily
due to the increase in average cash balance between the periods, resulting from
the receipt of up-front fees collected under new collaborations and the
collection of revenues from the shipment of compounds under the collaboration
with P&U. Interest expense increased to $1.0 million for the year ended December
31, 1997, from $670,000 in the same period in 1996. The increase was primarily
due to the higher debt balances carried under bank lines of credit. The company
has generally used draw-downs from its lending arrangements for capital
equipment acquisitions.
 
  Provision for income tax
 
     The company incurred a net operating loss in 1997 and, accordingly, no
provision for federal or state income taxes was recorded. As of December 31,
1997, the company had federal net operating tax loss carryforward of
approximately $21.7 million. The company's ability to utilize its net operating
loss carryforwards may be subject to an annual limitation in future periods
pursuant to the "change in ownership rules" under Section 382 of the Internal
Revenue Code of 1986, as amended.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     The company has financed its operations since inception primarily through
private and public offerings of capital stock, through corporate collaborative
research agreements, and sales of combinatorial chemistry compounds. As of
December 31, 1998, the company had realized approximately $182 million (of which
approximately $86 million was derived from Sequana) in net proceeds from
offerings of its capital stock. In addition, the company had realized
approximately $160 million (of which approximately $60 million was derived from
Sequana) since inception from its collaborative research agreements and the sale
of compound libraries.
 
     The company's principal sources of liquidity are its cash and investments,
which totaled $72.7 million as of December 31, 1998. The company has two lines
of credit under which it had borrowed a total of $25.9 million under the
agreements as of December 31, 1998. The company has no additional borrowing
capacity under these agreements.
 
     Net cash used in operating activities during the year ended December 31,
1998 was $27.2 million on a consolidated basis with Sequana, compared to $14.5
million, which represents Arris Pharmaceutical Corporation only in the same
period in 1997. The increase was primarily due to the increase in net loss for
the year ended December 31, 1998, which was principally due to the combined
operating results of Arris and Sequana
 
                                       37
<PAGE>   39
 
and cash used in the acquisition of Sequana. Cash used in operating activities
is expected to fluctuate from year to year depending, in part, upon the timing
and amounts, if any, of cash received from existing and new collaboration
agreements and the sale of compound libraries.
 
     The company also used approximately $8.3 million for the purchase of
property, plant and equipment during the year ended December 31, 1998.
Additional equipment is expected to be acquired or leased in connection with the
company's continuing research and development activities.
 
     The company expects that its existing capital resources, including research
and development revenues from existing collaborations, will enable the company
to maintain current and planned operations for at least two years. The company
will need to raise substantial additional capital to fund its operations beyond
the end of such period. The company plans to seek such additional funding
through use of various financing mechanisms that may then be available to the
company.
 
     There can be no assurance that the company will be able to enter into new
collaborations on acceptable terms or that additional financing will be
available to the company on acceptable terms, or at all. Any additional funds
raised by issuing equity securities may result in further dilution to
stockholders. If adequate funds are not available, the company may be required
to delay, to reduce the scope of or to eliminate one or more of its research or
development programs or to obtain funds through arrangements with collaborative
partners or others that may require the company to relinquish rights to certain
of its technologies or products that the company would otherwise seek to develop
or commercialize itself.
 
IMPACT OF THE YEAR 2000
 
     The Year 2000 problem or the "Y2K problem" is a problem that may arise at
the turn of the century in computers or other equipment that utilizes
microprocessor technology. Some computer software programs and computer
equipment, as well as other equipment using embedded microprocessors, use two
digit date fields rather than four date digit fields (that is, "98" in the
computer code refers to the year "1998"). As a result, time-related functions in
such software and equipment may misinterpret dates after January 1, 2000 to
refer to the twentieth century rather than the twenty-first century (that is,
"02" could be interpreted as "1902" rather than "2002"). This could potentially
cause system or equipment shutdowns, failures or miscalculations, resulting in
inaccuracies in computer output. The Y2K problem is a global problem and has the
potential to impact virtually every company to one degree or another, including
our company.
 
     The company is addressing the Y2K problem by reviewing its core information
technology systems, including its servers, databases, desktop computers,
significant applications (whether licensed from third parties or developed
internally) and significant microprocessor-controlled equipment for Y2K
readiness. Because the Y2K problem potentially affects many other companies, we
are also in the process of reviewing the Y2K readiness of our vendors, service
providers and other companies (including collaboration partners and customers)
with whom we have significant business relationships ("Important Third
Parties").
 
     As the company completes these internal and external reviews, the company
has been prioritizing the responses it needs to take to address the Y2K problem,
to address the highest priorities first and to develop by the end of the second
quarter of 1999 such contingency plans as management believes to be prudent.
With respect to the company's core information technology systems and desktop
computers, the company expects to have completed its review and to have made any
necessary modifications or replacements by the end of the second quarter of
1999. With respect to third party software applications, the company expects to
complete its review and to replace or upgrade such applications by the end of
the third quarter of 1999. In this regard, the company is currently in the final
stages of replacing its enterprise management information system with a new
system that will be Y2K ready. With respect to the few software applications the
company has developed and licensed to third parties, the company has completed
its review of some of these applications and believes them to be Y2K ready. The
remaining applications are being tested and if determined not to be Y2K ready,
the company expects to provide to upgrades to such applications to make them Y2K
ready by the third quarter of 1999. With respect to other internally-developed
software applications, the company has compiled a list of such applications and
has initiated the design of appropriate tests. The company expects to complete
its review and replacement or upgrade of these applications by the end of the
second quarter of 1999. Finally, with
 
                                       38
<PAGE>   40
 
respect to other significant microprocessor-controlled equipment, the company
has identified such equipment and is in the process of testing it.
 
     The company expects to complete its test of such equipment and to have made
any necessary upgrades or replacements by the end of the third quarter of 1999.
The review of the Y2K readiness of Important Third Parties is in-progress and is
expected to be substantially completed by the end of the second quarter of 1999.
Following completion, the company expects to assess the nature and extent of the
risk from non-readiness by such third parties and to either cease doing business
with such third parties, locate back-up businesses who are Y2K ready, obtain
reasonable assurances of Y2K readiness, or to implement other appropriate
contingency plans, by the end of 1999.
 
     The total costs associated with the company's Y2K readiness efforts is
estimated to be less than $250,000. Expenditures to date with respect to the Y2K
problem have not been material and have largely consisted of the time of company
personnel.
 
     The company believes that its Y2K readiness review and the actions it
intends to take prior to the end of 1999 should result in the absence of
significant Y2K-related problems for the company's computer systems,
applications and microprocessor-controlled equipment. However, there can be no
assurances that the company will be able to complete its review of various
systems within the time frames indicated, that the company, will be completely
Y2K ready by the end of 1999 or that the company will not encounter Y2K-related
problems that could have a material adverse affect on the company's results of
operations and financial condition. In addition, the company cannot guarantee
the Y2K readiness of Important Third Parties and certain business disruptions
could occur, such as a financial institution's inability to process checks drawn
on bank accounts, to accept deposits or process wire transfers, an Important
Third Party's business failure, interruption in deliveries of equipment,
supplies and services from Important Third Parties, loss of voice and/or data
connections, loss of power to electrical facilities, and other business
interruptions which cannot be predicted. Accordingly, there can be no assurance
that Y2K-related problems of Important Third Parties will not have a material
adverse affect on the company's results of operations and financial condition.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
     Due to the composition of the company's interest earning assets (82% mature
within one year) and interest bearing liabilities, the Company believes that the
market risk is not significant.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
                           AXYS PHARMACEUTICALS, INC.
 
                         INDEX TO FINANCIAL STATEMENTS
                  YEAR ENDED DECEMBER 31, 1998, 1997 AND 1996
                      WITH REPORT OF INDEPENDENT AUDITORS
 
<TABLE>
<CAPTION>
                                                              PAGE
                                                              ----
<S>                                                           <C>
Report of Independent Auditors..............................    40
Consolidated Balance Sheets.................................    41
Consolidated Statements of Operations.......................    42
Consolidated Statement of Stockholders' Equity..............    43
Consolidated Statements of Cash Flows.......................    44
Notes to Consolidated Financial Statements..................    45
</TABLE>
 
                                       39
<PAGE>   41
 
               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
 
Board of Directors and Stockholders
Axys Pharmaceuticals, Inc.
 
     We have audited the accompanying consolidated balance sheets of Axys
Pharmaceuticals, Inc. (formerly Arris Pharmaceutical Corporation) as of December
31, 1998 and 1997, and the related consolidated statements of operations,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1998. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
 
     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
 
     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Axys Pharmaceuticals, Inc. at December 31, 1998 and 1997, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1998, in conformity with generally accepted accounting
principles.
 
                                          ERNST & YOUNG LLP
 
Palo Alto, California
February 5, 1999
 
                                       40
<PAGE>   42
 
                           AXYS PHARMACEUTICALS, INC.
 
                          CONSOLIDATED BALANCE SHEETS
               (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
 
                                     ASSETS
 
<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                              ---------------------
                                                                1998       1997(1)
                                                              ---------    --------
<S>                                                           <C>          <C>
Current assets:
Cash and cash equivalents...................................  $  36,261    $ 22,938
Short-term marketable investments...........................     23,999      30,470
Accounts receivable, trade..................................      2,140       1,301
Inventory...................................................        435          --
Prepaid expenses and other current assets...................      4,513       2,767
                                                              ---------    --------
          Total current assets..............................     67,348      57,476
Marketable investments......................................     12,457          --
Property and equipment, net.................................     21,510      14,454
Investment in joint venture.................................      1,908          --
Note receivable from officer................................        821         810
Intangible assets, net......................................      2,200         175
Other assets................................................      1,018         669
                                                              ---------    --------
                                                              $ 107,262    $ 73,584
                                                              =========    ========
                       LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable............................................  $   3,788    $  1,622
Accrued compensation........................................      4,232       1,793
Other accrued liabilities...................................      2,956       2,148
Current portion of deferred revenue.........................      8,698       5,410
Current portion of capital lease and debt obligations.......      9,872       3,390
                                                              ---------    --------
          Total current liabilities.........................     29,546      14,363
Deferred revenue, noncurrent................................         --         726
Capital lease and debt obligations, noncurrent..............     16,816      14,605
Minority interest...........................................        388          --
Commitments
Stockholders' equity:
  Preferred stock, $0.001 par value, 10,000,000 shares
     authorized, none issued or outstanding.................         --          --
  Common stock, $0.001 par value, 50,000,000 shares
     authorized, 30,234,150 and 15,203,089 shares issued and
     outstanding at December 31, 1998 and 1997,
     respectively...........................................    290,291     117,786
Note receivable from officer................................         --        (125)
Accumulated other comprehensive income......................        116          --
Accumulated deficit.........................................   (229,895)    (73,771)
                                                              ---------    --------
Total stockholders' equity..................................     60,512      43,890
                                                              ---------    --------
                                                              $ 107,262    $ 73,584
                                                              =========    ========
</TABLE>
 
---------------
(1) Represents the balances of Arris Pharmaceutical Corporation only.
 
                            See accompanying notes.
 
                                       41
<PAGE>   43
 
                           AXYS PHARMACEUTICALS, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                                 YEAR ENDED DECEMBER 31,
                                                             --------------------------------
                                                               1998       1997(1)     1996(1)
                                                             ---------    --------    -------
<S>                                                          <C>          <C>         <C>
Revenues:
  Collaboration and licensing revenues.....................  $  38,910    $ 22,499    $21,560
  Product revenues.........................................      8,512       2,315         --
                                                             ---------    --------    -------
     Total revenues........................................     47,422      24,814     21,560
Operating costs and expenses:
  Cost of goods sold.......................................      2,058       1,010         --
  Research and development.................................     62,176      30,040     24,319
  General and administrative...............................     14,460       7,153      5,409
  Acquired in-process research and development.............    124,888          --        230
                                                             ---------    --------    -------
     Total operating costs and expenses....................    203,582      38,203     29,958
                                                             ---------    --------    -------
Operating loss.............................................   (156,160)    (13,389)    (8,398)
Interest income............................................      4,720       3,436      3,140
Interest expense...........................................     (2,403)     (1,014)      (670)
Equity interest in loss of joint venture...................     (2,393)         --         --
Minority interest..........................................        112          --         --
                                                             ---------    --------    -------
Net loss...................................................  $(156,124)   $(10,967)   $(5,928)
                                                             ---------    --------    -------
Basic and diluted net loss per share.......................  $   (5.25)   $  (0.73)   $ (0.45)
                                                             =========    ========    =======
Shares used in computing basic and diluted net loss per
  share....................................................     29,758      15,025     13,177
                                                             =========    ========    =======
</TABLE>
 
---------------
(1) Represents the results of Arris Pharmaceutical Corporation only.
 
                            See accompanying notes.
 
                                       42
<PAGE>   44
 
                           AXYS PHARMACEUTICALS, INC.
 
                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
               (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                         NOTE                        ACCUMULATED
                                 COMMON STOCK         RECEIVABLE                        OTHER                           TOTAL
                            ----------------------       FROM         DEFERRED      COMPREHENSIVE    ACCUMULATED    STOCKHOLDERS'
                              SHARES       AMOUNT      OFFICER      COMPENSATION       INCOME          DEFICIT         EQUITY
                            ----------    --------    ----------    ------------    -------------    -----------    -------------
<S>                         <C>           <C>         <C>           <C>             <C>              <C>            <C>
Balances at December 31,
  1995....................  10,169,076    $ 64,389      $(200)          $(35)           $ --          $ (56,876)      $   7,278
Exercise of options and a
  warrant to purchase
  common stock............     466,088       1,425         --             --              --                 --           1,425
Issuance of common stock,
  net of issuance costs of
  $3,138..................    3,450,00      41,712         --             --              --                 --          41,712
Issuance of common stock
  in connection with the
  Employee Stock Purchase
  Plan ("ESPP")...........      66,692         393         --             --              --                 --             393
Issuance of common stock
  in connection with the
  exercise of the Arris
  Canada minority interest
  option..................     161,418       1,800         --             --              --                 --           1,800
Issuance of common stock
  in connection with the
  acquisition of Khepri
  Pharmaceuticals, Inc....     518,701       6,185         --             --              --                 --           6,185
Amortization of deferred
  compensation............          --          --         --             35              --                 --              35
Net loss..................          --          --         --             --              --             (5,928)         (5,928)
                            ----------    --------      -----           ----            ----          ---------       ---------
Balances at December 31,
  1996....................  14,831,975     115,904       (200)            --              --            (62,804)         52,900
Exercise of options and a
  warrant to purchase
  common stock............     313,000       1,327         --             --              --                 --           1,327
Issuance of common stock
  in connection with the
  ESPP....................      58,114         555         --             --              --                 --             555
Forgiveness of note
  receivable..............          --          --         75             --              --                 --              75
Net loss..................          --          --         --             --              --            (10,967)        (10,967)
                            ----------    --------      -----           ----            ----          ---------       ---------
Balances at December 31,
  1997....................  15,203,089     117,786       (125)            --              --            (73,771)         43,890
Exercise of options and
  warrants to purchase
  common stock............      91,649         621         --             --              --                 --             621
Issuance of common stock
  for cash................     132,254       1,063         --             --              --                 --           1,063
Issuance of common stock
  in connection with the
  ESPP....................     189,145       1,091         --             --              --                 --           1,091
Issuance of common stock
  in connection with the
  acquisition of Sequana
  Therapeutics, Inc.......  14,618,013     169,730         --             --              --                 --         169,730
Forgiveness of note
  receivable..............          --          --        125             --              --                 --             125
Net loss..................          --          --         --             --              --           (156,124)       (156,124)
Unrealized gain on
  securities..............          --          --         --             --             116                 --             116
                                                                                                                      ---------
Comprehensive loss........          --          --         --             --              --                 --        (156,008)
                            ----------    --------      -----           ----            ----          ---------       ---------
Balance at December 31,
  1998....................  30,234,150    $290,291      $  --           $ --            $116          $(229,895)      $  60,512
                            ==========    ========      =====           ====            ====          =========       =========
</TABLE>
 
                            See accompanying notes.
 
                                       43
<PAGE>   45
 
                           AXYS PHARMACEUTICALS, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
 
<TABLE>
<CAPTION>
                                                                   YEAR ENDED DECEMBER 31,
                                                              ---------------------------------
                                                                1998       1997 (1)    1996 (1)
                                                              ---------    --------    --------
                                                                       (IN THOUSANDS)
<S>                                                           <C>          <C>         <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss....................................................  $(156,124)   $(10,967)   $ (5,928)
Adjustments to reconcile net loss to net cash used in
  operating activities:
  Depreciation and amortization.............................     10,156       4,183       3,859
  Loss on disposal of fixed assets..........................         44          --         209
  Equity interest in loss of joint venture..................      2,393          --          --
  Acquired in-process research and development..............    124,888          --         230
  Forgiveness of note receivable from officer...............        155          75          --
  Minority interest.........................................        388          --          --
  Changes in assets and liabilities:
    Accounts receivable.....................................       (839)     (1,301)         --
    Inventory...............................................       (435)         --          --
    Prepaid expenses and other current assets...............        636        (585)     (1,419)
    Other assets............................................     (2,469)       (345)       (657)
    Accounts payable........................................     (5,818)        183         567
    Accrued compensation....................................      2,440         313        (203)
    Accrued merger costs....................................         --          --        (762)
    Other accrued liabilities...............................        808         578        (319)
    Deferred revenue........................................     (3,382)     (6,620)     (1,301)
                                                              ---------    --------    --------
Net cash and cash equivalents used in operating
  activities................................................    (27,159)    (14,486)     (5,724)
                                                              ---------    --------    --------
CASH FLOWS FROM INVESTING ACTIVITIES
Available for-sale-securities:
  Purchases.................................................    (56,065)    (22,092)    (11,628)
  Maturities................................................     92,107       3,249          --
Held-to-maturity securities:
  Purchases.................................................         --      (9,683)    (74,458)
  Maturities................................................         --      46,704      46,837
Sale (purchase) of restricted cash and investments..........         --       7,250      (7,250)
Acquisition, net of cash balances...........................     13,270          --          --
Investment in Genos joint venture...........................     (2,000)         --          --
Proceeds from sale of property and equipment................        119
Expenditures for property and equipment.....................     (8,263)     (6,297)     (6,881)
                                                              ---------    --------    --------
Net cash and cash equivalents provided by (used in)
  investing activities......................................     39,166      19,131     (53,380)
                                                              ---------    --------    --------
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from issuance of common stock..................      2,775       1,882      43,495
Proceeds from issuance of note payable and capital lease
  obligations...............................................      6,174      19,115       9,164
Principal payments on note payable and capital lease
  obligations...............................................     (7,633)    (13,526)     (4,439)
                                                              ---------    --------    --------
Net cash and cash equivalents provided by financing
  activities................................................      1,316       7,471      48,220
                                                              ---------    --------    --------
Net increase (decrease) in cash and cash equivalents........     13,323      12,116     (10,884)
Cash and cash equivalents, beginning of year................     22,938      10,822      21,706
                                                              ---------    --------    --------
Cash and cash equivalents, end of year......................  $  36,261    $ 22,938    $ 10,822
                                                              =========    ========    ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS INFORMATION
Cash paid during the year for interest......................  $   2,284    $    826    $    623
                                                              =========    ========    ========
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING ANDFINANCING
  ACTIVITIES
Issuance of common stock and value of options and warrants
  issued in acquisitions....................................  $ 169,730    $     --    $  6,185
                                                              =========    ========    ========
Issuance of common stock to Arris Canada minority interest
  investors.................................................  $      --    $     --    $  1,800
                                                              =========    ========    ========
Noncash acquisition of equipment under capital lease........  $      --    $  1,719    $     --
                                                              =========    ========    ========
</TABLE>
 
---------------
(1) Represents the results of Arris Pharmaceutical Corporation only.
                            See accompanying notes.
 
                                       44
<PAGE>   46
 
                           AXYS PHARMACEUTICALS, INC.
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
  Organization
 
     Axys Pharmaceuticals, Inc., a Delaware corporation ("Axys" or the
"Company"), formerly known as Arris Pharmaceutical Corporation ("Arris"),
focuses on transforming gene discoveries into drugs. Axys' business is focused
in three primary areas: (i) drug discovery and development programs in
collaboration with pharmaceutical and biotechnology companies, (ii) drug
discovery and development programs which are not partnered in the area of
oncology, and (iii) the spin out of affiliated businesses in combinatorial
chemistry, pharmacogenomics, and agricultural biotechnology.
 
     The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries, Arris Protease, Inc., Arris Pharmaceuticals
Canada, Inc., and Sequana Therapeutics, Inc. ("Sequana") (See "Acquisition of
Sequana", Note 2), and includes the accounts of Xyris Corporation, the Company's
majority owned subsidiary (See "Formation of Xyris Corporation", Note 4). All
significant intercompany accounts and transactions have been eliminated.
 
     Sequana owns 50% of Genos, a joint venture with Memorial Sloan Kettering
Cancer Center ("MSKCC"). This investment is accounted for under the equity
method.
 
  Use of Estimates
 
     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates, and such
differences could be material.
 
  Cash and Cash Equivalents and Investments
 
     The Company considers all highly liquid investments with maturities of
three months or less at the date of purchase to be cash equivalents. Investments
with maturities greater than three months and less than one year are classified
as short-term investments.
 
     Management determines the appropriate classification of debt securities at
the time of purchase and reevaluates such designation as of each balance sheet
date. Debt securities are classified as held-to-maturity when the Company has
the positive intent and ability to hold the securities to maturity.
Held-to-maturity securities are stated at amortized cost, including adjustments
for amortization of premiums and accretion of discounts. Amortization of
premiums and accretion of discounts to maturity are included in interest income.
 
     The Company currently considers all its investment securities as
available-for-sale. Available-for-sale securities are reported at estimated fair
market value with the related unrealized gains and losses included in
stockholders' equity. Realized gains and losses, and declines in value judged to
be other than temporary are also included in interest income and expense and
have been immaterial. The cost of securities sold is based on the specific
identification method.
 
  Inventories
 
     Inventories are stated at the lower of cost (first-in, first-out) or
market. At December 31, 1998, inventories consisted of the following (in
thousands):
 
<TABLE>
<S>                                             <C>
Raw materials.................................  $ 69
Finished goods................................   366
                                                ----
                                                $435
                                                ====
</TABLE>
 
                                       45
<PAGE>   47
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Depreciation and Amortization
 
     Depreciation is provided using the straight-line method over the estimated
useful lives of the respective assets. Machinery and equipment has estimated
useful lives ranging from 3 to 7 years and furniture and office equipment has a
useful life of 5 years. Purchased computer software is amortized over 3 years.
Leasehold improvements are amortized over the term of the lease or economic
useful life, whichever is shorter.
 
  Revenue Recognition
 
     The Company recognizes revenues from its collaborative research programs as
well as from product sales. Under the collaborative research agreements, revenue
is recorded when earned as defined in the respective agreements. In general,
these agreements have five components of revenue; (i) research support, (ii)
license fees, (iii) commitment fees, (iv) milestone payments, and (v) royalties.
Research funding and commitment fees are recognized over the research period and
payments received in advance are recorded as deferred revenue. Licensing fees
are recognized at the time of signing and milestone payments are recognized upon
the achievement of mutually agreed upon benchmarks.
 
     Product sales, which result from the delivery of libraries of combinatorial
chemistry compounds to pharmaceutical industry customers are recognized as
revenue when the compounds are shipped. Any licensing fees associated with these
compound supply agreements are recognized at the time of signing.
 
  Research and Development
 
     Research and development expenses consist of costs incurred for independent
and collaborative research and development. These costs include direct costs and
research-related overhead expenses. Research and development expenses under the
collaborative research agreements approximate the research support revenue
recognized under the agreements of $24,804,000, $13,622,000, and $12,801,000 in
1998, 1997 and 1996 respectively.
 
  Stock-Based Compensation
 
     As permitted by Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("FAS 123"), the Company has elected
to continue to follow Accounting Principles Board Opinion No. 25 "Accounting for
Stock Issued to Employees" ("APB 25") and related interpretations in accounting
for its employee stock option and purchase plans. See Note 8 for pro forma
disclosures required by FAS 123.
 
  Net Loss Per Share
 
     Basic earnings per share is computed based on the weighted average number
of shares of the Company's common stock outstanding. In addition, there were
other dilutive securities in the form of options and warrants to purchase
5,050,026, 2,168,860, and 1,932,981 shares of common stock outstanding at
December 31, 1998, 1997, and 1996, respectively. These shares, which would
normally be included in the computation of dilutive earnings per share, were not
included in that computation because the effect would be antidilutive.
 
  Comprehensive Income
 
     As of January 1, 1998, the Company adopted the Statement of Financial
Accounting Standards No. 130 (FAS 130), "Reporting Comprehensive Income."
Comprehensive loss is comprised of reported net loss and unrealized holding
gains on available-for-sale securities. Comprehensive loss has been shown in the
Consolidated Statements of Stockholders' Equity.
 
                                       46
<PAGE>   48
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Segment Information
 
     As of January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and
Related Information" (FAS 131). FAS 131 superseded FASB Statement No. 14,
"Financial Reporting for Segments of a Business Enterprise." FAS 131 establishes
standards for the way that public business enterprises report information about
operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial reports. FAS 131 also establishes standards for related disclosures
about products and services, geographical areas, and major customers. The
adoption of FAS 131 did not affect results of operations or financial position,
but did affect the disclosure of segment information (see "Segment Information",
Note 12).
 
  Reclassifications
 
     Certain prior year amounts have been reclassified to conform to the 1998
presentations.
 
 2. ACQUISITION OF SEQUANA
 
     On January 8, 1998, the Company acquired all of the outstanding capital
stock of Sequana, a genomics company that used industrial-scale gene discovery
technology and functional genomics to discover and characterize genes that cause
certain common diseases. The Company issued shares of Axys Common Stock in
exchange for all the outstanding common stock of Sequana, on the basis of 1.35
shares of Axys' common stock for one share of Sequana common stock. The purchase
price of $174,070,000 consisted of (i) the issuance of 14,618,013 shares of
Company common stock valued at $168,107,000, in exchange for all outstanding
Sequana capital stock, (ii) the issuance of Company warrants valued at
$1,623,000 in exchange for all of the outstanding Sequana warrants, and (iii)
transaction costs totaling $4,340,000.
 
     The allocation of the purchase price was determined as follows:
 
<TABLE>
<S>                                                           <C>
Net tangible assets acquired................................  $ 45,882,000
Assembled workforce of Sequana..............................     3,300,000
Acquired in-process research and development................   124,888,000
                                                              ------------
          Total.............................................  $174,070,000
                                                              ============
</TABLE>
 
     The acquisition has been accounted for as a purchase and accordingly, the
original purchase price was allocated to acquired assets and assumed liabilities
based upon their estimated fair values at the date of acquisition, and to the
estimated fair value of in-process research and development ("IPR&D") was
charged as an expense in the Axys consolidated financial statements as such
acquired IPR&D had not reached technological feasibility. Intangible assets,
other than the technology-related assets arising from the acquisition are being
amortized on a straight line basis over 36 months.
 
     The acquired in-process research and development projects in the Sequana
acquisition consisted of eight significant research and development projects. At
the time of the acquisition, Sequana was developing technology in gene
discovery, which included DNA sample collection, genetic and physical mapping,
DNA sequencing and mutation analysis, and gene characterization and assay
development. Projects were underway associated with the study of the genetic
causes of certain diseases, the development of software used in the study of
genetic causes of diseases, and projects in the field of pharmacogenomics (the
science of how genetic variation among individuals affects drug safety and
efficacy).
 
     The value allocated to purchased IPR&D was determined by estimating the
costs to develop the purchased in-process technology into viable products,
estimating the resulting net cash flows from such projects, and discounting the
net cash flows back to their present value. The discount rate included a factor
that takes into account the Company's weighted average cost of capital and the
uncertainty surrounding the
 
                                       47
<PAGE>   49
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
successful development of the purchased in-process technology. Should these
projects not be successfully developed, future revenue and profitability of the
Company may be adversely affected.
 
     A brief description of each of the eight in-process projects is set forth
below:
 
     - The study of the genetic causes of Asthma in collaboration with Boeringer
       Ingelheim Int'l GmbH ("BI")
 
     - The study of the genetic causes of Osteoporosis in collaboration with
       Corange International, Ltd. ("Corange")
 
     - The study of the genetic causes of Non-insulin Dependent Diabetes
       Mellitus (NIDDM or also Type II diabetes) in collaboration with Glaxo
       Wellcome, Inc. ("Glaxo")
 
     - The study of the genetic causes of Schizophrenia and Bipolar Disorder
       (manic depressive illness) in collaboration with Parke-Davis
       ("Parke-Davis")
 
     - The study of the genetic causes of Obesity
 
     - The study of the function of genes identified with Alzheimers disease
       using Sequana's nematode worm model system.
 
     - A program generally involved in the development of patient data, software
       tools and processes in the pursuit of pharmacogenomics activities.
 
     - Smaller studies of the genetic causes of other diseases (Alzheimers
       Disease, Cardiovascular Disease, Type I Diabetes, and Diseases associated
       with genetic variations in certain biological signaling processes
        -- (Potassium Channels) were also underway.
 
     The operating results of Sequana from January 1, 1998 to December 31, 1998
have been included in the Company's consolidated results of operations. The
operating results of Sequana from January 1, 1998 to January 8, 1998 (date of
acquisition) are considered immaterial.
 
     As part of the Company's acquisition of Sequana, the Company also obtained
50% ownership of Genos Biosciences, Inc. ("Genos") (see "Investment in Joint
Venture", Note 1).
 
     The following unaudited pro forma financial summary is presented as if the
operations of the Company and Sequana were combined as of January 1, 1997. The
unaudited pro forma combined results are not necessarily indicative of the
actual results that would have occurred had the acquisition been consummated at
that date, or of the future operations of the combined entities. Nonrecurring
charges, such as the acquired in-process research and development charge of
$124.9 million are not reflected in the following pro forma financial summary.
 
PRO FORMA FINANCIAL SUMMARY FOR THE YEAR ENDED DECEMBER 31, 1997 (UNAUDITED)
 
<TABLE>
<CAPTION>
                                                  (In thousands, except per
                                                        share amount)
                                                  -------------------------
<S>                                               <C>
Contract Revenues...............................          $ 44,399
Net Loss........................................           (26,108)
Basic and diluted net loss per share............          $  (0.89)
</TABLE>
 
 3. INVESTMENT IN JOINT VENTURE
 
     In January 1997, Sequana formed Genos with MSKCC to focus on research and
identification of genes and related genetic information of values in the
prognosis, diagnosis and positive treatment of certain common cancers. As of
December 31, 1998 Sequana had invested $5.2 million and licensed certain of its
technology to
 
                                       48
<PAGE>   50
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Genos and has contracted with Genos to conduct research and provide certain
other services to the joint venture. Payments to date for such research and
services have not been material.
 
     In connection with the formation of Genos, Sequana issued a warrant to
MSKCC to purchase 350,000 shares of Sequana's common stock. That warrant was
assumed by the Company as part of the acquisition of Sequana on January 8, 1998,
and was converted to a warrant to purchase an aggregate of 472,500 shares of
Axys common stock at a price of $12.87 per share.
 
 4. FORMATION OF XYRIS CORPORATION
 
     In May 1998, the Company formed a majority owned subsidiary, Xyris
Corporation ("Xyris"), which was established to leverage Axys' existing
pharmaceutical technology in the agricultural biotechnology market. In
connection with the formation of Xyris, the Company granted Xyris the right, for
a limited period, to negotiate an exclusive license in the field of agriculture
to all Axys technology in exchange for an 82% ownership interest. A third party
contributed $500,000 cash in exchange for a 15% ownership interest in Xyris.
Under the terms of the financing, the Company granted the third party the right
(the "Put Option") to require the Company to purchase all of the third party's
interest in Xyris in exchange for that number of shares of the Company whose
market value equals $500,000 at the date of the exercise of the Put Option. The
Put Option was replaced by a new put option upon the closing of a second round
of financing for Xyris in February 1999 (see "Subsequent Events-Second Round of
Financing for Xyris Corporation," Note 15).
 
 5. COLLABORATIVE RESEARCH AGREEMENTS AND PRODUCT SALES AGREEMENTS
 
     Since the Company's inception in April 1989 and subsequently with the
acquisition of Sequana, the Company and its subsidiaries have funded much of
their research through collaborative research agreements with pharmaceutical
companies and from the sales of libraries of combinatorial chemistry compounds.
 
     In general, the collaborative research agreements include: (i) research
support payments which the Company receives based on the number of researchers
Axys is committing to the collaboration. In many cases, the agreements call for
full-time scientific personnel with specific educational and professional
achievements, as well as, in certain cases, related expertise in the area. Many
of these agreements provide for extension periods at the option of the partner,
which if agreed by the Company, would extend the research commitment; (ii)
license fees or commitment fees received at the signing of a collaboration
agreement in exchange for certain technology or product rights; (iii) milestone
payments which are based on the Company or the collaboration partner achieving
certain designated technical or regulatory objectives; (iv) royalty payments
upon commercialization of any products resulting from the collaboration, usually
based on a percentage of sales by the collaboration partner.
 
     With respect to the Company's product sales through its Advanced
Technologies Division (see "Segment Information", Note 12), the Company has
agreements with pharmaceutical and biotechnology companies for the production of
combinatorial chemistry compounds, often referred to as libraries. These
agreements include: (i) revenues from the delivery of chemical compound
libraries based on a contracted price per compound; and (ii) license fees
received at the signing of the agreement in exchange for technology rights.
 
                                       49
<PAGE>   51
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 6. FAIR VALUE OF FINANCIAL INSTRUMENTS
 
  Cash equivalents and marketable investments:
 
     The following is a summary of available-for-sale securities at December 31,
1998 and 1997:
 
<TABLE>
<CAPTION>
                                                             GROSS        GROSS      ESTIMATED
                                                           UNREALIZED   UNREALIZED     FAIR
                                                  COST       GAINS        LOSSES       VALUE
                                                 -------   ----------   ----------   ---------
                                                                (IN THOUSANDS)
<S>                                              <C>       <C>          <C>          <C>
AT DECEMBER 31, 1998:
Commercial paper of U.S. corporations..........  $23,572      $ 35         $ --       $23,607
U.S. treasury securities.......................      500         1           --           501
Certificates of deposit........................    4,003         9           --          4012
Securities of foreign corporations.............    3,431        13           --         3,444
U.S. agency securities.........................    7,801        24           --         7,825
Municipal obligations..........................    4,001        34           --         4,035
                                                 -------      ----         ----       -------
                                                 $43,308      $116         $ --       $43,424
                                                 =======      ====         ====       =======
AT DECEMBER 31, 1997:
Commercial Paper of U.S. corporations..........  $21,430      $ --         $(45)      $21,385
U.S. treasury securities.......................   14,384        27           --        14,411
Certificates of deposit........................    2,999        --           --         2,999
Securities of foreign corporations.............    2,948         2           --         2,950
U.S. agency securities.........................    2,121        --          (43)        2,078
                                                 -------      ----         ----       -------
                                                 $43,882      $ 29         $(88)      $43,823
                                                 =======      ====         ====       =======
Balance sheet classification:
AT DECEMBER 31, 1998:
Cash equivalents...............................  $ 6,967      $  1         $ --       $ 6,968
Short-term marketable investments..............   23,928        71           --        23,999
Marketable investments.........................   12,413        44           --        12,457
                                                 -------      ----         ----       -------
                                                 $43,308      $116         $ --       $43,424
                                                 =======      ====         ====       =======
AT DECEMBER 31, 1997:
Cash equivalents...............................  $13,412      $ --         $ --       $13,412
Short-term marketable investments..............   30,470        29         $(88)       30,411
                                                 -------      ----         ----       -------
                                                 $43,882      $ 29         $(88)      $43,823
                                                 =======      ====         ====       =======
</TABLE>
 
     At December 31, 1998, the marketable investments of $12,457,000 have
contractual maturities that are due at various times up to 26 months.
 
  Estimated fair value of other financial instruments:
 
     The carrying value of the notes payable approximate their estimated fair
value. The fair value of the notes payable was estimated based on current
interest rates available to the Company for debt instruments with similar terms,
degree of risk and remaining maturities.
 
     The estimated fair value amounts have been determined by the Company using
available market information and appropriate valuation methodologies. However,
considerable judgment is required in interpreting market data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts that the Company would realize in a
current market exchange.
 
                                       50
<PAGE>   52
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 7. PROPERTY AND EQUIPMENT
 
     Property and equipment is recorded at cost and consists of the following:
 
<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                         --------------------
                                                           1998        1997
                                                         --------    --------
                                                            (IN THOUSANDS)
<S>                                                      <C>         <C>
Machinery and equipment................................  $ 33,039    $ 15,569
Purchased software.....................................     1,748         875
Furniture and office equipment.........................     2,220       1,397
Leasehold improvements.................................    12,420       9,747
Construction in progress...............................       262         204
                                                         --------    --------
                                                           49,689      27,792
Less accumulated depreciation and amortization.........   (28,179)    (13,338)
                                                         --------    --------
                                                         $ 21,510    $ 14,454
                                                         ========    ========
</TABLE>
 
     Property and equipment includes approximately $15,011,000 and $12,267,000
recorded under capital leases at December 31, 1998 and 1997, respectively.
Amortization is included with depreciation expense. Accumulated amortization of
equipment under capital leases was approximately $12,886,000 and $8,615,000 at
December 31, 1998 and 1997, respectively.
 
 8. STOCKHOLDERS' EQUITY
 
  Common Stock
 
     At December 31, 1998, common stock was reserved for issuance as follows (in
thousands):
 
<TABLE>
<S>                                                           <C>
Stock options (including the Stock Bonus and 401(K)
  Plans)....................................................  6,047
Warrants....................................................    630
Employee stock purchase plan................................     26
                                                              -----
                                                              6,703
                                                              =====
</TABLE>
 
  Stock Options
 
     The Company has various equity incentive plans under which it issues stock
option to employees, consultants and members of the Board of Directors. The 1997
Equity Incentive Plan was approved by the stockholders in January 1998 and
allows for incentive stock options or non-qualified stock options to be granted
to employees, directors and consultants to purchase the Company's common stock
at the discretion of the Board of Directors. The Company also has the 1997
Non-Officer Equity Incentive Plan, whereby non-officer employees and consultants
may be granted non-qualified stock options to purchase the Company's common
stock; the 1989 Stock Option Plan, whereby directors, officers, employees, and
consultants may be issued restricted stock or granted incentive stock options or
nonqualified stock options to purchase the Company's common stock at the
discretion of the Board of Directors; and the 1994 Non-Employee Directors' Stock
Option Plan, whereby nonqualified stock options are automatically granted to
non-employee directors to purchase the Company's Common stock.
 
     All options granted under these Plans become exercisable pursuant to the
applicable terms of the grant. For stock options granted through December 31,
1997, the exercise price of the options was computed at the average market value
of the Company's common stock for the 15 days preceding the grant date. For
options granted after December 31, 1997, the exercise price is equal to the
market value of the Company's common stock on the date of grant. All options
vest ratably over four years and expire ten years from the date of grant.
 
                                       51
<PAGE>   53
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     In October 1998, the Company offered its employees the right to exchange
their then outstanding options to purchase shares of common stock with exercise
prices ranging from $4.31 to $15.59, for new options to purchase shares with
exercise prices of $4.00 per share for non-officer employees and $5.00 per share
for executive officer employees. Under this program, options to purchase
3,643,387 shares were exchanged resulting in a decrease in aggregate purchase
price from $34,254,046 to $15,560,548. All new options have an additional year
of vesting added to the original vesting term and a one-year freeze on
exercisability except in some limited circumstances.
 
  Stock Bonus Plan
 
     In December 1993, the Board adopted the 1993 Employee Stock Bonus Plan,
whereby the Company would reward employees for their contributions and to align
the employees' long-term interests with those of the Company through the grant
of stock of the Company for no consideration. Shares granted under this plan do
not vest unless the recipient remains an employee of the Company for two years
from the date of grant. Under the plan, 50,000 shares of common stock were
reserved for grant. There were no grants outstanding under this plan at December
31, 1998. A total of 42,500 shares had vested and were exercised as of December
31, 1998.
 
     Transactions under all of the above equity incentive plans are as follows:
 
<TABLE>
<CAPTION>
                                                       OUTSTANDING STOCK OPTIONS        WEIGHTED-
                                                     -----------------------------       AVERAGE
                                         SHARES      NUMBER OF        PRICE PER          EXERCISE
                                       AVAILABLE       SHARES           SHARE             PRICE
                                       ----------    ----------    ---------------   ----------------
<S>                                    <C>           <C>           <C>               <C>
Balances at December 31, 1995.........    236,909     1,556,052    $ 0.07 - $13.08        $ 4.65
  Shares reserved.....................    550,000            --                 --            --
  Options granted.....................   (857,076)      857,076    $10.89 - $16.12        $13.64
  Options exercised...................         --      (431,409)   $ 0.70 - $13.02        $ 2.11
  Options canceled....................    217,363      (217,363)   $ 0.84 - $16.12        $ 9.17
                                       ----------    ----------
Balances at December 31, 1996.........    147,196     1,764,356    $ 0.07 - $16.12        $ 9.10
                                       ----------    ----------    ---------------        ------
  Shares reserved.....................  1,750,000            --                 --
  Options granted.....................   (646,744)      646,744    $ 9.56 - $15.12        $12.93
  Options exercised...................         --      (281,694)   $ 0.35 - $12.48        $ 2.91
  Options canceled....................    129,782      (129,782)   $ 1.23 - $15.53        $11.26
                                       ----------    ----------
Balances at December 31, 1997.........  1,380,234     1,999,624    $ 0.35 - $15.53        $11.06
                                       ----------    ----------    ---------------        ------
  Shares reserved.....................  2,850,000            --                 --            --
  Options granted..................... (7,080,180)    7,080,180    $ 3.81 - $ 9.88        $ 5.86
  Options exercised...................         --      (226,193)   $ 0.35 - $ 8.38        $ 3.23
  Options canceled....................  4,433,158    (4,433,158)   $ 1.85 - $15.59        $ 9.28
                                       ----------    ----------
Balances at December 31, 1998.........  1,583,212     4,420,453    $ 0.35 - $15.59        $ 4.80
                                       ==========    ==========    ===============        ======
</TABLE>
 
     The weighted average fair value of stock options outstanding under the
plans were $4.80, $11.06, and $11.13 in 1998, 1997 and 1996, respectively.
 
                                       52
<PAGE>   54
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     Options outstanding and exercisable by price range at December 31, 1998:
 
<TABLE>
<CAPTION>
                                  OPTIONS EXERCISABLE
                       ------------------------------------------        OPTIONS EXERCISABLE
                                          WEIGHTED-                  ---------------------------
                          OPTIONS          AVERAGE                      OPTIONS
                       OUTSTANDING AT     REMAINING     WEIGHTED-    EXERCISABLE AT    WEIGHTED-
                        DECEMBER 31,     CONTRACTUAL     AVERAGE      DECEMBER 31,      AVERAGE
      RANGE OF              1998            LIFE        EXERCISE          1998         EXERCISE
   EXERCISE PRICES        (SHARES)       (IN YEARS)       PRICE         (SHARES)         PRICE
   ---------------     --------------    -----------    ---------    --------------    ---------
<S>                    <C>               <C>            <C>          <C>               <C>
$ 0.07 - $ 3.81            108,681           5.65        $ 2.00          79,770         $ 1.37
$ 3.88 - $ 4.00          2,524,199           4.84        $ 4.00          15,019         $ 4.00
$4.313 - $ 5.00          1,069,870           6.93        $ 4.95           2,070         $ 4.22
$ 5.09 - $ 7.63            451,017           9.07        $ 5.98          91,068         $ 5.90
$ 7.75 - $15.36            266,686           8.36        $10.97         135,579         $12.21
                         ---------                                      -------
                         4,420,453           6.01        $ 4.80         323,506         $ 7.33
                         =========                                      =======
</TABLE>
 
  Warrants
 
     As of December 31, 1998, the Company had issued warrants to purchase a
total of 629,573 shares of the Company's common stock at prices ranging from
$2.45 to $13.46 per share. These warrants expire at various dates from 1999
through 2005.
 
  Employee Stock Purchase Plan
 
     In October 1993, the Company adopted the 1993 Employee Stock Purchase Plan
(the "Purchase Plan") under which employees who meet certain minimum employment
criteria are eligible to participate. Eligible employees may purchase common
stock of the Company at a purchase price of 85% of the lower of the fair market
value of the stock at the enrollment or purchase date, within a two-year
offering period. Under the Purchase Plan, 189,145 shares were issued in 1998.
 
  Shareholders Rights Plan
 
     On October 8, 1998, the Board of Directors adopted a Preferred Share
Purchase Rights Plan (the "Plan") designed to enable all stockholders to realize
the full value of their investment and to provide for fair and equal treatment
for all stockholders in the event an unsolicited attempt were made to acquire
the Company. In connection with the Plan, the Board declared a dividend of one
preferred share purchase right (a "Right") for each share of common stock of the
Company outstanding on October 28, 1998 and further directed the issuance of one
such right with respect to each share of the Company's common stock that is
issued after October 28, 1998. If a person, entity or group of affiliated or
associated persons acquires beneficial ownership of 15% or more of the Company's
common stock, or announces a tender offer for 15% or more of the Company's
common stock, the rights will be distributed. Each Right entitles the registered
holder to purchase from the Company one one-hundredth of a share of Series A
Junior Participating Preferred Stock, at a price of $35.00 per one one-hundredth
of a Preferred Share subject to adjustment. The Rights are redeemable prior to
any person's acquisition of more than 15% of the Company's common stock and will
expire on October 7, 2008.
 
  Stock-Based Compensation
 
     The Company has elected to follow APB 25 and related interpretations in
accounting for its stock-based compensation plans because, as discussed below,
the alternative fair value accounting provided for under SFAS 123 requires use
of option valuation models that were not developed for use in valuing employee
stock
 
                                       53
<PAGE>   55
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
options and employee stock-based awards. Compensation expense under APB 25 with
respect to such awards has been immaterial.
 
  Pro Forma Disclosures
 
     Pro forma information regarding net loss and net loss per share is required
by FAS 123, and has been determined as if the Company had accounted for its
stock-based awards granted subsequent to December 31, 1994 under the fair value
method of FAS 123. The fair value for these stock-based awards was estimated at
the date of grant using a Black-Scholes option-pricing model. The Black-Scholes
option valuation model was developed for use in estimating the fair value of
traded options, which have no vesting restrictions and are fully transferable.
In addition, option valuation models require the input of highly subjective
assumptions including the expected stock price volatility. Because the Company's
stock-based awards have characteristics significantly different from those of
traded options, and because changes in the subjective input assumptions can
materially affect the fair value estimate, in management's opinion, the existing
models do not necessarily provide a reliable single measure of the fair value of
the Company's stock-based awards to its employees.
 
     The fair value of the Company's stock-based awards to employees was
estimated assuming no expected dividends and the following weighted-average
assumptions:
 
<TABLE>
<CAPTION>
                                         OPTIONS                EMPLOYEE STOCK PURCHASE PLAN
                                 ------------------------      ------------------------------
                                 1998      1997      1996       1998        1997        1996
                                 ----      ----      ----      ------      ------      ------
<S>                              <C>       <C>       <C>       <C>         <C>         <C>
Expected life (years)..........   5.0       5.0       5.0        0.5         0.5         5.0
Expected volatility............  0.59      0.58      0.63       0.65        0.54        0.56
Risk-Free interest rate........  5.13%     6.23%     5.90%      5.17%       5.67%       5.30%
</TABLE>
 
     For purposes of pro forma disclosures, the estimated fair value of the
stock-based awards are amortized to pro forma net loss over the option's vesting
period and the purchase plan's six-month purchase period. The Company's as
reported and pro forma information follows (in thousands, except for net loss
per share information):
 
<TABLE>
<CAPTION>
                                                           YEAR ENDED DECEMBER
                                                     --------------------------------
                                                       1998         1997       1996
                                                     ---------    --------    -------
<S>                                                  <C>          <C>         <C>
Net loss
  As reported......................................  $(156,124)   $(10,967)   $(5,928)
  Pro forma........................................  $(163,470)   $(14,418)   $(8,308)
Net loss per share -- basic and diluted
  As reported......................................  $   (5.25)   $  (0.73)   $ (0.45)
  Pro forma........................................  $   (5.49)   $  (0.96)   $ (0.63)
</TABLE>
 
     For pro forma purposes in accordance with FAS 123, the repricing of
employee stock options during 1998 is treated as a modification of the
stock-based award, with the original options being repurchased and new options
granted. Any additional compensation arising from the modification is recognized
over the remaining vesting period of the new grant. FAS 123 is effective for
stock-based awards granted by the Company commencing January 1, 1995.
 
 9. COMMITMENTS
 
  Leases
 
     The Company leases office and laboratory facilities and equipment. Rent
expense, net of sublease income of $780,000 in 1998 ($597,000 in 1997, and
$32,000 in 1996), for the years ended December 31, 1998, 1997 and 1996 was
approximately $3,293,000, $1,622,000 and $1,155,000, respectively.
 
                                       54
<PAGE>   56
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     Future minimum lease payments under non-cancelable leases, net of
non-cancelable sublease income of $822,000, $748,000, $767,000, $816,000,
$836,000, and $1,480,000 for 1999, 2000, 2001, 2002, 2003, and thereafter are as
follows:
 
<TABLE>
<CAPTION>
                                                             CAPITAL   OPERATING
                                                             LEASES     LEASES
                                                             -------   ---------
                                                               (IN THOUSANDS)
<S>                                                          <C>       <C>
  1999.....................................................   3,163      2,844
  2000.....................................................     282      2,868
  2001.....................................................      --      2,804
  2002.....................................................      --        934
  2003.....................................................      --        761
  Thereafter...............................................      --        309
                                                             ------     ------
Total minimum lease payments...............................  (3,445)    10,520
                                                                        ======
Less amount representing interest..........................    (134)
                                                             ------
Present value of future lease payments.....................  (3,311)
                                                             ------
Less current portion Non-current portion of capital lease
  obligations..............................................     267
                                                             ======
</TABLE>
 
  Notes Payable
 
     The Company has two lines of credit, one with Sumitomo Bank, Limited
("Sumitomo") and one with Sumitomo and Silicon Valley Bank jointly, to provide
an aggregate of up to $27 million in debt financing. The loans are subject to
certain financial covenants over the course of the agreements. Interest is
computed at various rates based on a Eurodollar rate plus applicable margin. The
weighted average interest rate on these loans is approximately 7.5% at December
31, 1998. Interest and principal payments are due monthly over a term of up to
48 months. The Company was in compliance with all covenants at December 31,
1998. The balance outstanding on these loans at December 31, 1998 was $23.1
million.
 
     In February 1997, the Company entered into a lending arrangement with one
of its facility lessors for tenant improvements. The loan amount was for
$350,000, with interest accruing at 9% per annum. Principal and interest are due
monthly through July 1, 2001.
 
     Principal maturities of notes payable at December 31, 1998 are as follows:
 
<TABLE>
<CAPTION>
                                 (IN THOUSANDS)
<S>                              <C>
1999...........................      $6,828
2000...........................       6,835
2001...........................       6,381
2002...........................       3,333
</TABLE>
 
10. RELATED PARTY TRANSACTIONS
 
     In August 1997, the Company entered into an employment agreement with its
Chief Executive Officer that extends through December 31, 2000. The agreement
provides for compensation and bonus provisions in exchange for continued service
and an agreement not to compete. In addition, the agreement provides for
forgiveness on two notes receivable, one for $200,000 for the purchase of the
Company's common stock which was included in stockholders' equity on the balance
sheet and one for $750,000 which is included in noncurrent assets on the balance
sheet. In addition, the agreement provides for the forgiveness of accrued
interest, a partial tax gross-up and extends through 2001. The principal portion
of the first note forgiven in
 
                                       55
<PAGE>   57
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
1998 and 1997 was $125,000 and $75,000, respectively. The principal portion of
the second note forgiven in 1998 was $30,000.
 
11. EMPLOYEE BENEFIT PLAN
 
     The Company maintains a 401(k) retirement savings plan for all of its
eligible employees. Each participant in the plan may elect to contribute 1% to
15% of his or her annual salary to the plan, subject to statutory limitations.
The Company matches 50% of the first 6% of the salary contributed by the
employee. The Company's match is done with the Company's stock. The expense
charged to operations under this plan for fiscal 1998 and 1997 was $295,180 and
$276,000, respectively (none in 1996).
 
12. SEGMENT INFORMATION
 
     The Company operates two segments: (i) drug discovery, through
collaborative research agreements and unpartnered programs in oncology, and (ii)
combinatorial chemistry in the Advanced Technologies Division (ATD) through the
sale of chemical compound libraries. The Company's reportable segments are
strategic business units that offer different products and services. They are
each managed separately because they perform different services utilizing
different and distinct operations.
 
     Information as to the operations of drug discovery and ATD is set forth
below based on the nature of the products and services offered. The Company
evaluates performance based on several factors, of which the primary financial
measure is business segment operating income or loss, defined as income or loss
before interest income/expense and minority interest. Revenues for ATD include
product sales and license or commitment fees associated with the respective
agreement. Operating loss by segment for ATD does not include corporate overhead
allocations, except for a facilities charge. The Company does not evaluate
segment performance or allocate resources based on a segment's assets,
therefore, assets are not reported by segment. The accounting policies of the
business segments are the same as those described in the summary of accounting
policies (Note 1).
 
<TABLE>
<CAPTION>
                                                 YEAR ENDED DECEMBER 31,
                                             --------------------------------
                                               1998         1997       1996
                                             ---------    --------    -------
                                                      (IN THOUSANDS)
<S>                                          <C>          <C>         <C>
Revenues:
  Drug discovery...........................  $  35,760    $ 20,499    $19,893
  ATD......................................     11,662       4,315      1,667
                                             ---------    --------    -------
Total consolidated.........................  $  47,422    $ 24,814    $21,560
                                             ---------    --------    -------
Operating income (loss):
  Drug discovery (1).......................  $(160,290)   $(11,294)   $(5,928)
  ATD......................................      4,172         327         --
                                             ---------    --------    -------
Total consolidated.........................  $(156,124)   $(10,967)   $(5,928)
                                             =========    ========    =======
</TABLE>
 
---------------
(1) Includes $125 million and $0.2 million in acquired in-process research and
    development recorded in 1998 and 1996, respectively, related to certain
    acquisitions during the year.
 
13. INCOME TAXES
 
     As of December 31, 1998 and 1997, the Company had federal and state net
operating loss carryforwards of approximately $75,500,000 and $7,800,000,
respectively. As of December 31, 1998 and 1997, the Company also had federal
research and development tax credit carryforwards of approximately $5,300,000
and
 
                                       56
<PAGE>   58
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
$2,800,000, respectively. The net operating loss and credit carryforwards will
expire at various dates beginning in 2004 through 2018, if not utilized.
 
     The utilization of the net operating losses and credits may be subject to a
substantial annual limitation due to the "change in ownership" provisions of the
Internal Revenue Code of 1986 and similar state provisions. The annual
limitation may result in the expiration of net operating losses and credits
before utilization.
 
     Significant components of the Company's deferred tax assets and liabilities
for federal and state income taxes are as follows:
 
<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                         --------------------
                                                           1998        1997
                                                         --------    --------
                                                            (IN THOUSANDS)
<S>                                                      <C>         <C>
Net operating loss carryforwards.......................  $ 26,100    $  7,700
Research credit carryforwards..........................     7,200       2,600
Capitalized research and development...................    24,400      17,200
Other, net.............................................     5,000       2,100
                                                         --------    --------
Total deferred tax assets..............................    62,700      29,600
Valuation allowance of deferred tax assets.............   (62,700)    (29,600)
                                                         --------    --------
Net deferred tax assets................................  $     --    $     --
                                                         ========    ========
</TABLE>
 
     The net valuation allowance increased by approximately $4,700,000 and
$2,300,000 during 1997 and 1996, respectively.
 
     Approximately $1,200,000 of the valuation allowance for deferred tax assets
relates to benefits of stock options deductions which, when recognized, will be
allocated directly to contributed capital.
 
14. REVENUES FROM SIGNIFICANT PARTNERS AND CUSTOMERS
 
     Major customers, responsible for 10% or more of revenues include drug
discovery partners and pharmaceutical and biotechnology companies which purchase
ATD compound libraries. The percentages of sales of each of these major
customers to total revenue for the years ended December 31 were as follows:
 
<TABLE>
<CAPTION>
                                                          1998    1997    1996
                                                          ----    ----    ----
<S>                                                       <C>     <C>     <C>
Customer A..............................................   34%     --      --
Customer B..............................................   14%     --      --
Customer C..............................................   14%     --      --
Customer D..............................................   10%     41%     40%
All Others..............................................   28%     59%     60%
                                                          ---     ---     ---
          Total.........................................  100%    100%    100%
                                                          ===     ===     ===
</TABLE>
 
15. SUBSEQUENT EVENTS (UNAUDITED)
 
  Formation of PPGx, Inc.
 
     In February 1999, the Company announced the formation of a majority-owned
subsidiary, PPGx, Inc. ("PPGx") which is engaged in the business of providing
pharmacogenomic (the science of how genetic variations among individuals affects
drug safety and efficacy) products and services to the pharmaceutical industry.
In connection with the formation of PPGx, Axys contributed certain assets and
technology in exchange for an 82% ownership interest in PPGx. PPD, Inc. ("PPD"),
Axys' partner in PPGx, contributed
 
                                       57
<PAGE>   59
                           AXYS PHARMACEUTICALS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
certain assets, technology, cash and loan guarantees in exchange for an 18%
ownership interest in PPGx and the exclusive, worldwide right to market the
pharmacogenomic products and services of PPGx.
 
     Under the terms of a shareholder agreement between the Company and PPD, PPD
has the option (the "PPD Option") to purchase 32% of PPGx from the Company at
various escalating prices until February 1, 2002. Under certain circumstances,
the Company has the option to put (the "Axys Put") 32% of PPGx to PPD at various
escalating prices until August 1, 2002. At such time as either the PPD Option or
the Axys Put are exercised, the Company would also become a co-guarantor of a
certain PPGx line of credit to the extent any borrowings are outstanding at that
time. Additionally, at any time after the fifth anniversary of the formation of
PPGx, the Company and, provided either the PPD Option or the Axys Put have been
exercised, PPD have the right to buy all of the outstanding equity interests in
PPGx at fair market value in accordance with the terms of buy-sell provisions of
the shareholder agreement.
 
  Second Round of Financing for Xyris Corporation
 
     In February 1999, Xyris concluded the negotiation of an exclusive license
to all Axys technology in the field of agriculture (the "Technology License")
(See Note 4). This resulted in the Company receiving additional shares of Xyris
in exchange for the Technology License.
 
     Also in February 1999, Xyris completed a financing in which it raised
$4,500,000 from a third party. After this financing, the third party's
investment in Xyris totaled $5,000,000. Under the terms of the financing, the
Company granted the third party the right (the "New Put Option") to require the
Company to purchase all of the third party's interest in Xyris in exchange for
that number of shares of the Company whose market value equals $5,000,000 at the
date of the exercise of the New Put Option. The New Put Option may be exercised
at any time between August 5, 1999 and February 5, 2001.
 
     The net effect of issuance of shares in connection with the Technology
License and in connection with the financing reduced the Company's ownership in
Xyris from 82% to 70%.
 
                                       58
<PAGE>   60
 
                                   PART III.
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     The information required by this item is incorporated by reference from the
information under the captions "Proposals to be Voted Upon", "Nominees for
Directors" and "Compliance with the Reporting Requirements of Section 16"
contained in the Company's definitive proxy statement to be filed no later than
April 30, 1999 in connection with the solicitation of proxies for the Company's
annual meeting of stockholders to be held May 26, 1999 (the "Proxy Statement").
In addition, the information contained in Part I of this Form 10-K under the
caption "Executive Officers of the Registrant" is incorporated herein by
reference.
 
ITEM 11. EXECUTIVE COMPENSATION
 
     The information required by this item is incorporated by reference from the
information under the captions "Compensation of Executive Officers,"
"Compensation of Non-Employee Directors" and "Employment Agreements and
Change-in-Control Arrangements" contained in the Proxy Statement.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     The information required by this item is incorporated by reference from the
information under the caption "Axys Stock Ownership of Beneficial Owners,
Directors and Management" contained in the Proxy Statement.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     The information required by this item is incorporated by reference from the
information under the caption "Relationships and Transactions You Should Know
About" contained in the Proxy Statement.
 
                                       59
<PAGE>   61
 
                                    PART IV.
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
(a)(1) Index to Financial Statements
 
   The Financial Statements required by this item are submitted in Part II, Item
8 of this report.
 
   (2) Index to Financial Statements Schedules
 
    All schedules are omitted because they are not applicable or the required
    information is shown in the Financial Statements or in the notes thereto.
 
   (3) Exhibits.
 
<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                        DESCRIPTION OF DOCUMENT
            -------                       -----------------------
           <S>          <C>
             3.1        Amended and Restated Certificate of Incorporation.
                        Incorporated by reference to Ex. 3.1 filed on Form 10-K
                        filed on March 31, 1998.
             3.2        Amended and Restated Bylaws.(1)
             3.3        Registrant's Certificate of Designation of Series A Junior
                        Participating Preferred Stock, incorporated by reference to
                        Exhibit 99.3 filed on Form 8-K dated October 8, 1998.
             4.1        Rights Agreement dated as of October 8, 1998, among the
                        Registrant and ChaseMellon Shareholders Services, LLC,
                        incorporated by reference to Exhibit 99.2 filed on Form 8-K
                        dated October 8, 1998.
             4.2        Form of Rights Certificate, incorporated by reference to
                        Exhibit 99.4 filed on Form 8-K dated October 8, 1998.
            10.1        Registration Rights Agreement, among the Registrant and the
                        other parties therein, dated January 7, 1998.
            10.2        1989 Stock Plan, as amended.(2)
            10.3        Form of Employee Stock Purchase Plan and Form of Offering
                        Document.(2)(12)
            10.4+       1997 Equity Incentive Plan. Incorporated by reference to
                        Exhibit 10.4 filed on Form 10-Q filed on August 15, 1998.
            10.6        Standard Industrial Lease between the Registrant and Shelton
                        Properties, Inc., dated October 15, 1992, with related
                        addenda and amendment.(1)
            10.7        Third Amendment to Lease between Registrant and Shelton
                        Properties, Inc., dated March 29, 1994.(4)
            10.8        Master Equipment Lease Agreement between the Registrant and
                        Phoenix Leasing Incorporated, dated as of April 12, 1993,
                        with related amendments.(1)
            10.9        Re-Lease Agreement No. 6132A between the Registrant and
                        PacifiCorp Credit Inc., dated December 27, 1992, with
                        related agreements.(1)
            10.10       Master Equipment Lease Agreement No. 2982 between the
                        Registrant and MMC/GATX Partnership No. I, dated as of
                        January 7, 1992, with related addenda.(1)
            10.11**     Research and License Agreement between the Registrant and
                        Amgen Inc., dated May 28, 1993.(1)
            10.12**     Sponsored Research Agreement between the Registrant, the
                        Whitehead Institute for Biomedical Research and Dr. Harvey
                        Lodish, dated May 28, 1993.(1)
</TABLE>
 
                                       60
<PAGE>   62
 
<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                        DESCRIPTION OF DOCUMENT
            -------                       -----------------------
           <S>          <C>
            10.13**     License Agreement between the Registrant, the Whitehead
                        Institute for Biomedical Research and Massachusetts
                        Institute of Technology, dated May 28, 1993.(1)
            10.14       Consent and Waiver between the Registrant, Amgen Inc., and
                        the Whitehead Institute for Biomedical Research, dated May
                        28, 1993.(1)
            10.15**     Collaboration Agreement between the Registrant and Pharmacia
                        AB, dated March 29, 1993.(1)
            10.16**     Project Agreement between the Registrant and Pharmacia AB,
                        dated March 29, 1993.(1)
            10.17       Form of Restricted Stock Purchase Agreement.(1)(2)
            10.18+      Form of Indemnity Agreement entered into between the
                        Registrant and its officers and directors.(1)(2)
            10.19       Stock Bonus Grant Plan.(2)(3)
            10.20       Financing Agreement between Hambrecht and Quist Guaranty
                        Finance, L.P., dated March 29, 1994, including Security
                        Agreement and Warrant Purchase Agreement of even date.(4)
            10.22+      1994 Non-Employee Directors' Stock Option Plan, as amended
                        on January 7, 1998. Incorporated by reference to Exhibit
                        10.22 filed on Form 10-K filed on March 31, 1998.
            10.23       Fourth Amendment to Lease dated October 15, 1992 between the
                        Registrant and Shelton Properties, Inc., dated October 1,
                        1994.(5)
            10.24**     Collaborative Research and License Agreement between the
                        Registrant and Bayer AG, dated November 28, 1994.(6)
            10.25**     Research Agreement between the Registrant and Pharmacia AB,
                        dated December 21, 1994.(5)
            10.26       Form of Fifth Amendment to Lease dated October 15, 1992
                        between the Registrant and Shelton Properties, Inc. dated
                        August 28, 1996.(6)
            10.27       Master Equipment Lease Agreement between the Registrant and
                        GE Capital, dated August 18, 1995.(6)
            10.28**     Collaborative Research and License Agreement between the
                        Registrant and Pharmacia AB, dated August 29, 1995.(6)
            10.30       Agreement and Plan of Merger and Reorganization among the
                        Registrant, Chapel Acquisition Corp. and Khepri
                        Pharmaceuticals, Inc., dated November 7, 1995.(8)
            10.31       Form of Stockholder Agreement between the Registrant and
                        certain former stockholders of Khepri Pharmaceuticals,
                        Inc.(8)
            10.32       Form of Agreement among the Registrant, Khepri
                        Pharmaceuticals Canada, Inc. and the holders of Class B
                        Shares of Khepri Pharmaceuticals Canada, Inc.(8)
            10.33       Amendment to Agreement dated March 29, 1993 between the
                        Registrant and Kabi Pharmacia AB, dated January 31, 1996.(9)
            10.34       First Amendment to Research and License Agreement, dated May
                        28, 1993, between Registrant and Amgen, Inc., dated February
                        2, 1996.(9)
            10.35       Research Agreement between the Registrant and Pharmacia &
                        Upjohn, Inc., a Delaware corporation, dated February 29,
                        1996.(9)
</TABLE>
 
                                       61
<PAGE>   63
 
<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                        DESCRIPTION OF DOCUMENT
            -------                       -----------------------
           <S>          <C>
            10.36       Form of Sixth Amendment to Lease dated October 15, 1992
                        between the Registrant and Shelton Properties, Inc., dated
                        March 29, 1996.(9)
            10.37       Financing Agreement between Hambrecht and Quist Guaranty
                        Finance, LLC, dated March 29, 1996, including Security
                        Agreement and Warrant Purchase Agreement of even date.(9)
            10.38       Amendment to Lease Schedule under Master Property Lease
                        Agreement dated March 29, 1994 between Hambrecht and Quist
                        Guaranty Finance, L.P., dated March 29, 1996.(9)
            10.39       Standard Industrial Lease between the Registrant and The
                        Equitable Life Assurance Society of the United States, dated
                        August 5, 1996.(10)
            10.40       Business Loan Agreement between Registrant and Bank of
                        America National Trust and Savings Association, dated
                        September 24, 1996.(10)
            10.41       Sublease Agreement between Registrant and Fibrogen, Inc.,
                        dated September 30, 1996.(10)
            10.42**     Research Collaboration and License Agreement between Merck &
                        Co., Inc. and the Registrant, dated November 6, 1996.(7)
            10.44       Collaborative Research and License Agreement between
                        SmithKline Beecham Corporation and the Registrant, dated
                        June 27, 1996.(11)
            10.46       Loan Agreement among the Registrant, as Borrower, and The
                        Sumitomo Bank, Limited and Silicon Valley Bank, as Lenders
                        and The Sumitomo Bank, Limited, as Agent, dated September
                        29, 1997.(13)
            10.47       Sequana 1994 Incentive Stock Plan.(14)
            10.48       Sequana 1995 Employee Stock Purchase Plan.(14)
            10.49+      Sequana 1995 Director Stock Option Plan.(14)
            10.50       Master Lease Agreement dated November 1, 1993 by and between
                        Comdisco, Inc. and Sequana.(14)
            10.52       Expansion Lease by and between Health Science Properties,
                        Inc. and Sequana dated as of November 20, 1995.(15)
            10.53**     Collaborative Research Agreement dated as of June 30, 1995
                        by and between Sequana and Corange International, Ltd.(14)
            10.54**     Collaborative Research Agreement dated as of June 12, 1995
                        by and between Sequana and Boehringer Ingelheim
                        International GmbH.(14)
            10.55+      Form of Indemnification Agreement between the Registrant and
                        its officers and directors.(14)
            10.57       Letter Agreement dated September 7, 1993 between Sequana and
                        Timothy J.R. Harris.(14)
            10.58**     Research Agreement dated as of April 2, 1996 by and between
                        Sequana and Aurora Biosciences Corporation.(16)
            10.59       Merger Agreement and Plan of Reorganization Agreement
                        between Sequana, Sequana Merger Sub, Inc., NemaPharm, Inc.
                        and the Shareholders of NemaPharm, Inc., dated July 19,
                        1996.(17)
            10.60       Loan Agreement between Sequana and The Sumitomo Bank,
                        Limited, dated as of October 23, 1996.(18)
</TABLE>
 
                                       62
<PAGE>   64
 
<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                        DESCRIPTION OF DOCUMENT
            -------                       -----------------------
           <S>          <C>
            10.61**     Joint Venture Agreement among Sequana Therapeutics, Inc.,
                        Memorial Sloan-Kettering Cancer Center and Genos
                        Biosciences, Inc., dated January 29, 1997.(19)
            10.62*      Amendment to Collaborative Research Agreement of June 12,
                        1995 between Sequana and Boehringer Ingelheim International
                        GmbH, dated June 19, 1997.(20)
            10.63       Second Amendment to Expansion Lease by and between Sequana
                        and Alexandria Real Estate Equities, Inc., dated as of May
                        20, 1997.(20)
            10.64       Agreement and Plan of Merger and Reorganization dated
                        November 2, 1997, by and among the Registrant, Beagle
                        Acquisition Sub, Inc., a California corporation and wholly
                        owned subsidiary of the Registrant and Sequana.(21)
            10.65       First Amendment to Loan Agreement Between the Registrant and
                        The Sumitomo Bank, Limited, dated as of January 8, 1998.
                        Incorporated by reference to Exhibit 10-65 filed on Form
                        10-K filed on March 31, 1998.
            10.66       First Amendment to Loan Agreement Between Sequana and The
                        Sumitomo Bank, Limited, dated as of January 8, 1998.
                        Incorporated by reference to Exhibit 10-66 filed on Form
                        10-K filed on March 31, 1998.
            10.67*      Collaboration Agreement dated as of October 1997 by and
                        between the Registrant and Bristol-Myers Squibb Company.
                        Incorporated by reference to Exhibit 10-67 filed on Form
                        10-K filed on March 31, 1998.
            10.68*      Collaboration Agreement dated as of October 31, 1997 by and
                        between Sequana and Warner-Lambert Company. Incorporated by
                        reference to Exhibit 10-68 filed on Form 10-K filed on March
                        31, 1998.
            10.69       Sequana Common Stock Purchase Agreement, dated October 31,
                        1997. Incorporated by reference to Exhibit 10-69 filed on
                        Form 10-K filed on March 31, 1998.
            10.70       $200,000 Promissory Note, dated September 2, 1997, issued by
                        John P. Walker, to the Registrant. Incorporated by reference
                        to Exhibit 10-70 filed on Form 10-K filed on March 31, 1998.
            10.71       $750,000 Promissory Note, dated September 2, 1997, issued by
                        John P. Walker, to the Registrant. Incorporated by reference
                        to Exhibit 10-71 filed on Form 10-K filed on March 31, 1998.
            10.72       Employment Agreement, dated August 29, 1997, by and between
                        John Walker and the Registrant. Incorporated by reference to
                        Exhibit 10-72 filed on Form 10-K filed on March 31, 1998.
            10.73       Amended and Restated Severance Agreement by and between the
                        Registrant and Kevin Kinsella, dated January 7, 1998.
                        Incorporated by reference to Exhibit 10-73 filed on Form
                        10-K filed on March 31, 1998.
            10.74       Amended and Restated Restricted Stock Purchase Agreement by
                        and between Sequana and Kevin Kinsella, dated January 7,
                        1998. Incorporated by reference to Exhibit 10-74 filed on
                        Form 10-K filed on March 31, 1998.
            10.75       Consulting Agreement by and between Sequana and Kevin
                        Kinsella, dated January 8, 1998. Incorporated by reference
                        to Exhibit 10-75 filed on Form 10-K filed on March 31, 1998.
            10.78       1997 Equity Incentive Plan, dated January 7, 1998.(22)
</TABLE>
 
                                       63
<PAGE>   65
 
<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                        DESCRIPTION OF DOCUMENT
            -------                       -----------------------
           <S>          <C>
            10.79       First Amendment to Lease Schedules Master Property Lease
                        Agreement No. 943, dated March 29, 1994, Schedules Nos. 1
                        and 4 through 59, dated from March 29, 1994, through January
                        1, 1995.(23)
            10.80       First Amendment to Lease Schedule Master Property Lease
                        Agreement No. 963, dated March 29, 1996, Schedule No. 2,
                        dated March 29, 1996.(23)
            10.81       Second Amendment to Lease Schedule Master Property Lease
                        Agreement No. 943, dated March 29, 1994, Schedule No. 2,
                        dated March 29, 1994.(23)
            10.82       First Amendment to Lease Schedule Master Property Lease
                        Agreement No. 943, dated March 29, 1994, Schedule No. 3,
                        dated March 29, 1994.(23)
            10.83       Amendment to the Collaborative Research Agreement between
                        Sequana and Corange International Ltd., effective June 30,
                        1995, dated January 9, 1998.(24)
            10.84*      Amendment No. 2 to the Collaborative Research Agreement
                        between Sequana and Corange International Ltd., dated June
                        30, 1995, effective February 23, 1998.(24)
            10.85       Employment Agreement by and between Tim Harris and the
                        Company, dated as of January 8, 1998.(24)
            10.86       Lease Agreement between Sequana and ARE-John Hopkins Court,
                        LLC, dated as of January 7, 1998.(24)
            10.87*      Termination of Collaborative Research Agreement between
                        Sequana and Glaxo Wellcome, Inc., effective February 1,
                        1998.(25)
            10.88*      Combinatorial Chemistry Agreement between the Registrant and
                        Warner-Lambert Company, dated May 15, 1998.(25)
            10.89*      Collaboration Agreement by and among the Registrant and its
                        subsidiaries, NemaPharm, Inc. and Sequana, and Roche
                        Bioscience, dated June 1, 1998.(25)
            10.90*      Amendment dated September 21, 1998 to the Collaboration
                        Agreement between Warner-Lambert Company and Sequana, dated
                        October 31, 1997.(26)
            10.91       1997 Non-Officer Equity Incentive Plan.(26)
            10.93*      Second Amendment to the Research Collaboration and License
                        Agreement between Arris Pharmaceutical Corp. and Merck and
                        Co., Inc., dated November 5, 1998.
            10.94*      Collaborative Research and License Agreement between the
                        Registrant and Rhone-Poulenc Rorer Pharmaceuticals, Inc.,
                        dated December 11, 1998.
            10.95*      Combinatorial Chemistry Agreement between the Registrant and
                        Rhone-Poulenc Rorer Pharmaceuticals, Inc., dated December
                        22, 1998.
            10.96       Agreement, dated June 11, 1998, by and between William
                        Newell and the Registrant.
            21          Subsidiaries of the Registrant.
            23.1        Consent of Ernst & Young LLP.
            24.1        Power of Attorney (incorporated in the signature page of
                        this Form 10-K).
            27          Financial Data Schedule.
</TABLE>
 
---------------
  +  Compensatory Benefit Plan or management contract.
 
  *  Confidential treatment has been requested with respect to certain portions
     of this exhibit.
 
                                       64
<PAGE>   66
 
 **  Confidential treatment has been granted with respect to certain portions of
     this exhibit.
 
 (1) Incorporated herein by reference to the Registration Statement on Form S-1
     filed October 5, 1993, as amended thereto (file number 33-69972).
 
 (2) Compensation plan.
 
 (3) Incorporated herein by reference to the Registration Statement on Form S-8
     filed January 31, 1994 (file number 33-69972).
 
 (4) Incorporated herein by reference to the Registrant's Report on Form 10-Q
     for the quarter ended March 31, 1994.
 
 (5) Incorporated herein by reference to the Registrant's Annual Report on Form
     10-K for the fiscal year ended December 31, 1994.
 
 (6) Incorporated herein by reference to the Registrant's Report on Form 10-Q
     for the quarter ended September 30, 1995.
 
 (7) Incorporated herein by reference to the Registrant's Registration Report on
     Form 10-K for the fiscal year ended December 31, 1996
 
 (8) Incorporated herein by reference to the Registrant's Current Report on Form
     8-K, filed November 13, 1995.
 
 (9) Incorporated herein by reference to the Registration Report on Form 10-Q
     for the quarter ended March 31, 1996.
 
(10) Incorporated herein by reference to the Registration Report on Form 10-Q
     for the quarter ended September 30, 1996.
 
(11) Incorporated herein by reference to the Registration Statement filed on
     Form S-3/A filed September 19, 1996 (file number 333-09307).
 
(12) Incorporated by reference to the Registration Statement on Form S-8 filed
     July 29, 1996 (file number 333-09095).
 
(13) Incorporated by reference to exhibit 10.47 to the Registrant's Report on
     Form 10-Q for the quarter ended October 31, 1997.
 
(14) Incorporated by reference to exhibits filed with Sequana's Registration
     Statement on Form S-1, filed June 14, 1995 as amended (Reg. No. 33-93460).
 
(15) Incorporated by reference to exhibits filed with Sequana's Registration
     Statement on Form S-1, filed February 12, 1996 as amended (Reg. No.
     333-01226).
 
(16) Incorporated by reference to exhibit 10.14 to Sequana's Report on Form 10-Q
     for the quarter ended June 30, 1996.
 
(17) Incorporated by reference to exhibit 10.15 to Sequana's Report on Form 10-Q
     for the quarter ended September 30, 1996.
 
(18) Incorporated by reference to exhibit 10.16 filed with Sequana's Report on
     Form 10-K, as amended, for the fiscal year ended December 31, 1996.
 
(19) Incorporated by reference to exhibit 10.17 to Sequana's Report on Form 10-Q
     for the quarter ended March 31, 1997.
 
(20) Incorporated by reference to exhibit 10.18 to Sequana's Report on Form 10-Q
     for the quarter ended June 30, 1997.
 
(21) Incorporated by reference to exhibit 4.1 to the Schedule 13D filed by the
     Registrant on November 12, 1997.
 
(22) Incorporated by reference to Appendix E to the Registrants Registration
     Statement on Form S-4, filed November 27, 1997.
 
(23) Incorporated herein by reference to the Registrant's Registration Report on
     Form 10-K for the fiscal year ended December 31, 1997.
 
(24) Incorporated herein by reference to the Registrant's Registration Report on
     Form 10-Q for the fiscal year ended March 31, 1998.
 
                                       65
<PAGE>   67
 
(25) Incorporated herein by reference to the Registrant's Registration Report on
     Form 10-Q for the fiscal year ended June 30, 1998.
 
(26) Incorporated herein by reference to the Registrant's Registration Report on
     Form 10-Q for the fiscal year ended September 30, 1998.
 
(b) Reports on Form 8-K
 
    On October 9, 1998 the Company filed a report on Form 8-K with the
Securities and Exchange Commission disclosing under "Item 5 -- Other Events"
that on October 8, 1998, the Board of Directors of Axys Pharmaceuticals, Inc.
approved the adoption of a Preferred Share Purchase Rights Plan.
 
(c) See Exhibits listed under Item 14(a)(3).
 
(d) All schedules are omitted because they are not applicable or the required
information is shown in the Financial Statements or in the noted thereto.
 
                                       66
<PAGE>   68
 
                                   SIGNATURES
 
     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized on the 30th day of
March, 1999.
 
                                          AXYS PHARMACEUTICALS, INC.
 
                                          BY:      /s/ JOHN P. WALKER
 
                                            ------------------------------------
                                            John P. Walker
                                            Chairman and Chief Executive Officer
 
                               POWER OF ATTORNEY
 
     KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears on
the following page constitutes and appoints John P. Walker and Frederick J.
Ruegsegger, or any of them, his attorneys-in-fact, each with the power of
substitution, for him in any and all capacities, to sign any amendments to this
Report on Form 10-K, and to file the same, with exhibits thereto and other
documents in connection therewith, with the Securities and Exchange Commission,
hereby ratifying and confirming all that the said attorney-in-fact, or his
substitute or substitutes, may do or cause to be done by virtue hereof.
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated on the dates indicated.
 
<TABLE>
<CAPTION>
                      SIGNATURE                                     TITLE                    DATE
                      ---------                                     -----                    ----
<S>                                                    <C>                              <C>
                 /s/ JOHN P. WALKER                      Chief Executive Officer and    March 30, 1999
-----------------------------------------------------        Director (Principal
                   John P. Walker                            executive officer)
 
             /s/ FREDERICK J. RUEGSEGGER               Senior Vice President, Finance   March 30, 1999
-----------------------------------------------------   and Corporate Development and
               Frederick J. Ruegsegger                     Chief Financial Officer
                                                          (Principal financial and
                                                             accounting officer)
 
                                                                  Director
-----------------------------------------------------
Brook H. Byers
 
             /s/ ANTHONY B. EVNIN, PH.D.                          Director              March 30, 1999
-----------------------------------------------------
               Anthony B. Evnin, Ph.D.
 
                /s/ VAUGHN M. KAILIAN                             Director              March 30, 1999
-----------------------------------------------------
                  Vaughn M. Kailian
 
              /s/ DONALD KENNEDY, PH.D.                           Director              March 30, 1999
-----------------------------------------------------
                Donald Kennedy, Ph.D.
 
               /s/ ANN M. ARVIN, M.D.                             Director              March 30, 1999
-----------------------------------------------------
                 Ann M. Arvin, M.D.
 
                  /s/ IRWIN LERNER                                Director              March 30, 1999
-----------------------------------------------------
                    Irwin Lerner
 
             /s/ J. LEIGHTON READ, M.D.                           Director              March 30, 1999
-----------------------------------------------------
               J. Leighton Read, M.D.
</TABLE>
 
                                       67
<PAGE>   69
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                        DESCRIPTION OF DOCUMENT
            -------                       -----------------------
           <S>          <C>
             3.1        Amended and Restated Certificate of Incorporation.
                        Incorporated by reference to Ex. 3.1 filed on Form 10-K
                        filed on March 31, 1998.
             3.2        Amended and Restated Bylaws.(1)
             3.3        Registrant's Certificate of Designation of Series A Junior
                        Participating Preferred Stock, incorporated by reference to
                        Exhibit 99.3 filed on Form 8-K dated October 8, 1998.
             4.1        Rights Agreement dated as of October 8, 1998, among the
                        Registrant and ChaseMellon Shareholders Services, LLC,
                        incorporated by reference to Exhibit 99.2 filed on Form 8-K
                        dated October 8, 1998.
             4.2        Form of Rights Certificate, incorporated by reference to
                        Exhibit 99.4 filed on Form 8-K dated October 8, 1998.
            10.1        Registration Rights Agreement, among the Registrant and the
                        other parties therein, dated January 7, 1998.
            10.2        1989 Stock Plan, as amended.(2)
            10.3        Form of Employee Stock Purchase Plan and Form of Offering
                        Document.(2)(12)
            10.4+       1997 Equity Incentive Plan. Incorporated by reference to
                        Exhibit 10.4 filed on Form 10-Q filed on August 15, 1998.
            10.6        Standard Industrial Lease between the Registrant and Shelton
                        Properties, Inc., dated October 15, 1992, with related
                        addenda and amendment.(1)
            10.7        Third Amendment to Lease between Registrant and Shelton
                        Properties, Inc., dated March 29, 1994.(4)
            10.8        Master Equipment Lease Agreement between the Registrant and
                        Phoenix Leasing Incorporated, dated as of April 12, 1993,
                        with related amendments.(1)
            10.9        Re-Lease Agreement No. 6132A between the Registrant and
                        PacifiCorp Credit Inc., dated December 27, 1992, with
                        related agreements.(1)
            10.10       Master Equipment Lease Agreement No. 2982 between the
                        Registrant and MMC/GATX Partnership No. I, dated as of
                        January 7, 1992, with related addenda.(1)
            10.11**     Research and License Agreement between the Registrant and
                        Amgen Inc., dated May 28, 1993.(1)
            10.12**     Sponsored Research Agreement between the Registrant, the
                        Whitehead Institute for Biomedical Research and Dr. Harvey
                        Lodish, dated May 28, 1993.(1)
            10.13**     License Agreement between the Registrant, the Whitehead
                        Institute for Biomedical Research and Massachusetts
                        Institute of Technology, dated May 28, 1993.(1)
            10.14       Consent and Waiver between the Registrant, Amgen Inc., and
                        the Whitehead Institute for Biomedical Research, dated May
                        28, 1993.(1)
            10.15**     Collaboration Agreement between the Registrant and Pharmacia
                        AB, dated March 29, 1993.(1)
            10.16**     Project Agreement between the Registrant and Pharmacia AB,
                        dated March 29, 1993.(1)
            10.17       Form of Restricted Stock Purchase Agreement.(1)(2)
</TABLE>
 
                                       68
<PAGE>   70
 
<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                        DESCRIPTION OF DOCUMENT
            -------                       -----------------------
           <S>          <C>
            10.18+      Form of Indemnity Agreement entered into between the
                        Registrant and its officers and directors.(1)(2)
            10.19       Stock Bonus Grant Plan.(2)(3)
            10.20       Financing Agreement between Hambrecht and Quist Guaranty
                        Finance, L.P., dated March 29, 1994, including Security
                        Agreement and Warrant Purchase Agreement of even date.(4)
            10.22+      1994 Non-Employee Directors' Stock Option Plan, as amended
                        on January 7, 1998. Incorporated by reference to Exhibit
                        10.22 filed on Form 10-K filed on March 31, 1998.
            10.23       Fourth Amendment to Lease dated October 15, 1992 between the
                        Registrant and Shelton Properties, Inc., dated October 1,
                        1994.(5)
            10.24**     Collaborative Research and License Agreement between the
                        Registrant and Bayer AG, dated November 28, 1994.(6)
            10.25**     Research Agreement between the Registrant and Pharmacia AB,
                        dated December 21, 1994.(5)
            10.26       Form of Fifth Amendment to Lease dated October 15, 1992
                        between the Registrant and Shelton Properties, Inc. dated
                        August 28, 1996.(6)
            10.27       Master Equipment Lease Agreement between the Registrant and
                        GE Capital, dated August 18, 1995.(6)
            10.28**     Collaborative Research and License Agreement between the
                        Registrant and Pharmacia AB, dated August 29, 1995.(6)
            10.30       Agreement and Plan of Merger and Reorganization among the
                        Registrant, Chapel Acquisition Corp. and Khepri
                        Pharmaceuticals, Inc., dated November 7, 1995.(8)
            10.31       Form of Stockholder Agreement between the Registrant and
                        certain former stockholders of Khepri Pharmaceuticals,
                        Inc.(8)
            10.32       Form of Agreement among the Registrant, Khepri
                        Pharmaceuticals Canada, Inc. and the holders of Class B
                        Shares of Khepri Pharmaceuticals Canada, Inc.(8)
            10.33       Amendment to Agreement dated March 29, 1993 between the
                        Registrant and Kabi Pharmacia AB, dated January 31, 1996.(9)
            10.34       First Amendment to Research and License Agreement, dated May
                        28, 1993, between Registrant and Amgen, Inc., dated February
                        2, 1996.(9)
            10.35       Research Agreement between the Registrant and Pharmacia &
                        Upjohn, Inc., a Delaware corporation, dated February 29,
                        1996.(9)
            10.36       Form of Sixth Amendment to Lease dated October 15, 1992
                        between the Registrant and Shelton Properties, Inc., dated
                        March 29, 1996.(9)
            10.37       Financing Agreement between Hambrecht and Quist Guaranty
                        Finance, LLC, dated March 29, 1996, including Security
                        Agreement and Warrant Purchase Agreement of even date.(9)
            10.38       Amendment to Lease Schedule under Master Property Lease
                        Agreement dated March 29, 1994 between Hambrecht and Quist
                        Guaranty Finance, L.P., dated March 29, 1996.(9)
            10.39       Standard Industrial Lease between the Registrant and The
                        Equitable Life Assurance Society of the United States, dated
                        August 5, 1996.(10)
            10.40       Business Loan Agreement between Registrant and Bank of
                        America National Trust and Savings Association, dated
                        September 24, 1996.(10)
</TABLE>
 
                                       69
<PAGE>   71
 
<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                        DESCRIPTION OF DOCUMENT
            -------                       -----------------------
           <S>          <C>
            10.41       Sublease Agreement between Registrant and Fibrogen, Inc.,
                        dated September 30, 1996.(10)
            10.42**     Research Collaboration and License Agreement between Merck &
                        Co., Inc. and the Registrant, dated November 6, 1996.(7)
            10.44       Collaborative Research and License Agreement between
                        SmithKline Beecham Corporation and the Registrant, dated
                        June 27, 1996.(11)
            10.46       Loan Agreement among the Registrant, as Borrower, and The
                        Sumitomo Bank, Limited and Silicon Valley Bank, as Lenders
                        and The Sumitomo Bank, Limited, as Agent, dated September
                        29, 1997.(13)
            10.47       Sequana 1994 Incentive Stock Plan.(14)
            10.48       Sequana 1995 Employee Stock Purchase Plan.(14)
            10.49+      Sequana 1995 Director Stock Option Plan.(14)
            10.50       Master Lease Agreement dated November 1, 1993 by and between
                        Comdisco, Inc. and Sequana.(14)
            10.52       Expansion Lease by and between Health Science Properties,
                        Inc. and Sequana dated as of November 20, 1995.(15)
            10.53**     Collaborative Research Agreement dated as of June 30, 1995
                        by and between Sequana and Corange International, Ltd.(14)
            10.54**     Collaborative Research Agreement dated as of June 12, 1995
                        by and between Sequana and Boehringer Ingelheim
                        International GmbH.(14)
            10.55+      Form of Indemnification Agreement between the Registrant and
                        its officers and directors.(14)
            10.57       Letter Agreement dated September 7, 1993 between Sequana and
                        Timothy J.R. Harris.(14)
            10.58**     Research Agreement dated as of April 2, 1996 by and between
                        Sequana and Aurora Biosciences Corporation.(16)
            10.59       Merger Agreement and Plan of Reorganization Agreement
                        between Sequana, Sequana Merger Sub, Inc., NemaPharm, Inc.
                        and the Shareholders of NemaPharm, Inc., dated July 19,
                        1996.(17)
            10.60       Loan Agreement between Sequana and The Sumitomo Bank,
                        Limited, dated as of October 23, 1996.(18)
            10.61**     Joint Venture Agreement among Sequana Therapeutics, Inc.,
                        Memorial Sloan-Kettering Cancer Center and Genos
                        Biosciences, Inc., dated January 29, 1997.(19)
            10.62*      Amendment to Collaborative Research Agreement of June 12,
                        1995 between Sequana and Boehringer Ingelheim International
                        GmbH, dated June 19, 1997.(20)
            10.63       Second Amendment to Expansion Lease by and between Sequana
                        and Alexandria Real Estate Equities, Inc., dated as of May
                        20, 1997.(20)
            10.64       Agreement and Plan of Merger and Reorganization dated
                        November 2, 1997, by and among the Registrant, Beagle
                        Acquisition Sub, Inc., a California corporation and wholly
                        owned subsidiary of the Registrant and Sequana.(21)
            10.65       First Amendment to Loan Agreement Between the Registrant and
                        The Sumitomo Bank, Limited, dated as of January 8, 1998.
                        Incorporated by reference to Exhibit 10-65 filed on Form
                        10-K filed on March 31, 1998.
</TABLE>
 
                                       70
<PAGE>   72
 
<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                        DESCRIPTION OF DOCUMENT
            -------                       -----------------------
           <S>          <C>
            10.66       First Amendment to Loan Agreement Between Sequana and The
                        Sumitomo Bank, Limited, dated as of January 8, 1998.
                        Incorporated by reference to Exhibit 10-66 filed on Form
                        10-K filed on March 31, 1998.
            10.67*      Collaboration Agreement dated as of October 1997 by and
                        between the Registrant and Bristol-Myers Squibb Company.
                        Incorporated by reference to Exhibit 10-67 filed on Form
                        10-K filed on March 31, 1998.
            10.68*      Collaboration Agreement dated as of October 31, 1997 by and
                        between Sequana and Warner-Lambert Company. Incorporated by
                        reference to Exhibit 10-68 filed on Form 10-K filed on March
                        31, 1998.
            10.69       Sequana Common Stock Purchase Agreement, dated October 31,
                        1997. Incorporated by reference to Exhibit 10-69 filed on
                        Form 10-K filed on March 31, 1998.
            10.70       $200,000 Promissory Note, dated September 2, 1997, issued by
                        John P. Walker, to the Registrant. Incorporated by reference
                        to Exhibit 10-70 filed on Form 10-K filed on March 31, 1998.
            10.71       $750,000 Promissory Note, dated September 2, 1997, issued by
                        John P. Walker, to the Registrant. Incorporated by reference
                        to Exhibit 10-71 filed on Form 10-K filed on March 31, 1998.
            10.72       Employment Agreement, dated August 29, 1997, by and between
                        John Walker and the Registrant. Incorporated by reference to
                        Exhibit 10-72 filed on Form 10-K filed on March 31, 1998.
            10.73       Amended and Restated Severance Agreement by and between the
                        Registrant and Kevin Kinsella, dated January 7, 1998.
                        Incorporated by reference to Exhibit 10-73 filed on Form
                        10-K filed on March 31, 1998.
            10.74       Amended and Restated Restricted Stock Purchase Agreement by
                        and between Sequana and Kevin Kinsella, dated January 7,
                        1998. Incorporated by reference to Exhibit 10-74 filed on
                        Form 10-K filed on March 31, 1998.
            10.75       Consulting Agreement by and between Sequana and Kevin
                        Kinsella, dated January 8, 1998. Incorporated by reference
                        to Exhibit 10-75 filed on Form 10-K filed on March 31, 1998.
            10.78       1997 Equity Incentive Plan, dated January 7, 1998.(22)
            10.79       First Amendment to Lease Schedules Master Property Lease
                        Agreement No. 943, dated March 29, 1994, Schedules Nos. 1
                        and 4 through 59, dated from March 29, 1994, through January
                        1, 1995.(23)
</TABLE>
 
                                       71
<PAGE>   73
 
<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                        DESCRIPTION OF DOCUMENT
            -------                       -----------------------
           <S>          <C>
            10.80       First Amendment to Lease Schedule Master Property Lease
                        Agreement No. 963, dated March 29, 1996, Schedule No. 2,
                        dated March 29, 1996.(23)
            10.81       Second Amendment to Lease Schedule Master Property Lease
                        Agreement No. 943, dated March 29, 1994, Schedule No. 2,
                        dated March 29, 1994.(23)
            10.82       First Amendment to Lease Schedule Master Property Lease
                        Agreement No. 943, dated March 29, 1994, Schedule No. 3,
                        dated March 29, 1994.(23)
            10.83       Amendment to the Collaborative Research Agreement between
                        Sequana and Corange International Ltd., effective June 30,
                        1995, dated January 9, 1998.(24)
            10.84*      Amendment No. 2 to the Collaborative Research Agreement
                        between Sequana and Corange International Ltd., dated June
                        30, 1995, effective February 23, 1998.(24)
            10.85       Employment Agreement by and between Tim Harris and the
                        Company, dated as of January 8, 1998.(24)
            10.86       Lease Agreement between Sequana and ARE-John Hopkins Court,
                        LLC, dated as of January 7, 1998.(24)
            10.87*      Termination of Collaborative Research Agreement between
                        Sequana and Glaxo Wellcome, Inc., effective February 1,
                        1998.(25)
            10.88*      Combinatorial Chemistry Agreement between the Registrant and
                        Warner-Lambert Company, dated May 15, 1998.(25)
            10.89*      Collaboration Agreement by and among the Registrant and its
                        subsidiaries, NemaPharm, Inc. and Sequana, and Roche
                        Bioscience, dated June 1, 1998.(25)
            10.90*      Amendment dated September 21, 1998 to the Collaboration
                        Agreement between Warner-Lambert Company and Sequana, dated
                        October 31, 1997.(26)
            10.91       1997 Non-Officer Equity Incentive Plan.(26)
            10.93*      Second Amendment to the Research Collaboration and License
                        Agreement between Arris Pharmaceutical Corp. and Merck and
                        Co., Inc., dated November 5, 1998.
            10.94*      Collaborative Research and License Agreement between the
                        Registrant and Rhone-Poulenc Rorer Pharmaceuticals, Inc.,
                        dated December 11, 1998.
            10.95*      Combinatorial Chemistry Agreement between the Registrant and
                        Rhone-Poulenc Rorer Pharmaceuticals, Inc., dated December
                        22, 1998.
            10.96       Agreement, dated June 11, 1998, by and between William
                        Newell and the Registrant.
            21          Subsidiaries of the Registrant.
            23.1        Consent of Ernst & Young LLP.
            24.1        Power of Attorney (incorporated in the signature page of
                        this Form 10-K).
            27          Financial Data Schedule.
</TABLE>
 
---------------
  +  Compensatory Benefit Plan or management contract.
 
  *  Confidential treatment has been requested with respect to certain portions
     of this exhibit.
 
 **  Confidential treatment has been granted with respect to certain portions of
     this exhibit.
 
 (1) Incorporated herein by reference to the Registration Statement on Form S-1
     filed October 5, 1993, as amended thereto (file number 33-69972).
 
 (2) Compensation plan.
 
                                       72
<PAGE>   74
 
 (3) Incorporated herein by reference to the Registration Statement on Form S-8
     filed January 31, 1994 (file number 33-69972).
 
 (4) Incorporated herein by reference to the Registrant's Report on Form 10-Q
     for the quarter ended March 31, 1994.
 
 (5) Incorporated herein by reference to the Registrant's Annual Report on Form
     10-K for the fiscal year ended December 31, 1994.
 
 (6) Incorporated herein by reference to the Registrant's Report on Form 10-Q
     for the quarter ended September 30, 1995.
 
 (7) Incorporated herein by reference to the Registrant's Registration Report on
     Form 10-K for the fiscal year ended December 31, 1996
 
 (8) Incorporated herein by reference to the Registrant's Current Report on Form
     8-K, filed November 13, 1995.
 
 (9) Incorporated herein by reference to the Registration Report on Form 10-Q
     for the quarter ended March 31, 1996.
 
(10) Incorporated herein by reference to the Registration Report on Form 10-Q
     for the quarter ended September 30, 1996.
 
(11) Incorporated herein by reference to the Registration Statement filed on
     Form S-3/A filed September 19, 1996 (file number 333-09307).
 
(12) Incorporated by reference to the Registration Statement on Form S-8 filed
     July 29, 1996 (file number 333-09095).
 
(13) Incorporated by reference to exhibit 10.47 to the Registrant's Report on
     Form 10-Q for the quarter ended October 31, 1997.
 
(14) Incorporated by reference to exhibits filed with Sequana's Registration
     Statement on Form S-1, filed June 14, 1995 as amended (Reg. No. 33-93460).
 
(15) Incorporated by reference to exhibits filed with Sequana's Registration
     Statement on Form S-1, filed February 12, 1996 as amended (Reg. No.
     333-01226).
 
(16) Incorporated by reference to exhibit 10.14 to Sequana's Report on Form 10-Q
     for the quarter ended June 30, 1996.
 
(17) Incorporated by reference to exhibit 10.15 to Sequana's Report on Form 10-Q
     for the quarter ended September 30, 1996.
 
(18) Incorporated by reference to exhibit 10.16 filed with Sequana's Report on
     Form 10-K, as amended, for the fiscal year ended December 31, 1996.
 
(19) Incorporated by reference to exhibit 10.17 to Sequana's Report on Form 10-Q
     for the quarter ended March 31, 1997.
 
(20) Incorporated by reference to exhibit 10.18 to Sequana's Report on Form 10-Q
     for the quarter ended June 30, 1997.
 
(21) Incorporated by reference to exhibit 4.1 to the Schedule 13D filed by the
     Registrant on November 12, 1997.
 
(22) Incorporated by reference to Appendix E to the Registrants Registration
     Statement on Form S-4, filed November 27, 1997.
 
(23) Incorporated herein by reference to the Registrant's Registration Report on
     Form 10-K for the fiscal year ended December 31, 1997.
 
(24) Incorporated herein by reference to the Registrant's Registration Report on
     Form 10-Q for the quarter ended March 31, 1998.
 
(25) Incorporated herein by reference to the Registrant's Registration Report on
     Form 10-Q for the quarter ended June 30, 1998.
 
(26) Incorporated herein by reference to the Registrant's Registration Report on
     Form 10-Q for the quarter ended September 30, 1998.
 
                                       73