<PAGE>
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C.  20549

                                   FORM 10-K
                                        
[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934
                  For the fiscal year ended December 31, 1998

[_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
     EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _______ TO _______

                          Commission File No. 0-12943

                            CYPRESS BIOSCIENCE, INC.
             (Exact name of registrant as specified in its charter)
                                _______________

          DELAWARE                                        22-2389839
(State or other jurisdiction of                 (I.R.S. Employer Identification 
incorporation or organization)                                 No.)

   4350 EXECUTIVE DRIVE, SUITE 325
        SAN DIEGO, CALIFORNIA                                 92121
(Address of principal executive offices)                    (Zip Code)

      Registrant's telephone number, including area code:  (619) 452-2323
                                        
       SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:  NONE
          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
                          COMMON STOCK $.02 PAR VALUE
                        COMMON STOCK PURCHASE WARRANTS
                     UNITS CONSISTING OF TWO (2) SHARES OF
            COMMON STOCK AND ONE (1) COMMON STOCK PURCHASE WARRANT
                               (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. [X]

The aggregate market value of the voting stock held by nonaffiliates of the
Registrant as of March 1, 1999 was $61,941,239.*

The number of shares outstanding of the Registrant's Common Stock as of March 1,
1999 was 41,552,750.

DOCUMENTS INCORPORATED BY REFERENCE:  None

______________________

* Calculated based on 20,222,409 shares of Common Stock held as of March 1, 1999
by nonaffiliates and a per share market price of $3.063. Excludes 21,330,341
shares of Common Stock held by directors and executive officers and stockholders
whose ownership exceeds five percent of the Common Stock outstanding at March 1,
1999. Exclusion of such shares should not be construed to indicate that any 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.
<PAGE>
 
                           CYPRESS BIOSCIENCE, INC.

                                   FORM 10-K

                                     INDEX

                                    PART I

                                                                            Page
                                                                            ----
ITEM 1   Business..........................................................    1
ITEM 2   Properties........................................................   15
ITEM 3   Legal Proceedings.................................................   15
ITEM 4   Submission Of Matters To a Vote of Security Holders...............   15

                                    PART II

ITEM 5   Market For The Company's Common Stock And Related Security Holder 
         Matters...........................................................   16
ITEM 6   Selected Consolidated Financial Data..............................   17
ITEM 7   Management's Discussion And Analysis Of Financial Condition
         And Results Of Operations.........................................   18
ITEM 7A  Quantitative and Qualitative Disclosure About Market Risk.........   23
ITEM 8   Financial Statements And Supplementary Data.......................   23
ITEM 9   Changes In And Disagreements With Accountants On Accounting
         And Financial Disclosure..........................................   23

                                    PART III

ITEM 10  Directors And Executive Officers Of The Company...................   24
ITEM 11  Executive Compensation............................................   27
ITEM 12  Security Ownership Of Certain Beneficial Owners And Management....   33
ITEM 13  Certain Relationships And Related Transactions....................   34

                                    PART IV

ITEM 14  Exhibits, Financial Statement Schedules And Reports on Form 8-K...   36
         Signatures........................................................   40

                                       i.
<PAGE>
 
                                     PART I

Item 1.  BUSINESS

     Except for the historical information contained herein, the matters
discussed in this Annual Report on Form 10-K contain forward-looking statements
within the meaning of Section 27A of the Securities Act and Section 21E of the
Exchange Act, including, in particular, statements in this Annual Report about
the Company's plans, strategies and prospects.  These statements, which may
include words such as "may," "will," "expect," "believe," "intend," "plan,"
"anticipate," "estimate," or similar words, are based on the Company's current
beliefs, expectations and assumptions and are subject to a number of risks and
uncertainties.  Although the Company believes that its beliefs, expectations and
assumptions reflected in these statements are reasonable, the Company's actual
results and financial performance may prove to be very different from what the
Company might have predicted on the date of this Annual Report.  Some of the
risks and uncertainties that might cause such differences are discussed below
and others are discussed in the Company's Annual Report on Form 10-K under the
heading "Risk Factors" beginning on page 13 and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" beginning on page 22.

COMPANY OVERVIEW AND RECENT DEVELOPMENTS

     Cypress Bioscience, Inc. (the "Company") researches, develops, manufactures
and markets medical devices and therapeutics for the treatment of certain types
of immune system disorders and is engaged in the development of novel
therapeutic agents for the treatment of blood platelet disorders.  The Company's
first product, the Prosorba(R) column, a medical device, treats a patient's
defective immune system so that it can more effectively respond to certain
diseases.  The Company received marketing approval from the U.S. Food and Drug
Administration ("FDA") in December 1987 to distribute the Prosorba column for
the treatment of idiopathic thrombocytopenic purpura ("ITP"), an immune-mediated
bleeding disorder.  On March 16, 1999 the Company received marketing approval
from the FDA to distribute the Prosorba column for the treatment of moderate to
severe rheumatoid arthritis ("RA").

     In 1996, the Company initiated a Phase IV marketing study for the use of
the Prosorba column in the treatment of ITP.  However, the Company determined
that continued investment in the ITP market was not the best use of its
resources and terminated its ITP trial during the fourth quarter of 1997.  The
Company's current clinical efforts to expand the approved indications for the
Prosorba column have been focused primarily on RA.  In June 1996, the Company
commenced a prospective, randomized, multi-center, double blind, controlled
Phase III pivotal trial designed to confirm the findings of an earlier pilot
study evaluating the use of the Prosorba column in the treatment of RA. In
January 1998, the Company's Phase III clinical trial was stopped early due to
the achievement of favorable safety and statistically significant efficacy
results. Based on such results, the Company filed a Pre-Market Approval ("PMA")
application for the Prosorba column for the treatment of RA with the FDA in July
1998.

     The Company appeared at a hearing before the FDA's Gastroenterology and
Urology Device Advisory Panel (the "FDA Panel") on October 29, 1998. The FDA
Panel recommended on that day to the FDA that the Prosorba column be approved
for the treatment of moderate to severe RA, subject to certain requirements. On
March 16, 1999, the Company received marketing approval for the Prosorba column
subject to the requirement that the Company conduct a post-marketing trial for
the treatment of RA with a combination of the Prosorba column and a disease
modifying anti-rheumatic drug ("DMARD"). The Company's anticipated commercial
launch in the United States for the Prosorba column for the RA indication is
April 5, 1999.

     On March 26, 1999, the Company entered into a partnership with Fresenius
Aktiengesellschaft ("Fresenius AG"), a provider of blood processing products,
and Fresenius Hemotechnology, Inc. ("FHI"), a wholly-owned subsidiary of 
Fresenius AG (collectively, the "Fresenius Parties"), for the co-marketing and
distribution of the Prosorba column in the United States and for the
registration and distribution of the Prosorba column in Europe, Mexico, the
Caribbean, Central America and South America. Subject to certain diligence
obligations, Japan, Thailand, China, New Zealand, Hong Kong, South Korea, India
and Canada also will be included in the territory. The partnership is based upon
a sharing of responsibilities for the Prosorba column related activities and a
sharing of profits from the sale of the Prosorba column in the U.S. territory
and separately in the non-U.S. territory. Pursuant to the Asset Purchase Option
Agreement, FHI also received an option, until the end of the year 2000, to
purchase the Company's manufacturing facilities in Redmond, Washington (the
"Option"). In connection with the Option, Fresenius AG agreed to extend a

                                       1.
<PAGE>
 
revolving line of credit to the Company in an amount equal to the purchase price
of the leasehold interest and non-inventory assets, the fair market value of
inventory on hand and as built and the cost of approved capital expenditures for
the manufacturing facility which is located in Redmond, Washington (the "Redmond
Facility"). The outstanding line of credit is evidenced by a promissory note and
the balance under the promissory note becomes payable on the earlier of (i) the
date on which FHI exercises the Option or (ii) the expiration of the Option (in
which event the promissory note is payable through the issuance of a new three-
year interest-bearing amortizing note). The total amount due under the
promissory note may be offset against the purchase price of the assets which
includes, among other items, the aggregate amount advanced by Fresenius AG under
the line of credit for capital expenditures at the Redmond facilities. On March
26, 1999, the Company entered into a promissory note and received approximately
$4.1 million in proceeds.

     In addition, on March 26, 1999 Fresenius AG purchased 297,530 shares of
the Company's common stock for approximately $1.0 million or $3.361 per share
and purchased for $500,000 a three-year warrant to purchase 342,466 shares of
common stock for $7.50 per share. The Company also has called for redemption on
March 18, 1999 warrants to purchase approximately 2.7 million shares of common
stock at a price of $2.00 per share. The Company expects to receive net proceeds
of approximately $5.4 million from the exercise of the warrants.

     The Company is also developing Cyplex(TM), a platelet alternative,
previously known as Infusible Platelet Membranes ("IPM") as an alternative to
traditional platelet transfusions.  The Company initiated a double-blinded Phase
II controlled clinical trial of Cyplex(TM) as an alternative to traditional
platelet transfusions in March 1998 which the Company terminated in September 
1998.

The Prosorba(R) Column
----------------------

     The Company's Prosorba column is a therapeutic, extracorporeal
immunoadsorption device which removes circulating immune complexes ("CICs") and
immunoglobulin G ("IgG") from a patient's plasma in a procedure that takes place
in an extracorporeal loop (i.e., outside the body) and returns all the other
necessary plasma components back to the patient. During the Prosorba column
therapy, blood is drawn from one arm of the patient, plasma and blood cells are
separated, the plasma is filtered through the Prosorba column to remove unwanted
CICs and IgG, then combined with the red blood cells and returned to the
patient's other arm. The Prosorba column therapy is usually administered on an
outpatient basis. The Company received marketing approval from the FDA in
December 1987 to distribute the Prosorba column for the treatment of ITP, an
immune-mediated bleeding disorder and in March 1999 to distribute the Prosorba
column for the treatment of moderate to severe RA.

     The Prosorba column treats a defective immune system by modulating the
immune system to respond more effectively.  The modulation can result in the
clearance of antigens or control of an autoimmune disease.  The Company believes
that the Prosorba column treats a dysfunctional immune system response rather
than treating the disease itself.  The Company is providing financial support
for an extramural program with leading academic laboratories to study the
mechanisms of action of the Prosorba column.

     The Prosorba column is a plastic cylinder measuring three inches in
diameter and three and one half inches in height. The cylinder contains a solid
binding matrix composed of protein A bound to dry silica (sand) granules.
Protein A, a molecule produced by the fermentation of a bacterium, specifically
binds to both CICs and IgG, with preference for CICs. The FDA considers the
Prosorba column to be a medical device. A patient is treated with the Prosorba
column once a week for 12 weeks. The treatment process is similar to dialysis.
The patients blood is slowly removed, the plasma is separated and treated with
the Prosorba column. The treated plasma and blood is then retransfused into the
body.

     The Company believes that key factors in its commercial performance will be
its ability to commercially launch the Prosorba column in the RA market and
achieve significant market penetration, and reimbursement coverage from private
and public insurance plans.

Rheumatoid Arthritis
--------------------

     RA is a potentially crippling autoimmune disease that in 1997 was estimated
to affect approximately 2.5 million people in the United States and
approximately 3.5 million people in Europe and Japan. In RA, the body's immune
system inappropriately makes antibodies, called rheumatoid factors, that collect
in the joints and surrounding soft tissue causing inflammation and tissue
damage. Joints, typically those in the hand, become painful and swollen, lose

                                       2.
<PAGE>
 
movement, and become deformed. These individuals not only suffer a significantly
reduced quality of life, but also a shortened life expectancy.

     In September 1995, the Company announced the results of its 15 patient
pilot clinical trial that used the Prosorba column for therapy in RA.  The
results showed a statistically significant 76% reduction in painful joints and a
70% reduction in swollen joints in 11 patients three months after completing
treatment with the Prosorba column.  The Company believes that these findings
confirm the potential utility of the Prosorba column in treating RA reported by
an earlier independent study published in the JOURNAL OF RHEUMATOLOGY in May
1994.

     In 1996, the Company began providing financial support to several leading
research facilities in the form of grants and contractual support to further
efforts in studying the mechanism of action of the Prosorba column in the
treatment of RA.  For the years ended December 31, 1998 and 1997, the amounts of
financial support provided by the Company were approximately $152,000 and
$148,000, respectively.

     In June 1996, the Company commenced a prospective, randomized, multi-
center, double blind, sham controlled Phase III pivotal trial designed to
confirm the findings of the pilot study in a larger group of patients. The
patients were randomly entered into two treatment groups with approximately half
of the patients treated with the Prosorba column and the other half of the
patients with a placebo treatment.

     In January 1998, the Company announced that an independent Data Safety and
Monitoring Board ("DSMB") recommended the early cessation of the Company's Phase
III clinical trial evaluating the use of the Prosorba column in the treatment of
RA. The recommendation to end enrollment in the Phase III trial was based on the
achievement of favorable safety and statistically significant efficacy results.
In July 1998, the Company filed a PMA application for submission to the FDA
requesting new labeling for the Prosorba column to incorporate the RA
indication. The Company appeared at a hearing before the FDA's Panel on October
29, 1998. The FDA Panel recommended on that day to the FDA that the Prosorba
column be approved for the treatment of moderate to severe RA, subject to
certain requirements. On March 16, 1999, the Company received marketing approval
for the Prosorba Column for use in the treatment of moderate to severe RA. A
condition of approval of the Prosorba column by the FDA was that Cypress agree
to conduct a Phase IV study of the Prosorba column used with concomitant
methotrexate therapy. Phase IV trials are post-marketing studies in order to
gather additional data concerning the product's performance after commercial
sales begin. In this case, Cypress will study the safety and effectiveness of
the Prosorba column in patients who continue to take a common rheumatoid
arthritis medication, methotrexate.

Cyplex(TM) (Infusible Platelet Membranes), A Platelet Alternative
-----------------------------------------------------------------

     The Company's strategy is to produce therapeutic agents that enhance,
inhibit, modify or replace the natural activity of platelets that have been
depleted or damaged by disease or therapy.  In November 1996, the Company
acquired PRP, Inc ("PRP").  PRP's primary product, Cyplex(TM) (Infusible
Platelet Membranes), a platelet alternative, which is still in the clinical
research phase, is being developed as a potential substitute for traditional
platelet transfusions.  Currently, the Company is focusing most of its efforts
related to PRP on the development of Cyplex(TM), a freeze-dried (lyophilized)
powder prepared from either fresh or outdated human platelets.  A proprietary
production process removes interior platelet components, resulting in a product
consisting primarily of platelet membrane fragments.  Cyplex(TM) is heat-treated
during processing to inactivate, below any detection levels, viruses (HIV,
hepatitis, etc.) that may be present.  Preclinical and clinical trials conducted
to date have shown that Cyplex(TM) is not thrombogenic or immunogenic, and no
dose limiting toxicity has been noted in humans or animals.  The lead indication
for Cyplex(TM) is as an alternative to platelet transfusions to restore control
of bleeding due to platelet deficiency in refractory patients.

Treatment of Thrombocytopenia
-----------------------------

     If blood platelet levels become too low (severe thrombocytopenia), the
hemostasis system begins to deteriorate.  Left untreated, thrombocytopenia can
lead to spontaneous bruising and bleeding and may progress to shock, circulatory
collapse, and death.  Thrombocytopenia is a common side effect of the chemo- and
radiation 

                                       3.
<PAGE>
 
therapies used to treat cancer and can also be caused by liver disease or by
major blood loss from traumatic injuries. Platelet dysfunction that is similar
in consequence to thrombocytopenia is caused by prolonged exposure to some
medical devices, such as heart-lung bypass machines used in open-heart surgery.

     Thrombocytopenia is currently treated with transfusion of human platelets.
In 1992, sales of platelets to hospitals for this purpose were about $1.3
billion worldwide, including approximately $550 million in the U.S.  The Company
estimates that associated costs with platelet transfusions, including filters,
HLA cross matching and donor recruitment add another approximately $200 million
in the U.S. Platelet usage in the U.S. grew at an average annual rate of about
5% to 7% since 1987, and the Company expects this growth to continue for at
least the next several years.  Cyplex(TM) has the potential to replace a major
fraction of platelet transfusions for thrombocytopenia.

     Platelet transfusion is generally an effective therapy, but it has a number
of significant drawbacks.  Cyplex(TM)'s characteristics allow it to overcome a
majority of the disadvantages of platelet transfusion, as summarized in the
table below:

------------------------------------------------------------------------------
Human Platelets            Cyplex(TM) Benefits     Cyplex(TM) Economic Impact
------------------------------------------------------------------------------
Can transmit viruses       Viral Inactivation      Increased safety, reduced
                                                    liability and testing
                                                    costs 
Patients frequently        Does not induce         Reduced hospitalization,
 become alloimmunized*      alloimmunization        no platelet typing, 
                                                    improved outcomes 
Platelets do not           Cyplex(TM) controls     Reduced morbidity and
 control bleeding           bleeding in many        mortality 
 in some patients           of these patients     
Shelf life of              Shelf life greater      Reduced loss from out-
 3 to 5 days                than one year           dating, emergency 
                                                    availability, improved
                                                    logistics and reduced
                                                    infrastructure  
Must be agitated           Vial in refrigerator    Reduced storage costs
 constantly                                       
------------------------------------------------------------------------------
*Alloimmunization is the process whereby the body develops antibodies to
 platelets that cause later transfusions to be ineffective.

     In addition to safety and toxicity testing in animals and humans, the
Company recently concluded a trial designed to study efficacy in patients with
low platelet counts during active bleeding episodes.  The Phase II trial, which
began in early 1996, showed that Cyplex(TM) controlled or halted bleeding in 17
of 26 patients, a 65% response rate.  Of the 26 patients, 12 had previously not
responded to platelet transfusions, the traditional therapy for uncontrolled
bleeding.  In this subgroup of refractory non-responders, Cyplex(TM) was
effective in controlling or halting bleeding in 7 out of 12 patients, or 58% of
the time.

     In February 1998, the Company entered into a collaborative agreement with a
leading Dutch manufacturer and supplier of blood derivatives, as well as having
a strong tradition of research.  The collaboration is on process development and
scale-up of Cyplex(TM).  The collaborative work is intended to accelerate
commercialization of Cyplex(TM) and to broaden its potential market beyond
patients who are resistant to platelet transfusions.

Potential Follow-on Indications
-------------------------------

     The Company believes that Cyplex(TM) may also be useful as an adjunct to
cardiac surgery or angioplasty.  Of the nearly 800,000 patients who currently
undergo angioplasty to open blocked arteries worldwide each year, approximately
30% to 45% will suffer postangioplasty restenosis.  A key factor in the
development of restenosis is exposure of smooth muscle proliferation in the
artery walls to platelet derived growth factor ("PDGF") causing smooth muscle
proliferation.  This happens when the patient's platelets adhere to injuries in
the artery walls that are always produced as a side effect of the angioplasty
procedure.  After adhesion, the platelets become activated, release their
interior components, including PDGF and various coagulation-inducing factors.
If platelets can be prevented from adhering to these injured areas, they will
not become activated and thus not release PDGF, and, therefore, will not
contribute to restenosis.  Both animal and in-vitro work at the Company have
shown that Cyplex(TM) binds to arterial lesions and thereby reduces platelet
adhesion.  Work at the Company and elsewhere has shown that Cyplex(TM) can also
carry anti-platelet agents to the lesions and, in principle, concentrate
activity of those agents to further reduce platelet adhesion.

                                       4.
<PAGE>
 
     Other areas of potential interest include the use of Cyplex(TM) during open
heart surgery to prevent peri-operative bleeding and other complications, the
use of Cyplex(TM) to prevent or control bleeding that can result from the use of
anti-platelet agents, (in particular anti-GP IIb/IIIa agents), and the use of
Cyplex(TM) in disseminated intravascular coagulation.

     Cyplex(TM) may also be studied in general surgical and emergency room
indications such as trauma.  Efficacy in preventing or improving bleeding in
these indications could have great benefits in situations where the storage of
human platelets presents logistical difficulties, such as in military use and in
rural areas, and in situations in which there are potential imbalances between
supply and demand (e.g., in liver transplants which require hundreds of units of
platelets).

MARKETING AND SALES

     Prior to 1994, the Prosorba column was sold by the Company's internal sales
force to physicians in the fields of immunology, hematology and oncology.  In
April 1994, Baxter assumed sales and marketing responsibilities under a 10-year
exclusive distribution agreement, granting distribution rights of the Prosorba
column in the United States and Canada for the treatment of ITP. Effective May
1, 1996, the Company and Baxter terminated the exclusive distribution agreement,
and the Company regained marketing rights. In August 1996, the Company
established an internal sales and marketing program. The program included hiring
a domestic sales force of approximately six representatives as well as
initiating marketing efforts including medical education, direct mail, trade
show participation and limited journal advertising.

     In the latter part of 1996, the Company launched a controlled clinical
study evaluating the efficacy of the Prosorba column in ITP.  This was the first
prospective and controlled study of the device in its approved indication and
was designed to confirm observations from 10 years of historical use.  Increased
competition for patients from other ITP studies caused enrollment to be below
expectations.  The increased competition and low enrollment caused the Company
to re-evaluate its ability to complete the study in a timely and cost effective
manner.  In light of more promising opportunities in the RA market, the Company
determined that continued investment in the ITP market was not the best use of
its resources.

     As of March 26, 1999, the Company will market the Prosorba column in both
RA and ITP indications with the Fresenius Parties. The Company and the Fresenius
Parties will have the joint responsibility to co-market the Prosorba column in
the U.S. The Company will take the lead in marketing the Prosorba column to
rheumatologists who will prescribe the Prosorba column for RA treatment (the
Company's present marketing strategy) and the Fresenius Parties will be
responsible for introducing the Prosorba column to providers such as renal
dialysis centers and other apheresis providers that can perform the treatment
using the Prosorba column (a marketing strategy that the Company has not yet
employed). Effective January 4, 1999, the Company increased its direct sales
force from 3 to 17 and the Company anticipates that it may have to increase its
direct sales staff as sales grow. The Fresenius Parties have exclusive
distribution rights and responsibility for clinical trial and regulatory
registration outside the United States. The agreement includes a 50/50 profit
split in the territories other than the U.S. The profit sharing is 50/50 in the
U.S. until the Prosorba column revenue reaches a pre-determined sales threshold
within a contract year, after which time the Company will receive 60% of the
profits for such contract year and the Fresenius Parties will receive 40%. In
addition, the Company is entitled to receive up to $54 million in license
payments upon the achievement of certain cumulative net sales of the Prosorba
column (subject to conditions relating to the timing of such payments). In the
United States, the license payments are payable in some cases in cash and in
others in equity investments by Fresenius at market prices, and in the non-U.S.
territory, the license payments are payable in cash.

     The agreement defines profits as net sales of the Prosorba column (and in
the United States only, net sales of Fresenius disposables) less the following
deductions in order (i) cost of goods sold (as defined in the agreement without
any markup for corporate allocations of overhead and without any profit margin),
(ii) royalties payable to third parties, (iii) the cost of clinical trials and
research and development approved by the steering committee (which will include
the costs of the mandatory Phase IV trial in the U.S.) and (iv) sales and
marketing expense of up to 20% of net sales for the applicable period (with 15%
allocated to the Company in the U.S. and 5%  to the FHI and 20% allocated to
Fresenius in the non-U.S. territories).  The U.S. and the non-U.S. territories
are each separate profit 

                                       5.
<PAGE>
 
sharing centers. During the first two years of the partnership, the Company
expects to spend up to $9 million in sales and marketing expenses in excess of
the 15% of net sales allocated to the Company due to the product launch costs.
If net sales during the first two years are higher than expected, the Company
may be able to recover all or a portion of its unreimbursed sales and marketing
expenses pursuant to the agreement. The Company also is responsible for paying
for any operating losses of the manufacturing facility that are incurred during
calendar year 1999, prior to Fresenius' exercise of the option.

     Generally, in the United States the cost of treatment for ITP using the
Prosorba column has been reimbursed by third-party payors.  The Company
anticipates that the cost of treatment for RA using the Prosorba column will be
reimbursed by third-party payors, although the process for obtaining
reimbursement from government and private payors may take a year or more.  Under
the partnership with the Fresenius Parties, the Company has the lead
responsibility in the United States for arranging for third-party reimbursement.

     No customer represented more than 10% of the Company's annual sales during
the years ended December 31, 1997 and 1996, respectively.  For the years ended
December 31, 1995 and 1994, sales to Baxter represented approximately 91% and
70%, respectively, of the Company's sales.

     Sale of the Prosorba column is not subject to seasonal fluctuation.

PATENTS, TRADEMARKS AND PROPRIETARY TECHNOLOGY

     The Company believes that its success depends primarily on the experience,
capabilities, and skills of its personnel.  Notwithstanding this fact, however,
the Company seeks to protect its intellectual property rights by a variety of
means, including patents, maintaining trade secrets and proprietary know-how,
and technological innovation to develop and maintain its competitive position.
There can be no assurance that the Company will be able to obtain additional
patents either in the United States or in foreign jurisdictions or that, if
issued, such patents will provide sufficient protection or be of commercial
benefit to the Company.  Insofar as the Company relies on trade secrets and
unpatented proprietary know-how, there can be no assurance that others will not
independently develop similar technology or that secrecy will not be breached.
Finally, there can be no assurance that the Company will be able to develop
further technological innovations.

The Prosorba Column
-------------------

     The Company presently owns ten issued U.S. patents and two international
patents (excluding patents relating to the area of platelet therapeutics) which
expire during 2004 to 2015.  The process used in manufacturing the Prosorba
column is covered by several of these patents. Pursuant to the License and
Distribution Agreement, the Company has granted to the Fresenius Parties an
exclusive license under certain patents related to the Prosorba column to
manufacture, use and distribute the Prosorba column in the territory for use in
the treatment of ITP, RA and any other indications that are approved by the FDA.
See "-- Company Overview" and "-- Marketing and Sales".  Certain patents cover
the use of the Prosorba column in the treatment of ITP and RA.  U.S. and
international applications are pending.

     The Company also owns the registered trademark Prosorba(R) in the United
States and other jurisdictions.  The Company expects that the value of its
trademark will increase with sales of the Prosorba column for RA.  The Company
intends to enforce its trademarks and brand names.

Cyplex(TM) (Infusible Platelet Membranes), A Platelet Alternative
-----------------------------------------------------------------

     The Company presently owns seven issued U.S. patents and three pending U.S.
patent applications relating to the area of platelet therapeutics.  Certain
international patent applications corresponding to the issued U.S. patents have
been filed. To date, four foreign patents have been issued while others are
still pending in countries or jurisdictions outside the U.S.  These patents and
those that might be issued on the pending patent applications are scheduled to
expire during 2010 to 2015.

                                       6.
<PAGE>
 
General
-------

     There can be no assurance that the Company's patents will afford
commercially significant protection of its proprietary technology or have
commercial application.  There has been no judicial determination of the
validity or scope of its proprietary rights.  Moreover, the patent laws in
foreign countries may differ from those of the United States, and the degree of
protection afforded by foreign patents may be different.

     Others have filed applications for, or have been issued, patents and may
obtain additional patents and other proprietary rights relating to products or
processes competitive with those of the Company.  The scope and validity of such
patents is presently unknown.  If existing or future patents are upheld as valid
by courts, the Company may be required to obtain licenses to use technology
covered by such patents.

     The Company has nonexclusive licenses to certain third-party patents
relating to the Prosorba column for which the Company pays royalties based upon
the Prosorba column sales.  These licenses have been sublicensed to the
Fresenius parties.

GOVERNMENT REGULATION

     The Company's research and development activities and the future
manufacturing and marketing of products by the Company are subject to regulation
for safety and efficacy by numerous governmental authorities in the United
States and other countries.  In the United States, both biologics and medical
devices are subject to rigorous FDA regulation.  The Federal Food, Drug and
Cosmetic Act and the Public Health Service Act govern the testing, manufacture,
safety, efficacy, labeling, storage, record keeping, approval, advertising and
promotion of the Company's products.  In addition to the FDA regulations, the
Company is also subject to other federal and state regulations such as the
Occupational Safety and Health Act and the Environmental Protection Act.
Product development and approval within this regulatory framework takes a number
of years and involves the expenditure of substantial resources.  In addition,
there can be no assurance that this regulatory framework will not change or that
additional regulation will not arise at any stage of the Company's product
development which may affect approval or delay of an application or require
additional expenditures by the Company.

     The Company's regulatory strategy is to pursue clinical development and
marketing approval of its products worldwide.  The Company intends to seek input
from the FDA at each stage of the clinical process to facilitate appropriate and
timely clinical development, focusing on issues such as trial design and
clinical endpoints.  Where appropriate, the Company intends to pursue available
opportunities, to the extent available, for accelerated approval of products.  A
corporate partner may be helpful to accelerate international development.

     The time required for completing such testing and obtaining such approvals
is uncertain and approval itself may not be obtained.  In addition, delays or
rejections may be encountered based upon changes in FDA policy during the period
of product development and FDA regulatory review of each submitted New Drug
Application ("NDA") or Product License Application ("PLA"). Similar delays may
also be encountered in foreign countries. There can be no assurance that even
after such time and expenditures, regulatory approval will be obtained for any
products developed by the Company. Moreover, if regulatory approval of a product
is granted, such approval may entail limitations on the indicated uses for which
the product may be marketed. Further, even if such regulatory approval is
obtained, a marketed product, its manufacturer and the facilities in which the
product is manufactured are subject to continual review and periodic
inspections. Late discovery of previously unknown problems with the product,
manufacturer or facility may result in restrictions on such product or
manufacturer, including withdrawal of the product from the market.

     Whether regulated by the FDA as a medical device or biologic, or otherwise
by any state or foreign authorities, the approval process for any of the
Company's products is expensive and time consuming and no assurance can be given
that any regulatory agency will grant its approval.  There is no assurance that
the Company will have sufficient resources to complete the required testing and
regulatory review processes.  Furthermore, the Company is unable to predict the
extent of adverse governmental regulation, which might arise from future United
States, or foreign legislative or administrative action.

                                       7.
<PAGE>
 
The Prosorba Column
-------------------

     The Prosorba column is regulated by the FDA as a Class III medical device.
The regulatory approval of a Class III medical device in the United States
intended for therapeutic use in humans involves many steps including pre-
clinical and clinical testing.  Pre-clinical evaluation of a Class III device
includes testing to demonstrate that in clinical studies with human subjects the
product would not present an unreasonable hazard.  Pre-clinical and clinical
evaluation of the Prosorba column was conducted as part of the approval process
for treatment of patients with ITP.

     For each additional disease that the Company wants to treat with the
Prosorba column, clinical testing must be conducted. Before such clinical
testing can begin, an Investigational Device Exemption ("IDE") application must
be prepared and filed with the FDA. This application consists of (i) information
on the composition of the product, (ii) manufacturing data, (iii) results of all
pre-clinical safety and effectiveness studies, and (iv) a design of the study
and protocol.

     The clinical testing of a device may consist of a preliminary feasibility
study leading to a larger study of safety and effectiveness, or it may consist
of only the larger safety and effectiveness study. Upon completion of the study
and compilation of the data, a PMA application can be filed. The FDA is required
to respond to the PMA submission within 180 days, although the FDA may not and
often does not adhere to this schedule and further review may take additional
time. After the FDA completes its review of the PMA application, the clinical
study data may be reviewed by an advisory panel of medical experts who are not
part of the FDA. The applicant is required to answer questions posed by this
panel. Based upon its review of the data, the advisory panel may make a
recommendation of approval or nonapproval to the FDA. The FDA usually follows
the recommendation of the panel but is not required to. Assuming the advisory
panel recommends approval of the PMA, the FDA may approve the application and
the product may then be commercially distributed. The FDA approval process is
lengthy and expensive and there can be no assurance that FDA approval will be
received for any particular product on a timely basis, if at all. The
manufacture and distribution of medical devices are subject to continuing FDA
regulation. In addition to the requirement that the device be marketed only for
its approved uses, applicable law requires compliance with the FDA's Good
Manufacturing Practices ("GMP") regulations. Failure to comply with the GMP
regulations or with other applicable legal requirements can lead to federal
seizure of violating products, injunctive actions brought by the federal
government, and potential criminal liability on the part of the Company and of
the officers and employees of the Company who are responsible for the activities
that lead to the violations.

     Although the Company has received marketing approval from the FDA for the
treatment of ITP and RA with the Prosorba column, there can be no assurance that
any marketing clearances for other diseases or products will be granted on a
timely basis, or at all, or that it will be economically feasible to
commercialize the Prosorba column for these other diseases.  The FDA may also
require post-marketing testing and surveillance programs to monitor the
effectiveness and safety of the Company's products.  As a condition to the
approval of the PMA for the treatment of moderate to severe RA, the Company has
agreed to perform a post-market approval Phase IV clinical trial to determine
the safety and effectiveness of a combination treatment of RA with the Prosorba
column and methotrexate, a DMARD.

     In addition to the mandatory Phase IV clinical trial, the Company, subject
to Steering Committee approval, may elect to conduct additional trials on the
use of the Prosorba column following the failure of other RA drugs or treatments
in order to enhance marketability of the Prosorba column.  While the Company
expects that the clinical trial data will enhance marketability of the Prosorba
column, the results of clinical trials are unpredictable and could adversely
affect FDA approval of the Prosorba column, product labeling, potential sales of
the Prosorba column and/or withdrawal of FDA approval and thereby adversely
affect the financial results, financial condition and prospects of the Company.

     Product marketing approvals may be withdrawn for noncompliance with
regulatory standards or the occurrence of unforeseen problems following initial
marketing.

     The Prosorba column is commercially distributed for use in the treatment of
ITP under a PMA that was approved by the FDA in 1987 and for the treatment of
moderate to severe RA under a PMA that was approved by the FDA in March 1999.
Changes to the product and its manufacturing process, and certain types of
labeling changes must be approved by the FDA prior to implementation.  The
Company completed and received approval for a supplement to the PMA in
connection with the treatment of ITP with the FDA for the consolidation of its

                                       8.
<PAGE>
 
manufacturing facilities into one site in April 1997.  There can be no assurance
that any future supplements will be approved by the FDA.

     Fresenius AG will be responsible for obtaining CE approval for the Prosorba
column in Europe and obtaining any other registrations or regulatory approvals
in the territory outside the United States. The Company expects that 
Fresenius AG will obtain the European CE approval within the next one to two
years.

Cyplex(TM) (Infusible Platelet Membranes), A Platelet Alternative
-----------------------------------------------------------------

     Cyplex(TM) is regulated by the FDA as a biologic. The steps required before
a biologic may be marketed in the United States include (i) preclinical
laboratory and animal tests, (ii) the submission to the FDA of an application
for an Investigational New Drug Application ("IND"), which must become effective
before human clinical trials may commence in the United States, (iii) adequate
and well-controlled human clinical trials to establish the safety and efficacy
of the biologic, (iv) the submission of a PLA to the FDA and (v) the FDA
approval of the PLA prior to any commercial sale or shipment of the biologic. In
addition to obtaining FDA approval for each product, each domestic biologic
manufacturing establishment must be registered with, and approved by, the FDA.

     Preclinical tests include laboratory evaluation of product chemistry and
animal studies to assess the safety and efficacy of the product and its
formulation.  The results of the preclinical tests are submitted to the FDA as
part of an IND, and unless the FDA objects, the IND will become effective 30
days following its receipt by the FDA.

     Clinical trials involve the administration of the biologic to healthy
volunteers, or to patients identified as ones with the condition for which the
biologic is being tested, under the supervision of a qualified principal
investigator.  Clinical trials are conducted in accordance with protocols that
detail the objectives of the study, the parameters to be used to monitor safety,
and the efficacy criteria to be evaluated.  Each protocol is submitted to the
FDA as part of the IND.  Each clinical study is conducted under the auspices of
an independent Institutional Review Board ("IRB") at the institution at which
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
institution.

     Clinical trials are typically conducted in three sequential phases, but the
phases may overlap.  In Phase I, the initial introduction of the biologic into
healthy human subjects, the product is tested for safety (adverse effects),
dosage tolerance, metabolism, distribution, excretion and clinical pharmacology.
Phase II involves studies in a limited patient population to (i) determine the
efficacy of the drug for specific targeted indications, (ii) determine dosage
tolerance and optimal dosage and (iii) identify possible adverse side effects
and safety risks.  When a compound is found to be effective and to have an
acceptable safety profile in Phase II evaluations, Phase III trials are
undertaken to further evaluate clinical efficacy and to test further for safety
within an expanded patient population at multiple clinical study sites.  The FDA
reviews both the clinical plans and the results of the trials and may
discontinue the trials at any time if there are significant safety issues.

     The results of the preclinical tests and clinical trials are submitted to
the FDA in the form of a NDA or PLA for marketing approval.  The testing and
approval process is likely to require substantial time and effort and there can
be no assurance that any approval will be granted on a timely basis, if at all.
The approval process is affected by a number of factors, including the severity
of the disease, the availability of alternative treatments and the risks and
benefits demonstrated in clinical trials.  Additional animal studies or clinical
trials may be requested during the FDA review period and may delay marketing
approval.  After FDA approval for the initial indications, further clinical
trials may be necessary to gain approval for the use of the product for
additional indications.  The FDA mandates that adverse effects be reported to
the FDA and may also require post-marketing testing to monitor for adverse
effects, which can involve significant expense.

     Among the conditions for NDA or PLA approval is the requirement that the
prospective manufacturer's quality control and manufacturing facilities are
subject to biennial FDA inspections and foreign manufacturing facilities are
subject to periodic FDA inspections or inspections by the foreign regulatory
authorities with reciprocal inspection agreements with the FDA.

                                       9.
<PAGE>
 
     The Prescription Drug Act of 1992 requires companies engaged in
pharmaceutical development, such as the Company, to pay user fees in the amount
of at least $100,000 upon submission of a PLA.  The Company does not believe
that this requirement will have a material adverse effect on the Company's
business.

     For marketing outside the United States, the Company also is subject to
foreign regulatory requirements governing human clinical trials and marketing
approval for drugs.  The requirements governing the conduct of clinical trials,
product licensing, pricing and reimbursement vary widely from country to
country.

COMPETITION

The Prosorba Column
-------------------

     The Prosorba column, as well as other products which may be developed by
the Company in the future, are intended to compete with conventional methods of
treatment which generally consist of surgery, drug, or radiation therapy and
which have been accepted by the medical community as classical treatment
methods.  In addition, the Company intends to compete with methods of treatment
focusing on the artificial stimulation and/or modification of the human immune
system by material or synthetic drugs or genetically engineered compounds, which
are being pursued by numerous biotechnology medical companies and research
institutions, including a recombinant protein based drug that is believed to
block tumor necrosis factor and relieve inflammation associated with RA that was
recently approved by the FDA.  Many of the Company's current and potential
competitors have significantly greater resources than the Company.  The Prosorba
column, represents a different approach to the treatment of immune-related
diseases inasmuch as they focus on the removal of CIC's that are suppressive to
the body's immune system.  The Company is aware of a select number of other
companies which are known to be pursuing approaches to disease treatment similar
to the Company's methodology.  In addition, it is always possible that
established companies and research institutions with greater resources may
develop other treatment methods for both ITP and RA.

     The Company believes that its success will depend primarily on, among other
things, the market acceptance of its therapeutic approach, its scientific
expertise, the Prosorba column's performance measured against competing
products, adequate funding, the outcome of Phase IV clinical trials, and on its
ability to develop, protect, and market products in the future.  The Company's
competitive success will also depend on its continued ability to attract and
retain skilled and experienced personnel, to develop and secure the rights to
advanced proprietary technology and to commercially exploit its technology prior
to the development of competitive products by others.

Cyplex(TM) (Infusible Platelet Membranes), A Platelet Alternative
-----------------------------------------------------------------

     When and if the Company receives FDA approval for Cyplex(TM), it will
initially be launched for the control of bleeding in patients who are non-
responsive to platelet transfusions. There are currently no competing therapies
for such platelet-refractory patients. With respect to the remaining platelet
market, Cyplex(TM)'s advantages over traditional platelet therapy support its
usage. Cyplex(TM) also has several advantages over its closest competition, CMV-
free leukodepleted single-donor platelets. Products in development to filter or
virally deactivate platelets will only address one of the five advantages of
Cyplex(TM). The most important clinical advantage of Cyplex(TM) is its
nonimmunogeinicity, which, the Company believes, no other competitive product in
development currently addresses. There can be no assurance, however, that other
parties will not develop competing therapies.

MANUFACTURING AND SUPPLY

     The Company believes that raw materials and other components are available
in sufficient quantities to meet production requirements for the Prosorba
column. The Company's principal manufacturing operations for its Prosorba column
are based in Redmond, Washington at the Redmond Facility. The Company recently
added an additional 21,000 square feet to its Redmond Facility in anticipation
of scaling up its production of the Prosorba column to meet the expected
increase in Prosorba column sales. The Company expects to make substantial
capital investments in connection with the scale-up, including the replacement
of existing equipment and other process improvements. The Company has granted to
FHI a two-year option to purchase the leasehold title and other manufacturing
assets of the Redmond Facility. If FHI exercises its option, the Company will no
longer have a facility to manufacture the Prosorba column. However, the
Fresenius Parties have agreed to supply the Company

                                      10.
<PAGE>
 
with the Prosorba column for its clinical trial needs and for sales outside the
territory for as long as the Company requires and will do so on favorable terms
to the Company.

     The Company has retained all rights to Cyplex(TM) and its Cyplex(TM)-
related manufacturing and research and development equipment. If FHI acquires
the Redmond Facility, the Company will not have a facility in which to produce
Cyplex(TM). The Company believes it currently has adequate supplies of
Cyplex(TM) to conduct ongoing clinical trials and does not anticipate having to
replace the Cyplex(TM) manufacturing capability during the next 12 months.
However, the Company may have to rely on contract manufacturing or purchase or
build a new manufacturing facility in the future to meet its Cyplex(TM) supply
needs.

     Upon termination of the Fresenius partnership for any reason other than the
Company's breach, the Fresenius Parties have a continuing obligation to supply
the Prosorba column to the Company, subject to a termination right that requires
36 prior months prior notice and the payment of substantial amounts to enable
the Company to resume manufacturing the Prosorba column.

     The Company has single sources of supply for certain components but
believes it could obtain alternate sources of supplies if its current suppliers
were unable to provide the Company with adequate quantities of such components.
There can be no assurance that the Company will resume the production of
Cyplex(TM) on a timely basis, or that it will have an adequate supply of
Cyplex(TM) to complete its Phase II clinical trial. Further, there is no
assurance that if FHI acquires the Redmond Facility, the Company would be able
to resume manufacturing the Prosorba column in a timely manner.

EMPLOYEES

     As of March 1, 1999, the Company employed approximately 56 full-time
employees, including 21 employed in sales and marketing, 20 employed in
manufacturing, 6 employed in research and development, and 9 employed as
administrative and support staff.  None of the Company's employees is covered by
collective bargaining agreements, and management considers relations with its
employees to be good.

                                      11.
<PAGE>
 
                                  RISK FACTORS

Commercial Launch of the Prosorba Column for the Rheumatoid Arthritis Indication
--------------------------------------------------------------------------------

     Since we have recently received FDA approval for the use of the Prosorba
column for the treatment of moderate to severe RA, we are planning the
commercial launch of the Prosorba column in the RA market.  We have spent
considerable time and expense in obtaining FDA approval for the RA indication.
Pursuant to our agreement with the Fresenius Parties, we must incur significant
additional expense and assume most of the risk associated with the market launch
and ongoing sales and marketing of the Prosorba column in the United States and
we must share any profits (as defined in our agreement).  The success of our
product launch will depend upon, among other things, acceptance of the product
by leading physicians and medical groups, availability and convenience of
treatment centers, availability of insurance reimbursement, effectiveness of our
and the Fresenius Parties' marketing strategy and competition. We cannot assure
you that the commercial launch of the Prosorba column will be successful and
achieve sales levels that enable us to become a profitable company in the
future.

Insurance Reimbursement
-----------------------

     Successful commercialization of a new medical product, such as the Prosorba
column for the RA indication or Cyplex(TM), platelet alternative, depends on
reimbursement by public and private health insurers to health care providers for
use of such products.  Such reimbursement may not be available due to a variety
of factors, many of which could affect us as we commercialize use of the
Prosorba column for RA and continue the development and commercialization of
Cyplex(TM), platelet alternative. We have generally been successful in assisting
health care providers in arranging reimbursement for the use of the Prosorba
column in the treatment of ITP. We cannot assure you, however, that public and
private insurers will agree to reimbursement of the use of the Prosorba column
for RA indications or the Prosorba treatment on a basis that bundles the column
and treatment costs of dialysis and other apheresis centers. We expect that it
may take several years to gain favorable reimbursement status from managed care
and other private third-party payors. The ability to obtain reimbursement may
also depend on the data from the Phase IV clinical trials or in the treatment of
any other disease indications approved by the FDA. In addition, we do not know
whether health care providers will reimburse us for the use of Cyplex(TM),
platelet alternative.

Our Sales Force
---------------

     We recently hired thirteen new sales representatives for the commercial
launch of the Prosorba column for the treatment of RA. To date, our sales force
has made commercial sales of the Prosorba column only for use in the treatment
of ITP. Our sales force, including our recent new hires for the commercial
launch, have had no experience in marketing the Prosorba column for use in the
treatment of disease indications other than ITP, and there can be no assurance
that, the Company's sales force will be successful in marketing the Prosorba
column for RA or any other such use. The Company's marketing strategy depends in
part on gaining medical association support and the support of leading opinion
leaders in the rheumatology community. There is no assurance that our sales
force will succeed in gaining this acceptance. Any such failure to successfully
market the Prosorba column for RA, or any other disease indications other than
ITP could have a material adverse effect on our business.

     In addition, there can be no assurance that our sales force will be
successful in marketing Cyplex(TM) or any other products we may develop, if and
when we receive FDA approval for and we are able to commercialize for sale any
such products. Any such failure to receive FDA approvals or otherwise
successfully market our products could have a material adverse effect on our
business.

Competitive Environment; Technological Change; Effectiveness of Products
------------------------------------------------------------------------

     The health care field in general and the particular areas in which we
market our products are extremely competitive.  In developing and marketing
medical devices to treat immune-mediated diseases, we compete with other
products, therapeutic techniques and treatments offered by national and
international healthcare and pharmaceutical companies, many of which have
greater marketing, human and financial resources than we do.  In 

                                      12.
<PAGE>
 
addition, we expect to compete with new products and therapeutic techniques and
treatments that are in various stages of clinical development, some of which are
expected to ultimately receive FDA approval.

     The immunological therapy market is characterized by rapid technological
change and potential introductions of new products or therapies.  To respond to
these changes, we may be required to develop or purchase new products to protect
our technology from obsolescence.  We may not be able to develop or obtain such
products.  Even if we develop or obtain new products, such products may not be
commercially viable.  In addition, we cannot assure you that our Prosorba column
will prove effective in the treatment of RA or that Cyplex(TM), platelet
alternative, if approved for sale by the FDA, will be an effective alternative
to traditional platelet therapy.  If the Prosorba column fails to be effective
in the treatment of RA or if Cyplex(TM), platelet alternative, fails to be an
effective alternative to traditional platelet therapy, our entire business will
be materially adversely affected.

Need for Additional Capital
---------------------------

     As part of the Fresenius transaction, we recently received gross proceeds
of $1.0 million from the sale of our common stock, $500,000 from the issuance of
a warrant to purchase 342,466 shares at an exercise price of $7.50 per share,
and approximately $4.1 million under a revolving line of credit. We expect to
receive approximately $5.4 million in net proceeds from the exercise of
approximately 2.7 million in outstanding warrants assuming all holders exercise
their warrants. The outstanding publicly traded warrants priced at $2.00 per
share will be redeemed on April 19, 1999 for all holders who fail to exercise
their warrants on or prior to 5:00 p.m. (New York time) on April 12, 1999. As a
result of these fundraising activities, we believe we have adequate working
capital to fund the commercial launch of the Prosorba column for the RA
indication, and to develop new and complete existing research. However,
depending upon product sales volumes and other factors during the next 12
months, we may need to raise additional capital to complete the Prosorba column
launch and the expenses not being covered through the Fresenius partnership. In
addition, if we decide to continue the development of products other than the
Prosorba column and Cyplex(TM), platelet alternative, we will be required to
raise additional capital. The amount of capital we will require is difficult to
predict, and we cannot assure you that we will be able to raise any additional
capital from any source. If we are unable to obtain additional financing, we may
have to scale back our marketing expenses on the Prosorba column for the RA
indication and delay, scale back or eliminate some or all of our research and
development activities. In addition, we may be required to license to third
parties technologies that we would otherwise seek to develop ourselves, to seek
financing at potentially higher costs to us or to seek additional methods of
financing. These results may have a detrimental effect on our financial
condition and could prevent us from realizing our long-term goals.

History of Operating Losses
---------------------------

     We are operating at a loss and have been operating at a loss since our
formation in October 1981.  As of December 31, 1998, we had an accumulated
deficit of approximately $80.0 million.  Our ability to become profitable
depends upon our ability to launch the Prosorba column in the United States for
the treatment of RA and the ability of the Fresenius Parties to market the
Prosorba column in the United States and outside the United States to apheresis
providers. Under the profit sharing arrangement with Fresenius AG, we expect to
have to invest a substantial amount of additional working capital during the
first two years and do not expect to be profitable unless we succeed in
achieving expected Prosorba sales volumes and rates of sales growth we will not
become profitable.

FDA Approval and Regulations
----------------------------

     As a condition to the FDA's approval of our PMA for the Prosorba column for
the treatment of RA, we are obligated to conduct a Phase IV clinical trail on
the use of the Prosorba column in combination with a DMARD. We are in the
process of finalizing the protocol for the Phase IV trial which we expect will
require a significant number of clinical trail patients and take approximately 2
to 4 years to complete (depending upon the number of patients and enrollment
rates). The Phase IV trials costs are shared with the Freeness Parties through
the profit sharing mechanism but will reduce profits. In addition, outcome of
the Phase IV trials could adversely affect our FDA approval of the Prosorba
column for the RA indication, including changes to our product labeling,
potential sales of the Prosorba column and/or withdrawal of FDA approval.

Uncertainty of Health Care Reform
---------------------------------

     There are widespread efforts to control health care costs in the U.S. and
worldwide.  Various federal and state legislative initiatives regarding health
care reform and similar issues continue to be at the forefront of social and
political discussion. These trends may lead third-party payors to decline or
limit reimbursement for the Company's product, which could negatively impact the
pricing and profitability of, or demand for, our product. We believe that
government and private efforts to contain or reduce health care costs are likely

                                      13.
<PAGE>
 
to continue. There can be no assurance concerning the likelihood that any such
legislative or regulatory initiative will be enacted, or market reform
initiated, or that, if enacted such reform or initiative will not result in a
material adverse impact on the business, financial condition or results of
operations of the Company.

Uncertainty of Patent Protection and Claims to Technology
---------------------------------------------------------

     As a policy, we seek to protect our proprietary technology and inventions
which are used in the Prosorba column and Cyplex(TM), platelet alternative,
through patents, trade secret law and other legal protections. We may, however,
incur significant expense in protecting our intellectual property and defending
or assessing claims with respect to intellectual property owned by others. Any
patent or other infringement litigation by or against us could result in
significant expense to us and diversion of our management resources, which in
turn could have an adverse effect on our financial performance. The process used
in manufacturing the Prosorba column is covered by one of various patents that
we hold; however, we cannot assure you that this patent will afford significant
protection of our proprietary technology. We also could be forced to modify or
abandon the Prosorba column or Cyplex(TM), platelet alternative, based upon our
assessment of intellectual property risks or actual or threatened claims by
others. Since the Prosorba column is our only FDA approved product, our entire
business will be materially adversely affected if we are unable to sell that
product.

     Others have filed applications for, or have been issued, patents and may
obtain additional patents and other proprietary rights competing with our
products or processes.  Although we do not presently know the scope and validity
of these patents, if existing or future patents are upheld as valid by courts,
we may be required to obtain licenses to use technology covered by these
patents.

Product Liability
-----------------

     The use of the Prosorba column and, if approved for use by the FDA, 
Cyplex(TM), platelet alternative, may result in adverse side effects to the end-
users that could expose us to product liability claims. We currently hold
product liability insurance of $15 million, which we believe is adequate in
light of our business. However, we cannot predict all the possible harms or side
effects that may result from treatment of patients with our products and
therefore, we cannot assure you that the amount of coverage we currently hold
will be adequate to protect us. We also cannot assure you that we will have
sufficient resources to pay any liability resulting from such a claim beyond our
insurance coverage.

Hazardous Material
------------------

     Our research and development programs involve the controlled use
of biohazardous materials such as viruses, and may include the use of the HIV
virus that causes AIDS. Although we believe that our safety procedures for
handling such materials comply with the standards prescribed by state and
federal regulations, the risk of accidental contamination or injury from these
materials cannot be completely eliminated. In the event of such an accident, we
could be held liable for any damages that result, and any such liability could
exceed our resources.

Limitation of Net Operating Loss Carryforwards
----------------------------------------------

     Our sales of common stock in September 1991 and October 1997 caused the
limitation of Section 382 of the Internal Revenue Code of 1986, as amended, to
be applicable. This limitation will allow us to use only a portion of the net
operating loss carryforwards to offset future taxable income, if any, for
federal income tax purposes. Based upon the limitations of Section 382, we may
be allowed to use no more than a prescribed amount of such losses each year to
reduce taxable income, if any. To the extent not utilized by us, unused losses
will carry forward subject to the limitations to offset future taxable income,
if any, until such unused losses expire. All unused net operating losses will
expire 15 years after any year in which they were generated. The years in which
such expiration will take place range from 1999 to 2012.

                                      14.
<PAGE>
 
Item 2.  PROPERTIES

     The Company currently occupies approximately 8,000 square feet of leased
office space in San Diego, California. The San Diego facility houses the
Company's executive and administrative offices.

     The Company recently entered into a sublease in February 1999 for 21,000
square feet for a manufacturing facility in Redmond under a lease expiring in
May 2005. The Company entered into such lease in order to expand its
manufacturing operations.

     The Company leases an additional 6,916 square feet for its manufacturing
facility in Redmond under a lease expiring in 2004.  The facility has
historically been used to produce commercial quantities of both protein A and
the chemically coated silica matrix used in the manufacture of the Prosorba
column.  The Redmond Facility received FDA GMP approval in April 1997 and
recently passed a subsequent GMP inspection in March 1998.

     The Fresenius Parties were granted a two-year option to purchase the
leasehold title to both of the Company's manufacturing facilities in Redmond,
Washington and all related assets. See  "Business-Company Overview and Recent 
Developments."

     The Company believes that its property and equipment are generally well
maintained and in good operating condition. The Company believes that the
manufacturing facility, with its new expanded space, is adequate in size to meet
the commercial production needs for the Prosorba column. The Company expects
that it or the Fresenius Parties, if the Fresenius Parties exercises its
purchase option, will incur significant capital expenditures in connection with
scaling up the facility for higher production volumes. The Company believes,
based upon discussions with the Fresenius Parties, that the Fresenius Parties
will elect to purchase the facility during the next 12 months. The Company's
existing facilities are in compliance with appropriate regulatory standards.

ITEM 3.  LEGAL PROCEEDINGS

     The Company is not a party to any material legal proceedings.

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

     The information called for by this Item 4 was published in the Company's
Quarterly Report on Form 10-Q for the period ended June 30, 1998 and is
incorporated herein by reference.

                                      15.
<PAGE>
 
                                    PART II

Item 5.  MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER
         MATTERS

     The Company's common stock is traded on the over-the-counter market on the
NASDAQ SmallCap Market under the symbol "CYPB". Prior to May 21, 1996 the
Company's common stock was traded on the NASDAQ SmallCap Market under the symbol
"IMRE". Set forth below are the high and low sales prices for the Company's
common stock for the first quarter of 1999 (through March 1, 1999) and each
quarter of 1998 and 1997 as reported by the NASDAQ Stock Market, Inc.

                                                Price Range of Common Stock
                                              --------------------------------
                                              High                         LOW
                                              ----                         ---
YEAR ENDED DECEMBER 31, 1999:
 First Quarter (through March 1, 1999)....    $3.97                        $2.31

YEAR ENDED DECEMBER 31, 1998:
 First Quarter............................    $3.81                        $1.28
 Second Quarter...........................     3.69                         2.56
 Third Quarter............................     3.00                         1.44
 Fourth Quarter...........................     3.25                         2.19
 
YEAR ENDED DECEMBER 31, 1997
 First Quarter............................    $2.06                        $1.50
 Second Quarter...........................     2.56                         1.18
 Third Quarter............................     2.63                         1.50
 Fourth Quarter...........................     1.97                         1.15

     The above quotations are interdealer prices, without retail mark-up, mark-
down or commission and may not necessarily represent actual transactions.  As of
March 1, 1999, there were approximately 943 holders of record of the Common
Stock of the Company.  The Company has never paid cash dividends on its common
stock and does not anticipate any being paid in the foreseeable future.

Recent Sales of Unregistered Securities
---------------------------------------

     In September 1998, the Company completed a private placement of 3,063,561
shares of the Company's Series A convertible preferred stock (the "Preferred
Shares") at a price of $1.50 per share for an aggregate offering price of
approximately $4.6 million. Net proceeds (after deducting placement fees of
approximately $113,000, and other related expenses of approximately $152,000) to
the Company were approximately $4.3 million. Each of the purchasers of the
Preferred Shares was an "accredited investor" within the meaning of rule 501(a)
promulgated under the Securities Act. The Company relied on the exemption
provided by Section 4(2) under the Act.

                                      16.
<PAGE>
 
ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA

     The following table presents selected consolidated financial data of the
Company.  The information set forth below is not necessarily indicative of the
results of future operations and should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" in Item 7 of this report and the consolidated financial statements
and the related notes thereto included elsewhere herein.

<TABLE>
<CAPTION>
                                                                            YEARS ENDED DECEMBER 31,
                                            ---------------------------------------------------------------------------------------
                                                1998              1997               1996               1995              1994
                                            ------------      ------------        ------------       -----------       ------------
<S>                                         <C>                <C>                <C>                <C>               <C>
CONSOLIDATED STATEMENT OF OPERATIONS
 DATA:
Results of Operations:
   Product sales                            $  2,374,970       $ 2,970,342        $  1,967,976       $ 1,104,224        $ 4,918,126
   Grant income                                  308,470           325,316                   -                 -                  -
   Revenue under distribution
     agreement                                         -                 -                   -         3,000,000                  -
                                            ------------       -----------        ------------       -----------        -----------
                                               2,683,440         3,295,658           1,967,976         4,104,224          4,918,126
Costs and expenses:
   Production costs                            2,113,781         1,772,681           1,482,563         2,041,422          2,571,168
   Sales and marketing                         2,378,443         1,292,942             794,356           819,907          3,550,037
   Research and development                    4,290,727         6,707,557           4,002,968         3,219,324          2,107,694
   General and administrative                  3,345,241         2,803,079           4,649,298         2,626,817          2,694,489
   Acquired in-process research
     and development (1)                               -                 -           5,146,943           625,000                  -
   Restructuring expense                               -                 -             493,712           644,656                  -
   Debt conversion expense                             -                 -             276,688         1,124,386                  -
                                            ------------       -----------        ------------       -----------        -----------
                                              12,128,192        12,576,259          16,846,528        11,101,512         10,923,388
Other income (expense):
   Interest income                               341,755           425,935             458,070           118,994             71,986
   Interest expense                              (41,953)          (31,737)         (1,119,726)         (261,958)          (218,036)
                                            ------------       -----------        ------------       -----------        -----------
                                                 299,802           394,198            (661,656)         (142,964)          (146,050)
                                            ------------       -----------        ------------       -----------        -----------
Net loss before imputed dividend on
    preferred stock                           (9,144,950)       (8,886,403)        (15,540,208)       (7,140,252)        (6,151,312)
 
Undeclared, imputed dividend on
    preferred stock                           (2,078,431)                -                   -                 -                  -
                                            ------------       -----------        ------------       -----------        -----------
Net loss applicable to common
    stockholders                            $(11,223,381)      $(8,886,403)       $(15,540,208)      $(7,140,252)       $(6,151,312)
                                            ============       ===========        ============       ===========        ===========
Net loss per share applicable to common
    stockholders - basic and diluted        $      (0.29)      $     (0.25)       $      (0.53)      $     (0.41)       $     (0.40)
                                            ============       ===========        ============       ===========        ===========
Weighted average number of
   shares outstanding - basic and diluted     39,234,741        35,236,579          29,206,470        17,598,735         15,243,860
                                            ============       ===========        ============       ===========        ===========
</TABLE> 
<TABLE> 
<CAPTION> 
                                                                                 DECEMBER 31,
                                            ---------------------------------------------------------------------------------------
                                                1998              1997                1996              1995               1994
                                            ------------       -----------        ------------       -----------        -----------
<S>                                         <C>                <C>                <C>                <C>                <C> 
Consolidated Balance Sheet Data:
Cash, cash equivalents and short-
   term investments                         $  5,619,568       $ 8,515,653        $ 10,935,668       $ 1,009,878        $ 3,670,616
Total assets                                $  9,316,035       $11,788,766        $ 14,961,076       $ 4,563,709        $ 7,721,013
Long term debt (net of current portion)     $    566,300       $   407,735        $    412,020       $ 1,539,722        $ 4,247,759
Total stockholders' equity (deficit)        $  6,844,571       $ 9,525,992        $ 12,134,565       $  (524,762)       $ 1,980,719
Working capital (deficit)                   $  5,567,938       $ 7,916,228        $ 10,161,170       $  (688,771)       $ 4,360,749
</TABLE>

(1)  Reflects the acquisition of in-process research and development associated
     with the acquisition by the Company of PRP, Inc. in 1996 and the
     acquisition of the minority interest in one of the Company's subsidiaries
     in 1995.

                                      17.
<PAGE>
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS

RESULTS OF OPERATIONS

Revenues
--------

     Revenues associated with product shipments were $2.4 million, $3.0 million
and $2.0 million in 1998, 1997 and 1996, respectively. The decrease in sales in
1998 from 1997 is a result of the Company's sales force focusing its efforts on
pre-market launch activities in anticipation of FDA approval for the Prosorba
column to be used for the treatment of RA in addition to ITP, the current FDA
approval indication. The significant increase in sales in 1997 from 1996 is a
result of the Company regaining the distribution rights to the Prosorba column
in May 1996 and initiating direct sales and marketing efforts as mentioned
below.

     On May 1, 1996, the Company terminated an exclusive distribution agreement
with Baxter Healthcare Corporation, whereby the Company regained the right to
sell its Prosorba column directly to customers who had previously purchased the
Prosorba column through Baxter as well as to any other potential customers who
wish to purchase the Prosorba column.  Although the Company's direct sales and
marketing efforts have proven more effective than those under the Baxter
distribution agreement, ITP remains a small market.  The Company has entered 
into agreement with the Fresenius Parties for the co-marketing of the Prosorba 
column. See "Business--Company Overview and Recent Developments."

     In 1996, the Company initiated a Phase IV marketing study for use of the
Prosorba column in the treatment of ITP in an effort to generate more rigorous
clinical data than has been available to date.  The Company believes that such
data is a prerequisite for increasing the usage of the Prosorba column in the
treatment of ITP.  However, due to increased competition for patients from other
ITP studies, below expected enrollment in the Company's study and the increased
opportunities in the RA market, the Company terminated its ITP trial during the
fourth quarter of 1997.  The Company plans to launch the new RA indication on
April 5, 1999, which is expected to have an impact on sales volume in 1999.

     In connection with the Company's acquisition of PRP in November 1996, the
Company acquired an NIH Small Business Innovation Research (SBIR) Phase II
grant. For the year ended December 31, 1998, the Company recorded approximately
$308,000 in grant income. Revenues from the grant are recognized as grant
expenditures are incurred. Expenses related to the grant are classified as
research and development expenses. The Company does not expect grant revenue to
become a significant contribution to its operations. The NIH grant expired on
December 31, 1998 and all available funds were exhausted.

                                      18.
<PAGE>
 
Operating Expenses
------------------

     Consolidated operating expenses for the years ended December 31, 1998,
1997, and 1996 were approximately $12.1 million, $12.6 million and $16.8
million, respectively.  The decrease of approximately $500,000 in 1998 from 1997
reflects significant savings in research and development expenses offset by
increased sales and marketing and general and administrative expenses.  The
decrease of $4.2 million in 1997 from 1996 reflects certain non-recurring, and
primarily non-cash, charges in 1996 related to the acquisition of PRP and the
Company's restructuring and recapitalization totaling $5.9 million, which were
partially offset by a significant expansion in the Company's research and
development activities.

     Production costs were approximately $2.1 million, $1.8 million and $1.5
million for the years ended December 31, 1998, 1997 and 1996, respectively.  The
increase of approximately $300,000 in 1998 from 1997 was due to increased
production of the Prosorba column in anticipation of FDA approval in 1999.
During the first half of 1996, production was impacted by both the termination
of the Baxter agreement and the consolidation of facilities undertaken in
connection with the restructuring.  There were very few Prosorba columns shipped
during the first four months of 1996 as the Company did not resume direct
shipments to domestic customers until May 1996.  In anticipation of a temporary
cessation of manufacturing during the remodeling and subsequent FDA re-approval
process of the Redmond, Washington facility, the Company increased production
during the second and third quarters to build its inventories.  As a result,
production costs for the year reflect this unusual activity. However, the
increase in production costs in 1997 from 1996 also reflected an increase in
columns manufactured to accommodate increases in sales and columns used in the
RA trial.  The Company expects that its production costs will increase in 1999
as it expands production of the Prosorba columns for RA sales but expects its
per unit costs to decline with increasing volumes. Under the Fresenius
partnership, the Company is responsible for incurring any other losses relating
to production during 1999 even if Fresenius exercises its option and purchases
the Redmond Facility.

     Sales and marketing costs were approximately $2.4 million, $1.3 million and
$794,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
The increase of approximately $1.1 million in 1998 from 1997 is a result of the
Company hiring three management level marketing personal, recruiting efforts to
hire additional sales personnel and pre-market launch efforts.  The Company
recently hired 13 new sales representatives and expects to incur substantially
higher sales marketing expenses in 1999 due to the commercial launch of the
Prosorba column for RA.

     Research and development expenses were approximately $4.3 million, $6.7
million and $4.0 million in 1998, 1997 and 1996, respectively.  The decrease of
approximately $2.4 million in 1998 from 1997 was due to the cessation of the
Phase III pivotal trial.  In addition, the Company closed its Boston facility in
June 1998 which helped to reduce costs further.  Research and development
expenses typically increase with each phase of a product's development as such
product advances to FDA approval.  The Company records research and development
costs as incurred, including the costs associated with its clinical trials.  The
Company enrolls patients in various clinical trial sites and records the related
cost as the work is performed by the respective research entities.  The Company
accrues costs related to clinical trials until such costs are actually paid by
the Company.  The significant increase in research and development expenses of
$2.7 million in 1997 from 1996 is attributable to the Company's efforts to
establish a stronger scientific base for its products by continuing to expend
funds on clinical trials and increasing efforts in studying the mechanism of
action of the Prosorba column.  Approximately $1.7 million of the increase in
research and development expenses from 1996 to 1997 was directly related to
amounts expended on the further development of Cyplex(TM) in connection with the
Company's acquisition of PRP in November 1996.  The remaining increase of
approximately $1.0 million in research and development expenses from 1996 to
1997 was primarily due to increased spending on the Company's controlled
clinical trial for use of the Prosorba column in the treatment of RA.  The
company expects to incur significant ongoing research and development expenses
in connection with the mandatory Phase IV trial for treatment of RA
using the Prosorba column in combination with methotrexate, a DMARD.

     General and administrative expenses were approximately $3.3 million, $2.8
million, and $4.6 million for the years ended December 31, 1998, 1997 and 1996,
respectively.  The increase of approximately $500,000 in 1998 from 1997 is the
result of business development efforts such as hiring a Director of Business
Development and increased travel for management.  The decrease of approximately
$1.8 million in 1997 from 1996 was a result of the

                                      19.
<PAGE>
 
Company's efforts to control costs and nonrecurring expenses in 1996 associated
with the hiring of the Company's Chief Executive Officer and its former
President and Chief Operating Officer, both of whom joined the Company in
December 1995, and severance payments paid to the Company's former Chief
Scientific Officer in connection with his resignation in March 1996. The
decrease was partially offset by non-recurring bonuses paid in the third quarter
of 1997 to the Company's Chief Executive Officer and President and Chief
Operating Officer in connection with the Company's achieving certain milestones.

     The Company recorded a non-cash expense of approximately $277,000 for debt
conversion expense in the year ended December 31, 1996.  Such expense represents
the fair market value of the increased number of shares issued by the Company
under the terms of an exchange offering to holders of the Company's 7%
Convertible Debentures.

     In January 1996, the Company terminated 20 employees from various
departments, nearly half of its work force, as part of its cost restructuring.
In March 1996, the Company entered into a termination agreement with its former
Chief Scientific Officer.  Costs related to these terminations were
approximately $494,000 and were recorded as a restructuring expense in 1996. In
addition, the Company incurred approximately $300,000 in costs associated with
moving the administration, research and medical departments to San Diego, with
most costs being attributable to relocation costs of the few members of
management moving to San Diego.  Such costs were recorded as general and
administrative expenses in 1996.

Acquisition of PRP
------------------

     On November 1, 1996, the Company acquired PRP.  As a result of the
acquisition, the Company assumed all of the assets and liabilities of PRP.  The
transaction has been accounted for as a purchase and the Company recorded a non-
recurring expense of approximately $5.1 million as acquired in-process research
and development in the fourth quarter of 1996.

     In connection with the acquisition, the Company issued to certain holders
of outstanding debt of PRP, in full satisfaction and settlement of such
indebtedness, Units (with each Unit being comprised of two shares of the
Company's common stock and one common stock purchase warrant) with an
approximate total value of $4.5 million (based upon a price of $4.00 per Unit).

     The holders of PRP equity securities (including holders of options and
warrants of PRP) (the "Equity Holders") will also be entitled to receive earn-
out payments, if any, on a pro rata basis, on net sales of products developed
using PRP's technology acquired by the Company in the acquisition.  The earn-out
payments if earned will be treated as compensation expense because most of such
earn-out payments will be made to former stockholders of PRP. The Company's
obligation to make earn-out payments commence on the date of the first
commercial sale of Cyplex(TM) for the treatment of thrombocytopenia to any third
party. In addition, in conjunction with obtaining approval from the FDA of the
use of Cyplex(TM) for the treatment of thrombocytopenia, the Company shall make
a payment of $5 million to the Equity Holders, with such payment being in the
form of, at the Company's discretion, cash, Company common stock, or a
combination of the two. The milestone payments, if earned, will either be
expensed as acquired research and development or capitalized as purchased
technology, depending upon the evaluation of the technology to be made by the
Company at such future date.

     In consideration of certain investment banking advisory services provided
by EGS Securities Corp. ("EGS') to PRP in connection with the acquisition of
PRP, the Company issued to EGS Units with a total value of approximately
$120,000.  In addition, the Company is obligated to pay EGS an amount in cash
equal to two and one-half percent (2 1/2%) of a certain milestone payment and
each earn-out payment made to the Equity Holders, at the time any such payments
are made.

                                      20.
<PAGE>
 
Interest Expense
----------------

     Interest expense was approximately $42,000, $32,000, and $1.1 million for 
the years ended December 31, 1998, 1997 and 1996, respectively. The increase of
approximately $10,000 in 1998 from 1997 is due to the Company's line of credit
established in March 1998. The decrease in 1997 from 1996 is due to
approximately $1.1 million of interest expense in 1996 related to Senior
Convertible Debentures which were issued with a discounted conversion feature.

Net Loss
--------

     Net loss applicable to common stockholders was approximately $11.2 million,
$8.9 million and $15.5 million for the years ended December 31, 1998, 1997 and
1996, respectively. The increase of approximately $2.3 million in 1998 from 1997
is the result of a one time, non-recurring and undeclared imputed dividend
charge which amounted to approximately $2.1 million.

LIQUIDITY AND CAPITAL RESOURCES

     The Company's principal sources of liquidity are its cash, cash equivalents
and short-term investments. The Company's cash, cash equivalents and short-term
investments totaled $5.6 million and $8.5 million at December 31, 1998 and 1997,
respectively. The decrease in cash, cash equivalents and short-term investments
of approximately $2.9 million was primarily due to cash used in operations of
approximately $8.5 million for the year ended December 31, 1998, which was
partially offset by net proceeds of approximately $4.3 million received by the
Company in the private placement of Series A convertible preferred stock
completed in September 1998 and by net proceeds received from exercises of stock
options and warrants of approximately $1.5 million during 1998. Working capital
at December 31, 1998 was approximately $5.6 million.

     Although the Company is not obligated under any third party agreements,
capital expenditures during 1999 are expected to be approximately $2.0 million
and will be used to support continued product commercialization and research and
development activities.

     In September 1998, the Company completed a private placement of 3,063,561
shares of the Company's Series A convertible preferred stock (the "Preferred
Shares") at a price of $1.50 per share. Net proceeds to the Company were
approximately $4.3 million. As part of the Fresenius transaction in March 1999,
the Company recently received gross proceeds of $1.0 million from the sale of
297,530 shares of our common stock, $500,000 for the issuance of a warrant to
purchase 342,466 shares at an exercise price of $7.50 per share, and a revolving
line of credit, of which the Company received approximately $4.1 million. The
Company expects to receive approximately $5.4 million in net proceeds from the
exercise of approximately 2.7 million outstanding publicly traded warrants
priced at $2.00 per share that will be redeemed on April 19, 1999 if not
exercised on or prior to 5:00 p.m. (New York time) on April 12, 1999.

                                      21.
<PAGE>
 
     The Company believes its cash balance on December 31, 1998, together with
the proceeds received from the Fresenius transactions, are sufficient to fund
operations for at least the next twelve months. The Company is seeking
opportunities to raise additional capital to fund the development of new
research, additional clinical trials for the Prosorba column for other
indications, and the further development and marketing of Cyplex(TM). To the
extent the Company decides to develop products other than the Prosorba column
and Cyplex(TM), it will be required to raise additional capital. The amount of
capital required by the Company is dependent upon many factors, including the
following: the Company's ability to successfully market the Prosorba column in
the RA market, results of clinical trials, results of current research and
development efforts, the FDA regulatory process, costs of commercialization of
products and potential competitive and technological advances and levels of
product sales. Because the Company is unable to predict the outcome of the
foregoing factors, some of which are beyond the Company's control, the Company
is unable to estimate with certainty its mid-to long-term capital needs.
Although the Company may seek to raise additional capital through a combination
of additional equity sources, there can be no assurance the Company will be able
to raise additional capital through such sources or the funds raised thereby
will allow the Company to maintain its current and planned operations. If the
Company is unable to obtain additional capital, it may be required to delay,
scale back or eliminate some or all of its research and development and
marketing activities, to license to third parties technologies that the Company
would otherwise seek to develop itself, to seek financing through the debt
market at potentially higher costs to the Company and/or to seek additional
methods of financing.

Impact of Year 2000
-------------------

     The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define the applicable year.  Any of the Company's
computer programs or hardware that have date-sensitive software or embedded
chips may recognize a date using "00" as the year 1900 rather than the Year
2000.  This could result in a system failure or a miscalculation causing
disruption of operations, including, among other things, a temporary inability
to process transactions, send invoices, or engage in similar normal business
activities.

     The Company's plan to resolve the Year 2000 Issue involves the following
four phases: assessment, remediation, testing and implementation.  The Company
has completed all phases related to its internal operations in San Diego and is
engaged in the testing and implementation phase in Redmond.  As of December 31,
1998, the total cost of the internal Year 2000 Issue project was less than
$50,000.  The Company expects to complete all phases related to its internal
operations by mid-1999.  The external Year 2000 Issue project, which involves
the Company's significant suppliers, financial institutions and others with whom
the Company does business with, is expected to be completed by mid-1999. Total
costs expected to be incurred, based upon management's estimates, is
approximately $50,000. The Company believes it has mitigated the Year 2000 Issue
so that the Company's operations or business will not be materially adversely
affected. However, there can be no assurance that the systems of other companies
on which the Company's systems rely will be timely converted and will not have
an adverse effect on the Company's systems.

     The Company currently has no contingency plan in place in the event it has
omitted systems which are susceptible to the Year 2000 Issue.  The Company plans
to evaluate the status of internal changes in mid 1999 and determine whether
such a plan is necessary.

     The discussion above contains certain forward-looking statements.  The cost
of the Year 2000 Issue project and the date on which the Company believes it has
completed the Year 2000 internal modifications are based on management's best
estimates, which were derived utilizing numerous assumptions.  However, there is
no guarantee that these predictions and estimates are or will be achieved and
actual results could differ materially from those 

                                      22.
<PAGE>
 
anticipated. Specific factors that might cause such material differences
include, but are not limited to the success of the Company in identifying
systems that are not Year 2000 compliant, the success of the Company's completed
conversion efforts, the success of the Year 2000 conversion efforts of others
and similar uncertainties.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

      The Company invests its excess cash in interest-bearing investment-grade 
securities that it holds for the duration of the term of the respective
instrument. The Company does not utilize derivative financial instruments,
derivative commodity instruments or other market risk sensitive instruments,
positions or transactions in any material fashion. Accordingly, the Company
believes that, while the investment-grade securities it holds are subject to
changes in the financial standing of the issuer of such securities, the Company
is not subject to any material risks arising from changes in interest rates,
foreign currency exchange rates, commodity prices, equity prices or other market
changes that affect market risk sensitive instruments.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

      Refer to the Index on Page F-1 of the Financial Report included herein.

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE

      None.

                                      23.
<PAGE>
 
                                    PART III

Item 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY

     The executive officers and directors of the Company, the positions held by
them and their ages as of March 4, 1999 are as follows:

<TABLE>
<CAPTION>
                NAME                       AGE                                   POSITION
-----------------------------------     ----------   ---------------------------------------------------------------
<S>                                     <C>          <C>
Jay D. Kranzler, M.D., Ph.D. (1)(2)         41       Chief Executive Officer, Chief Financial Officer and Chairman
                                                       of the Board of Directors
Carl F. Bobkoski                            46       President, Chief Operating Officer and Corporate Secretary
R. Michael Gendreau, M.D., Ph.D.            43       Executive Vice President, Research & Development, Chief Medical
                                                       Officer and Chief Scientific Officer
Richard M. Crooks, Jr. (4)(5)               59       Director
Philip J. O'Reilly (3)(4)(5)                60       Director
Jack H. Vaughn (3)(5)                       78       Director
Samuel D. Anderson                          68       Director
David W. Golde, M.D.                        58       Director
</TABLE>
________
(1) Member of the 401(k) Plan Committee
(2) Member of the Non-Executive Officer Stock Option Committee
(3) Member of Audit Committee
(4) Member of Stock Option Committee

     JAY D. KRANZLER, M.D., PH.D., was appointed Chief Executive Officer and
Vice-Chairman of the Company in December 1995.  In April 1996, Dr. Kranzler also
assumed the position of Chief Scientific Officer of the Company, and in November
1997, also assumed the position of Chief Financial Officer.  In April 1998, Dr.
Kranzler was appointed as Chairman of the Board.  From January 1989 until August
1995, Dr. Kranzler served as President, Chief Executive Officer and a director
of Cytel Corporation, a publicly held biotechnology company.  Dr. Kranzler has
been an adjunct member of the Research Institute of Scripps Clinic since January
1989.  Before joining Cytel, Dr. Kranzler was employed by McKinsey & Company, a
management-consulting firm, from 1985 to January 1989 as a consultant
specializing in the pharmaceutical industry.

     CARL F. BOBKOSKI, was appointed President and Chief Operating Officer in
March 1999.  Prior to joining the Company, from May 1995 to February 1999, Mr.
Bobkoski served as Executive Vice President of Signal Pharmaceuticals, Inc., a
biopharmaceutical company.  From 1990 to 1995, Mr. Bobkoski was Executive Vice
President and a director at Gensia, Inc ("Gensia"), a biopharmaceutical company,
where he was responsible for directing all commercialization activities for
proprietary products, overseeing the operations of Gensia Laboratories, Ltd., a
wholly-owned subsidiary of Gensia, and supervising product development, finance,
management information systems and corporate development.

     MICHAEL GENDREAU, M.D., PH.D., was appointed Vice President of Research and
Development and Chief Medical Officer of the Company in December 1996 and was
promoted to Executive Vice President of Research and Development and Chief
Scientific Officer in February 1999.  Dr. Gendreau joined the Company in 1994
and held various positions from 1994 through 1996, including Executive Director
of Scientific Affairs.  From 1991 to 1994, Dr. Gendreau was Vice President of
Research and Development and Chief Medical Officer for MicroProbe Corporation, a
developer and manufacturer of DNA probe-based diagnostic equipment.

     RICHARD M. CROOKS, JR., has been a director of the Company since 1991. He
has been President of RMC Consultants, a financial advisory services firm, since
June 1990. Mr. Crooks is a director of and consultant to Allen & Company
Incorporated, a privately held investment-banking firm, which is the Company's
principal

                                      24.
<PAGE>
 
stockholder. He served as a Managing Director of Allen & Company Incorporated
for more than five years prior to June 1990. Mr. Crooks is also a director of
Excalibur Technologies Corporation.

     PHILIP J. O'REILLY, has been a director of the Company since 1994. He is a
partner in the law firm of O'Reilly, Marsh, Kearney & Corteselli P.C., in Garden
City, New York. He has been in private practice for more than twenty years. Mr.
O'Reilly also serves as a director of Excalibur Technologies Corporation.

     JACK H. VAUGHN, has served as a director of the Company since 1991.
Currently, Mr. Vaughn is Chairman of ECOTRUST, a Portland, Oregon-based
foundation promoting environmentally friendly development in the Pacific
Northwest. From 1988 to 1992, he was the U.S. Government's Senior Environmental
Advisor for Central America. Prior to that, Mr. Vaughn had been the founding
Chairman of Conservation International, a private foundation encouraging
biological diversity. Mr. Vaughn was a director of Allegheny & Western Energy
Corporation from 1981 through 1995 and was a member of its Compensation
Committee.

     SAMUEL D. ANDERSON, was elected by the Board to serve as a director of the
Company in April 1998.  Currently, Mr. Anderson is an independent consultant for
various medical, pharmaceutical and biotechnology companies.  He has held Board
of Director positions at Hycor Biomedical, Inc. since 1986 and Sera Care Inc.
since 1996.  He was named Chairman of the Board of Directors at Hycor in 1998.
From 1990 to 1991, he was the President and Chief Executive Officer of Trancel
Corporation, a biotechnology company.  From 1984 to 1989 Mr. Anderson was the
Chief Executive Officer of Alpha Therapeutics Corporation, a blood plasma
fractionator, and between 1989 and 1990 served as its Chairman of the Board.

     DAVID W. GOLDE, M.D., was elected by the Board to serve as a director of
the Company in April 1998.  Dr. Golde has been the Physician-in-Chief of
Memorial Sloan-Kettering Cancer Center since 1991.  He has been a Professor of
Medicine at Cornell University Medical College since 1991 and at UCLA School of
Medicine since 1979. Dr. Golde is also a director of Eron, Inc.  Dr. Golde is a
consultant to numerous medical and research institutions.

     Each officer serves at the discretion of the Board of Directors.  The
Company's Bylaws permit the Board of Directors to establish by resolution the
authorized number of directors, and the Company currently has six directors
authorized.  Pursuant to the Fresenius agreement, the Company has agreed, if
Fresenius AG so requests, to increase the number of directors authorized from
six to seven and to appoint a Fresenius designee to the new seat. The Company's
Restated Certificate of Incorporation and Bylaws provide that the Board of
Directors shall be divided into three classes, each class consisting, as nearly
as possible, of one-third of the total number of directors, with each class
having a three-year term. Each director holds office until the annual meeting of
stockholders of the Company which coincides with the end of such director's
three-year term and until such director's successors have been elected and duly
qualified. There are no family relationships among any of the directors or
officers of the Company.

BOARD COMMITTEES

     The Board of Directors has an Audit Committee, a Compensation Committee and
a Stock Option Committee.  In addition, the Stock Option Committee has a Non-
Executive Officer Stock Option Committee.

     The Audit Committee meets with the Company's independent auditors at least
annually to review the results of the annual audit and discuss the financial
statements; recommends to the Board the independent auditors to be retained; and
receives and considers the auditors' comments (out of the presence of
management) as to controls, adequacy of staff and management performance and
procedures in connection with audit and financial controls.  The Audit Committee
is composed of three directors: Messrs. Vaughn (Chairman), Crooks and O'Reilly.

     The Compensation Committee makes recommendations based on management's
inputs concerning salaries and incentive compensation, awards stock options to
executives under the Company's stock option plans and otherwise determines
compensation levels and performs such other functions regarding compensation as
the Board may delegate.  The Compensation Committee is composed of three
directors: Messrs. Vaughn, Crooks and O'Reilly.

                                      25.
<PAGE>
 
     The Stock Option Committee considers and recommends to the Board of
Directors the number and terms of stock options to be granted to officers and
employees of the Company.  The Stock Option Committee is composed of two
directors: Messrs. Crooks and O'Reilly.

     The Non-Executive Officer Stock Option Committee was created by the Stock
Option Committee in February 1996.  It has the authority to grant certain
numbers of options to employees who are not executive officers of the Company;
provided, however, that the number of options granted to employee by the Non-
Executive Officer Stock Option Committee is limited to 200,000 each period
between Board meetings.  The Non-Executive Officer Stock Option Committee is
comprised of one director: Dr. Kranzler.

SCIENTIFIC ADVISORY BOARDS

     The Company has established four scientific advisory boards to provide
scientific and clinical support and guidance related to the Company's products.
The areas of focus of the scientific advisory boards are immunology,
rheumatology, hematology, and platelet therapy.

     The Immunology Advisory Board  (the "IAB") is currently composed of Gerald
T. Nepom (appointed July 1996), M.D., Ph.D., Scientific Director of the Virginia
Mason Research Center in Seattle, Washington; Eng Tan (appointed June 1996),
M.D., Director, W.M. Keck Autoimmune Disease Center, The Scripps Clinic and
Research Institute, San Diego, California. The focus of the IAB will be to
provide guidance to the extramural research investigating the Prosorba(R)
column's immunologic mechanism of action.

     The Rheumatology Advisory Board (the "RAB") is composed of David Felson
(appointed June 1996), M.D., M.P.H. Professor of Medicine and Public Health,
Director, Boston University Arthritis Health Services Center; Richard Panush
(appointed June 1996), M.D., Professor and Chairman, Department of Medicine, St.
Barnabas Medical Center, Livingston, New Jersey; George Ehrlich (appointed June
1996), M.D., University of Pennsylvania Medical School, Member, Expert Advisory
Panel on Chronic Degenerative Disease, World Health Organization.  The RAB will
oversee and guide the Company's programs in RA.  The RAB members are all serving
as advisors to the FDA in the Drug Division which reviews New Drug Applications
for rheumatology pharmaceutical product.

     The Hematology Advisory Board (the "HAB") is composed of James B. Bussel
(appointed May 1996), M.D., Associate Professor of Pediatrics, Director of ITP
Program, Division of Pediatrics Hematology/Oncology, Cornell Medical Center;
John Harlan (appointed May 1996), M.D., Professor of Medicine, Division Head,
Hematology, Massachusetts General Hospital; and David J. Kuter (appointed June
1996), M.D., D.Phil., Chairman, Department of Hematology, Massachusetts General
Hospital.  The HAB will oversee and guide the Company's programs in ITP.

     The Platelet Advisory Board (the "PAB") is composed of Richard H. Aster
(appointed November 1996), M.D., former President, Blood Center of Southeast
Wisconsin; Ernest Beutler (appointed June 1997), M.D., Chairman, Department of
Molecular and Experimental Medicine, The Scripps Clinic and Research Foundation,
San Diego, California; Leon W. Hoyer (appointed November 1996), M.D., Director,
Holland Laboratories, Vice President, Research and Development, American Red
Cross; John Lawler (appointed November 1996), Ph.D., Associate Professor,
Department of Pathology, Harvard Medical School, Brigham and Women's Hospital;
Ernest R. Simon (appointed June 1997), M.D., Retired Executive Vice President,
Medical Affairs, Blood Systems, Inc.; Scott N. Swisher (appointed November
1997), M.D., Chairman, FDA Blood Products Advisory Committee; Professor of
Medicine (emeritus), University of Michigan; Paul C. Zamecnik (appointed
November 1996), M.D., Professor of Medicine (emeritus) Harvard Medical School,
Principal Scientist, Hybridon; Sherrill Slichter (appointed October 1997), M.D.,
Puget Sound Blood Center.  The PAB will oversee the Company's programs as they
relate to platelet therapy.

     There are no material consulting or other agreements between the Company
and any member of the Company's various scientific advisory boards.

                                      26.
<PAGE>
 
ITEM 11.  EXECUTIVE COMPENSATION

Compensation of Directors

     Each non-employee director of the Company is entitled to receive between
$12,000 and $24,000 per year for such person's service as a director.  Messrs.
O'Reilly and Vaughn each received $12,000 in cash compensation for service as a
director during fiscal year 1998.  Messrs. Golde and Anderson each received
$18,000 in cash compensation for service as director during fiscal year 1998.
In addition, each non-employee director is entitled to receive an option to
purchase 10,000 shares of common stock of the Company upon such non-employee
director's initial election to the Board and an option to purchase an additional
10,000 shares of common stock of the Company upon each annual meeting of such
non-employee director to the Board, however, Messrs. Anderson and Golde received
an option to purchase 100,000 shares of common stock of the Company upon their
initial election to the Board and are not entitled to receive additional option
grants upon any annual meeting.  Each of Messrs. Crooks, O'Reilly and Vaughn
received an option to purchase 10,000 shares of common stock for service as a
director during fiscal year 1998.  Directors who are employees of the Company do
not receive any fee for their service as directors.  None of the Company's
directors receive any fees for their service on any committee of the Board.  All
of the Company's directors are reimbursed for their out-of-pocket travel and
accommodation expenses incurred in connection with their service as directors of
the Company.

COMPENSATION OF EXECUTIVE OFFICERS

     The following table sets forth all compensation awarded or paid to and
earned by, the Chief Executive Officer of the Company during the fiscal years
ended December 31, 1998, 1997 and 1996 as well as those executive officers whose
salary and bonus were in excess of $100,000 for services rendered to the Company
during the fiscal year ended December 31, 1998 and one former executive officer
who departed from the Company in March 1999 (collectively, the "Named Executive
Officers"):

                           SUMMARY COMPENSATION TABLE
                                        
<TABLE>
<CAPTION>
                                                                          LONG-TERM
                                                ANNUAL COMPENSATION     COMPENSATION (1)
                                               ---------------------    ----------------
                                                                            SHARES           ALL OTHER
                                      FISCAL     BASE                     UNDERLYING        COMPENSATION
Name and Principal Position            YEAR    SALARY($)    BONUS($)       OPTIONS(#)            ($)
---------------------------           ------   ---------    --------    ----------------   --------------
<S>                                   <C>      <C>          <C>         <C>                <C>
Jay D. Kranzler, M.D., Ph.D.,           1998    $277,000    $      -                  -        $ 11,300(2)
 Chief Executive Officer, Chief         1997     245,000     125,000            277,440          10,800(3)
 Financial Officer and Chairman of      1996     240,000     135,000          3,025,327          10,700(4)
 the Board
 
Debby Jo Blank, M.D.(5),                1998     244,000           -                  -          52,000(6)
 President, Chief Operating Officer     1997     215,500     101,500            101,415           9,500(7)
 and Director                           1996     210,000     135,000          1,134,497         164,236(8)
 
R. Michael Gendreau, M.D.               1998     167,400           -            150,000          10,000(9)
 Executive Vice President, Research     1997     149,000         262                  -           4,472(10)
 and Development, Chief Medical         1996     145,000      25,000            125,000          57,805(11)
 Officer; and Chief Scientific
 Officer
</TABLE>
____________________
(1)  The Company's 1996 Equity Incentive Plan (the "1996 Plan"), Incentive Stock
     Option and Appreciation Plan and the 1988 Non-Qualified Stock Option Plan
     (collectively, the "Plans") are intended to further the interests of the
     Company by providing for the grant of stock awards to directors, officers
     and employees of and consultants to the Company.
(2)  Includes $1,300 paid by the Company on behalf of Dr. Kranzler for life
     insurance premiums during 1998, and $10,000 of contributions made by the
     Company under its 401(k) plan.

                                      27.
<PAGE>
 
(3)  Includes $1,300 paid by the Company on behalf of Dr. Kranzler for life
     insurance premiums during 1997, and $9,500 of contributions made by the
     Company under its 401(k) plan.
(4)  Includes $1,200 paid by the Company on behalf of Dr. Kranzler for life
     insurance premium during 1996, and $9,500 of contributions made by the
     Company under its 401(k) plan.
(5)  Dr. Blank resigned from the Company effective March 1999.
(6)  Includes $42,000 paid to Dr. Blank for relocation costs associated with Dr.
     Blank's relocation to San Diego, California upon joining the Company.  Also
     includes $10,000 of contributions made by the Company under its 401(k)
     plan.
(7)  Represents $9,500 in contributions made by the Company under its 401(k)
     plan.
(8)  Includes $154,736 paid to Dr. Blank for relocation costs and related tax
     gross-ups associated with Dr. Blank's relocation to San Diego, California
     upon joining the Company.  Also includes $9,500 of contributions made by
     the Company under its 401(k) plan.
(9)  Represents $10,000 in contributions made by the Company under its 401(k)
     plan.
(10) Represents $4,472 in contributions made by the Company under its 401(k)
     plan.
(11) Includes $52,583 paid to Dr. Gendreau for relocation costs associated with
     Dr. Gendreau's relocation to San Diego, California.  Also includes $5,222
     of contributions made by the Company under its 401(k) plan.

             STOCK OPTION GRANTS AND EXERCISES IN LAST FISCAL YEAR

     The following table sets forth certain information regarding options
granted during the fiscal year ended December 31, 1998 to the Named Executive
Officers:

<TABLE>
<CAPTION>
                                                        INDIVIDUAL GRANTS
                                    -----------------------------------------------------
                                                                                                               POTENTIAL REALIZABLE 
                                                                                                                 VALUE AT ASSUMED
                                                                                                               ANNUAL RATES OF STOCK
                                       SHARES              % OF TOTAL                                            APPRECIATION FOR 
                                     UNDERLYING         OPTIONS GRANTED TO      EXERCISE                         OPTION TERM($)(2)
                                       OPTIONS          EMPLOYEES IN FISCAL     PRICE PER       EXPIRATION     ---------------------
              NAME                   GRANTED (#)          YEAR(%)(1)            SHARE($)          DATE           5%            10%
              ----                   -----------        -------------------     ---------       ----------     ------        -------
<S>                                  <C>                 <C>                    <C>               <C>          <C>           <C> 
R. Michael Gendreau, M.D., Ph.D.      50,000 (3)                 3.9%           $1.43750      12/31/07         45,202        114,500
                                     100,000 (3)                 7.8%           $2.34375        8/9/08         73,699        186,767
</TABLE>
____________________
(1)  Based upon options to purchase a total of 1,311,625 shares of common stock
     of the Company granted during the fiscal year 1998.
(2)  The potential realizable value is based upon the assumption that the fair
     market value of the common stock appreciates at the annual rate shown
     (compounded annually) from the date of grant until the end of the option
     term.  Actual realizable value, if any, on stock option exercises is
     dependent on the future performance of the common stock and overall market
     conditions, as well as the option holder's continued employment through the
     vesting period.
(3)  Such options vest 25% on the one-year anniversary of the date of grant with
     the remainder vesting ratably and daily over the following three-year
     period.

                                      28.
<PAGE>
 
                AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
                       AND FISCAL YEAR-END OPTION VALUES

     The following table sets forth certain information as of December 31, 1998,
regarding options held by the Named Executive Officers.  None of such
individuals exercised any options during the fiscal year ended December 31,
1998.  There were no stock appreciation rights outstanding at December 31, 1998.

<TABLE>
<CAPTION>
                                                                     Number of Shares
                                                                  Underlying Unexercised              Value of Unexercised
                                                                          Options                     In-The-Money Options
                               Shares Acquired     Value               at FY-End (#)                   as of FY-End ($)(2)
         Name                   Upon Exercise    Realized(1)     Exercisable    Unexercisable     Exercisable       Unexercisable
                               --------------------------------------------------------------------------------------------------
 <S>                           <C>               <C>             <C>            <C>               <C>               <C> 
Jay Kranzler, M.D., Ph.D.         199,998        $174,998         2,653,144     449,625           $3,962,341           $657,133
 
Debby Jo Blank, M.D.              199,998        $174,998           868,614     167,300           $1,296,570           $244,625
 
R. Michael Gendreau, M.D.               -               -           224,235     191,765           $  245,070           $193,080
</TABLE>
____________________
(1)  Calculations based upon $2.375, the closing sales price, of common stock as
     reported on the Nasdaq SmallCap Market on August 6, 1998 (the exercise
     date), less exercise price.
(2)  Calculation based upon $3.00, the closing sales price of the underlying
     shares of common stock as reported on the Nasdaq SmallCap Market on
     December 31, 1998, less exercise price.

EMPLOYMENT AND CHANGE OF CONTROL AGREEMENTS

     Jay D. Kranzler, MD., Ph.D., the Company's Chief Executive Officer, Chief
Financial Officer and Chief Scientific Officer had a base salary in 1998 of
$277,000, and was entitled to performance based bonuses of up to an additional
twenty-five percent (25%) of annual base salary and certain options to purchase
common stock of the Company, as described below.

     In addition to his base salary and bonus, under his employment agreement,
Dr. Kranzler was granted an option to purchase 3,025,327 shares of common stock
of the Company (which amount represented eight percent (8%) of the Company's
common stock on a fully diluted basis on the date of grant) at an exercise price
equal to $1.50 per share.  The options vest twenty-five (25%) immediately upon
grant and thereafter ratably and daily over a four (4) year period.  Dr.
Kranzler's options shall fully vest upon the occurrence of any merger,
consolidation, corporate reorganization or transfer of all or substantially all
of the assets of the Company and upon the termination without cause of Dr.
Kranzler's employment with the Company.  In August 1997, Dr. Kranzler was
granted an option to purchase 277,440 shares of the Company's common stock at an
exercise price of $1.625 per share.  As of March 1, 1999, options to purchase
2,998,772 shares of common stock had vested.

     In April 1996, the Company entered into an employment agreement with Dr. R.
Michael Gendreau, the Company's Executive Vice President, Research and
Development, Chief Scientific Officer and Chief Medical Officer, whereby Dr.
Gendreau annual compensation consists of base salary of $167,400. The Company
also granted Dr. Gendreau options to purchase up to 125,000 shares of the
Company's common stock at an exercise price of $2.019 per share. On January 1,
1998, Dr. Gendreau was granted an option to purchase 50,000 shares of common
stock of the Company at an exercise price of $1.4375 per share and On August 10,
1998 he was granted an additional option to purchase 100,000 shares of the
Company's common stock at an exercise price of $2.3438. As of March 1, 1999,
options to purchase a total of 309,846 shares of common stock had vested. In the
event that Dr. Gendreau's employment with the Company is terminated by the

                                      29.
<PAGE>
 
Company without cause due to a corporate merger or acquisition, Dr. Gendreau
will receive severance pay equal to $72,500.

     In February 18, 1999, the Company entered into an employment agreement with
Carl F. Bobkoski, the Company's President, Chief Operating Officer and Corporate
Secretary, whereby Mr. Bobkoski's annual compensation consists of base salary of
$215,000 and he is eligible at the sole discretion of the Board for an annual
bonus equal to 25% of his base salary. The Company also granted Mr. Bobkoski
options to purchase up to 500,000 shares of the Company's common stock at an
exercise price of $2.75 per share. In the event that Mr. Bobkoski's employment
with the Company is terminated by the Company without cause due to a corporate
merger or acquisition, Mr. Bobkoski's options shall become fully exercisable.

REPORT OF COMPENSATION COMMITTEE ON EXECUTIVE COMPENSATION

     The Compensation Committee (the "Committee") is comprised of directors who
are not employees of the Company.  The Committee is responsible for establishing
and administering the Company's executive compensation arrangements.

     The Company believes that a competitive, goal-oriented compensation policy
is critically important to the creation of value for stockholders.  To that end,
the Company has created an incentive compensation program intended to reward
outstanding individual performance.

     Under the Omnibus Budget Reconciliation Act of 1993, beginning in 1994, the
federal income tax deduction for certain types of compensation paid to the Chief
Executive Officer and four other most highly compensated officers of publicly
held companies is limited to $1,000,000 per officer per fiscal year unless such
compensation meets certain requirements. The Committee is aware of this
limitation and believes that the deductibility of compensation payable in 1997
will not be affected by this limitation.

Compensation Philosophy
-----------------------

     The Company's compensation program is intended to implement the following
principles:

          .  Compensation should be related to the value created for
             stockholders.
          .  Compensation programs should support the short-term and long-term
             strategic goals and objectives of the Company.
          .  Compensation programs should reflect and promote the Company's
             values and reward individuals for outstanding contributions to
             the Company's success.
          .  Short-term and long-term compensation programs play a critical role
             in attracting and retaining well-qualified executives.
          .  While compensation opportunities should be based in part upon
             individual contribution, the actual amounts earned by executives
             in variable compensation programs should also be based upon how
             the Company performs.

     The Company's executive compensation for the Chief Executive Officer and
all other executives is based upon three components, each of which is intended
to serve the Company's compensation principles:

Base Salary
-----------

     Base salary is targeted at the competitive median for similar companies in
the biotechnology industry.  For the purpose of establishing these levels, the
Committee compares the Company's compensation structure from time to time with
the companies covered in a compensation survey of the biotechnology industry
entitled, Biotechnology Compensation and Benefits Survey, which is prepared by
Radford Associates and sponsored by the Biotechnology Industry Organization.
Many of the Companies covered in that survey are also included in the published
industry line-of-business index included in the Company's Stock Price
Performance Graph, included elsewhere in this document.

                                      30.
<PAGE>
 
     Based upon its reviews of industry data, the Compensation Committee
determined that the base salaries of the Chief Executive Officer and all other
executive officers were appropriate and necessary to attract individuals of such
high caliber within the biotechnology industry.

     The Committee reviews the salaries of the Chief Executive Officer and other
executive officers each year and such salaries may be increased based upon (i)
the individual's performance and contribution to the Company and (ii) increases
in median competitive pay levels.

Annual Incentives
-----------------

     The Company has a cash bonus program whereby bonus amounts are determined
based upon the achievement of corporate goals and individual performance. Any
bonus is based, in part, upon Company performance and in part on individual
performance.  The Committee believes bonus amounts are similar to those paid by
other companies in the biotechnology industry.

     Based upon the Committee's review of the financial performance of the
Company, no annual incentive bonuses were awarded to any members of senior
management for 1998.

Long-Term Incentives
--------------------

     Long-term incentive compensation is provided through grants of options to
purchase shares of the Company's common stock to the Chief Executive Officer and
other executive officers.  The stock options are intended to retain and motivate
all employees to improve long-term performance of the Company.  It is common in
the biotechnology industry to grant stock options to all employees.  As of the
beginning of 1997, stock options had been granted to all full-time employees of
the Company.  The Committee believes the amount and value of such grants are
based upon levels similar to other companies in the biotechnology industry.

COMPENSATION OF THE CHIEF EXECUTIVE OFFICER

     The Company appointed Jay D. Kranzler, M.D., Ph.D. as its new Chief
Executive Officer on December 28, 1995. Accordingly, his compensation was
determined based upon prevailing compensation packages in the biotechnology
industry, since a compensation package consistent with the biotechnology
industry was believed necessary to attract an individual of Dr. Kranzler's
caliber. His annual compensation consists of base salary of $277,000 and cash
bonuses of up to twenty-five percent (25%) of his annual base salary. In
addition, under his employment agreement, Dr. Kranzler was granted options to
purchase 3,025,327 shares of the Company's Common Stock at an exercise price of
$1.50 per share. During 1998, Dr. Kranzler was not paid any cash bonuses
determined as a percentage of his base salary and his base compensation was not 
increased.

     Generally, stock options are granted with an exercise price equal to
prevailing market value.  The stock options generally vest in increments over a
period of years and an employee must be employed by the Company at the time of
vesting in order to exercise his or her options.

                                           Compensation Committee
                                              Richard M. Crooks, Jr.
                                              Philip J. O'Reilly
                                              Jack H. Vaughn

                                      31.
<PAGE>
 
                         STOCK PRICE PERFORMANCE GRAPH

Comparison of Cumulative Return on Investment

     The following Stock Price Performance Graph compares the Company's
cumulative total stockholder return on the Company's common stock for the
periods indicated with the cumulative total return of the NASDAQ OTC Index and
the NASDAQ Pharmaceuticals Stock Index. The Company has not declared any
dividends since its inception.  The Board and the Committee recognize that the
market price of the Company's common stock is influenced by many factors, only
one of which is Company performance.  The historical stock price performance
shown on the Stock Price Performance Graph is not necessarily indicative of
future stock price performance.

     The above comparison assumes $100 was invested in the Company's common
stock and each index on December 31, 1993.


                             [GRAPH APPEARS HERE]



            Nasdaq OTC      Cypress Bioscience     Nasdaq Pharmaceutical Index  
          (black diamond)     (black square)            (white triangle)
          ---------------   ------------------     ---------------------------
     1993       100.0             100.0                      100.0
     1994        97.8              56.7                       75.3
     1995       138.3              70.8                      138.0 
     1996       170.0              49.1                      138.5
     1997       208.6              35.8                      143.0
     1998       293.2              74.8                      183.0



                                      32.
<PAGE>
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The following table sets forth information as of March 1, 1999 with respect
to (i) each stockholder known to the Company to be the beneficial owner of more
than five percent (5%) of the outstanding common stock or Series A Preferred
Stock of the Company, (ii) each director, (iii) each Named Executive Officer and
(iv) all directors and Named Executive Officers of the Company as a group.
Except as set forth below, each of the named persons and members of the group
has sole voting and investment power with respect to the shares shown.

<TABLE>
<CAPTION>     
                                                                  AMOUNT AND NATURE OF
                                                                 BENEFICIAL OWNERSHIP OF     PERCENT OF CLASS OF
BENEFICIAL OWNER OF COMMON STOCK (1)                               COMMON STOCK  (2)          COMMON STOCK (2)
------------------------------------                             -----------------------     -------------------
<S>                                                              <C>                         <C>
Allen & Company Incorporated.............................            7,328,307  (3)                 17.6%
 711 Fifth Avenue
 New York, New York  10022
Paramount Capital Asset Management, Inc..................            9,450,635  (4)                 22.7%
 787 Seventh Avenue, 44th Floor
 New York, NY 10019
Jay D. Kranzler..........................................            3,477,277  (5)                  7.8%
Debby Jo Blank...........................................            1,465,966  (6)                  3.4%
R. Michael Gendreau......................................              322,414  (7)                  *
Richard M. Crooks, Jr....................................            1,131,897  (8)                  2.7%
Jack H. Vaughn...........................................               66,000  (9)                  *
Philip J. O'Reilly.......................................               66,050 (10)                  *
Samuel D.  Anderson......................................              128,558 (11)                  *
David  Golde.............................................               27,052 (12)                  *
All Directors and Named Executive Officers as a                                                    
 Group (8 persons).......................................            6,685,214                      14.5% 
                                                                    ----------
</TABLE>
________________________
*Less than one percent

(1)  This table is based upon information supplied by officers, directors and
     principal stockholders and Schedule 13Ds filed with the Securities and
     Exchange Commission (the "Commission"). Except as shown otherwise in the
     table, the address of each stockholder listed is in care of the Company at
     4350 Executive Drive, Suite 325, San Diego, California, 92121.
(2)  Except as otherwise indicated in the footnotes of this table and pursuant
     to applicable community property laws, the persons named in the table have
     sole voting and investment power with respect to all shares of Common
     Stock. Beneficial ownership is determined in accordance with the rules of
     the Commission and generally includes voting or investment power with
     respect to securities. Shares of Common Stock subject to options or
     warrants exercisable within 60 days of March 1, 1999 are deemed outstanding
     for computing the percentage of the person or entity holding such options
     or warrants but are not deemed outstanding for computing the percentage of
     any other person. Percentage of beneficial ownership is based upon
     41,552,750 shares of the Company's Common Stock outstanding as of March 1,
     1999.
(3)  This information was derived from information provided to the Company by
     Allen & Company Incorporated. Includes warrants to purchase 478,000 shares
     of Common Stock exercisable within 60 days of March 1, 1999 (125,000 of the
     warrants are held in the name of Susan Allen). Also includes 250,000 shares
     of Common Stock held in the name of Susan Allen.
(4)  Dr. Lindsay A. Rosenwald is the sole shareholder of Paramount Capital Asset
     Management, Inc. ("Paramount Capital"). Paramount Capital is the general
     partner of Aries Domestic Fund, L.P., a limited partnership incorporated in
     Delaware ("Aries Domestic") and the investment manager of The Aries Master
     Fund, a Cayman Islands trust ("The Aries Master Fund").  Includes warrants
     to purchase 37,500 shares of Common Stock held by Aries Domestic and
     warrants to purchase 87,500 shares of Common Stock held by The Aries Master
     Fund, in each case such warrants being exercisable within 60 days of March
     1, 1999.  Of the 9,325,635 shares of Common Stock (excluding warrants)
     indicated as beneficially held, Paramount Capital shares voting and
     dispositive power with the following persons or entities: Dr. Rosenwald
     with respect to 666,667 of the shares; Aries Domestic with respect to
     2,522,667 of the shares; and The Aries Master Fund with respect to
     6,011,301 of the shares.

                                      33.
<PAGE>
 
(5)  Includes 3,007,343 shares of Common Stock issuable pursuant to options
     exercisable within 60 days of March 1, 1999. Also includes 264,936 shares
     of Common Stock held by the Company's 401(k) plan for which Dr. Kranzler,
     as co-trustee of the 401(k) plan, has voting rights to such shares and
     5,000 shares of Common Stock held by the Kranzler Children's Trust dated
     1991. Mr. Kranzler disclaims beneficial ownership of the shares held by the
     Kranzler Children's Trust.
(6)  Includes 1,001,032 shares of Common Stock issuable pursuant to options
     exercisable within 60 days of March 1, 1999. Also includes 264,936 shares
     of Common Stock held by the Company's 401(k) plan for which Dr. Blank, as
     co-trustee of the 401(k) plan, has voting rights to such shares.
(7)  Includes 322,414 shares of Common Stock issuable pursuant to options
     exercisable within 60 days of March 1, 1999.
(8)  Includes 50,000 shares of Common Stock issuable pursuant to options
     exercisable within 60 days of March 1, 1999. Also includes 692,829 shares
     of Common Stock and presently exercisable warrants to purchase 6,667 shares
     of Common Stock held by Allen & Company Incorporated, in which Mr. Crooks
     has a pecuniary interest pursuant to an arrangement with Allen & Company
     Incorporated.
(9)  Includes 65,000 shares of Common Stock issuable pursuant to options
     exercisable within 60 days of March 1, 1999.
(10) Includes 50,000 shares of Common Stock issuable pursuant to options or
     other rights exercisable within 60 days of March 1, 1998.
(11) Includes 100,000 shares of Common Stock held by Samuel D. and Mary Ann H.
     Anderson as trustees of the Samuel and Mary Ann Anderson trust dated March
     22, 1979.  Also includes 28,558 shares of Common Stock issuable pursuant to
     options exercisable within 60 days of March 1, 1999.
(12) Includes 27,052 shares of Common Stock issuable pursuant to options
     exercisable within 60 days of March 1, 1998.

<TABLE>
<CAPTION>
                                                                AMOUNT AND NATURE OF        PERCENT OF CLASS OF
                                                               BENEFICIAL OWNERSHIP OF      SERIES A PREFERRED 
BENEFICIAL OWNER OF SERIES A PREFERRED STOCK                SERIES A PREFERRED STOCK (1)          STOCK
--------------------------------------------                ----------------------------    -------------------
<S>                                                         <C>                             <C>
Paramount Capital...................................                666,667(2)                     63.2%
Paradigm Group, LLC.................................                161,333                        15.3%
</TABLE>
________________________
(1)  Percentage of beneficial ownership is based upon 1,054,832 shares of the
     Company's Series A Convertible Preferred Stock outstanding as of March 1,
     1999.
(2)  Dr. Lindsay A. Rosenwald is the sole shareholder of Paramount Capital Asset
     Management, Inc. ("Paramount Capital"). Paramount Capital is the general
     partner of Aries Domestic Fund, L.P., a limited partnership incorporated in
     Delaware ("Aries Domestic") and the investment manager of The Aries Master
     Fund, a Cayman Islands trust ("The Aries Master Fund"). Of the shares of
     Series A Convertible Preferred Stock indicated as beneficially held,
     Paramount Capital shares voting and dispositive power with the following
     persons or entities: Aries Domestic with respect to 173,333 of the shares;
     and The Aries Master Fund with respect to 493,334 of the shares.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     In September 1998, the Company completed a private placement of 3,063,561
shares of the Company's Series A Convertible Preferred Stock (the "Preferred
Shares") with certain accredited investors at a purchase price of $1.50 per
share. Net proceeds (after deducting placement fees of approximately $113,000,
and other related issuing costs of approximately $152,000) to the Company were
approximately $4.3 million. Merrill Weber & Company, Joseph Stevens & Co., Inc.,
Evolution Capital and The May Davis Group acted as non-exclusive placement
agents for the Company and received $2,250, $16,260, $67,500 and $27,000,
respectively, in placement agency fees. Samuel D. Anderson, a director of the
Company, and James A Holland, Mr. Anderson's brother-in-law, both participated
in the private placement. Mr. Anderson purchased 100,000 shares of the Preferred
Shares in the name of Samuel D. Anderson and Mary Ann H. Anderson, Trustees of
the Samuel and Mary Ann Anderson Trust dated March 22, 1979.

                                      34.
<PAGE>
 
     Mr. Richard Crooks, Jr., a director of the Company, is a director of and
consultant to, Allen & Company Incorporated, a principal stockholder of the
Company.  As of March 1, 1999, Mr. Crooks beneficially held approximately 2.7%
of the Company's common stock.

     The Company has also entered into an employment agreement with its three
executive officers, as described under the caption "Management--Employment
Agreements." The Company has granted stock options to certain directors and
executive officers of the Company.  See "Management--Executive Compensation."

     The Company's Bylaws provide that the Company will indemnify its directors
and executive officers and may indemnify its other officers, employees and other
agents to the fullest extent permitted by Delaware law.  The Company is also
empowered under its Bylaws to enter into indemnification contracts with its
directors and officers and to purchase insurance on behalf of any person whom it
is required or permitted to indemnify.  Pursuant to this provision, the Company
has entered into indemnity agreements with each of its directors and officers
and currently maintains directors and officers insurance coverage.

                                      35.
<PAGE>
 
                                    PART IV

Item 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

  (a)  (1)  Financial Statements

            The financial statements of the Company are included herein as
            required under Item 8 of this Annual Report on Form 10-K. See Index
            on page F-1.

       (2)  Financial Statement Schedules

            Financial statement schedules have been omitted since they are
            either not required, not applicable, or the information is otherwise
            included.

       (3)  EXHIBITS

<TABLE>
<CAPTION>
Exhibit No.           Description                                 INCORPORATED BY REFERENCE TO
-----------           -----------                                 ----------------------------
<C>                   <S>                                         <C>
    3.1               Amended and Restated Certificate of         Exhibit 3.1 to Form 10-Q for the quarter ended
                      Incorporation                               March 30, 1996

    3.2               By-Laws, as amended                         Exhibit 3.2 to 1995 Form 10-K

    4.1               Form of Stock Certificate                   Exhibit 4.1 to Form S-1 Registration Statement
                                                                  No. 33-41225

    4.2               Warrant Certificate                         Exhibit 4.2 to Form 8-K filed November 1, 1996

   10.1               Form of Common Stock Purchase Warrant       Exhibit 3.1 to Form S-1 Registration Statement
                                                                  No. 33-41225

   10.2               Form of Employee Stock Warrant              Exhibit 10.13 of Form S-1 Registration Statement
                                                                  No. 33-41225

   10.3               Agreement and Plan of Merger and            Exhibit 2.1 to Form 10-Q for quarter ended
                      Reorganization dated October 10, 1996,      September 30, 1996
                      by and among Registrant, Cypress
                      Acquisition Sub, Inc. and PRP, Inc.

   10.4               Warrant Agreement dated September 18,       Exhibit 4.1 to Form 10-Q for quarter ended
                      1996, between Registrant and American       September 30, 1996
                      Stock Transfer & Trust Company

   10.5               Exchange of Bridge Debt and Warrant         Exhibit 4.2 to Form 10-Q for quarter ended
                      Termination Agreement between Registrant    September 30, 1996
                      and certain holders of indebtedness of
                      PRP, Inc.

   10.6               Incentive Stock Option                      Exhibit 28.2 to Form S-8 Registration Statement
                                                                  No. 33-20188

   10.7               Form of Nonqualified Stock Option           Exhibit 4.5 to Form 10-K for the year ended
                                                                  December 31, 1993

   10.8               Form of 7% Convertible Debentures           Exhibit 10.1 to Form 10-Q for the quarter ended
                                                                  March 31, 1994

   10.9               Warrant Agreement dated as of April 22,     Exhibit 10.3 to Form 10-Q  for the quarter ended
                      1994 between IMRE Corporation and Allen     March 31, 1994
                      & Company Incorporated

</TABLE> 
                                      36.
<PAGE>
<TABLE> 
<CAPTION> 
   <S>                <C>                                         <C>  
   10.10              Form 7% Convertible Debenture Purchase      Exhibit 10.4 to Form 10-Q for the quarter ended
                      Agreement                                   March 31, 1994

   10.11              Form of Senior Convertible Debenture        Exhibit 4.10 to 1995 From 10-K

   10.12              Form of Senior Convertible Debenture        Exhibit 4.11 to 1995 Form 10-K
                      Purchase Agreement

   10.13              Form of Stock Purchase Agreement for        Exhibit 4.12 to 1995 Form 10-K
                      January 1996 Private Placement

   10.14              Form of Warrant to Purchase Common Stock    Exhibit 99.1 to Form S-8 Registration Statement
                                                                  No. 333-19465

   10.15              1996 Equity Incentive Plan (the "1996       Exhibit 99.1 to Form S-8 Registration Statement
                      Plan")                                      No. 333-06771

   10.16              Sub-Lease Agreement dated April 15,         Exhibit 3.1 to Form 10-Q for the quarter ended
                      1996, between the Company and               March 30, 1996
                      Bristol-Myers Squibb Company

   10.17              Common Stock Purchase Warrant dated June    Exhibit 99.1 to Form S-8 Registration Statement
                      10, 1991                                    No. 333-06765

   10.18              Warrant Agreement dated as of August 29,    Exhibit 99.1 to Form S-3 Post Effective
                      1991 between IMRE Corporation and           Amendment to Registration Statement No. 33-71278
                      Manufacturers of Hanover Trust Company
                      of California (now know as Chemical
                      Trust Company of California)

   10.19              Successor Warrant Agent Agreement date      Exhibit 99.2 to Form S-3 Post Effective
                      July 23, 1996 between the Registrant and    Amendment to Registration Statement No. 33-71278
                      American Stock Transfer & Trust Company

   10.20              Form of Incentive Stock Option Agreement    Exhibit 3.1 to Form 10-Q for the quarter ended
                      under the 1996 Plan                         March 30, 1996

   10.21              1996 Equity Incentive Plan Form of          Exhibit 3.1 to Form 10-Q for the quarter ended
                      Non-Statutory Stock Option Agreement        March 30, 1996

   10.22              Incentive Stock Option and Appreciation     Exhibit 99.4 to Form S-8 Registration Statement
                      Plan, as amended June 29, 1992              No. 333-06771

   10.23              Form of Incentive Stock Option Agreement    Exhibit 99.5 to Form S-8 Registration Statement
                      under the ISO Plan                          No. 333-06771

   10.24              Amended and Restated 1988 Nonqualified      Exhibit 99.6 to Form S-8 Registration Statement
                      Stock Option Plan                           No. 333-06771

   10.25              Form of Nonqualified Stock Option           Exhibit 99.7 to Form S-8 Registration Statement
                      Agreement under the 1988 Plan               No. 333-06771

   10.26              Form of Stock Option Agreement for          Exhibit 99.8 to Form S-8 Registration Statement
                      issuance's of all non-plan options          No. 333-06771

   10.27              Form of Nonstatutory Stock Option           Exhibit 99.3 to Form S-8 Registration Statement
                      Agreement under the 1996 Plan               No. 333-06771

   10.28              Stock Option and Stock Appreciation Plan    Exhibit 28.1 to Form S-8 Registration Statement
                                                                  No. 333-06771
</TABLE> 
                                      37.
<PAGE>
<TABLE> 
<CAPTION> 
   <S>                <C>                                         <C> 
   10.29              Warrant Agreement dated September 19,       Exhibit 10.1 to Form S-3 Registration Statement
                      1996 between the Registrant and American    No. 333-15483
                      Stock Transfer & Trust company

   10.30              1988 Nonqualified Stock Option Plan         Exhibit 28.3 to Form S-8 Registration Statement
                                                                  No. 333-06771

   10.31              Sub-lease Agreement dated October 11,       Exhibit 10.3 to 1993 Form 10-K
                      1991

   10.32              Lease Agreement dated April 26, 1994        Exhibit 10.4 to 1994 Form 10-K

   10.33              Warrant Agreement dated as of August 29,    Exhibit 99.1 to Form S-3 Registration Statement
                      1991 between IMRE Corporation and           No. 33-71278
                      Manufacturers Hanover Trust Company of
                      California (now known as Chemical Trust
                      Company of California)

   10.34              Form of Exchange of Bridge Debt and         Exhibit 10.1 to Form S-3 Registration Statement
                      Warrant Termination Agreement               No. 333-15483

   10.35              Employment Agreement with Jay D. Kranzler   Exhibit 10.8 to 1995 Form 10-K

   10.36              Employment Agreement with Debby Jo Blank    Exhibit 10.9 to 1995 Form 10-K

   10.37              Spear, Leeds & Kellogg Stock Purchase       Exhibit 10.37 to Form S-1 Registration Statement
                      Agreement                                   No. 333-45705

   10.38              Employment Offer Letter dated as of
                      February 18, 1999 between the Registrant
                      and Carl F. Bobkoski

   10.39              Separation Agreement dated March 15,
                      1999 between the Registrant and Debby Jo
                      Blank

   10.41              Sublease dated February 1, 1999 between
                      the Company and Cardia Pacemakers, Inc. 
                      and related lease dated August 1991 
                      between Michael R. Mastro and Redmond 
                      East Associates and Incontrol, Inc. 
                      and Amendments One through Ten.

   23.1               Consent of Ernst & Young LLP,
                      Independent Auditors

   24.1               Power of Attorney                           Reference is made to page [37]

   27.1               Financial Data Schedule
</TABLE>

(b)  Reports on Form 8-K

     None

                                      38.
<PAGE>
 
(c)  EXHIBITS

     The Company hereby files as part of this Form 10-K the exhibits listed in
     Item 14(a)(3) set forth above.

                                      39.
<PAGE>
 
                                   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.

                                    CYPRESS BIOSCIENCE, INC.

                                    By:     /s/ JAY D. KRANZLER 
                                           ---------------------         
                                                Jay D. Kranzler, M.D., Ph. D.
                                                Chief Executive Officer, and
                                                Chief Financial Officer

Date:  March 30, 1999

                               POWER OF ATTORNEY

     KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Jay D. Kranzler, M.D., Ph.D., as his true
and lawful attorney-in-fact and agent, with full power of substitution and
resubstitution, for him and in his name, place and stead, in any and all
capacities, to sign any and all amendments to this Annual Report on Form 10-K,
and to file the same, with all exhibits thereto, and other documents in
connection therewith, with the Securities and Exchange Commission, granting unto
said attorney-in-fact and agent, and full power and authority to do and perform
each and every act and thing requisite and necessary to be done in connection
therewith, as fully to intents and purposes as he might or could do in person,
hereby ratifying and confirming that all said attorney-in-fact and agent, or any
of them or their or his substitute or resubstitute, may lawfully 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 and on the dates indicated.

<TABLE>
<CAPTION>
SIGNATURE                                                          TITLE                               DATE
---------                                                          -----                               ----
<S>                                         <C>                                                    <C> 
/s/ JAY D. KRANZLER                         Chief Executive Officer, Chief Financial Officer and   March 30, 1999
-----------------------------------------   Chairman of the Board (Principal Executive Officer
Jay D. Kranzler, M.D., Ph.D.                and Principal Financial and Accounting Officer)
                
/s/ RICHARD M. CROOKS, JR.                  Director                                               March 30, 1999
-----------------------------------------
Richard M. Crooks, Jr.
 
/s/ PHILIP J. O'REILLY                      Director                                               March 30, 1999
-----------------------------------------
Philip J. O'Reilly
 
/s/ JACK H. VAUGHN                          Director                                               March 30, 1999
-----------------------------------------
Jack H. Vaughn
 
/s/ SAMUEL D. ANDERSON                      Director                                               March 30, 1999
-----------------------------------------
Samuel D. Anderson
 
/s/ DAVID GOLDE                             Director                                               March 30, 1999
-----------------------------------------
David Golde, M.D.
</TABLE>

                                      40.
<PAGE>
 
                            CYPRESS BIOSCIENCE, INC.
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<S>                                                                                                       <C> 
Report of Ernst & Young LLP, Independent Auditors......................................................   F-2
Consolidated Balance Sheets as of December 31, 1998 and 1997...........................................   F-3
Consolidated Statements of Operations for the years ended December 31, 1998, 1997 and 1996.............   F-4
Consolidated Statements of Stockholders' Equity for the years ended December 31, 1998, 1997 and 1996...   F-5
Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996.............   F-6
Notes to Consolidated Financial Statements.............................................................   F-7
</TABLE>

                                      F-1
<PAGE>
 
               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
                                        
The Board of Directors and Stockholders

Cypress Bioscience, Inc.

We have audited the accompanying consolidated balance sheets of Cypress
Bioscience, Inc. 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 upon 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 principals used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide 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 Cypress
Bioscience, Inc. as of 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


San Diego, California
January 21, 1999,
except for Note 11, as to which the date is
March 26, 1999


                                      F-2
<PAGE>
 
                            CYPRESS BIOSCIENCE, INC.
                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                                December 31,
                                                                                  1998                             1997
                                                                                ------------                   ------------
<S>                                                                             <C>                            <C>
ASSETS
Current assets:
 Cash and cash equivalents                                                      $  5,619,568                   $  7,541,320
 Short-term investments                                                                    -                        974,333
 Accounts receivable:
  Trade, net of allowance for doubtful accounts of $32,645 in 1998              
   and $178,719 in 1997                                                              408,902                        372,741 
  Other                                                                              175,298                        140,487
 Inventories                                                                       1,014,443                        628,004
 Prepaid expenses                                                                    254,891                        114,382
                                                                                ------------                   ------------
  Total current assets                                                             7,473,102                      9,771,267
 
Property and equipment, net                                                        1,789,976                      1,991,777
Restricted cash                                                                       35,000                              -
Convertible debenture issuance costs, net                                             17,957                         25,722
                                                                                ------------                   ------------
  Total assets                                                                  $  9,316,035                   $ 11,788,766
                                                                                ============                   ============
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 Current liabilities:
  Accounts payable                                                              $    778,061                   $    530,132
  Accrued compensation                                                               164,832                        175,929
  Accrued liabilities                                                                952,448                      1,144,692
  Current portion of capital leases                                                    9,823                          4,286
                                                                                ------------                   ------------
   Total current liabilities                                                       1,905,164                      1,855,039
 
 Convertible debentures                                                              400,000                        400,000
 Capital leases, net of current portion                                               21,496                          7,735
 Note payable                                                                        144,804                              -
 
 Commitments and contingencies (Note 6)
 
 Stockholders' equity:
  Series A convertible preferred stock, $.02 par value; authorized
   3,333,333 shares; issued and outstanding, 1,156,832 shares at
   December 31, 1998; liquidation preference of $1,735,248 at
   December 31, 1998                                                                  23,136                              -
 
  Common stock, $.02 par value; authorized 60,000,000 shares;
   issued and outstanding, 41,402,045 and 38,545,808 shares at
   December 31, 1998 and 1997, respectively                                          828,041                        770,916
 
  Additional paid-in capital                                                      86,238,466                     78,041,636
  Deferred compensation                                                             (239,446)                      (504,315)
  Accumulated deficit                                                            (80,005,626)                   (68,782,245)
                                                                                ------------                   ------------
   Total stockholders' equity                                                      6,844,571                      9,525,992
                                                                                ------------                   ------------
   Total liabilities and stockholders' equity                                   $  9,316,035                   $ 11,788,766
                                                                                ============                   ============
</TABLE>
See accompanying notes.

                                      F-3
<PAGE>
 
                            CYPRESS BIOSCIENCE, INC.
                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                    Years Ended December 31,
                                                     1998                         1997                          1996
                                                 ------------                  -----------                  ------------
<S>                                              <C>                           <C>                          <C>
Product sales                                    $  2,374,970                  $ 2,970,342                  $  1,967,976
Grant income                                          308,470                      325,316                             -
                                                 ------------                  -----------                  ------------
                                                    2,683,440                    3,295,658                     1,967,976
Costs and expenses:
  Production costs                                  2,113,781                    1,772,681                     1,482,563
  Sales and marketing                               2,378,443                    1,292,942                       794,356
  Research and development                          4,290,727                    6,707,557                     4,002,968
  General and administrative                        3,345,241                    2,803,079                     4,649,298
  Acquired in-process research and
   development                                              -                            -                     5,146,943
  Restructuring expense                                     -                            -                       493,712
  Debt conversion expense                                   -                            -                       276,688
                                                 ------------                  -----------                  ------------
                                                   12,128,192                   12,576,259                    16,846,528
Other income (expense):
  Interest income                                     341,755                      425,935                       458,070
  Interest expense                                    (41,953)                     (31,737)                   (1,119,726)
                                                 ------------                  -----------                  ------------
                                                      299,802                      394,198                      (661,656)
Net loss before imputed dividend on
  Series A convertible preferred stock             (9,144,950)                  (8,886,403)                  (15,540,208)

Undeclared, imputed dividend on
  Series A convertible preferred stock             (2,078,431)                           -                             -
                                                 ------------                  -----------                  ------------
Net loss applicable to common
  stockholders                                   $(11,223,381)                 $(8,886,403)                 $(15,540,208)
                                                 ============                  ===========                  ============
Net loss per share applicable to common
  stockholders - basic and diluted               $      (0.29)                 $     (0.25)                 $      (0.53)
                                                 ============                  ===========                  ============
Shares used in computing net loss
  per share applicable to common
  stockholders - basic and diluted                 39,234,741                   35,236,579                    29,206,470
                                                 ============                  ===========                  ============
</TABLE>
See accompanying notes.

                                      F-4
<PAGE>
 
                           CYPRESS BIOSCIENCE, INC.
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                 YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
                                                       Preferred Stock           Common Stock         Additional  
                                                  -----------------------  ----------------------      Paid-in      Deferred
                                                     Shares    Par Value     Shares     Par Value      Capital    Compensation
                                                  ----------    --------   ----------   --------     -----------   -----------
<S>                                               <C>          <C>         <C>          <C>         <C>           <C>
Balance December 31, 1995                                  -   $       -   18,693,595   $373,872     $43,457,000   $         -
 Stock options exercised                                   -           -       47,500        950          84,050             -
 Stock issued for services                                 -           -       31,765        635          54,365             -
 Stock issued for debenture interest                       -           -       12,005        240          28,963             -
 Stock issued for debt conversion                          -           -    1,435,955     28,719       2,495,713             -
 Debt discount related to Senior Convertible                                                                      
  Debentures                                               -           -            -          -       1,063,000             -
 Stock issued to match 401(k) contributions                -           -       50,791      1,016         100,910             -
 Stock issued in 1996 private placements                   -           -   12,008,702    240,174      17,951,611             -
 Stock issued in conjunction with the acquisition                                                                 
  of PRP, Inc.                                             -           -    2,292,798     45,856       4,539,740             -
 Deferred compensation related to stock options            -           -            -          -       1,756,949    (1,756,949)
 Compensation related to stock options                     -           -            -          -         822,382             -
 Amortization of deferred compensation                     -           -            -          -               -       741,211
 Net loss                                                  -           -            -          -               -             -
                                                  ----------    --------   ----------   --------     -----------   -----------
Balance December 31, 1996                                  -           -   34,573,111    691,462      72,354,683    (1,015,738)
 Stock options exercised                                   -           -       20,000        400          37,100             -
 Deferred compensation related to stock options            -           -            -          -         (10,284)       10,284
 Stock issued to match 401(k) contributions                -           -      101,668      2,033         163,623             -
 Stock issued in October 1997 private placement            -           -    3,851,029     77,021       5,496,514             -
 Amortization of deferred compensation                     -           -            -          -               -       501,139
 Net loss                                                  -           -            -          -               -             -
                                                  ----------    --------   ----------   --------     -----------   -----------
Balance December 31, 1997                                  -           -   38,545,808    770,916      78,041,636      (504,315)
 Stock options and warrants exercised                      -           -      876,681     17,534       1,448,435             -
 Deferred compensation related to stock options                                                                   
  and warrants                                             -           -            -          -         194,870      (194,870)
 Stock issued to match 401(k) contributions                -           -       72,827      1,456         205,898             -
 Series A convertible preferred stock issued in                                                                   
  September 1998 private placement                 3,063,561      61,271            -          -       4,269,196             -
 Imputed dividend on Series A convertible                                                                         
  preferred stock                                          -           -            -          -       2,078,431             -
 Preferred stock conversions                      (1,906,729)    (38,135)   1,906,729     38,135               -             -
 Amortization of deferred compensation                     -           -            -          -               -       459,739
 Net loss                                                  -           -            -          -               -             -
                                                  ----------    --------   ----------   --------     -----------   -----------
Balance December 31, 1998                          1,156,832    $ 23,136   41,402,045   $828,041     $86,238,466   $  (239,446)
                                                  ==========    ========   ==========   ========     ===========   =========== 
</TABLE>

<TABLE>
<CAPTION>
                                                   Accumulated
                                                     Deficit           Total
                                                   -------------     -------------------
<S>                                                <C>               <C>
Balance December 31, 1995                          $(44,355,634)     $   (524,762)
 Stock options exercised                                      -            85,000
 Stock issued for services                                    -            55,000
 Stock issued for debenture interest                          -            29,203
 Stock issued for debt conversion                             -         2,524,432
 Debt discount related to Senior Convertible
  Debentures                                                  -         1,063,000
 Stock issued to match 401(k) contributions                   -           101,926
 Stock issued in 1996 private placements                      -        18,191,785
 Stock issued in conjunction with the acquisition
  of PRP, Inc.                                                -         4,585,596
 Deferred compensation related to stock options               -                 -
 Compensation related to stock options                        -           822,382
 Amortization of deferred compensation                        -           741,211
 Net loss                                           (15,540,208)      (15,540,208)
                                                   ------------      ------------
Balance December 31, 1996                           (59,895,842)       12,134,565
 Stock options exercised                                      -            37,500
 Deferred compensation related to stock options               -                 -
 Stock issued to match 401(k) contributions                   -           165,656
 Stock issued in October 1997 private placement               -         5,573,535
 Amortization of deferred compensation                        -           501,139
 Net loss                                            (8,886,403)       (8,886,403)
                                                   ------------      ------------
Balance December 31, 1997                           (68,782,245)        9,525,992
 Stock options and warrants exercised                         -         1,465,969
 Deferred compensation related to stock options
  and warrants                                                -                 -
 Stock issued to match 401(k) contributions                   -           207,354
 Series A convertible preferred stock issued in
  September 1998 private placement                            -         4,330,467
 Imputed dividend on Series A convertible
  preferred stock                                    (2,078,431)                -
 Preferred stock conversions                                  -                 -
 Amortization of deferred compensation                        -           459,739
 Net loss                                            (9,144,950)       (9,144,950)
                                                   ------------      ------------
Balance December 31, 1998                          $(80,005,626)     $  6,844,571
                                                   ============      ============
</TABLE>
See accompanying notes.
----------------------
                                      F-5
<PAGE>
 
                            CYPRESS BIOSCIENCE, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                  YEARS ENDED DECEMBER 31,
                                                                1998                        1997                         1996
                                                            -----------                 -----------                 ------------
<S>                                                         <C>                         <C>                         <C>
OPERATING ACTIVITIES
Net loss                                                    $(9,144,950)                $(8,886,403)                $(15,540,208)
Adjustments to reconcile net loss to net cash used
  in operating activities:
 Depreciation and amortization                                  549,953                     481,567                      182,845
 Acquired in-process research and development                         -                           -                    5,146,943
 Amortization of deferred compensation                          459,739                     501,139                      741,211
 Compensation related to stock options                                -                           -                      822,382
 Common stock issued for services and expenses                  207,354                     165,656                      186,129
 Debt conversion expense                                              -                           -                      276,688
 Gain on disposal of property and equipment                      (6,610)                     (3,298)                     (11,110)
 Debt discount related to Senior Convertible Debentures               -                           -                    1,063,000
 Changes in operating assets and liabilities, net of
   effects from acquisition of PRP, Inc.:
  Accounts receivable, net                                      (36,161)                    (28,700)                    (320,191)
  Other receivables                                             (34,811)                     10,467                     (111,020)
  Inventories                                                  (386,439)                    345,763                      174,739
  Prepaid expenses                                             (140,509)                     56,849                       39,655
  Accounts payable and other accrued liabilities                 44,588                    (536,530)                     (94,678)
                                                            -----------                 -----------                 ------------
  Net cash used in operating activities                      (8,487,846)                 (7,893,490)                  (7,443,615)
 
INVESTING ACTIVITIES
 Purchase of property and equipment                            (345,636)                   (118,038)                    (997,602)
 Proceeds from sale of property and equipment                    11,859                       7,685                       36,735
 Purchase of short-term investments                          (1,000,900)                 (2,006,773)                  (2,890,160)
 Sale of short-term investments                               1,975,233                   3,922,600                            -
 Restricted cash                                                (35,000)                          -                            -
 Acquisition of PRP, Inc., net of $83,399 cash acquired               -                           -                     (361,029)
                                                            -----------                 -----------                 ------------
  Net cash provided by (used in) investing activities           605,556                   1,805,474                   (4,212,056)
 
FINANCING ACTIVITIES
 Net proceeds from issuance of common stock                           -                   5,573,535                   18,276,785
 Net proceeds from issuance of preferred stock                4,330,467                           -                            -
 Net proceeds from exercises of stock options and
   warrants                                                   1,465,969                      37,500                            -
 Proceeds from issuance of convertible debentures                     -                           -                      500,000
 Proceeds (payment) of capital lease obligation                  19,298                     (27,207)                     (13,565)
 Note payable                                                   144,804                           -                            -
 Debt issuance and conversion costs                                   -                           -                      (71,919)
                                                            -----------                 -----------                 ------------
  Net cash provided by financing activities                   5,960,538                   5,583,828                   18,691,301
 
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS             (1,921,752)                   (504,188)                   7,035,630
 Cash and cash equivalents at beginning of the year           7,541,320                   8,045,508                    1,009,878
                                                            -----------                 -----------                 ------------
 Cash and cash equivalents at end of the year               $ 5,619,568                 $ 7,541,320                 $  8,045,508
                                                            ===========                 ===========                 ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
 Interest paid                                              $    40,873                 $    31,661                 $     14,681
                                                            ===========                 ===========                 ============
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES
 Stock issued for debt conversion                           $         -                 $         -                 $  2,524,432
                                                            ===========                 ===========                 ============
</TABLE>
See accompanying notes.

                                      F-6
<PAGE>
 
                           CYPRESS BIOSCIENCE, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  FORMATION AND BUSINESS OF THE COMPANY

     Cypress Bioscience, Inc. (the "Company") researches, develops, manufactures
and markets medical devices and therapeutics for the treatment of certain types
of immune system disorders and is engaged in the development of novel
therapeutic agents for the treatment of blood platelet disorders.  The Company's
first product, the Prosorba column, a medical device, treats a patient's
defective immune system so that it can more effectively respond to certain
diseases.  The Company received marketing approval from the U.S. Food and Drug
Administration ("FDA") in December 1987 to distribute the Prosorba column for
the treatment of idiopathic thrombocytopenic purpura ("ITP"), an immune-mediated
bleeding disorder. The Company's sales are primarily derived from within the
United States. The Company is also developing Cyplex(TM), a platelet
alternative, previously known as Infusible Platelet Membranes ("IPM"), as an
alternative to traditional platelet transfusions.

     The Company's current clinical efforts to expand the approved indications
for the Prosorba column are focused primarily on rheumatoid arthritis ("RA").
In January 1998, the Company's Phase III clinical trial evaluating the use of
the Prosorba column in the treatment of RA was stopped early due to the
achievement of favorable safety and statistically significant results.  In
October 1998, a U.S. Food and Drug Administration ("FDA") Gastroenterology and
Urology Device Advisory Panel recommended for approval the Prosorba column for
the treatment of moderate to severe RA.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation
---------------------------

     The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries.  All material intercompany accounts and
transactions have been eliminated in consolidation.

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 reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period.  Actual results could differ from those estimates.

Cash, Cash Equivalents and Short-term Investments
-------------------------------------------------

     The Company considers all investments with an original maturity of three
months or less when purchased to be cash equivalents.  Management determines the
appropriate classification of its cash equivalents and investment securities at
the time of purchase and reevaluates such determination as of each balance sheet
date.  Management has classified the Company's cash equivalents and investment
securities as available-for-sale securities in the accompanying financial
statements.  Available-for-sale securities are carried at fair value, with
unrealized gains and losses reported in a separate component of stockholders'
equity.  The cost of debt securities classified as available-for-sale is
adjusted for amortization of premiums and accretion of discounts to maturity.
Such amortization and accretion, as well as interest and dividends, are included
in interest income.  Realized gains and losses are also included in interest
income.  The cost of securities sold is based on the specific identification
method.

     The Company invests its excess cash in U.S. Government agency securities,
and money market funds with strong credit ratings.  The Company has established
guidelines regarding diversification of its investments and their maturities,
which should maintain safety and liquidity.

Inventories
-----------

     Inventories are stated at the lower of cost (using the weighted average
method based on the first-in, first-out method) or market.

                                      F-7
<PAGE>
 
Property and Equipment
----------------------

     Property and equipment, including assets acquired under capital leases, are
recorded at cost and depreciated or amortized over the estimated useful lives of
the assets (three to five years) or the lease term using the straight-line
method.  The Company does not depreciate assets classified as construction in
progress assets until the assets are placed in operations.

Accrued Clinical Trial Costs
----------------------------

     The Company enrolls patients in various clinical trial sites which are
conducted in the United States.  The Company records the cost of such studies as
the clinical work is performed by the respective research entities.  The Company
accrues costs related to clinical trials in the period incurred.

Convertible Debenture Issuance Costs
------------------------------------

     Convertible debenture issuance costs are being amortized over the life of
the related debentures.

Stock and Stock Warrants Issued for Services
--------------------------------------------

     Common stock and common stock warrants issued for services rendered to the
Company are recorded at the fair market value of the stock or stock warrant
issued or the value of the services rendered, whichever is more clearly
determinable.

Revenue Recognition
-------------------

     Revenue from product sales is recognized when products are shipped.
Revenues from government grants are recognized based on performance requirements
of the grant or as the grant expenditures are incurred.  Research and
development expenses are recognized as incurred.

Net Loss Per Share
------------------

     In accordance with Statement of Financial Accounting Standards No. 128,
Earnings per Share, the computation of net loss per share is based upon the
weighted average number of shares of common stock issued and outstanding for
each period.  Common stock equivalents related to options, warrants and
convertible debentures are excluded from the computation, as their effect is
antidilutive.

Long-Lived Assets
-----------------

     In accordance with Statement of Financial Accounting Standards No. 121,
Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to be
Disposed Of ("SFAS 121"), impairment losses are recorded on long-lived assets
used in operations when indicators of impairment are present and the estimated
undiscounted cash flows estimated to be generated by those assets are less than
the assets' carrying amount.  To date, the Company has not identified any
indicators of impairment or recorded any impairments of long-lived assets.

Recently Issued Accounting Standards
------------------------------------

     In 1998, the Company adopted Statement of Financial Accounting Standards
No. 130, Reporting Comprehensive Income ("SFAS 130"), and Statement of Financial
Accounting Standards No. 131, Segment Information ("SFAS 131"). SFAS 130
requires that all components of comprehensive income, including net income, be
reported in the financial statements in the period in which they are recognized.
Comprehensive income is defined as the change in equity during a period from the
transactions and other events and circumstances from non-owner sources.
Comprehensive net loss is the same as the net loss in all years presented.

     SFAS 131 redefines segments and requires companies to report financial and
descriptive information about their operating segments.  The Company has
determined that it operates in one business segment and therefore the adoption
of SFAS 131 had no effect on the Company's financial statements.

                                      F-8
<PAGE>
 
3.  FINANCIAL STATEMENT DETAILS

Short-term Investments and Cash Equivalents
-------------------------------------------

     A summary of the estimated fair value of cash equivalents and short-term
investments is shown below as of December 31:

                                                    1998           1997
                                                 -----------    -----------
   Money market funds                            $ 4,611,162    $   996,075
   U.S. government agency securities                       -      6,947,133    
                                                 -----------    -----------
       Total securities                            4,611,162      7,943,208
   Less amounts classified as cash equivalents    (4,611,162)    (6,968,875)
                                                 -----------    -----------
       Total short-term investment securities    $         -    $   974,333
                                                 ===========    ===========

     The estimated fair value of each cash equivalent and short-term investment
security approximates cost and no unrealized gains or losses were reported as of
December 31, 1998 or 1997.  Realized gains or losses on sales of available-for-
sale securities in 1998 and 1997 were not significant.

Inventories
-----------

     Inventories are comprised of the following as of December 31:

                                              1998          1997
                                            ----------    --------
     Raw materials and components           $  536,513    $166,714
     Work in progress                          288,930     354,010
     Finished goods                            189,000     107,280
                                            ----------    --------
                                            $1,014,443    $628,004
                                            ==========    ========

Property and Equipment
----------------------

     Property and equipment are comprised of the following as of December 31:

                                                           1998         1997
                                                      -----------  -----------
     Laboratory and production equipment              $ 2,551,468  $ 2,610,417
     Office equipment                                     628,928      456,343
     Vehicles                                              20,924       20,924
     Leasehold improvements                                73,407       51,753
                                                      -----------  -----------
                                                        3,274,727    3,139,437
     Accumulated depreciation and amortization         (1,484,751)  (1,147,660)
                                                      -----------  -----------
                                                      $ 1,789,976  $ 1,991,777
                                                      ===========  ===========

     Depreciation expense for the years ended December 31, 1998, 1997 and 1996
was $542,188, $473,802 and $171,015, respectively.  The cost and accumulated
depreciation for assets acquired under capital leases totaled $120,387 and
$51,414, respectively, at December 31, 1998 and $98,495 and $34,658,
respectively, at December 31, 1997.

Accrued Liabilities
-------------------

     Accrued liabilities are comprised of the following as of December 31:

                                          1998            1997
                                        --------       ----------
     Accrued clinical trial costs       $576,690       $  834,815
     Other                               375,758          309,877
                                        --------       ----------
                                        $952,448       $1,144,692
                                        ========       ==========

                                      F-9
<PAGE>
 
4.  ACQUISITIONS

PRP, Inc.
---------

     On November 1, 1996, the Company acquired all of the assets and assumed the
liabilities of PRP, Inc. ("PRP") in a transaction accounted for as a purchase.
The Company recorded a non-recurring charge of approximately $5.1 million in the
fourth quarter of 1996 as acquired in-process research and development as the
feasibility of the acquired technology had not been established nor had
alternative future uses been identified at the time of the purchase.

     In connection with the acquisition, the Company issued to certain holders
of outstanding debt of PRP, in full satisfaction and settlement of such
indebtedness, Units with an approximate total fair value of $4.5 million, based
upon a price of $4.00 per Unit, which was the price identical units were sold
for in a private placement in October 1996 (see Note 9).  Each Unit was
comprised of two shares of the Company's common stock and one common stock
purchase warrant.

     The holders of PRP equity securities (including holders of options and
warrants of PRP) (the "Equity Holders") will also be entitled to receive earn-
out payments, if any, on a pro rata basis, on net sales of products developed
using PRP's technology acquired by the Company in the acquisition.  In addition,
in conjunction with obtaining approval from the FDA of the use of Cyplex(TM), a
platelet alternative for the treatment of thrombocytopenia, the Company shall
make a payment of $5.0 million (the "Milestone Payment") to the Equity Holders,
with such payment being in the form of, at the Company's discretion, cash,
Company common stock, or a combination of the two.  The earn-out payments, if
earned, will be treated as compensation expense because most of such earn-out
payments will be made to former stockholders of PRP and the milestone payments,
if earned will either be expensed as acquired in-process research and
development or capitalized as purchased technology, depending upon the
evaluation of the technology to be made by the Company at such future date.

     In consideration of certain investment banking advisory services provided
by EGS Securities Corp. ("EGS") to PRP in connection with the acquisition, the
Company issued to EGS Units with a total value of approximately $120,000.  In
addition, the Company is obligated to pay EGS an amount in cash equal to two and
one-half percent (2 1/2%) of a certain milestone payment and each earn-out
payment made to the Equity Holders, at the time any such payments are made.

     Subject to limited exceptions, the Company is obligated to spend $4.0
million to commercialize Cyplex(TM). The only circumstances under which the
Company may decrease or cease commercialization of Cyplex(TM) prior to expending
$4.0 million would be if the Company encounters critical problems with the
commercialization of Cyplex(TM), including problems related to efficacy or
economic viability, such as would render Cyplex(TM), on a stand-alone basis,
unsafe, ineffective or incapable of generating a reasonable, positive cash flow.
As of December 31, 1998, the Company has spent approximately $4.2 million in its
effort to commercialize Cyplex(TM).

     The following unaudited pro forma data reflects the combined results of
operations of the Company and PRP for the year ended December 31, 1996 as though
the acquisition had occurred on January 1, 1995, and assumes the charge of
$5,147,000 for acquired in-process research and development was recorded on that
date.

                        PRO FORMA RESULTS OF OPERATIONS
                                        
                                                 December 31, 1996
                                                 -----------------
     Revenues                                       $  2,029,773
     Net loss                                       $(12,111,248)
     Net loss per share - basic and diluted         $      (0.39)

5.  RESTRUCTURING EXPENSE

     In January 1996, the Company notified approximately twenty employees, which
was slightly greater than half of its work force, that their positions were
being terminated immediately as part of the restructuring.  Such positions were
from all departments of the Company.  In March 1996, the Company entered into a
termination agreement with its former Chief Scientific Officer which included
the issuance of non-qualified stock options to

                                      F-10
<PAGE>
 
purchase 705,000 shares of common stock (see Note 6). Costs related to these
terminations were approximately $494,000 and were recorded as a restructuring
expense in 1996. In addition, the Company incurred approximately $300,000 in
costs associated with moving the administration, research and medical
departments to San Diego, with most costs being attributable to relocation costs
of the few members of management moving to San Diego. Such costs were recorded
as general and administrative expenses in 1996.

6.  COMMITMENTS AND CONTINGENCIES

Operating Leases
----------------

     The Company currently occupies approximately 8,000 square feet of leased
office space in San Diego, California.  The San Diego facility houses the
Company's executive and administrative offices.  The five-year lease for this
facility expires in 2001. In accordance with the San Diego facility lease, the
Company has maintained a $35,000 certificate of deposit which is classified as
restricted cash on the December 31, 1998 balance sheet.

     The Company leases 6,916 square feet for its manufacturing facility in
Redmond under a lease expiring in 2004.  The facility has historically been used
to produce commercial quantities of both protein A and the chemically coated
silica matrix used in the manufacture of the Prosorba column.   Assembly of the
Prosorba column had historically been performed in the Company's Seattle
facility.  The Redmond facility, however, has been renovated so that both raw
material production and assembly of the Prosorba column can be performed in a
single facility.  In June 1998, the Company signed a new lease for 3,400 square
feet in Redmond to house the Company's research and medical personnel.  In
August 1998, the Company leased a 4,000 square foot single family residence
which is used by the Company's executives, medical employees, and consultants
while traveling to Redmond.

     The table below indicates future minimum lease obligations under the
operating leases as of December 31, 1998:

                     1999                            $235,504
                     2000                             217,552
                     2001                             174,990
                     2002                             113,184
                     2003                             113,184
                     Thereafter through 2004          113,184
                                                     --------
                                                     $967,598
                                                     ========

     Total rent expense was approximately $367,000, $501,000, and $494,000 for
the years ended December 31, 1998, 1997 and 1996, respectively.  Sublease income
was approximately $117,000 and $149,000 for the years ended December 31, 1997
and 1996, respectively.  No sublease income was received in 1998.

Severance Agreement
-------------------

     The Company entered into a severance agreement as of March 29, 1996 with
its former Chief Scientific Officer, the terms of which correlate to the
employment agreement renegotiated with the former officer as of December 28,
1995.  Such terms include the payment of $244,000 in 1996 and the issuance of
non-qualified stock options to purchase 705,000 shares of common stock at $2.25
per share.  These options replaced an equal number of options and warrants
outstanding at the date of termination.  During the year ended December 31,
1996, the Company valued these options using the Black Scholes model and
recorded compensation expense totaling approximately $822,000.

Employment Agreements
---------------------

     The Company entered into employment agreements in December 1995 with a new
Chief Executive Officer and a new President, Chief Operating Officer each for a
term of five years.  The agreements provide for specified compensation which
include salary, bonuses and a lump sum payment in the event of a termination of
employment, without cause, as defined.  Bonuses of $270,000 and $225,000 were
earned and included in general and administrative expenses in the years ended
1997 and 1996, respectively.

                                      F-11
<PAGE>
 
     The agreements provided for the granting of an aggregate of 4,159,824
options to purchase the Company's common stock. On the date the options were
granted, the closing bid price of the Company's stock was $1.875 per share.  The
exercise price of the options was $1.50 per share, reflecting the price per
share of stock sold in the private placement of approximately 8,500,000 shares
on the same date (see Note 9).  The Company recorded $1,559,934 of deferred
compensation expense on such date, reflecting the difference between the closing
bid price of the Company's common stock on the date of issuance and the option
exercise price.  Options to purchase 25% of the total amount granted vested
immediately with the remainder to vest over a four year period.  The deferred
compensation balance is being amortized 25% immediately with the remainder over
the four year vesting period.  Such options will vest immediately upon a merger
of the Company or in the event of a termination of employment without cause, as
defined.

7.  LONG-TERM OBLIGATIONS

7% Convertible Debentures
-------------------------

     In April 1994, the Company completed a private placement of $4,245,000
principal amount of 7% convertible debentures due March 2001 ("7% Convertible
Debentures").  Interest is payable in cash or shares of common stock at the
option of the Company.

     In September 1995, the Company completed an exchange offering to holders of
the 7% Convertible Debentures.  The Company offered to exchange the 7%
Convertible Debentures for restricted common stock at $2.25 per share at the
time the fair market value of the Company's common stock was $3.81.  Of the
original $4,245,000 outstanding principal amount,  $2,200,000 of the 7%
Convertible Debentures was converted.  In the fourth quarter of 1995 and the
first quarter of 1996, an additional $700,000 and $100,000, respectively, of 7%
Convertible Debentures was converted into common stock at the original
conversion price of $2.88 per share.

     In March 1996, the Company completed a second exchange offering made to
holders of its outstanding 7% Convertible Debentures at the time the fair market
value of the Company's common stock was $2.25.  The Company offered to exchange
the 7% Convertible Debentures for common stock of the Company at a price of
$2.25 per share. Of the $1,245,000 outstanding principal amount, $845,000 was
converted into 399,252 shares of common stock of the Company (which amount
includes 23,700 shares issued as interest on the 7% Convertible Debentures),
pursuant to the exchange offering.  At December 31, 1996, there was outstanding
principal of $400,000 of the 7% Convertible Debentures.  The Company recorded a
non-cash expense of $183,688 in 1995, which represents the fair market value of
the increased number of shares issued under the terms of the offering memorandum
compared to the original conversion terms.  In 1996, the Company charged an
additional $93,000 to debt conversion expense for the unamortized deferred debt
issuance costs related to the debentures converted in 1996.

Note Payable
------------

     In March 1998, the Company received a loan totaling $440,000 to finance the
purchase of fixed assets of which $144,804 is outstanding at December 31, 1998.
In accordance with the terms, the line matures in March 2002 and interest is
accrued at the banks prime rate plus 0.5% (7.75% at December 31, 1998). The loan
is fully collateralized by the fixed assets financed with the line of credit
with a net book value of approximately $126,000 at December 31, 1998.

8.  SENIOR CONVERTIBLE DEBENTURES

     In December 1995, the Company completed a private placement of $1,500,000
principal amount of Senior Convertible Debentures due in July 1996 to a group of
investors, including $500,000 issued to Allen & Company.  The Company received
$1.0 million in cash on 1995 and the remaining $500,000 during the first week of
January 1996.  The debt was convertible into common stock at the price of the
Company's next equity financing round.

     In January 1996, the Senior Convertible Debentures, under their original
terms, were automatically converted, at $1.50 per share, into 1,000,000 shares
of the Company's common stock simultaneously with the closing of a private
placement of common stock (see Note 9). The Company recorded approximately $1.1
million of interest expense in January 1996 for the difference between the fair
market value of the Company's common stock on the conversion date and the
conversion price of $1.50.

                                      F-12
<PAGE>
 
9.  STOCKHOLDERS' EQUITY

Authorized Shares
-----------------

     The Company is authorized to issue up to 15,000,000 shares of preferred
stock.

Private Placements
------------------

     In January 1996, the Company sold approximately 8,500,000 shares of common
stock for $1.50 per share in a private placement, resulting in net proceeds to
the Company of approximately $12,000,000. As a result of this private placement,
the Senior Convertible Debentures automatically converted into 1,000,000 shares
of common stock (see Note 8).  In addition, upon closing of the private
placement, the Company issued stock options to the new Chief Executive Officer
and President aggregating 4,159,824 shares at an exercise price of $1.50 per
share.

     In October 1996, the Company completed a private placement of units with
each unit consisting of two shares of common stock and one common stock purchase
warrant (the "1996 Warrants") collectively priced at $4.00 per unit.  Holders of
each warrant are entitled to purchase one share of the Company's common stock at
an exercise price of $2.00 per share over a five-year period.  A total of
1,734,000 units were sold resulting in net proceeds to the Company of
approximately $6.3 million.

     In October 1997, the Company sold approximately 3,851,000 shares of common
stock for $1.50 per share in a private placement.  The net proceeds to the
Company were approximately $5.6 million.

     In September 1998, the Company completed a private placement of 3,063,561
shares of the Company's Series A convertible preferred stock at a price of $1.50
per share for an aggregate offering price of approximately $4.6 million.  Net
proceeds to the Company were approximately $4.3 million.  The Company recorded a
non-cash imputed dividend of approximately $2.1 million related to the sales of
Series A convertible preferred stock.

Preferred Stock
---------------

     The Series A preferred stock is senior to the common stock with respect to
dividend rights and liquidation preferences. In the event the Board of Directors
declares any cash dividends on common stock, the Board must also declare a cash
dividend on the Series A preferred stock in an amount equal to the common
equivalent per share dividend declared on the common stock. As of December 31,
1998, no dividends have been declared.  In the event of any liquidation or
winding up of the Company, the holders of the Series A preferred shares are
entitled to receive, prior and in preference to the holders of common stock , a
liquidation preference of $1.50 per share.

     Shareholders have the right to convert at any time the Series A preferred
shares into shares of common stock of the Company initially on a one-for-one
basis.  The Series A preferred stock will automatically convert into common
stock upon the first to occur of the following events:  (i) completion by the
Company of a public offering of equity securities raising gross proceeds of $15
million or more at a price that equals or exceeds $3.00; (ii) if the average
closing sales price of the common stock as quoted on the Nasdaq SmallCap Market
equals or exceeds $3.00 per share for any twenty trading days within a period of
thirty consecutive trading days; or (iii) upon the written consent of the
holders of a majority of the Preferred shares then outstanding.

     As of December 31,1998, the Company has reserved 1,156,832 shares of common
stock for issuance upon the conversion of the authorized Series A preferred
stock.

Warrants
--------

     In 1991, the Company granted warrants to purchase 749,900 shares of common
stock to certain officers, directors and employees, which are exercisable
through June 2001 at $1.875 per share.  In April 1994, the Company issued Allen
& Company a five-year warrant to purchase 300,000 shares of Common stock at
$2.875 for its services as a placement agent for the 7% Convertible Debentures
(see Note 8).  In conjunction with the private placement completed in October
1996, as well as in conjunction with the PRP, Inc. acquisition, the Company
granted warrants to purchase 2,880,399 shares of common stock.  The warrants
entitle the holder to purchase a share of common stock for $2.00 per share.  The
warrants expire in October 2001 and are redeemable, in certain circumstances,
for

                                      F-13
<PAGE>
 
$0.10 per warrant, beginning in September 1997. In 1998, the Company granted
warrants to purchase 250,800 shares of common stock to consultants which are
exercisable through November 2001 at prices ranging from $1.88 to $2.40.

Stock Options
-------------

     1996 EQUITY INCENTIVE PLAN.  In April 1996, the Company adopted the 1996
Equity Incentive Plan authorizing the issuance of both incentive and non-
qualified options to purchase the Company's Common Stock, as well as the
granting of stock appreciation rights, stock bonuses and rights to purchase
restricted stock.  Under the plan, 10,000,000 shares of the Company's Common
Stock are reserved for issuance to directors, officers and key employees of, and
consultants and certain advisors to, the Company.

     INCENTIVE STOCK OPTIONS.  In June 1985, the Company adopted an Incentive
Stock Option and Appreciation Plan.  The plan authorizes options to purchase,
and appreciation rights with respect to, the Company's common stock, which may
be granted to such officers and key employees as may be selected by the Board of
Directors or a committee appointed by the Board to administer the plan. The plan
was amended in June 1992 to increase the number of shares reserved for issuance
to 750,000.  The plan expired in 1995; however, options previously granted under
the plan remain outstanding according to their respective terms and conditions.

     NON-QUALIFIED STOCK OPTIONS.  The Company has reserved 572,000 shares of
common stock for issuance under its 1988 Non-qualified Stock Option Plan, as
amended in 1992 and 1995 (the "1988 Plan").  The plan expired February 10, 1998.
Under the 1988 Plan, directors, officers, employees and consultants may be
granted non-qualified stock options at exercise prices and terms determined by
the Board of Directors.

     STOCK OPTIONS-OTHER.  The Company has, at various times, granted to
employees and others options to purchase common stock, other than from under a
formal option plan.

     Options granted pursuant to each of the plans above have a term of up to
ten years and generally vest over four years.

     The following table summarizes the activity of the Company's stock options
and warrants:

<TABLE>
<CAPTION>
                                                               NUMBER OF WARRANTS / OPTIONS
                                  -------------------------------------------------------------------------------------
 
                                                         1996             INCENTIVE
                                                   EQUITY INCENTIVE         STOCK         NON-QUALIFIED         Other
                                   WARRANTS          PLAN OPTIONS          OPTIONS        STOCK OPTIONS        Options
                                  -------------------------------------------------------------------------------------
<S>                               <C>              <C>                    <C>             <C>                 <C>
Balance December 31, 1995          2,819,800                      -         268,600           1,522,500         675,835
     Granted                       2,880,399              5,607,157               -              30,000         929,000
     Exercised                             -                      -               -             (47,500)              -
     Canceled                       (335,000)               (20,000)       (207,600)           (533,000)       (454,000)
     Expired                               -                      -               -            (500,000)              -
                                  -------------------------------------------------------------------------------------
Balance December 31, 1996          5,365,199              5,587,157          61,000             472,000       1,150,835
     Granted                               -                789,522               -              30,000               -
     Exercised                             -                (20,000)              -                   -               -
     Canceled                       (180,800)              (322,479)        (33,250)            (32,000)         (6,000)
     Expired                      (1,850,000)                     -          (1,500)                  -        (192,730)
                                  -------------------------------------------------------------------------------------
Balance December 31, 1997          3,334,399              6,034,200          26,250             470,000         952,105
     Granted                         250,800              1,311,625               -                   -               -
     Exercised                      (125,250)              (664,650)              -             (10,000)       (118,000)
     Canceled                              -               (260,346)              -                   -               -
     Expired                          (6,800)               (17,951)              -                   -         (33,105)
                                  -------------------------------------------------------------------------------------
Balance December 31, 1998          3,453,149              6,402,878          26,250             460,000         801,000
                                  =====================================================================================
</TABLE>

     All warrants are exercisable at December 31, 1998 at exercise prices
ranging from $1.88 to $2.88, and 3,453,149 shares of common stock were reserved
for future issuance.

                                      F-14
<PAGE>
 
     With respect to stock options, at December 31, 1998, 2,912,472 options were
available for future grant and 10,602,600 shares of common stock were reserved
for future issuance.

     Following is a further breakdown of the options outstanding as of December
31, 1998:

<TABLE>
<CAPTION>
                                         WEIGHTED                                    WEIGHTED
                                         AVERAGE       WEIGHTED                       AVERAGE
                                        REMAINING       AVERAGE                   EXERCISE PRICE OF
       RANGE OF          OPTIONS       CONTRACTUAL     EXERCISE      OPTIONS          OPTIONS
    EXERCISE PRICES    OUTSTANDING    LIFE IN YEARS     PRICE      EXERCISABLE      EXERCISABLE
    ---------------    -----------    -------------    --------    -----------    -----------------
      <S>              <C>            <C>              <C>         <C>            <C>        
      $1.00 - $1.50     4,238,495          7.2           $1.50      3,548,170          $1.50
      $1.51 - $2.25     2,475,447          5.7           $1.98      1,957,287          $2.02
      $2.26 - $3.25       890,186          8.7           $2.57        208,871          $2.69
      $3.26 - $4.00        86,000          5.5           $3.61         46,000          $3.77
                        ---------                                   ---------
                        7,690,128                                   5,760,328
                        =========                                   =========
</TABLE>

     The weighted average exercise prices and fair values for options granted in
1998 are as follows:

                                                   WEIGHTED AVERAGE  
                                                  -------------------
                  Exercise Price on              FAIR      EXERCISE 
                    DATE OF GRANT               VALUE       PRICE   
            ------------------------------       -----      -------- 
            Equal to market price of stock       $2.14       $2.66  

     The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Employees" ("APB 25") and related Interpretations in
accounting for its employee stock options because, as discussed below, the
alternative fair value accounting provided for under FASB Statement No. 123,
"Accounting for Stock-Based Compensation," requires use of option valuation
models that were not developed for use in valuing employee stock options.  Under
APB 25, when the exercise price of the Company's employee stock options equals
the market price of the underlying stock on the date of grant, no compensation
expense is recognized.

     For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period.  The Company's
pro forma information follows:

<TABLE>
<CAPTION>
                                                       1998          1997         1996
                                                     --------      --------     -------- 
<S>                                                  <C>           <C>          <C>
Pro forma net loss (in thousands)                    $(13,079)     $(11,302)    $(18,452)
Pro forma net loss per share  basic and diluted      $  (0.33)     $  (0.32)    $  (0.63)
</TABLE>

     The proforma results above for 1998, 1997 and 1996 are not likely to be
representative of the effects of applying FAS 123 on reported net income or loss
for future years as these amounts reflect the expense for less than four years
of vesting.

     Pro forma information regarding net loss and net loss per share is required
by Statement 123, and has been determined as if the Company had accounted for
its employee stock options under the fair value method of that Statement.  The
fair value for these options was estimated at the date of grant using a Black-
Scholes option pricing model with the following weighted-average assumptions for
1998: a risk-free interest rate of 4.8%; a dividend yield of 0%; a volatility
factor of 92.5%; and an option life of 7 years; for 1997: a risk-free interest
rate of 6.49%; a dividend yield of 0%; a volatility factor of 93.9%; and an
option life of 7 years; for 1996: a risk-free interest rate of 6.49%; a dividend
yield of 0%; a volatility factor of 65%; and an option life of 7 years.

                                      F-15
<PAGE>
 
     The weighted average exercise prices for stock option activity are as
follows:

<TABLE>
<CAPTION>
                                                  NUMBER OF STOCK OPTIONS              WEIGHTED AVERAGE
                                                      UNDER ALL PLANS                  EXERCISE PRICES
                                                  ------------------------             ----------------
<S>                                               <C>                                  <C>
   Balance December 31, 1995                             2,466,935                           $2.34
        Granted                                          6,566,157                           $1.69
        Exercised                                          (47,500)                          $1.79
        Canceled                                        (1,214,600)                          $2.46
        Expired                                           (500,000)                          $2.19
                                                        ----------
   Balance December 31, 1996                             7,270,992                           $1.74
        Granted                                            819,522                           $1.72
        Exercised                                          (20,000)                          $1.88
        Canceled                                          (393,729)                          $2.08
        Expired                                           (194,230)                          $2.26
                                                        ----------
   Balance December 31, 1997                             7,482,555                           $1.71
        Granted                                          1,311,625                           $2.36
        Exercised                                         (792,650)                          $1.68
        Canceled                                          (260,346)                          $2.26
        Expired                                            (51,056)                          $2.73
                                                        ----------                    
   Balance December 31, 1998                             7,690,128                           $1.80
                                                        ==========
</TABLE>

Defined Contribution Plan
-------------------------

     The Company sponsors a defined contribution plan pursuant to Section 401(k)
of the Internal Revenue Code of 1986.  This plan covers substantially all
employees who provide more than 1,000 hours of service during the year.

     The Plan provides for matching contributions whereby the Company
contributes common stock to the Plan on behalf of participants in an amount
equal to 100% of the participants' contributions during the six-month periods
ending on the last day of June and December.  The Company's contributions will
vest six months after the amount of the contribution is determined if the
employee is still employed by the Company at the end of the vesting period,
except for employees who have been with the Company more than five years for
whom contributions will vest immediately.  The expense recognized for shares
contributed on behalf of employees was approximately $207,000, $166,000, and
$102,000 for the years ended December 31, 1998, 1997 and 1996, respectively,
based upon the market value of the Company's common stock on the date of the
contribution.

10.  INCOME TAXES

     Significant components of the Company's deferred income tax assets as of
December 31 are as follows:

                                                 1998                 1997
                                             ------------         ------------
     Net operating loss carryforwards        $ 21,416,000         $ 18,686,000
     Capitalized research & development         5,563,000            4,756,000
     Other                                      1,418,000            1,829,000
                                             ------------         ------------
                                               28,397,000           25,271,000
     Valuation allowance                      (28,397,000)         (25,271,000)
                                             ------------         ------------
                                             $          -         $          -
                                             ============         ============

     As of December 31, 1998, the Company has accumulated Federal and California
net operating loss carryforwards of approximately $62,540,000 and $2,541,000,
respectively. The federal tax loss carryforwards will continue to expire in
1999.  The California tax loss carryforward will begin to expire in 2001 unless
previously utilized.  Additionally, the Company has Federal and California
research and development tax credit carryforwards of approximately $965,000 and
$34,000, respectively, which will begin expiring in 2004 unless previously
utilized.

                                      F-16
<PAGE>
 
     In accordance with certain provision of the Internal Revenue Code ("IRC"),
a change in ownership of greater than 50% within a three-year period will place
an annual limitation on the Company's ability to utilize its existing net
operating loss and tax credit carryforwards.

     As a result of the Company's sales of common stock, ownership changes
occurred in September 1991 and October 1997.  Accordingly, the utilization of
net operating loss carryforwards which had accumulated as of September 1991 and
October 1997 will be limited to a prescribed amount in each successive year.
However, the Company believes that this limitation will not have a material
effect on the financial statements.


11.  SUBSEQUENT EVENTS

     In February 1999, the Company entered into a sublease to occupy 21,000 
additional square feet of manufacturing space in Redmond, Washington, which
expires in 2005. Future minimum lease obligations under this operating lease is
as follows: $243,250 in 1999; $357,000 in 2000; $369,250 in 2001; $378,000 in
2002; $388,500 in 2003, and $565,250 thereafter.

     In February 1999, the Company entered into an employment agreement to hire 
a president, chief operating officer and corporate secretary, whereby the 
compensation consists of a base salary of $215,000 and the eligibility, at the 
sole discretion of the Board of Directors, for an annual bonus equal to 25% of 
the base salary. The Company also granted options to purchase up to 500,000 
shares of the Company's common stock at an exercise price of $2.75 per share,
the fair market value on the date of grant. The options vest 25% in February
2000 and monthly thereafter. In the event the employment is terminated by the
Company without cause due to a corporate merger or acquisition, the options will
vest and become fully exercisable.

     The Company entered into a license and distribution agreement with
Fresenius AG, a German company, and its U.S. subsidiary, Fresenius
Hemotechnology, Inc. ("Fresenius") on March 26, 1999, whereby the Company
granted to Fresenius the exclusive right to manufacture, sell and distribute the
Prosorba column in the United States, Europe and Latin America, and subject to
certain conditions, Japan, Thailand, China, New Zealand, Hong Kong, Korea, India
and China. The agreement also provides for the equal sharing of profits
attributable to the marketing of the Prosorba column and related products. As
part of this agreement, the Company received approximately $1.0 million from the
sale of 297,530 shares of the Company's common stock at $3.361 per share,
$500,000 from the issuance of a warrant to purchase 342,466 shares of the
Company's common stock at $7.50 per share, and approximately $4.1 million under
a line of credit agreement due upon the earlier of (i) the date on which
Fresenius exercises its option to purchase the Company's manufacturing facility
in Redmond, Washington or (ii) December 31, 2000. Management believes that these
funds, along with the existing cash balances, are adequate to fund operations
through December 31, 1999.

     In March 1999, the Company demanded redemption of warrants to purchase 
approximately 2.7 million shares of common stock with an exercise price of $2.00
per share. The warrants will be redeemed on April 19, 1999 if not exercised 
prior to or on April 12, 1999.

     In March 1999, the closing sales price of the Company's common stock was 
equal to or greater than $3.00 per share for a period of 20 out of 30 trading
days. Therefore, the 1,156,832 shares of outstanding preferred stock at December
31, 1998 will be automatically converted into common stock in 1999.

                                      F-17