<PAGE>   1
                                  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, 1997

[ ]     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
          incorporation or organization)             Identification No.)

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

       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 THREE (3) 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 January 30, 1998 was $84,654,351.*

The number of shares outstanding of the Registrant's Common Stock as of January
30, 1998 was 38,652,003.

DOCUMENTS INCORPORATED BY REFERENCE:  None

----------------------
* Calculated based on 28,793,997 shares of Common Stock held as of January 30,
1998 by nonaffiliates and a per share market price of $2.94. Excludes 9,858,006
shares of Common Stock held by directors and executive officers and stockholders
whose ownership exceeds five percent of the Common Stock outstanding at January
30, 1998. 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>   2

                            CYPRESS BIOSCIENCE, INC.

                                    FORM 10-K

                                      INDEX

                                     PART I


<TABLE>
<CAPTION>
                                                                                        Page
                                                                                        ----
<S>            <C>                                                                       <C>
ITEM 1         Business................................................................   3
ITEM 2         Properties..............................................................  17
ITEM 3         Legal Proceedings.......................................................  17
ITEM 4         Submission Of Matters To a Vote of Security Holders ....................  17

                                                PART II

ITEM 5         Market For The Company's Common Stock And Related
               Security Holder Matters.................................................  18
ITEM 6         Selected Consolidated Financial Data....................................  19
ITEM 7         Management's Discussion And Analysis Of Financial Condition
               And Results Of Operations...............................................  20
ITEM 8         Financial Statements And Supplementary Data.............................  25
ITEM 9         Changes In And Disagreements With Accountants On Accounting
               And Financial Disclosure................................................  25

                                               PART III

ITEM 10        Directors And Executive Officers Of The Company.........................  26
ITEM 11        Executive Compensation..................................................  28
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.........  35

               Signatures..............................................................  38
</TABLE>


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<PAGE>   3
                                     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 21E of the Securities Exchange Act of 1934, as
amended (the "Exchange Act") that involve risks and uncertainties. The Company's
actual results may differ materially from those discussed below and elsewhere in
this report. Factors that could cause or contribute to such differences include,
without limitation, those discussed in the description of the Company's business
below as well as those discussed in the sections entitled "Risk Factors"
beginning on page 12 and "Management's Discussion and Analysis of Financial
Condition and Results of Operations" beginning on page 20.

COMPANY OVERVIEW

        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(R)
column for the treatment of idiopathic thrombocytopenic purpura ("ITP"), an
immune-mediated bleeding disorder. In May 1996, the Company terminated its
exclusive distribution arrangement with Baxter Healthcare Corporation ("Baxter")
and regained the right to sell its Prosorba(R) column directly to customers.
Although the Company's direct sales and marketing efforts have proven more
effective than those under the Baxter distribution arrangement, ITP remains a
small market. In 1996, the Company initiated a Phase IV marketing study for the
use of the Prosorba(R) column in the treatment of ITP in an effort to generate
more rigorous clinical data then has been available to date. However, due to
increased competition for patients from other ITP studies, below expected
enrollment in the Company's study, and the more promising opportunities in the
rheumatoid arthritis ("RA") market, 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. Although the
termination of the study is not expected to have any negative effects on the
existing sales of the Prosorba(R) column for the treatment of ITP, lack of data
from the study will make it difficult to effect any appreciable increase in
sales above their current levels in the area of ITP.

        The Company's current clinical efforts to expand the approved
indications for the Prosorba(R) column are focused primarily on RA. In June
1996, the Company commenced a prospective, randomized, multicenter, double
blind, controlled Phase II 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
results. Based on such results, the Company plans to file a Pre-Market Approval
("PMA") application for the Prosorba(R) column for the treatment of RA with the
FDA in mid-1998. However, there can be no assurance that the Company will be
able to file the PMA by mid-1998, or if the PMA is filed, that FDA approval or
the Prosorba(R) column for the treatment of RA will be received on a timely
basis, if at all.

        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.

THE PROSORBA(R) COLUMN

        The Company's Prosorba(R) 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(R) column
therapy, blood is drawn from one arm of the patient, plasma and red blood cells
are separated, the plasma is filtered through the Prosorba(R) column to remove
unwanted CICs and IgG, then combined with the red blood cells and returned to
the patient's other arm. The Prosorba(R) column therapy is usually administered
on an outpatient basis. The Company received marketing approval from the FDA in
December 1987 to distribute the Prosorba(R) column for the treatment of ITP, an
immune-mediated bleeding disorder.

        The Prosorba(R) 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(R) column treats a dysfunctional immune system response rather
than treating the disease itself. The


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<PAGE>   4

Company is providing financial support for an extramural program with leading
academic laboratories to study the mechanisms of action of the Prosorba(R)
column.

        The Prosorba(R) 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(R) column to be a medical device. The Company has historically produced
the Prosorba(R) column at its own manufacturing facility which meets FDA good
manufacturing practice ("GMP") regulations for the manufacture of the product in
commercial quantities.

        The Company believes that key factors in its commercial performance will
be its ability to improve Prosorba(R) column sales for its currently approved
ITP indication, as well as additional disease indications for the Prosorba(R)
column, and obtain and develop complementary technologies.

Rheumatoid Arthritis

        RA is a potentially crippling autoimmune disease that is estimated to
affect over 5,000,000 people in North America and Europe. 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 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(R) 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(R) column. The Company believes that these findings
confirm the potential utility of the Prosorba(R) 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(R) column in
the treatment of RA. For the years ended December 31, 1997 and 1996, the amounts
of financial support provided by the Company were approximately $148,000 and
$90,000, respectively.

        In June 1996, the Company commenced a prospective, randomized,
multi-center, double blind, controlled Phase III pivotal trail 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(R) 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(R) 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
results. The Company is now in the process of preparing a PMA application for
submission to the FDA requesting new labeling for the Prosorba(R) column to
incorporate the RA indication. The Company expects to file the PMA by mid-1998,
and, if FDA approval is granted, expects to begin marketing the Prosorba(R)
column for use in the treatment of RA in 1999. However, there can be no
assurance that the Company will be able to file the PMA by mid-1998 or, if it
is, that FDA approval of the Prosorba(R) column for the treatment of RA will be
received on a timely basis, if at all.

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

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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 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. Current sales of platelets to hospitals for this purpose are about
$1.5 billion worldwide, including approximately $600 million in the U.S.
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% over
the period 1980 to 1992, 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.

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<PAGE>   6


        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:

<TABLE>
<CAPTION>
-------------------------------- -------------------------------- --------------------------------------
Human Platelets                  Cyplex(TM) Benefits                 Cyplex(TM) Economic Impact
-------------------------------- -------------------------------- --------------------------------------
<S>                              <C>                              <C>
Can transmit viruses             Viral Inactivation               Increased safety, reduced liability
                                                                  and testing costs

Patients frequently become       Does not induce                  Reduced hospitalization, no platelet
alloimmunized*                   alloimmunization                 typing, improved outcomes

Platelets do not control         Cyplex(TM) controls bleeding in  Reduced morbidity and mortality
bleeding in some patients        many of these patients

Shelf life of 3 to 5 days        Shelf life greater than one      Reduced loss from out-dating,
                                 year                             emergency availability, improved
                                                                  logistics and reduced infrastructure

Must be agitated constantly      Vial in refrigerator             Reduced storage costs
-------------------------------- -------------------------------- --------------------------------------
</TABLE>

*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 500,000 patients who currently
undergo coronary angioplasty to open blocked arteries in the U.S. each year,
about 25% will suffer reocclusion (restenosis) of the treated artery within a
few months, and nearly half within a couple of years. A key factor in the
development of restenosis is exposure of smooth muscle cells in the artery walls
to platelet derived growth factor ("PDGF") causing smooth muscle proliferation
development. 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.

        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

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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(R) 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(R) column in the United States and Canada for the treatment of ITP.
Baxter, at its own expense, was to provide sales and marketing support for the
sale of the product during the term of the agreement. The Company was to provide
significant marketing and promotional support to Baxter for the first three
years of the agreement.

        Effective May 1, 1996, the Company and Baxter terminated the exclusive
distribution agreement, whereby the Company regained the right to sell its
Prosorba(R) column directly to customers who had previously purchased the
Prosorba(R) column through Baxter as well as to any other potential customers
who wish to purchase the Prosorba(R) column. 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(R) 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.

        Internationally, the Company has entered into exclusive agreements for
distribution of the Prosorba(R) column in Spain, Korea, Mexico, Brazil,
Argentina, and Hong Kong. However, sales to international customers represent
less than 5% of the Company's product sales.

        Generally, in the United States the cost of treatment for ITP using the
Prosorba(R) column has been reimbursed by third-party payors.

        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(R) column is not subject to seasonal fluctuation.

PATENTS 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(R) COLUMN

        The Company presently owns nine issued U.S. patents and six
international patents (excluding patents relating to the area of platelet
therapeutics) which expire during 2004 to 2009. The process used in
manufacturing the Prosorba(R) column is covered by one of these patents. In
addition, the Company owns patents covering the use of the Prosorba(R) column in
the treatment of ITP and RA. Certain U.S. and international applications are
pending.

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<PAGE>   8

CYPLEX(TM) (INFUSIBLE PLATELET MEMBRANES), A PLATELET ALTERNATIVE

        The Company presently owns four 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 2014.

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.

        On June 30, 1997, the Company settled a patent infringement claim filed
against the Company alleging that the manufacture, use and sale of the
Prosorba(R) column infringed a patent issued to Dr. Meir Strahilevitz (the
"Strahilevitz Patent"). Pursuant to the terms of the settlement, the Company was
granted a nonexclusive license permitting the Company to use the Strahilevitz
Patent in connection with the manufacture, use and sale of its Prosorba(R)
column for the treatment of ITP and RA. The Company paid $70,000 upon settling
the patent infringement claim and accrued an additional $70,000 to be paid to
Dr. Strahilevitz in April 1998. In addition, the Company granted to Dr.
Strahilevitz an option to purchase up to 26,667 shares of Common Stock of the
Company at an exercise price of $1.50 per share.

        In November 1995, a complaint was filed with the United States District
Court, Northern District of California, claiming that the Company's Prosorba(R)
column allegedly infringes a patent issued to David S. Terman, M.D., which was
assigned in July 1993 to DTER-ENT, Inc., a California corporation ("DTER-ENT").
The Company first received notice of a claim of infringement from DTER-ENT in
July 1993. The Company has disclosed this claim in its public filings for the
past three years. The patent infringement claim was settled in April 1996
whereby the Company was granted a non-exclusive license to use the Terman
invention. The settlement of the claim did not and will not have a material
impact on the Company's financial position or results of operations.

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


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<PAGE>   9

product development and FDA regulatory review of each submitted new drug
application or product license application. 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.

THE PROSORBA(R) COLUMN

        The Prosorba(R) 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(R) 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(R) column, clinical testing must be conducted. Before such clinical
testing can begin, an 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, 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 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 with the Prosorba(R) 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(R) 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. Product marketing approvals
may be withdrawn for noncompliance with regulatory standards or the occurrence
of unforeseen problems following initial marketing.

        The Prosorba(R) column is commercially distributed for use in the
treatment of ITP under a PMA that was approved by the FDA in 1987. Changes to
the product and its manufacturing process, and certain types of labeling changes
must be


                                       9
<PAGE>   10

approved by the FDA prior to implementation. The Company completed and received
approval for a supplement to the PMA with the FDA for the consolidation of its
manufacturing facilities into one site in April 1997. There can be no assurance
that any future supplements will be approved by the FDA.

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 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.

        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.


                                       10
<PAGE>   11
COMPETITION

THE PROSORBA(R) COLUMN

        The Prosorba(R) 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. Many of the Company's potential competitors have significantly
greater resources than the Company. The Prosorba(R) 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
various diseases.

        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(R) column's performance measured against competing
products, adequate funding, 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(R) column. The Company's principal manufacturing operations for its
Prosorba(R) column are based in Redmond, Washington.

        The Company currently manufactures Cyplex(TM) in its Boston,
Massachusetts facility. In November 1997 the Company's management decided to
close its Boston facility by mid-1998. The Company expects to have adequate
amounts of Cyplex(TM) on hand by the closure of the facility to complete its
Phase II clinical trial, which was initiated in March 1998. The Company expects
to resume the production of Cyplex(TM) for trial purposes by mid-1999. 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 the Company commenced prior to closing the Boston
facility.

EMPLOYEES

        As of January 30, 1998, the Company employed approximately 39 full-time
employees. None of the Company's employees is covered by collective bargaining
agreements, and management considers relations with its employees to be good.


                                       11
<PAGE>   12
                                  RISK FACTORS

        Except for the historical information contained herein, the following
discussion contains forward-looking statements within the meaning of Section 21E
of the Exchange Act that involve risks and uncertainties. The Company's actual
results could differ materially from those discussed below and elsewhere in this
Report. Factors that could cause or contribute to such differences include,
those discussed in the following Risk Factors as well as in the sections
entitled "Business" beginning on page 3 and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" beginning on page 20.

Need for Additional Capital

        The Company is actively seeking opportunities to raise additional
capital to be used primarily to develop new and complete existing research, to
fund the proposed commercial launch of the Prosorba(R) column, to fund
additional clinical trials for other indications related to the proposed use of
the Prosorba(R) column for the treatment of RA, and to further the development
and marketing of Cyplex(TM). Except in very limited circumstances, the Company
is obligated to expend no less than $4.0 million on the development of
Cyplex(TM), of which the Company has expended approximately $3.3 million as of
December 31, 1997. To the extent the Company decides to continue the development
of products other than the Prosorba(R) column and Cyplex(TM), it will be
required to raise additional capital. The amount of capital required by the
Company is primarily dependent upon the following factors: results of clinical
trials, results of current research and development efforts, the FDA regulatory
process, costs of commercialization of any approved products and potential
competitive and technological advances and levels of product sales. Because the
Company is unable to predict the outcome of the previously noted factors, some
of which are beyond the Company's control, the Company is unable to estimate,
with certainty, its mid- to long-term total capital needs. Although the Company
may seek to raise additional capital through a combination of additional equity
offerings, joint ventures, strategic alliances, borrowings and other available
sources, there can be no assurance that the Company will be able to raise
additional capital through such sources or that funds raised thereby will allow
the Company to maintain its current and planned operations as provided herein.
If the Company is unable to obtain additional financing, it may be required to
delay, scale back or eliminate some or all of its research and development
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. The Company believes that current capital amounts are sufficient to
fund operations through 1998.

History of Operating Losses

        The Company has operated at a loss since its formation in October 1981.
As of December 31, 1997, the Company had an accumulated deficit of approximately
$68.8 million. The ability of the Company to achieve profitability is dependent
upon, among other things, successful completion of anticipated clinical trials
and obtaining FDA marketing approval of the Prosorba(R) column in disease
indications other than ITP in a timely manner. The Company would have to
significantly scale back its plans, curtail clinical trials, and limit its
present operations in order to become profitable or operate on a break-even
basis if it does not receive marketing approval from the FDA for the Prosorba(R)
column for the treatment of diseases in addition to ITP or for Cyplex(TM) for
the treatment of platelet disorders. There can be no assurance that the Company
will successfully complete any present or future clinical trials, gain FDA
approval to begin any new clinical trials, receive FDA approval of any future
PMA applications, meet applicable regulatory standards or successfully market
its products to generate sufficient revenues to render the Company profitable.
See "Recently Established Sales Force."

FDA Approval and Regulations

        The Company's Phase III clinical trial evaluating the use of the
Prosorba(R) column in the treatment of RA was stopped early in January 1998 on
the recommendation of the independent DSMB after the achievement of favorable
safety and statistically significant results. The Company intends to file a PMA
application with the FDA in mid-1998 to request new labeling for the Prosorba(R)
column to incorporate the RA indication. However, there can be no assurance that
the Company will successfully file such PMA application by mid-1998, if at all,
or when filed, if FDA approval of such application will be received on a timely
basis, if at all. In addition, there can be no assurance that the FDA will
approve the Prosorba(R) column for treatment of any other disease indications in
a timely manner, if at all. Even if FDA approval is received, there can be no
assurance that the Company will be successful in marketing the Prosorba(R)
column for the treatment of RA. Any such failure to successfully market the
Prosorba(R) column for use in the treatment of RA could have a material adverse
effect on the Company's business.


                                       12
<PAGE>   13

        The Company plans to continue development of Cyplex(TM) with an
additional Phase II clinical trial started in March 1998. Clinical trials are
vigorously regulated by the FDA and must meet requirements for institutional
review board oversight and informed consent as well as FDA review and oversight
and good clinical practice regulations. There can be no assurance that the
clinical trials being conducted for Cyplex(TM) will be completed successfully
within any specified period of time, if at all, or that if successful the
Company will be able to further develop and successfully commercialize
Cyplex(TM). Furthermore, the Company or the FDA may delay or suspend clinical
trials at any time if it is determined that the subjects participating in such
trials are being exposed to unacceptable health risks. Any such delay or
suspension could have a material adverse effect on the Company's business.

        The Prosorba(R) column is commercially distributed for use in the
treatment of ITP under a PMA application that was approved by the FDA in
December 1987. Changes to the product and its manufacturing process, and certain
types of labeling changes must be approved by the FDA before the Prosorba(R)
column can be used in the treatment of disease indications other than ITP. There
can be no assurance that any new PMA applications or supplements will be
approved by the FDA.

        Even if FDA approval is granted to market a product for the treatment of
a particular disease, subsequent discovery of previously unknown problems may
result in restrictions on the product's future use or withdrawal of the product
from the market. In addition, any other products developed in the future will
require clinical testing and FDA marketing approval before they can be
commercially exploited in the United States. Such approval process is typically
very lengthy and there is no assurance that FDA approvals will be obtained.

        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 use, applicable law requires compliance with the
FDA's GMP regulations. Failure to comply with the FDA's GMP regulations or with
other applicable legal requirements can lead to federal seizure of non-complying
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. Any such seizure, injunctive action or other enforcement measure
could have a material adverse effect on the Company's business.

        The Company produces commercial quantities of the raw materials utilized
in the production of the Prosorba(R) column and assembles the column at its
GMP-approved facility located in Redmond, Washington. In addition, the Company,
occupies a facility that includes a GMP-approved pilot production plant where
all phases of production of clinical-grade Cyplex(TM) occurs, except for filling
and lyophilization. In November 1997, the Company's management decided to close
its Boston facility by mid-1998. The Company expects to have an adequate supply
of Cyplex(TM) on hand by the closure of the facility to complete its Phase II
clinical trial started in March 1998. The Company expects to resume
the production of Cyplex(TM) for trial purposes by mid-1999. However, 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 prior to closing the Boston facility. In addition,
there can be no assurance that the Company will be able to maintain its
facilities' GMP-approved status or that, if approval is not maintained, it will
be able to find alternate GMP-approved production facilities.

Recently Established Sales Force

        In March 1996, the Company and Baxter terminated their exclusive
distribution agreement, whereby, effective May 1, 1996, the Company regained the
right, among other things, to sell its Prosorba(R) column directly to customers
who had previously purchased Prosorba(R) columns through Baxter as well as to
any other potential customers who wish to purchase Prosorba(R) columns. As a
result of the termination of the distribution agreement with Baxter, the Company
has established a domestic sales force to sell the Prosorba(R) column directly
to customers who previously purchased Prosorba(R) columns from Baxter and to
other potential customers who wish to purchase Prosorba(R) columns directly from
the Company. However, there can be no assurance that the Company's domestic
sales force will be successful in selling the Prosorba(R) column for use in the
treatment of ITP.

        Furthermore, to date, the Company's sales force has made commercial
sales of the Prosorba(R) column only for use in the treatment of ITP. The
Company's sales force has had no experience in marketing the Prosorba(R) column
for use in the treatment of disease indications other than ITP, and there can be
no assurance that, if the Company receives FDA approval to use the Prosorba(R)
column in the treatment of RA or any other disease indications other than ITP,
the Company's sales force will be successful in marketing the Prosorba(R) column
for any such use. Any such failure to successfully market the Prosorba(R)


                                       13
<PAGE>   14
column for RA, if approved, or any other disease indications other than ITP
could have a material adverse effect on the Company's business.

        In addition, there can be no assurance that the Company's sales force
will be successful in marketing the Company's Cyplex(TM) or any other products
developed by the Company, if and when the Company receives FDA approval for and
is able to commercialize for sale any such products. Any such failure to receive
FDA approvals or otherwise successfully market the Company's products could have
a material adverse effect on the Company's business.

Dependence Upon Key Personnel

        The Company's success is dependent upon certain key management and
technical personnel, including the members of senior management. The loss of the
services of any of these key employees could have a material adverse effect on
the Company. The Company does not currently maintain any key employee insurance
coverage.

Competitive Environment; Technological Change; Effectiveness of Products

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

        The immunological therapy market is characterized by rapid technological
change and potential introductions of new products or therapies. To respond to
these changes, the Company may be required to develop or purchase new products
to protect its technology from obsolescence. There can be no assurance that the
Company will be able to develop or obtain such products, or, if developed or
obtained, that such products will be commercially viable. In addition, there can
be no assurance that the Company's Prosorba(R) column will prove effective in
the treatment of diseases other than ITP or that Cyplex(TM), if approved for
sale by the FDA, will be an effective alternative to traditional platelet
therapy.

Dependence on Third Party Arrangements

        The Company's commercial sale of its proposed products and its future
product development may be dependent upon entering into arrangements with
corporate partners and other third parties for the development, marketing,
distribution and/or manufacturing of products utilizing the Company's
proprietary technology. While the Company is currently seeking collaborative
research and development arrangements and joint venture opportunities with
corporate sponsors and other partners, there can be no assurance that the
Company will be successful in entering into such arrangements or joint ventures
or that any such arrangements will prove to be successful.

Limited International Sales and Marketing

        The Company conducts limited marketing of the Prosorba(R) column outside
the United States through foreign distributors. Sales to foreign distributors
have not been material to the Company's results from operations. There can be no
assurance that foreign sales arrangements will become material to the Company's
results of operations.

Uncertainty of Patent Protection and Claims to 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, the maintenance of 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 Company presently owns nine issued U.S. patents and six
international patents (excluding patents relating to the area of platelet
therapeutics) which expire during 2004 to 2009. The process used in
manufacturing the Prosorba(R) column is


                                       14
<PAGE>   15
covered by one of these patents. Certain U.S. and international applications are
pending. The Company has an exclusive license for a U.S. patent for a genetic
screening test to predict which RA patients will develop severe disease. In
addition, the Company has an exclusive license for a U.S. patent for treating
cellular Fc receptor-mediated hypersensitivity immune disorders.

        The Company presently owns four issued U.S. patents and three pending
U.S. patent applications relating to the area of platelet therapeutics.
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 2014.

        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 the Company's 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.

Concentration of Ownership

        As of January 30, 1998, Allen & Company Incorporated and Mr. Richard M.
Crooks, a director of the Company, beneficially owned approximately 14.7% and
2.9% respectively, of the outstanding Common Stock of the Company. Mr. Crooks is
also a director and consultant to Allen & Company Incorporated. In addition,
Paramount Capital, Inc., through its affiliates, currently beneficially holds
13.4% of the Company's outstanding Common Stock. Together, Mr. Crooks, Allen &
Company Incorporated and Paramount Capital, Inc. own a significant amount of the
total outstanding Common Stock of the Company and may be able to exert
substantial influence over the outcome of matters requiring stockholder
approval.

Insurance Reimbursement

        Successful commercialization of a new medical product, such as the
Prosorba(R) column or Cyplex(TM) depends, in part, on reimbursement by public
and private health insurers to health care providers for use of such products.
The availability of such reimbursement is subject to a variety of factors, many
of which could affect the Company as it commercializes use of the Prosorba(R)
column and continues development and commercialization of Cyplex(TM). Although
the Company has been generally successful in assisting health care providers in
arranging reimbursement for the use of the Prosorba(R) column in the treatment
of ITP, there can no assurance that public and private insurers will continue to
reimburse the Company for the use of the Prosorba(R) column or that such
reimbursement will be available in connection with the use of the Prosorba(R)
column in the treatment of other disease indications approved by the FDA, if
any. In addition, there can be no assurance that health care providers will
reimburse the Company for the use of Cyplex(TM), when and if commercialized.

Product Liability

        The use of the Prosorba(R) column and, when and if approved for use by
the FDA, Cyplex(TM), involves the possibility of adverse effects occurring to
end-users that could expose the Company to product liability claims. The Company
believes that its product liability insurance coverage is adequate in light of
the Company's business. However, although the Company currently maintains
product liability insurance coverage, there can be no assurance that such
coverage or any increased amount


                                       15
<PAGE>   16

of coverage will be adequate to protect the Company and there can be no
assurance that the Company will have sufficient resources to pay any liability
resulting from such a claim.

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, the Company's product. The Company
believes that government and private efforts to contain or reduce health care
costs are likely 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.

Possible Volatility of Stock Price; Absence of Dividends

        There has been significant volatility in the market prices of securities
of biomedical companies in general, including the Company's securities. Factors
such as announcements by the Company or by others of technological innovations,
results of clinical trials, new commercial products, regulatory approvals or
proprietary rights developments, coverage decisions by third-party payors for
therapies and public concerns regarding the safety and other implications of
biotechnology and biomedical products may have a significant impact on the
Company's business and market price of the Company's securities. In addition, in
connection with the acquisition of PRP the Company is obligated to make a $5.0
million milestone payment to the former holders of equity securities (including
holders of warrants and options) of PRP upon the public announcement of an FDA
approval letter relating to the use of Cyplex(TM) for the treatment of
thrombocytopenia. The Company has the option to make such milestone payment in
the form of cash or common stock of the Company. The payment of $5.0 million in
cash could have a material adverse effect on the Company's financial condition.
In addition, the issuance of common stock with a value of $5.0 million could
have a significant impact on the market price of the Company's securities.

        No dividends have been paid on the Company's common stock to date, and
the Company does not anticipate paying dividends on its capital stock in the
foreseeable future.

Hazardous Material

        The Company's 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 the Company believes that its 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, the Company could be held liable for any damages that result, and any
such liability could exceed the resources of the Company.

Limitation of Net Operating Loss Carryforwards

        The Company's sales of common stock in November 1990 and September 1991,
when taken together with prior issuances, caused the limitation of Section 382
of the Internal Revenue Code of 1986, as amended, to be applicable. This
limitation will allow the Company 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 and before consideration
of the effect of issuances of common stock after 1991, the Company 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 the Company, 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 1998 to 2010.

                                       16
<PAGE>   17
ITEM 2.   PROPERTIES

        The Company currently occupies approximately 17,800 square feet of
leased office and manufacturing facilities in San Diego, California, Redmond,
Washington and Boston, Massachusetts. The 2,800 square foot San Diego facility
houses the Company's executive offices, as well as its administration, research
and medical personnel. The five-year lease for this facility expires in 2001. In
November 1997, the Company's management decided to close its Boston facility by
mid-1998. The Boston facility is approximately 7,000 square feet, and is used
primarily for the manufacture of clinical-grade Cyplex(TM). The Company expects
to have adequate amounts of Cyplex(TM) on hand by the closure of the facility to
complete its Phase II clinical trial started in March 1998. The Company expects
to resume the production of Cyplex(TM) for trial purpose by mid-1999 in one if
its existing facilities, a new facility or under agreement with a third party.

        The Company leases 8,000 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(R) column. Assembly of the
Prosorba(R) 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(R) column can be performed in a
single facility. The Redmond facility received FDA GMP approval in April 1997
and recently passed a subsequent GMP inspection in March 1998.

        The Company leased a 14,400 square foot facility in Seattle, Washington
under a lease expiring in 2004. In conjunction with the Company's 1996
restructuring plan and corresponding reduction in facilities, this space was
subleased to another party in April 1996, and was subsequently released from any
obligations by the owner of the property in August 1997.

        The Company believes that its property and equipment are generally well
maintained and in good operating condition. The Company believes that its
production plant in Redmond, Washington, which is currently operating at
approximately 30% of capacity, is adequate and will allow the Company to meet
its production needs for sales and clinical use of the Prosorba(R) column in
1998. 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 September 30, 1997 and is
incorporated herein by reference.


                                       17
<PAGE>   18
                                     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 closing sale prices for the
Company's common stock for each quarter of 1997 and 1996 as reported by the
NASDAQ Stock Market, Inc.

<TABLE>
<CAPTION>
                                                      PRICE RANGE OF COMMON STOCK
                                                      ---------------------------
                                                        HIGH              LOW
                                                      --------         ----------
    <S>                                               <C>              <C>
    YEAR ENDED DECEMBER 31, 1998:
      First Quarter (through March 26, 1998) ...      $   3.81         $   1.28

    YEAR ENDED DECEMBER 31, 1997
      First Quarter ......................            $   2.00         $   1.56
      Second Quarter .....................                2.56             1.22
      Third Quarter ......................                2.44             1.53
      Fourth Quarter .....................                1.97             1.19

    YEAR ENDED DECEMBER 31, 1996
      First Quarter ......................            $   2.63         $   1.88
      Second Quarter .....................                2.56             2.25
      Third Quarter ......................                2.25             1.75
      Fourth Quarter .....................                2.38             1.63
</TABLE>

        The above quotations are interdealer prices, without retail mark-up,
mark-down or commission and may not necessarily represent actual transactions.
As of March 24, 1998, there were approximately 993 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 October 1997, the Company sold in a private placement 3,851,029
shares of the Company's common stock at a price of $1.50 per share, resulting in
net proceeds (after deducting placement agent fees of $203,000) to the Company
of $5,573,535. The shares were sold to certain individuals and entities either
generally previously known to the Company to be investors in the Company's
Common Stock or introduced to the Company by the placement agents retained by
the Company to assist it in the private placement (the "Shareholder Class"). The
sale and issuance of the shares in the private placement was deemed to be exempt
under the Securities Act by virtue of Section 4(2) of the Securities and
Exchange Act of 1933, as amended and/or Regulation D promulgated thereunder. The
members of the Shareholder Class represented their intention to acquire the
shares for investment purposes only and not with a view to the distribution
thereof.


                                       18
<PAGE>   19
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,
                                    --------------------------------------------------------------------------------
                                        1997             1996             1995             1994             1993
                                    ------------     ------------     ------------     ------------     ------------
                                                      (RESTATED)       (RESTATED)
<S>                                 <C>              <C>              <C>              <C>              <C>
CONSOLIDATED STATEMENT OF
OPERATIONS DATA:
Results of Operations:
   Product sales                    $  2,970,342     $  1,967,976     $  1,104,224     $  4,918,126     $  5,410,530
   Grant income                          325,316               --               --               --               --
   Revenue under
   distribution agreement                     --               --        3,000,000               --               --
                                    ------------     ------------     ------------     ------------     ------------
                                       3,295,658        1,967,976        4,104,224        4,918,126        5,410,530
Costs and expenses:
   Production costs                    1,772,681        1,482,563        2,041,422        2,571,168        1,582,986
   Sales and marketing                 1,292,942          794,356          819,907        3,550,037        4,758,427
   Research and development            6,707,557        4,002,968        3,219,324        2,107,694        2,059,129
   General and administrative          2,803,079        4,649,298        2,626,817        2,694,489        2,105,743
   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               --               --
                                    ------------     ------------     ------------     ------------     ------------
                                      12,576,259       16,846,528       11,101,512       10,923,388       10,506,285
Other income (expense):
   Interest income                       425,935          458,070          118,994           71,986          134,483
   Interest expense                      (31,737)      (1,119,726)        (261,958)        (218,036)          (7,659)
                                    ------------     ------------     ------------     ------------     ------------
                                         394,198         (661,656)        (142,964)        (146,050)         126,824
                                    ------------     ------------     ------------     ------------     ------------

Loss from operations                  (8,886,403)     (15,540,208)      (7,140,252)      (6,151,312)      (4,968,931)
Minority interest in loss                     --               --               --               --           47,711
                                    ------------     ------------     ------------     ------------     ------------
Net loss                            $ (8,886,403)    $(15,540,208)    $ (7,140,252)    $ (6,151,312)    $ (4,921,220)
                                    ============     ============     ============     ============     ============

Net loss per share - basic and
  diluted                           $      (0.25)    $      (0.53)    $      (0.41)    $      (0.40)    $      (0.33)
                                    ============     ============     ============     ============     ============

Weighted average number of
   shares outstanding - basic
   and diluted                        35,236,579       29,206,470       17,598,735       15,243,860       14,716,472
                                    ============     ============     ============     ============     ============
</TABLE>

<TABLE>
<CAPTION>
                                                                      DECEMBER 31,
                                    --------------------------------------------------------------------------------
                                        1997             1996             1995             1994             1993
                                    ------------     ------------     ------------     ------------     ------------
<S>                                 <C>              <C>              <C>              <C>              <C>
CONSOLIDATED BALANCE SHEET
DATA:
Cash, cash equivalents and
  short-term investments            $  8,515,653     $ 10,935,668     $  1,009,878     $  3,670,616     $  2,283,583
Total assets                        $ 11,788,766     $ 14,961,076     $  4,563,709     $  7,721,013     $  7,761,598
Long term debt (net of
  current portion)                  $    407,735     $    412,020     $  1,539,722     $  4,247,759     $         --
Total stockholder's equity
  (deficit)                         $  9,525,992     $ 12,134,565     $   (524,762)    $  1,980,719     $  4,839,725
Working capital (deficit)           $  7,916,228     $ 10,161,170     $   (688,771)    $  4,360,749     $  3,787,412
</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.


                                       19
<PAGE>   20
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS

        Except for the historical information contained herein, the following
discussion contains forward-looking statements within the meaning of Section 21E
of the Exchange Act that involve risks and uncertainties. The Company's actual
results could differ materially from those discussed below and elsewhere in this
Report. Factors that could cause or contribute to such differences include,
without limitation, those discussed in this section as well as those discussed
in the sections entitled "Business" beginning on page 3 and "Risk Factors"
beginning on page 12.

LIQUIDITY AND CAPITAL RESOURCES

        Cash, cash equivalents and short-term investments totaled $8.5 million
and $10.9 million, at December 31, 1997 and 1996 respectively. The decrease in
cash, cash equivalents and short-term investments of approximately $2.4 million
was due primarily to the Company's $8.9 million loss for the year ended December
31, 1997, which was partially offset by net proceeds of approximately $5.6
million received by the Company in the private placement of common stock
completed in October 1997. Working capital at December 31, 1997 was
approximately $7.9 million.

        The Company expects to incur operating losses until it obtains marketing
approval from the FDA for additional disease indications for the Prosorba(R)
column, or until sales for the Prosorba(R) column for its existing indication of
ITP increase significantly, or until it obtains FDA approval for and
successfully commercializes Cyplex(TM). There can be no assurance that the
Company will be able to obtain FDA approval to market the Prosorba(R) column for
disease indications other than ITP, increase sales in the area of ITP or obtain
FDA approval for or be able to successfully commercialize Cyplex(TM).

        In January 1998, the Company announced that its Phase III pivotal study
of the Prosorba(R) column in the treatment of RA was stopped. The study was
halted based on the recommendation of the independent DSMB after an analysis of
the available data showed that the Prosorba(R) column had achieved both
statistically significant efficacy and favorable safety results. The Company has
begun its efforts to prepare an application for PMA to be filed with the FDA's
Medical Device Division and is expected to be completed in mid-1998. The
application will request new labeling for the Prosorba(R) column to incorporate
the RA indication. However, there can be no assurance that the Company will file
its PMA application on a timely basis or that FDA approval to market the
Prosorba(R) column for disease indication other than ITP will be received on a
timely basis, if at all.

        Although the Company is not obligated under any third party agreements,
capital expenditures during 1998 are expected to be approximately $450,000 and
will be used to support continued product commercialization and research and
development activities.

        In the future, the Company's capital requirements will depend on
numerous factors, including the progress of the Company's research and
development activities and PMA application for RA. The Company currently
believes it has sufficient funds to support its operations through December 31,
1998. To the extent necessary, further sources of funds may include future
strategic alliances or joint venture arrangements which may provide funding to
the Company, and additional public or private offerings of debt or equity
securities, among others. There can be no assurance, however, that the Company
will be successful or that additional funds will be available on acceptable
terms, if at all.

        In October 1997, the Company completed a private placement of 3,851,029
shares of the Company's common stock at a price of $1.50 per share. The net
proceeds to the Company were approximately $5.6 million or $1.45 per share,
after total costs of approximately $203,000.

        The Company will require additional financing in order to launch the
Prosorba(R) column in RA, initiate pivotal clinical trials using the Prosorba(R)
column in other diseases and to apply the Company's technology to applications
beyond the Prosorba(R) column, such as Cyplex(TM). There can be no assurance
that the Company will receive FDA approval for use of the Prosorba(R) column in
the treatment of RA, or if it does, that the Company will be able to
successfully market the Prosorba(R) column for use in RA. In addition, there can
be no assurance that additional financing will be available on terms favorable
to the Company, if at all.


                                       20
<PAGE>   21
RESULTS OF OPERATIONS

Revenues

        Revenues associated with product shipments were $3.0 million, $2.0
million and $1.1 million in 1997, 1996 and 1995, respectively. The significant
increase in sales in 1997 from 1996 is a result of the Company regaining the
distribution rights to the Prosorba(R) column in May 1996 and initiating direct
sales and marketing efforts as mentioned below. Revenues associated with product
shipments began to increase in 1996 in conjunction with the Company regaining
distribution rights effective in May 1996 and initiating direct sales and
marketing efforts as mentioned below.

        In April 1994, Baxter assumed sales and marketing responsibilities under
a 10-year exclusive distribution agreement, granting distribution rights of the
Prosorba(R) column in the United States and Canada for the treatment of
thrombocytopenia. Under the Baxter distribution agreement, Baxter was obligated
to purchase from the Company minimum numbers of Prosorba(R) columns at a
predetermined price per column. In the event such minimums were not purchased,
Baxter was nevertheless obligated to pay the Company for that number of
Prosorba(R) columns that Baxter was obligated to purchase under the distribution
agreement. Baxter, at its own expense, was to provide sales and marketing
support for the sale of the product during the term of the agreement. The
Company was to provide significant marketing and promotional support to Baxter
for the first three years of the agreement.

        In March 1995, the two companies amended the agreement whereby Baxter:
(a) made a non-refundable take-or-pay payment on March 31, 1995 for the first
sales year after the amendment of $3.0 million, (b) agreed to purchase $1.0
million of product during the second quarter of 1995, (c) released the Company
from its obligation to provide marketing and promotional support for the second
and third years of the agreement, (d) gave the Company the right to co-market
with Baxter, (e) relinquished its first right to negotiate for new Prosorba(R)
column indications, and (f) agreed under certain circumstances to provide
advance payments to the Company for Baxter's 1996 purchases. The Company agreed
to eliminate purchase minimums and the take-or-pay concept included in the
original agreement and freed Baxter to pursue competing thrombocytopenia
therapies.

        The impact of the revised Baxter agreement referred to above had a
variety of effects on the operations of the Company during the year ended
December 31, 1995. The Company's revenue included the non-refundable $3.0
million take-or-pay payment made by Baxter in March 1995. In addition, sales and
marketing costs relative to sales decreased based on Baxter agreeing to assume
all marketing and promotional costs.

        Effective May 1, 1996, the Company and Baxter terminated the exclusive
distribution agreement, whereby the Company regained the right to sell its
Prosorba(R) column directly to customers who had previously purchased the
Prosorba(R) column through Baxter as well as to any other potential customers
who wish to purchase the Prosorba(R) 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. In 1996, the Company initiated a Phase IV marketing study for use
of the Prosorba(R) 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(R)
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. Lack of data from that study
will make it difficult to effect any appreciable increase in sales above their
current levels until the Company obtains, if and when it does, FDA approval for
sale of the Prosorba(R) column for the treatment of RA. The Company hopes to
obtain such approval by mid-1999, however, there can be no assurance that such
approval will be obtained in the time expected, if at all.

        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, 1997 the Company recorded approximately
$325,000 in grant income. Revenues from the grant are recognized as grant
expenditures are incurred. The aggregate amount remaining under the grant is
approximately $371,000. 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.


                                       21
<PAGE>   22
Operating Expenses

        Consolidated operating expenses for the years ended December 31, 1997,
1996 and 1995 were $12.6 million, $16.8 million and $11.1 million, respectively.
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. The increase of $5.7 million in 1996 from 1995 relates
primarily to the non-recurring, and primarily non-cash, charges for the
acquisition of PRP and the Company's restructuring and recapitalization. These
increases were offset, in part, by a reduction in operating costs resulting from
the Company's restructuring. For the year ended December 31, 1996, consolidated
operating expenses include only the two months of PRP's operations subsequent to
its acquisition by the Company.

        Production costs were approximately $1.8 million, $1.5 million and $2.0
million for the years ended December 31, 1997, 1996 and 1995, respectively.
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(R) 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 1997 production costs from 1996 also reflected an increase in
columns manufactured to accommodate increases in sales and columns used in the
RA trial. The decrease in production costs in 1996 from 1995 is also
attributable to a reduction in manufacturing labor and overhead costs associated
with the restructuring. The total number of Prosorba(R) columns produced in 1996
was in excess of that amount produced in 1995. Since manufacturing overhead was
fairly consistent in 1995 and 1994, the fluctuation in production costs is
directly attributable to the decrease in the number of units produced in 1995.

        Sales and marketing costs were approximately $1.3 million, $794,000 and
$820,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
The increase of approximately $499,000 in 1997 from 1996 is a result of the
Company's initiation of direct sales and marketing efforts beginning in May of
1996 and the hiring of a direct sales force in August of 1996. The decrease in
1996 from 1995 is a result of the Company's March 1995 renegotiation agreement
with Baxter. During the first quarter of 1995, the Company was still obligated
to provide marketing and promotional support to Baxter. In March 1995, the
Company was released from that obligation and, thus, incurred significantly less
expense through the May 1996 re-initiation of product sales directly to
customers. As a result of that termination, however, and the related
establishment of an internal sales force to directly sell the Prosorba(R)
column, the Company anticipates an increase of sales and marketing expenses in
future periods.

        Research and development expenses increased to $6.7 million in 1997,
from $4.0 million and $3.2 million in 1996 and 1995, respectively. 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 cost 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(R) 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 increase
spending on the Company's controlled clinical trial for use of the Prosorba(R)
column in the treatment of RA. The 24% increase in 1996 from 1995 is indicative
of the Company's increased focus on the clinical development of new products and
relates primarily to the June 1996 launch of the Company's Phase III pivotal
trial of the Prosorba(R) column for use in RA. In January of 1998, the Company
announced that its Phase III pivotal trial evaluating the efficacy of the
Prosorba(R) column in the treatment of RA had been stopped early due to
achieving favorable safety and statistically significant efficacy results on an
intent-to-treat basis. The Company expects further increases in research and
development expenses in future periods as the aforementioned trial is concluded
and with the commencement in March 1998 of a Phase II efficacy trial for
Cyplex(TM).



                                       22
<PAGE>   23
General and administrative expenses were $2.8 million, $4.6 million, and $2.6
million for the years ended December 31, 1997, 1996 and 1995, respectively. The
decrease of approximately $1.8 million in 1997 from 1996 was a result of the
Company's efforts to control costs, and nonrecurring expenses in 1996 associated
with the hiring of the Company's new Chief Executive Officer, and 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 significant decrease in 1997
also relates to the Company's restatement of its previously issued financial
statements as of and for the years ended December 31, 1996 and 1995. The Company
recorded approximately $1.1 million of additional compensation expense in 1996
related to certain stock options granted in 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 achieving certain milestones, were also
non-recurring. The increase of approximately $2.0 million in 1996 from 1995 was
principally a result of costs associated with the hirings of the Company's new
Chief Executive Officer and President, Chief Operating Officer in December 1995
and the Company's restatement of its previously issued financial statements
resulting in a charge of $1.1 million to compensation expense in 1996 as
mentioned above. Such expenses were partially offset by the resignation of the
Company's Chief Scientific Officer in March 1996 whose duties were assumed by
the new Chief Executive Officer. In addition, approximately $501,000 and
$741,000 was recorded as compensation expense in 1997 and 1996, respectively for
stock options granted at less than the closing sales price on the date of grant.

        In 1995, the Company acquired the minority interest of CELx Corporation,
the Company's former majority owned subsidiary of the Company. In connection
with the acquisition, the Company recorded $625,000 as acquired in-process
research and development. The charge was based upon the fair market value of the
Company's common stock on the date of the transaction.

        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. The Company recorded a non-cash expense of approximately
$1.1 million in 1995 as a debt conversion expense for the conversion of the same
7% Convertible Debentures discussed above. The expense represents the fair
market value of the increased number of shares issued under the terms of the
exchange offering compared to the original terms of the 7% Convertible
Debentures. The above amounts reflect the Company's restatement of its
previously issued financial statements as of and for the years ended December
31, 1996 and 1995. The restatement required the Company to record an additional
$93,000 and $314,000 of debt conversion expense during the years ended December
31, 1996 and 1995 respectively, related to deferred debt issuance costs
associated with the March 1996 and September 1995 exchange offerings to the
holders of the 7% Convertible Debentures.

        In December 1995, the Company recorded a restructuring charge
aggregating $645,000 relating to the Company's plan to consolidate its
manufacturing facilities to one location in the state of Washington and to move
all other operations to San Diego, California. This charge included
approximately $350,000 related to write-downs of equipment and leasehold
improvements for the manufacturing facility vacated in 1996, $200,000 related to
abandonment of leases in Seattle and Princeton with the remainder related to a
severance commitment with its former Executive Vice President who resigned in
December 1995. 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.
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. 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 (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 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.


                                       23
<PAGE>   24
        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 and advance Cyplex(TM) as a principal product of the
Company. 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 Cyplex(TM), safety, 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.

Interest Expense

        Interest expense for the years ended December 31, 1997, 1996 and 1995
were approximately $32,000, $1.1 million and $262,000, respectively. The
decrease in 1997 from 1996 and the increase from 1995 to 1996 is due to the
restatement of the Company's previously issued financial statements as of and
for the years ended December 31, 1996 and 1995 in 1997. In accordance with EITF
D-60, which was issued in March 1997 but which is applicable to previously
issued financial statements, the Company recorded $1,063,000 of interest expense
in 1996 related to the Senior Convertible Debentures which were issued with a
discounted conversion feature.

Net Loss

        Net loss for the year ended December 31, 1997 was approximately $8.9
million compared to approximately $15.5 million in 1996. The decrease of
approximately $6.7 million is a result of an increase in research and
development related to the Company's RA trial offset in part by an increase in
revenue and a decrease in general and administrative costs. For the year ended
December 31, 1996, the acquisition of PRP, and the cost of the restructuring and
recapitalization, and the decrease in total revenues was only partially offset
by the decrease in recurring operating expenses thereby resulting in a net loss
of $15.5 million or $0.53 per share (basic and diluted). For the year ended
December 31, 1995, the Company reported a net loss of $7.1 million.

IMPACT OF YEAR 2000

        The "Year 2000 Issue" addresses the problems created by the fact that
most computer software programs have been written using two digits, rather than
four, to represent a specific year (e.g., "97" would represent 1997). Such
date-sensitive software programs may recognize a date using "00" as the year
1900 rather than the year 2000, which might result in system failures or
miscalculations causing a disruption in operations, including among others,
temporary inability to process normal accounting transactions, send invoices or
engage in similar normal business activities. In addition, to the extent a
company distributes products containing date-sensitive computer programs, a
company may incur substantial costs and time creating or modifying existing
software programs, inventory and returned products.

        The Company has completed an assessment of the impact of the Year 2000
Issue on its internal and external operations, and had determined that it will
be required to upgrade certain software programs it employs in the normal course
of business, including its accounting application software and certain other
administrative software. The total cost of the Year 2000 Issue project is
estimated to be less than $50,000 and is estimated to be completed no later than
December 31, 1998. The Company believes that the Year 2000 Issue will not have a
material adverse effect on its operations or business.

        The cost of the Year 2000 Issue project and the date on which the
Company believes it will complete the Year 2000 modifications are based on
management's best estimates, which were derived utilizing numerous assumptions
of future events, including the continued availability of certain resources and
other factors. However, there can be no guarantee that these estimates will be
achieved and actual results could differ materially from those anticipated.
Specific factors that might cause such material differences include, but are not
limited to the availability and cost of personnel trained in this area, the
ability to locate and correct all relevant computer codes, and similar
uncertainties.



                                       24
<PAGE>   25

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










                                       25
<PAGE>   26

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY

        The directors and executive officers of the Company as of February 28,
1998 are as follows:

<TABLE>
<CAPTION>
               NAME                     AGE                              POSITION
               ----                     ---                              --------
<S>                                     <C>     <C>
Jay D. Kranzler, M.D., Ph.D.(1)(2)      40      Chief Executive Officer, Chief Scientific Officer, Chief
                                                Financial Officer and Vice Chairman of the Board of
                                                Directors

Debby Jo Blank, M.D.(1)(2)              46      President, Chief Operating Officer and Director

R. Michael Gendreau, M.D.               42      Vice President, Research & Development and Chief Medical
                                                Officer

Richard M. Crooks, Jr.(3)(4)(5)         58      Chairman of the Board of Directors

Philip J. O'Reilly(3)(4)(5)             59      Director

Jack H. Vaughn(3)(5)                    77      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

(5)  Member of Compensation 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. 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.

        DEBBY JO BLANK, M.D., was appointed President, Chief Operating Officer
and Director of the Company in December 1995. Prior to joining the Company, from
1994 through the end of 1995, Dr. Blank was Senior Vice President, Marketing,
for Advanced Technology Laboratories, a publicly held manufacturer and
distributor of ultrasound equipment. From 1993 to 1994, she was Vice President,
U.S. Marketing for Syntex. From 1989 to 1993, Dr. Blank held various positions
at the DuPont Company and the DuPont Merck Pharmaceutical Company ("DuPont"),
including Vice President Worldwide Marketing, Vice President, New Product
Planning & Licensing, and Vice President, Strategy and Business Development.
Before joining DuPont, she was employed by the management-consulting firm,
Arthur D. Little, from 1986 to 1989 as a consultant in its pharmaceutical
practice.

        R. MICHAEL GENDREAU, M.D., was appointed Vice President of Research and
Development and Chief Medical Officer of the Company in December 1996. 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.

        MR. 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 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 Excaliber Technologies Corporation.

        MR. 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.


                                       26
<PAGE>   27

        MR. 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.

        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. 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.

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.,
Pugetsound 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.


                                       27
<PAGE>   28

ITEM 11. EXECUTIVE COMPENSATION

COMPENSATION OF DIRECTORS


        Each nonemployee director of the Company is entitled to receive $12,000
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 1997. In addition, each nonemployee director is entitled to receive
an option to purchase 10,000 shares of common stock of the Company upon such
nonemployee 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
re-election of such nonemployee director to the Board. 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 1997. 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 information concerning compensation
awarded or paid to, or earned for the fiscal years ended December 31, 1997, 1996
and 1995 by the Chief Executive Officer of the Company and those executive
officers whose salary and bonus for fiscal year 1997 exceeded $100,000
(collectively, the "Named Executive Officers"):

<TABLE>
<CAPTION>
                                                                            LONG-TERM
                                                                          COMPENSATION
                                                ANNUAL COMPENSATION            (1)
                                             ------------------------        -------      -----------
                                                                              SHARES        ALL OTHER
     NAME AND PRINCIPAL           FISCAL        BASE                        UNDERLYING    COMPENSATION
          POSITION                 YEAR       SALARY($)      BONUS($)       OPTIONS(#)         ($)
     ------------------           ------     ---------      ---------       ----------    ------------
<S>                                <C>       <C>            <C>              <C>          <C>
Jay D. Kranzler, M.D., Ph.D.,      1997      $ 245,000      $ 125,000        277,440      $  10,800(3)
   Chief Executive Officer,        1996        240,000        135,000      3,025,327         10,700(4)
   Chief Scientific Officer,       1995             --         50,000             --             --
   Chief Financial Officer
   and Vice Chairman(2)

Debby Jo Blank, M.D.,              1997        215,500        101,500        101,415          9,500(6)
   President, Chief Operating      1996        210,000        135,000      1,134,497        164,236(7)
     Officer and Director(5)       1995             --         50,000             --             --

R. Michael Gendreau, M.D           1997        149,000            262             --          4,472(6)
   Vice President, Research        1996        145,000         25,000        125,000         57,805(8)
   and Development and             1995        145,000             --        141,000          7,537(6)
   Chief Medical 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)     Dr. Kranzler was appointed Chief Executive Officer of the Company on
        December 28, 1995. Amounts shown as Annual Compensation do not reflect
        approximately $20,000 which Dr. Kranzler received as a consultant to the
        Company during 1995.

(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 was appointed President and Chief Operating Officer on
        December 28, 1995. Amounts shown as Annual Compensation do not reflect
        approximately $20,000 which Dr. Blank received as a consultant to the
        Company during 1995.

(6)     Represents contributions made by the Company under its 401(k) plan.


                                       28
<PAGE>   29

(7)     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.

(8)     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

        The following table sets forth certain information regarding options
granted during the fiscal year ended December 31, 1997 to the Named Executive
Officers:

<TABLE>
<CAPTION>
                                                  INDIVIDUAL GRANTS
                                  -------------------------------------------------    POTENTIAL REALIZABLE VALUE
                                                  % OF TOTAL                           AT ASSUMED ANNUAL RATES OF
                                                   OPTIONS                                STOCK APPRECIATION FOR
                                    SHARES        GRANTED TO                             APPRECIATION FOR OPTION
                                  UNDERLYING     EMPLOYEES IN   EXERCISE                        TERM($)(2)
                                    OPTIONS      FISCAL YEAR      PER      EXPIRATION    ----------------------
         NAME                     GRANTED(#)        (%)(1)       SHARE($)     DATE          5%            10%
         ----                     ----------     ------------ ----------   ----------    --------      --------

<S>                                <C>               <C>      <C>           <C>          <C>           <C>
Jay D. Kranzler, M.D., Ph.D.       277,440(3)        33.9%    $    1.625    8/29/07      $283,530      $718,523
Debby Jo Blank, M.D.               101,415(3)        12.4%    $    1.625    8/29/07      $103,641      $262,647
</TABLE>

(1)     Based upon options to purchase a total of 819,522 shares of Common Stock
        of the Company granted during fiscal year 1997.

(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 date of grant with the remainder vesting
        ratably and daily over the four-year period following the date of grant.

                 AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
                        AND FISCAL YEAR-END OPTION VALUES

        The following table sets forth certain information as of December 31,
1997, regarding options held by the Named Executive Officers. None of such
individuals exercised any options during the fiscal year ended December 31,
1997. There were no stock appreciation rights outstanding at December 31, 1997.

<TABLE>
<CAPTION>
                                          NUMBER OF SHARES           VALUE OF UNEXERCISED
                                       UNDERLYING UNEXERCISED        IN-THE-MONEY OPTIONS
                                       OPTIONS AT FY-END (#)         AS OF FY-END ($) (1)
                                     ---------------------------  --------------------------
         NAME                        EXERCISABLE   UNEXERCISABLE  EXERCISABLE  UNEXERCISABLE
         ----                        -----------   -------------  -----------  -------------
<S>                                   <C>            <C>               <C>           <C>
Jay D. Kranzler, M.D., Ph.D.          2,233,243      1,069,524         --             --

Debby Jo Blank, M.D.                    836,642        399,270         --             --

R. Michael Gendreau, M.D.               158,976        107,024         --             --
</TABLE>

(1)     All options held by each of the Named Executive Officers as of December
        31, 1997 were out-of-the money.

                                       29
<PAGE>   30

EMPLOYMENT AND CHANGE OF CONTROL AGREEMENTS


        On December 28, 1995, the Company entered into a five year employment
agreement with Dr. Jay Kranzler, the Company's Chief Executive Officer, Chief
Financial Officer and Chief Scientific Officer. Dr. Kranzler's annual
compensation consists of base salary of $240,000, 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 15, 1998,
options to purchase 2,358,921 shares of common stock had vested.

        On December 28, 1995, the Company entered into a five year employment
agreement with Dr. Debby Jo Blank, the Company's President and Chief Operating
Officer. Dr. Blank's annual compensation consists of base salary of $210,000,
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 her base salary and bonus, under her employment
agreement, Dr. Blank was granted an option to purchase 1,134,497 shares of
common stock of the Company (which amount represented three percent (3%) 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. Blank'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.
Blank's employment with the Company. In August 1997, Dr. Blank was granted an
option to purchase 101,415 shares of the Company's common stock at an exercise
price of $1.625 per share. As of March 15, 1998, options to purchase 883,671
shares of common stock had vested.

        In April 1996, the Company entered into an employment agreement with Dr.
R. Michael Gendreau, the Company's Vice President, Research and Development and
Chief Medical Officer, whereby Dr. Gendreau will receive an annual base salary
of $145,000. In addition, during 1996 Dr. Gendreau received $52,583 to offset
the costs of relocating from Seattle, Washington to San Diego, California. 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. As of March 15,
1998, options to purchase a total of 198,278 shares of common stock had vested.
In the event that Dr. Gendreau's employment with the Company is terminated by
the Company without cause due to a corporate merger or acquisition, Dr. Gendreau
will receive severance pay equal to $72,500.

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.

COMPENSATION PHILOSOPHY

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

        o   Compensation should be related to the value created for
            stockholders.

        o   Compensation programs should support the short-term and long-term
            strategic goals and objectives of the Company.


                                       30
<PAGE>   31

        o   Compensation programs should reflect and promote the Company's
            values and reward individuals for outstanding contributions to the
            Company's success.

        o   Short-term and long-term compensation programs play a critical role
            in attracting and retaining well-qualified executives.

        o   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.

COMPENSATION MIX AND MEASUREMENT

        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.

        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 1997.

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.

        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.


                                       31
<PAGE>   32

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 $240,000 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. In 1997, he earned bonuses totaling $125,000 pursuant to the
terms of his employment agreement.

        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.

        STOCK OPTION COMMITTEE                     COMPENSATION COMMITTEE
        Richard M. Crooks, Jr.                     Richard M. Crooks, Jr.
          Philip J. O'Reilly                         Philip J. O'Reilly
                                                       Jack H. Vaughn

                  NON-EXECUTIVE OFFICER STOCK OPTION COMMITTEE
                          Jay D. Kranzler, M.D., Ph.D.
                              Debby Jo Blank, M.D.

                            STOCK PRICE PERFORMANCE GRAPH

COMPARISON OF 5-YEAR CUMULATIVE RETURN

        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

                                    [GRAPH]

<TABLE>
<CAPTION>
                                92       93      94      95      96      97
-----------------------------------------------------------------------------
<S>                             <C>     <C>     <C>     <C>     <C>     <C>
NASDAQ OTC                      100     114.8   112.2   158.7   195.2   239.5
CYPRESS BIOSCIENCE, INC.        100     129.2    75      93.7    64.6    47.9
NASDAQ PHARMACEUTICAL INDEX     100      89.1    67.1   122.7   123.1   127.2
-----------------------------------------------------------------------------
</TABLE>

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, 1992.

                                       32


<PAGE>   33

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

        The following table sets forth information as of January 30, 1998 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 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 OWNER(1)                                BENEFICIAL OWNERSHIP(2)   PERCENT OF CLASS(2)
-------------------                                -----------------------   -------------------
<S>                                                      <C>                      <C>
Allen & Company Incorporated ..................          5,727,809(3)             14.7%
  711 Fifth Avenue
  New York, New York 10022
Paramount Capital Asset Management, Inc. ......          5,190,468(4)             13.4%
   787 Seventh Avenue, 44th Floor
   New York, NY 10019
Jay D. Kranzler ...............................          2,616,339(5)              6.3%
Debby Jo Blank ................................          1,119,084(6)              2.9%
R. Michael Gendreau ...........................            199,155(7)                *
Richard M. Crooks, Jr .........................          1,131,897(8)              2.9%
Jack H. Vaughn ................................             56,000(9)                *
Philip J. O'Reilly ............................             84,625(10)               *
All Directors and Named Executive Officers as a
  Group (8 persons) ...........................          5,207,100(11)            12.3%
</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 January 30, 1998 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 38,652,003 shares of the Company's Common Stock
        outstanding as of January 30, 1998.

(3)     This information was derived from information provided to the Company by
        Allen & Company Incorporated. Includes warrants to purchase 356,980
        shares of Common Stock exercisable within 60 days of January 30, 1998.

(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 Trust, a Cayman Islands trust ("Aries Trust"). 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 Trust, in each case such warrants being exercisable within 60
        days of January 30, 1998. Of the 5,190,468 shares of Common Stock
        (including warrants) indicated as beneficially held, Paramount Capital
        shares voting and dispositive power with the following persons or
        entities: Dr. Rosenwald with respect to 5,190,468 of the shares; Aries
        Domestic with respect to 1,623,617 of the shares; and The Aries Trust
        with respect to 3,566,851 of the shares.

(5)     Includes 2,386,095 shares of Common Stock issuable pursuant to options
        exercisable within 60 days of January 30, 1998. Also includes 220,244
        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.


                                       33

<PAGE>   34
(6)     Includes 893,840 shares of Common Stock issuable pursuant to options
        exercisable within 60 days of January 30, 1998. Also includes 220,244
        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 199,155 shares of Common Stock issuable pursuant to options
        exercisable within 60 days of January 30, 1998.

(8)     Includes 40,000 shares of Common Stock issuable pursuant to options
        exercisable within 60 days of January 30, 1998. 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 55,000 shares of Common Stock issuable pursuant to options
        exercisable within 60 days of January 30, 1998.

(10)    Includes 40,000 shares of Common Stock issuable pursuant to options or
        other rights exercisable within 60 days of January 30, 1998.

(11)    Includes 3,620,757 shares of Common Stock issuable pursuant to
        outstanding options and warrants exercisable within 60 days of January
        30, 1998. Also includes 220,244 shares of Common Stock held by the
        Company's 401(K) plan for which certain individuals in the group
        exercise voting power.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

        In October 1997, the Company completed a private placement of
approximately 3,851,000 shares of its Common Stock with certain accredited
investors at a purchase price of $1.50 per share, resulting in net proceeds to
the Company of approximately $5.6 million or $1.45 per share, after total costs
of approximately $203,000. Merrill Weber & Co. acted as a non-exclusive
placement agent for the Company and received $76,593 as a placement agent fee.
Paramount Capital Asset Management, Inc., the Company's second largest
stockholder, is the investment manager of Aries Domestic Fund, L.P. and The
Aries Trust, stockholders that participated in the private placement and who
collectively purchased 1,333,333 shares of the Company's Common Stock and
received $120,000 in placement agent fees.

        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 January 30, 1998, Mr. Crooks beneficially held approximately 2.9%
of the Company's Common Stock.

        Allen & Company Incorporated is compensated for investment banking
services rendered to the Company under a one-year consulting agreement
specifying monthly payments of $5,000. In 1997, the Company paid Allen & Company
Incorporated a total of $40,000 under this agreement.

        The Company entered into employment agreements with each of its three
executive officers, as described in Item 11 "Executive Compensation - Employment
and Change of Control Agreements." In addition, the Company has granted stock
options to certain directors and executive officers of the Company. See "Item
11, 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.


                                       34
<PAGE>   35

                                     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
------------ ---------------------------------  -------------------------------------
  <S>        <C>                                <C>
  3.1        Amended and Restated Certificate   Exhibit 3.1 to Form 10-Q for the
             of Incorporation                   quarter ended 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      Exhibit 3.1 to Form S-1 Registration
             Warrant                            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
             Reorganization dated October 10,   ended September 30, 1996
             1996, by and among Registrant,
             Cypress Acquisition Sub, Inc.
             and PRP, Inc.

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

 10.5        Exchange of Bridge Debt and        Exhibit 4.2 to Form 10-Q
             Warrant Termination                for quarter ended September 30, 1996
             Agreement between Registrant 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      Exhibit 10.3 to Form 10-Q for the
             April 22, 1994 between IMRE        quarter ended March 31, 1994
             Corporation and Allen & Company
             Incorporated
</TABLE>



                                       35
<PAGE>   36

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 10.28       Stock Option and Stock             Exhibit 28.1 to Form S-8 Registration
             Appreciation Plan                  Statement No. 333-06771
</TABLE>


                                       36
<PAGE>   37
<TABLE>
 <S>         <C>                                <C>
 10.29       Warrant Agreement dated            Exhibit 10.1 to Form S-3 Registration
             September 19, 1996 between the     Statement No. 333-15483
             Registrant and American Stock
             Transfer & Trust company

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

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

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

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

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

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

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

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

 10.38       Form of Indemnity Agreement

 11.1        Statement regarding computation    Item 8 of 1995 Form 10-K
             of per share loss

 23.1        Consent of Ernst & Young LLP,
             Independent Auditors

 24.1        Power of Attorney                  Reference is made to page 38

 27.1        Financial Data Schedule
</TABLE>

(b)       REPORTS ON FORM 8-K

               None

(c)       EXHIBITS

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


                                       37
<PAGE>   38
                                   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,
                                                Chief Scientific Officer, and
                                                Chief Financial Officer

Date:  March 31, 1998

                                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                March 31, 1998
---------------------------------    Scientific Officer, Chief Financial
Jay D. Kranzler, M.D., Ph.D.         Officer and Vice Chairman of the Board
                                     (Principal Executive Officer and
                                     Principal Financial and Accounting
                                     Officer)

/s/ Debby Jo Blank                   President, Chief Operating Officer            March 31, 1998
---------------------------------    and Director
Debby Jo Blank, M.D.

/s/ Richard M. Crooks, Jr.           Chairman of the Board of Directors            March 31, 1998
---------------------------------
Richard M. Crooks, Jr.

/s/ Philip J. O'Reilly               Director                                      March 31, 1998
---------------------------------
Philip J. O'Reilly

/s/ Jack H. Vaughn                   Director                                      March 31, 1998
---------------------------------
Jack H. Vaughn
</TABLE>


                                       38
<PAGE>   39

                            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, 1996 and 1997...........................   F-3

Consolidated Statements of Operations for the Years ended
  December 31, 1995, 1996 and 1997.....................................................   F-4

Consolidated Statements of Stockholders' Equity for the Years ended
        December 31, 1995, 1996 and 1997...............................................   F-5

Consolidated Statements of Cash Flows for the years ended December 31, 1995,
1996 and 1997..........................................................................   F-6

Notes to Consolidated Financial Statements.............................................   F-7
</TABLE>


                                      F-1
<PAGE>   40
                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, 1997 and 1996, and the related consolidated
statements of operations, stockholders' equity and cash flows for each of the
three years in the period ended December 31, 1997. 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, 1997 and 1996, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended December 31, 1997, in conformity with generally accepted accounting
principles.



                                           ERNST & YOUNG LLP



San Diego, California
February 13, 1998


                                      F-2

<PAGE>   41
                            CYPRESS BIOSCIENCE, INC.
                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                         DECEMBER 31,
                                                              -------------------------------
                                                                   1997              1996
                                                              ------------       ------------
                                                                                  (Restated)
<S>                                                           <C>                <C>
ASSETS
Current assets:
  Cash and cash equivalents                                   $  7,541,320       $  8,045,508
  Short-term investments                                           974,333          2,890,160
  Accounts receivable:
    Trade, net of allowance for doubtful accounts of
      $178,719 in 1997 and $200,312 in 1996                        372,741            344,041
    Other                                                          140,487            150,954
  Inventories                                                      628,004            973,767
  Prepaid expenses                                                 114,382            171,231
                                                              ------------       ------------
    Total current assets                                         9,771,267         12,575,661

Property and equipment, net                                      1,991,777          2,351,928
Convertible debenture issuance costs, net                           25,722             33,487
                                                              ------------       ------------
    Total assets                                              $ 11,788,766       $ 14,961,076
                                                              ============       ============

LIABILITIES AND STOCKHOLDERS' EQUITY
  Current liabilities:
    Accounts payable                                          $    530,132       $    999,442
    Accrued compensation                                           175,929            485,751
    Accrued liabilities                                          1,144,692            902,090
    Current portion of capital leases                                4,286             27,208
                                                              ------------       ------------
      Total current liabilities                                  1,855,039          2,414,491

  Convertible debentures                                           400,000            400,000
  Capital leases, net of current portion                             7,735             12,020

  Commitments and contingencies (Note 7)

  Stockholders' equity:
    Common stock, $.02 par value; authorized 60,000,000
      shares; issued and outstanding, 38,545,808 and
      34,573,111 shares at December 31, 1997 and 1996,             770,916            691,462
      respectively
    Additional paid-in capital                                  78,041,636         72,354,683
    Deferred compensation                                         (504,315)        (1,015,738)
    Accumulated deficit                                        (68,782,245)       (59,895,842)
                                                              ------------       ------------
      Total stockholders' equity                                 9,525,992         12,134,565
                                                              ------------       ------------
      Total liabilities and stockholders' equity              $ 11,788,766       $ 14,961,076
                                                              ============       ============
</TABLE>

See accompanying notes.


                                      F-3
<PAGE>   42

                            CYPRESS BIOSCIENCE, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>
                                                       YEARS ENDED DECEMBER 31,
                                          --------------------------------------------------
                                               1997              1996               1995
                                          ------------       ------------       ------------
                                                              (Restated)         (Restated)
<S>                                       <C>                <C>                <C>
Product sales                             $  2,970,342       $  1,967,976       $  1,104,224
Grant income                                   325,316                  -                  -
Revenue under distribution agreement                 -                  -          3,000,000
                                          ------------       ------------       ------------
                                             3,295,658          1,967,976          4,104,224
Costs and expenses:
  Production costs                           1,772,681          1,482,563          2,041,422
  Sales and marketing                        1,292,942            794,356            819,907
  Research and development                   6,707,557          4,002,968          3,219,324
  General and administrative                 2,803,079          4,649,298          2,626,817
  Acquired in-process research and
    development                                      -          5,146,943            625,000
  Restructuring expense                              -            493,712            644,656
  Debt conversion expense                            -            276,688          1,124,386
                                          ------------       ------------       ------------
                                            12,576,259         16,846,528         11,101,512

Other income (expense):
   Interest income                             425,935            458,070            118,994
   Interest expense                            (31,737)        (1,119,726)          (261,958)
                                          ------------       ------------       ------------
                                               394,198           (661,656)          (142,964)
                                          ------------       ------------       ------------
Net loss                                  $ (8,886,403)      $(15,540,208)      $ (7,140,252)
                                          ============       ============       ============
Net loss per share-basic and diluted      $      (0.25)      $      (0.53)      $      (0.41)
                                          ============       ============       ============
Shares used in computing net loss
   per share-basic and diluted              35,236,579         29,206,470         17,598,735
                                          ============       ============       ============
</TABLE>


See accompanying notes.

                                      F-4


<PAGE>   43

                            CYPRESS BIOSCIENCE, INC.
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                  YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

<TABLE>
<CAPTION>
                                                 COMMON STOCK         ADDITIONAL
                                             ---------------------     PAID-IN        DEFERRED      ACCUMULATED
                                               SHARES    PAR VALUE     CAPITAL      COMPENSATION      DEFICIT           TOTAL
                                             ----------  ---------   ------------   ------------    ------------    ------------
<S>                                          <C>          <C>        <C>             <C>            <C>             <C>
Balance December 31, 1994                    17,000,012   $340,000   $ 38,856,101             --    $(37,215,382)   $  1,980,719
      Stock issued for services                  61,141      1,223         86,322             --              --          87,545
      Stock issued to match 401(k)
          contributions                          65,125      1,303        160,036             --              --         161,339
      Stock issued for minority
          interest in CELx                      312,500      6,250        618,750             --              --         625,000
      Stock issued for debt conversion
          (restated)                          1,254,817     25,096      3,735,791             --              --       3,760,887
      Net loss (restated)                            --         --             --             --      (7,140,252)     (7,140,252)
                                             ----------   --------   ------------    -----------    ------------    ------------
Balance December 31, 1995 (restated)         18,693,595    373,872     43,457,000             --     (44,355,634)       (524,762)
      Stock options exercised                    47,500        950         84,050             --              --          85,000
      Stock issued for services                  31,765        635         54,365             --              --          55,000
      Stock issued for debenture interest        12,005        240         28,963             --              --          29,203
      Stock issued for debt conversion
         (restated)                           1,435,955     28,719      2,495,713             --              --       2,524,432
      Debt discount related to Senior
         Convertible Debentures (restated)           --         --      1,063,000             --              --       1,063,000
      Stock issued to match 401(k)
          contributions                          50,791      1,016        100,910             --              --         101,926
      Stock issued in January 1996
          private placement                   8,540,702    170,814     11,736,057             --              --      11,906,871
      Stock issued in October 1996
          private placement                   3,468,000     69,360      6,215,554             --              --       6,284,914
      Stock issued in conjunction with
          the acquisition of PRP, Inc.        2,292,798     45,856      4,539,740             --              --       4,585,596
      Deferred compensation related
          to stock options                           --         --      1,756,949     (1,756,949)             --              --
      Compensation related to
          stock options (restated)                                        822,382                                        822,382
      Amortization of deferred
          compensation (restated)                    --         --             --        741,211              --         741,211
      Net loss (restated)                            --         --             --             --     (15,540,208)    (15,540,208)
                                             ----------   --------   ------------    -----------    ------------    ------------
Balance December 31, 1996 (restated)         34,573,111    691,462     72,354,683     (1,015,738)    (59,895,842)     12,134,565
      Stock options exercised                    20,000        400         37,100             --              --          37,500
      Deferred compensation related to
          stock options                              --         --        (10,284)        10,284              --              --
      Stock issued to match 401(k)
          contributions                         101,668      2,033        163,623             --              --         165,656
      Stock issued in October 1997
          private placement                   3,851,029     77,021      5,496,514             --              --       5,573,535
      Amortization of deferred
          compensation                               --         --             --        501,139              --         501,139
      Net loss                                       --         --             --             --      (8,886,403)     (8,886,403)
                                             ----------   --------   ------------    -----------    ------------    ------------
Balance December 31, 1997                    38,545,808   $770,916   $ 78,041,636    $  (504,315)   $(68,782,245)   $  9,525,992
                                             ==========   ========   ============    ===========    ============    ============
</TABLE>

See accompanying notes.


                                      F-5

<PAGE>   44
                            CYPRESS BIOSCIENCE, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                               YEARS ENDED DECEMBER 31,
                                                                  --------------------------------------------------
                                                                      1997               1996               1995
                                                                  ------------       ------------       ------------
                                                                                      (Restated)         (Restated)
<S>                                                               <C>                <C>                <C>
OPERATING ACTIVITIES
Net loss                                                          $ (8,886,403)      $(15,540,208)      $ (7,140,252)
Adjustments to reconcile net loss to net cash used
    by operating activities:
   Depreciation and amortization                                       481,567            182,845            373,306
   Acquired in-process research and development                             --          5,146,943            625,000
   Amortization of deferred compensation                               501,139            741,211                 --
   Compensation related to stock options                                                  822,382
   Common stock issued for services and expenses                       165,656            186,129            248,884
   Debt conversion expense                                                  --            276,688          1,124,386
   Restructuring expense                                                    --                 --            644,656
   (Gain) loss on disposal of property and equipment                    (3,298)           (11,110)            23,437
   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                                         (28,700)          (320,191)           394,549
      Other receivables                                                 10,467           (111,020)            30,034
      Inventories                                                      345,763            174,739            345,806
      Prepaid expenses                                                  56,849             39,655             64,805
      Accounts payable and accrued liabilities                        (536,530)           (94,678)           345,259
                                                                  ------------       ------------       ------------
      Net cash used by operating activities                         (7,893,490)        (7,443,615)        (2,920,130)

INVESTING ACTIVITIES
   Purchase of property and equipment                                 (118,038)          (997,602)          (714,947)
   Proceeds from sale of property and equipment                          7,685             36,735             30,393
   Purchase of short-term investments                               (2,006,773)        (2,890,160)                --
   Maturities from sale of short-term investments                    3,922,600                 --                 --
   Acquisition of PRP, Inc., net of $83,399 cash acquired                   --           (361,029)                --
                                                                  ------------       ------------       ------------
      Net cash provided by (used in) investing activities            1,805,474         (4,212,056)          (684,554)

FINANCING ACTIVITIES
   Net proceeds from issuance of common stock                        5,573,535         18,276,785                 --
   Net proceeds from exercises of stock options                         37,500                 --                 --
   Proceeds from issuance of convertible debentures                         --            500,000          1,000,000
   Payment of capital lease obligation and notes payable               (27,207)           (13,565)           (22,140)
   Notes payable, net                                                       --                 --            (11,812)
   Debt issuance and conversion costs                                       --            (71,919)           (22,102)
                                                                  ------------       ------------       ------------
      Net cash provided by financing activities                      5,583,828         18,691,301            943,946

INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                      (504,188)         7,035,630         (2,660,738)
   Cash and cash equivalents at beginning of the year                8,045,508          1,009,878          3,670,616
                                                                  ------------       ------------       ------------
   Cash and cash equivalents at end of the year                   $  7,541,320       $  8,045,508       $  1,009,878
                                                                  ============       ============       ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
   Interest paid                                                  $     31,661       $     14,681       $    322,968
                                                                  ============       ============       ============
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES
   Stock issued for debt conversion                               $         --       $  2,351,607       $  2,586,000
                                                                  ============       ============       ============
</TABLE>


See accompanying notes.


                                      F-6

<PAGE>   45
                            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(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(R)
column for the treatment of idiopathic thrombocytopenic purpura ("ITP"), an
immune-mediated bleeding disorder. 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(R) column are focused primarily on rheumatoid
arthritis ("RA"). In January 1998, the Company's Phase III clinical trial
evaluating the use of the Prosorba(R) column in the treatment of RA was stopped
early due to the achievement of favorable safety and statistically significant
results. Based on such results, the Company plans to file a Pre-Market Approval
("PMA") application for the Prosorba(R) column for the treatment of RA with the
FDA in mid-1998.

2.      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Restatement of Prior Period Financial Statements

        In 1997, the Company restated its previously issued financial statements
as of and for the years ended December 31, 1996 and 1995. In accordance with
EITF D-60, which was issued in March 1997 but which is applicable to previously
issued financial statements, the Company recorded $1,063,000 of interest expense
in 1996 related to the Senior Convertible Debentures which were issued with a
discounted conversion feature. In addition, the Company recorded $1,119,920 of
additional compensation expense in 1996 related to certain stock options granted
in 1996. The Company also recorded $93,000 and $314,000 of debt conversion
expense during the years ended December 31, 1996 and 1995, respectively, related
to deferred debt issuance costs associated with the March 1996 and September
1995 exchange offerings to the holders of the 7% Convertible Debentures.

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.

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.


                                      F-7
<PAGE>   46

        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.

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 at the time of patient enrollment.

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

        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.

        In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128, Earnings per Share ("SFAS
128"), which has been adopted by the Company for the year ended December 31,
1997. Under the new requirements for calculating basic net income per share, the
dilutive effect of stock options will be excluded. The adoption of SFAS 128 had
no effect as the Company has incurred losses for all periods presented.

Long-Lived Assets

        In 1996, the Company adopted 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"). SFAS 121 requires impairment losses to be
recorded on long-lived assets used in operations when indicators of impairment
are present


                                      F-8
<PAGE>   47

and the undiscounted cash flows estimated to be generated by those assets are
less than the assets carrying amount. SFAS 121 also addresses the accounting for
long-lived assets that are expected to be disposed of. Since the adoption, the
Company has not identified any indicators of impairment or recorded any
impairments of long-lived assets.

Recently Issued Accounting Standards

        In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 130, Reporting Comprehensive Income ("SFAS
130"), and Statement of Financial Accounting Standards No. 131, Segment
Information ("SFAS 131"). Both of these standards are effective for fiscal years
beginning after December 15, 1997. 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 transactions and other
events and circumstances from non-owner sources. Net income and other
comprehensive income, including foreign currency translation adjustment, minimum
pension accrual, and unrealized gains and losses on investments, shall be
reported, net of their related tax effect, to arrive at comprehensive income.
The Company intends to adopt SFAS 130 in 1998 and as previously reported does
not believe that comprehensive income or loss will be materially different than
net income or loss as previously reported. Historically, the Company has
operated in one business segment; however, SFAS 131 redefines segments. The
Company has not determined how operating segments will be defined for disclosure
purposes or which segments will meet the quantitative requirements for
disclosure. The adoption of SFAS 131 is not expected to have an impact on the
Company's future results of operations or financial position.

3.      FINANCIAL STATEMENT DETAILS

Short-term Investments

        A summary of the estimated fair value of cash equivalent and short-term
investment securities is shown below as of December 31:

<TABLE>
<CAPTION>
                                                      1997             1996
                                                  ------------     ------------
<S>                                               <C>              <C>
Money market funds                                $    996,075     $  6,202,938
U.S. government agency securities                    6,947,133        3,880,180
                                                  ------------     ------------
    Total debt securities                            7,943,208       10,083,118
Less amounts classified as cash equivalents         (6,968,875)      (7,192,958)
                                                  ------------     ------------
    Total short-term investment securities        $    974,333     $  2,890,160
                                                  ============     ============
</TABLE>

        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, 1997 or 1996. Realized gains or losses on sales of
available-for-sale securities in 1997 and 1996 were not significant. The
investments at December 31, 1997 mature by March 1998.

Inventories

        Inventories are comprised of the following as of December 31:

<TABLE>
<CAPTION>
                                                              1997        1996
                                                            --------    --------
<S>                                                         <C>         <C>
Raw materials and components                                $166,714    $214,632
Work in progress                                             354,010     700,815
Finished goods                                               107,280      58,320
                                                            --------    --------
                                                            $628,004    $973,767
                                                            ========    ========
</TABLE>


                                      F-9
<PAGE>   48

Property and Equipment

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

<TABLE>
<CAPTION>
                                                      1997             1996
                                                  ------------     ------------
<S>                                               <C>              <C>
Laboratory and production equipment               $  2,610,417     $    629,269
Office equipment                                       456,343          537,244
Vehicles                                                20,924           20,924
Leasehold improvements                                  51,753           51,753
Construction in progress                                    --        1,787,686
                                                  ------------     ------------
                                                     3,139,437        3,026,876
Accumulated depreciation and amortization           (1,147,660)        (674,948)
                                                  ------------     ------------
                                                  $  1,991,777     $  2,351,928
                                                  ============     ============
</TABLE>

        Depreciation expense for the years ended December 31, 1997, 1996 and
1995 was $473,802, $171,015 and $305,912, respectively.

        At December 31, 1996, construction in progress included approximately
$1.3 million related to the Company's consolidation of its two manufacturing
facilities into one location in the State of Washington. The remainder of the
balance of construction in progress relates to manufacturing machinery under
construction. Such construction was completed in 1997.

Accrued Liabilities

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

<TABLE>
<CAPTION>
                                                      1997               1996
                                                   ----------         ----------
<S>                                                <C>                <C>
Accrued clinical trial costs                       $  834,815         $  590,473
Other                                                 309,877            311,617
                                                   ----------         ----------
                                                   $1,144,692         $  902,090
                                                   ==========         ==========
</TABLE>

Advertising Costs

        The Company incurred advertising expenses of approximately $0, $18,000,
and $77,000 for the years ended December 31, 1997, 1996 and 1995, respectively.

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 10). 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


                                      F-10
<PAGE>   49
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.

        The following unaudited pro forma data reflects the combined results of
operations of the Company and PRP 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

<TABLE>
<CAPTION>
                                                   DECEMBER 31,
                                          -----------------------------
                                              1996             1995
                                          ------------     ------------
                                           (Restated)       (Restated)
<S>                                       <C>              <C>
Revenues                                  $  2,029,773     $  4,104,224
Net loss                                  $(12,111,248)     (14,762,974)
Net loss per share - basic and diluted    $      (0.39)           (0.74)
</TABLE>

CELx Corporation

        In 1995, the Company acquired the minority interest of CELx Corporation
("CELx"), the Company's former majority owned subsidiary, in exchange for an
aggregate of 312,500 shares of the Company's common stock valued at $625,000.
The transaction was accounted for as a purchase. The Company recorded a
non-recurring charge of $625,000 as in-process research and development as the
technological feasibility of the acquired technology had not been established
nor had alternative future uses been identified at the time of the purchase.

5.      RESTRUCTURING EXPENSE

        In December 1995, the Company recorded a restructuring charge
aggregating $645,000 relating to the Company's plan to consolidate its
manufacturing facilities to one location in the state of Washington and to move
all other operations to San Diego, California. This charge included
approximately $350,000 related to write-downs of equipment and leasehold
improvements for the manufacturing facility vacated in 1996, $200,000 related to
abandonment of leases in Seattle and Princeton with the remainder related to a
severance commitment with its former Executive Vice President who resigned in
December 1995.

        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 purchase 705,000 shares
of common stock (see Note 7). Costs related to these terminations were
approximately


                                      F-11
<PAGE>   50

$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.

        The Company has also incurred approximately $1.4 million of capital
expenditures related to the purchase of manufacturing and lab equipment through
December 31, 1997 in connection with the consolidation of its two Washington
manufacturing facilities. The consolidation was completed in April 1997 with the
Company receiving FDA good manufacturing practice ("GMP") approval of the
facility. The Company does not expect to incur any additional capital
expenditures directly related to the consolidation of these facilities.

6.      DISTRIBUTION AGREEMENT

        Prior to April 1994, the Prosorba(R) column was sold by the Company's
internal sales force to physicians in the fields of immunology, hematology and
oncology. In April 1994, Baxter Healthcare Corporation ("Baxter") assumed sales
and marketing responsibilities under a 10-year exclusive agreement, granting
distribution rights of the Prosorba(R) column in the United States and Canada
for the treatment of ITP. Under the Baxter distribution agreement, Baxter was
obligated to purchase from the Company minimum numbers of Prosorba(R) columns at
a predetermined price per column. In the event such minimums were not purchased,
Baxter was nevertheless obligated to pay the Company for that number of
Prosorba(R) columns that Baxter was obligated to purchase under the distribution
agreement. Baxter, at its own expense, was to provide sales and marketing
support for the sale of the product during the term of the agreement. The
Company was to provide significant marketing and promotional support to Baxter
for the first three years of the agreement.

        In March 1995, the two companies amended the agreement whereby Baxter:
(a) made a non-refundable take-or-pay payment on March 31, 1995 for the first
sales year after the amendment of $3.0 million, (b) agreed to purchase $1.0
million of product during the second quarter of 1995, (c) released the Company
from its obligation to provide marketing and promotional support for the second
and third years of the agreement, (d) gave the Company the right to co-market
with Baxter, (e) relinquished its first right to negotiate for new Prosorba(R)
column indications, and (f) agreed under certain circumstances to provide
advance payments to the Company for Baxter's 1996 purchases. The Company agreed
to eliminate purchase minimums and the take-or-pay concept included in the
original agreement and freed Baxter to pursue competing thrombocytopenia
therapies. In 1995, the Company recorded the $3 million payment as revenue since
it represented a non-refundable up-front payment with no future performance
obligation.

        Effective May 1, 1996, the Company and Baxter terminated the exclusive
distribution agreement, whereby the Company regained the right to sell its
Prosorba(R) column directly to customers who had previously purchased the
Prosorba(R) column through Baxter as well as to any other potential customers
who wish to purchase the Prosorba(R) column.

7.      COMMITMENTS AND CONTINGENCIES

Operating Leases

        The Company currently occupies approximately 17,800 square feet of
leased office and manufacturing facilities in San Diego, California, Redmond,
Washington and Boston, Massachusetts. The 2,800 square foot San Diego facility
houses the Company's executive offices, as well as its administration, research
and medical personnel. The five-year lease for this facility expires in 2001. In
November 1997, the Company's management decided to close its Boston facility by
mid-1998. The Boston facility is approximately 7,000 square feet, and is used
primarily for the manufacture of clinical-grade Cyplex(TM).

        The Company leases 8,000 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(R) column. Assembly of the
Prosorba(R) column had


                                      F-12
<PAGE>   51
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(R) column can be performed in a single facility.

        The Company leased a 14,400 square foot facility in Seattle, Washington
under a lease expiring in 2004. In conjunction with the Company's 1996
restructuring plan and corresponding reduction in facilities, this space was
subleased to another party in April 1996, and the Company was subsequently
released from any obligations by the owner of the property in August 1997.

        The table below indicates future minimum lease payments due, over the
remaining life of the leases, under the agreements in place as of December 31,
1997:

<TABLE>
<CAPTION>
           <S>                                          <C>
           1998                                         $  253,196
           1999                                            165,376
           2000                                            165,376
           2001                                            165,376
           2002                                            139,280
           Thereafter through 2004                         226,368
                                                        ----------
                                                        $1,114,972
                                                        ==========
</TABLE>

        Total rent expense was approximately $501,000, $494,000 and $521,000 for
the years ended December 31, 1997, 1996 and 1995, respectively. Sublease income
was approximately $117,000 and $149,000 for the years ended December 31, 1997
and 1996, respectively. No sublease income is expected to be received in 1998.

Severance Agreements

        The Company entered into a severance agreement as of December 28, 1995
with its former Chief Executive Officer. The terms of the severance agreement
were based primarily on the termination clause of the employment agreement
entered into between the former officer and the Company in September 1994. Such
terms include the payment of $225,000 in 1996 and $168,750 in 1997. The total
cost of this severance agreement of $393,750 was included in general and
administrative expense in 1995.

        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, signing bonuses, annual performance bonuses and a lump sum
payments in the event of a termination of employment, without cause, as defined.
Signing bonuses of approximately $100,000 were included in general and
administrative expense in 1995. Bonuses of $270,000 and $225,000 were earned and
included in general and administrative expenses in the years ended 1997 and
1996, respectively.

        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 10). 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


                                      F-13
<PAGE>   52

immediately upon a merger of the Company or in the event of a termination of
employment without cause, as defined.

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 $166,000, $102,000 and
$161,000 for the years ended December 31, 1997, 1996 and 1995, respectively,
based upon the market value of the Company's common stock on the date of the
contribution.

8.      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. The conversion price for the principal amount is $2.88
per share of registered common stock, the fair market value on the date of
closing. The conversion price for the interest is the lower of $4.00 per share
of common stock or the average closing price for the 10 days prior to the annual
April 30th interest payment date. The debentures are redeemable by the Company
after April 1998 at a redemption price of 106% of the principal amount reduced
to 104% and 102% the following two years. Allen & Company Incorporated ("Allen &
Company"), a shareholder of the Company, acted as placement agent with respect
to a majority of this private placement and received a five-year warrant valued
at $483,000 to purchase 300,000 shares of common stock at $2.88 for its services
as placement agent. The cost of issuing the 7% Convertible Debentures, including
the cost of the warrants, has been deferred and is reported on the accompanying
balance sheet net of amortization expense which is being recorded over the term
of the 7% Convertible Debentures. Allen & Company purchased $1.0 million of the
7% Convertible Debentures.

        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. The Company recorded a non-cash expense of
$810,386 in 1995, which represents the fair market value of the increased number
of shares issued under the terms of the offering compared to the original
conversion terms. 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. The weighted
average fair market value of the Company's common stock during the fourth
quarter 1995 conversion was $3.13, and the fair market value during the first
quarter 1996 conversion was $2.25. For substantially all 7% Convertible
Debentures that were converted, the interest accrued up to the date of
conversion was paid through the issuance of common stock at either $2.25 per
share or $2.88 per share. The Company also charged $314,000 to debt conversion
expense in 1995 for the unamortized deferred debt issuance costs related
to the converted debentures.

        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%


                                      F-14
<PAGE>   53
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 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.

9.      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 $1,000,000 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 10). 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.

10.     STOCKHOLDERS' EQUITY

Authorized Shares

        The Company is authorized to issue up to 15,000,000 shares of "blank
check" 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 9). 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.

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 September 1991, the Company granted
warrants to purchase 1,850,000 shares of common stock at an exercise price of
$2.50 per share in connection with its public offering of units. The warrants
expired on April 30, 1997, and are now redeemable by the Company at $0.75 each.
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 $0.10 per warrant, beginning
in September 1997.


                                      F-15
<PAGE>   54
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, 7,000,000 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 Company has elected to follow Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related
Interpretations in accounting for its employee stock 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>
                                                          1997           1996
                                                       ----------     ----------
                                                                      (Restated)
<S>                                                    <C>            <C>
Pro forma net loss (in thousands)                      $  (11,302)    $  (18,451)
Pro forma net loss per share - basic and diluted       $    (0.32)    $    (0.63)
</TABLE>

        The proforma results above for 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.


                                      F-16
<PAGE>   55

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

<TABLE>
<CAPTION>
                                                    NUMBER OF WARRANTS / OPTIONS
                               ---------------------------------------------------------------------
                                                1996
                                               EQUITY        INCENTIVE
                                              INCENTIVE        STOCK       NON-QUALIFIED      OTHER
                                WARRANTS     PLAN OPTIONS      OPTIONS     STOCK OPTIONS     OPTIONS
                               ----------     ----------     ----------     ----------     ----------
<S>                            <C>            <C>            <C>            <C>            <C>
Balance December 31, 1994       2,842,900             --        310,700        820,000        832,835
        Granted                        --             --             --      1,179,000         20,000
        Canceled                       --             --             --       (476,500)            --
        Expired                   (23,100)            --        (42,100)            --       (177,000)
                               ----------     ----------     ----------     ----------     ----------
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
                               ==========     ==========     ==========     ==========     ==========
</TABLE>

        All warrants are exercisable at December 31, 1997 at exercise prices
ranging from $1.85 to $2.88, and 3,334,399 shares of common stock were reserved
for future issuance.

        With respect to stock options, at December 31, 1997 there were 1,067,800
options available for future grant and 8,550,355 shares of common stock were
reserved for future issuance.

        Following is a further breakdown of the options outstanding as of
December 31, 1997:

<TABLE>
<CAPTION>
                                      WEIGHTED                                            WEIGHTED
                                       AVERAGE           WEIGHTED                         AVERAGE
  RANGE OF                            REMAINING           AVERAGE                      EXERCISE PRICE
  EXERCISE            OPTIONS        CONTRACTUAL         EXERCISE        OPTIONS         OF OPTIONS
   PRICES           OUTSTANDING     LIFE IN YEARS          PRICE       EXERCISABLE      EXERCISABLE
-------------       -----------     -------------       ----------     -----------     --------------
<C>                 <C>             <C>                 <C>            <C>             <C>
$1.00 - $1.50        4,497,686            8.0               $1.50        3,145,821         $1.50
$1.51 - $2.25        2,758,764            6.6               $1.96        1,756,531         $2.04
$2.26 - $3.25          177,105            4.3               $2.66          157,105         $2.67
$3.26 - $3.88           49,000            2.5               $3.77           49,000         $3.77
                     ---------                                           ---------
                     7,482,555                                           5,108,457
                     =========                                           =========
</TABLE>

        The weighted average exercise prices and fair values for options granted
in 1997 are as follows:

<TABLE>
<CAPTION>
                                                               WEIGHTED AVERAGE
                                                              -------------------
    EXERCISE PRICE ON                                         FAIR       EXERCISE
       DATE OF GRANT                                          VALUE       PRICE
-------------------------------                               ------     --------
<S>                                                           <C>         <C>
Equal to market price of stock                                $ 1.37      $ 1.72
Less than market price of stock                                   --          --
Exceeds market price of stock                                     --          --
</TABLE>

        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


                                      F-17
<PAGE>   56
model with the following weighted-average assumptions for 1995 and 1996: a
risk-free interest rate of 6.49%; a dividend yield of 0%; a volatility factor of
the expected market price of the Company's common stock of 65%; and a life of
the option of 7 years.

        The weighted average exercise prices for stock option activity are as
follows:

<TABLE>
<CAPTION>
                                NUMBER OF STOCK
                                 OPTIONS UNDER          WEIGHTED AVERAGE
                                  ALL PLANS             EXERCISE PRICES
                               -----------------        ---------------
<S>                            <C>                      <C>
Balance December 31, 1994         1,963,535                  $ 2.49
        Granted                   1,199,000                  $ 2.01
        Canceled                   (476,500)                 $ 2.05
        Expired                    (219,100)                 $ 2.53
                                 ----------
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
                                 ==========
</TABLE>

11.     INCOME TAXES

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

<TABLE>
<CAPTION>
                                                    1997               1996
                                                ------------       ------------
                                                                    (Restated)
<S>                                             <C>                <C>
Net operating loss carryforwards                $ 18,686,000       $ 14,346,000
Capitalized research & development                 4,756,000          3,212,000
Other                                              1,829,000          1,467,000
                                                ------------       ------------
                                                  25,271,000         19,025,000
Valuation allowance                              (25,271,000)       (19,025,000)
                                                ------------       ------------
                                                $         --       $         --
                                                ============       ============
</TABLE>

        As of December 31, 1997, the Company has accumulated Federal and
California net operating loss carryforwards of approximately $53,561,000 and
$2,435,000, respectively, which expire beginning in 1998. Additionally, the
Company has Federal and California research and development tax credit
carryforwards of approximately $749,000 and $20,000, respectively, which will
begin expiring in 2004 unless previously utilized.

        In accordance with certain provision of the Internal Revenue Code, 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 in November 1990 and
September 1991, the utilization of net operating loss carryforwards which had
accumulated as of November 1991 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.


                                      F-18