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                                  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, 1996

                                       OR

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

                         COMMISSION FILE NUMBER 0-26244

                           SEQUANA THERAPEUTICS, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

           California                                    33-0550509
(STATE OR OTHER  JURISDICTION OF            (I.R.S. EMPLOYER IDENTIFICATION NO.)
 INCORPORATION OR ORGANIZATION)

  11099 N. Torrey Pines Road, Ste. 160
         La Jolla, California                             92037
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                (ZIP CODE)

                                 (619) 452-6550
              (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

<TABLE>
<S>                                                                      <C>
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:              NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:              COMMON STOCK, $.001 PAR VALUE
                                                                                (TITLE OF CLASS)
</TABLE>

            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 such shorter period that the
registrant was required to file such reports and (2) has been subject to such
filing requirements for the past 90 days. Yes  X   No
                                              ---     ---

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

            The approximate aggregate market value of the voting stock held by
non-affiliates of the registrant was $113.3 million as of March 1, 1997. Shares
of common stock held by officers and directors and by each person who owns 5% or
more of the outstanding common stock have been excluded in that such persons may
be deemed to be affiliates. This determination of affiliate status is not
necessarily a conclusive determination for other purposes.

            As of March 1, 1997, the registrant had 10,189,595 shares of common
stock outstanding.

                       DOCUMENTS INCORPORATED BY REFERENCE

Designated portions of the Registrant's Definitive Proxy Statement to be
furnished for the 1997 Annual Meeting of Shareholders are incorporated by
reference in Part III of this Form 10-K.
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                                     PART I

ITEM 1.  BUSINESS

THE COMPANY

            Sequana Therapeutics, Inc. ("Sequana" or the "Company") was founded
to discover and characterize genes that cause or predispose individuals to
common diseases ("disease genes"). Sequana has developed a proprietary gene
discovery technology which is based on positional cloning, a method that uses
statistical analysis of disease inheritance patterns to isolate disease genes.
The Company believes that its integrated technology platform, which utilizes
high-throughput automated DNA analyzers, sophisticated robotics and advanced
computer systems to collect and analyze genetic information and establish its
relationship to disease, is the most rapid and efficient method of discovering
and characterizing disease genes. Sequana has also developed or acquired access
to a variety of technologies that the Company believes will be useful in
determining gene function. The Company believes that identification of disease
genes and determination of their biological function will provide insights into
the causes of common diseases and may facilitate the development of novel
prognostic, diagnostic and therapeutic products such as small molecule drugs,
recombinant proteins, gene therapy and antisense therapy. The Company's initial
focus is on discovering and characterizing disease genes associated with type II
diabetes, asthma, osteoporosis, obesity, schizophrenia, and manic depression,
among other common diseases. Additionally, Sequana expects to apply its
functional genomics and bioinformatics capabilities, including the study of
model organisms, to elucidate gene function, develop chemical screens, and
identify potential lead compounds for pharmaceutical development. In January
1996, Sequana announced the discovery of a gene associated with hereditary
melanoma, an often fatal form of skin cancer, and in April 1996, Sequana
announced the discovery of a gene associated with obesity in mice.

            Sequana's business strategy is to utilize its gene discovery,
functional genomics and bioinformatics technologies to facilitate the
development and commercialization of prognostic, diagnostic and therapeutic
products. As an integral component of this strategy, the Company seeks to
establish strategic alliances with major pharmaceutical and biotechnology
companies in order to commercialize its technologies and leverage the resources
and expertise of its strategic alliance partners. The Company's existing
strategic alliances provide for technical and financial support during the gene
discovery and characterization phase and may include up-front fees, research
support, milestone payments and royalty payments on product sales. To date,
Sequana has entered into strategic alliances with Glaxo Wellcome Inc. ("Glaxo")
in the areas of type II diabetes and human obesity, Boehringer Ingelheim
International GmbH ("Boehringer Ingelheim") in the area of asthma and Corange
International, Ltd. ("Corange"), the parent company of Boehringer Mannheim GmbH
("Boehringer Mannheim"), in the area of osteoporosis. In January 1997, the
Company entered into an additional collaboration with Glaxo under which
Sequana's wholly-owned subsidiary, NemaPharm, Inc. ("NemaPharm"), will examine
the function of certain human genes using its propriety C. elegans technology.

            The information set forth in this Business Section contains
forward-looking statements, including but not limited to statements concerning
the use of the Company's proprietary gene discovery technology to discover
disease genes, the use of its technologies in determining gene function and
identifying potential lead compounds for pharmaceutical development, research
and development time lines, the timing and


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likelihood of regulatory approval, the continuation of the Company's
collaborations with its partners, the Company's future capital requirements, and
business conditions and growth in the biotechnology and pharmaceutical
industries and general economy. The Company's actual results could differ
materially from those anticipated in these forward-looking statements as a
result of the aforementioned factors, as well as those set forth elsewhere in
this Form 10-K.


INDUSTRY BACKGROUND

            Many diseases are believed to have a genetic basis. Genes, which are
found in nearly every living cell, code for specific gene products, generally
proteins. A typical human cell contains thousands of proteins essential to
normal cellular structure, growth and function. A defect in a single gene,
leading to the over-production, improper function or absence of a single
protein, may cause an imbalance in this complex cellular system and result in
disease.

            Genes are unique sequences of DNA. DNA is composed of two "strands"
of nucleotides, or bases, which are joined together. There are four bases,
referred to as adenine (A), guanine (G), cytosine (C) and thymine (T).
Complementary base pairs (adenine-thymine; guanine-cytosine) bond, allowing the
two strands to be tightly associated. By determining the sequence of the bases
along a DNA strand, genes can be identified. Knowledge of the gene sequence
provides information regarding the protein it produces, but generally does not
provide information about the function of the protein in the complex metabolic
process.

            The entire genetic content of an organism is referred to as its
genome. The human genome consists of approximately three billion base pairs of
DNA divided into 23 chromosomes, each containing a specific portion of the
estimated 100,000 human genes. Nearly all human cells contain pairs of each
chromosome, one maternal and one paternal in origin. An inherited chromosome,
however, may not be an exact copy of a parental chromosome because of the
occurrence of crossover events. Crossover events are the natural random
shuffling of the DNA strands between a parental chromosome pair during
chromosome replication. This results in the offspring inheriting recombinant
chromosomes from the parents. Crossover events occur approximately 30 times in
each genome replication and serve to increase genetic diversity in a species.

            The three main approaches to gene discovery are functional cloning,
random sequencing and positional cloning. Functional cloning is a method of
discovering disease genes that depends on understanding the protein defect in
the metabolic pathway that causes disease. If the disease can be traced to a
specific protein defect, then determining the sequence of the defective protein
enables the identification of the disease gene. This is accomplished by
retracing the natural process by which the specific gene sequence encodes for
such protein. Developing an understanding of the specific protein defects that
lead to disease is difficult because the metabolic pathways involved in many
common diseases are not well understood.

            Random sequencing is the determination of the order of a sufficient
number of bases in a gene fragment to allow the identification of the gene.
Random sequencing enables the rapid identification of genes, but generally does
not provide an understanding of the function of a gene or its role in a
particular disease. Any determination of function, or "characterization," of
randomly sequenced genes is dependent on structural similarities, or homology,
existing between such randomly sequenced genes and genes with


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known function. Genes with known function currently number fewer than 6,000, or
less than six percent of the estimated total number of human genes. The
characterization of novel randomly sequenced genes will require intensive
biological research even if there is homology to known genes. A number of groups
are randomly sequencing partial human genes and are expected to create a
publicly available collection of all of the estimated 100,000 human genes,
albeit largely without known function, within two years.

            Positional cloning utilizes analysis of disease inheritance patterns
to isolate the chromosomes which contain target disease genes. Further
refinement of these locations can be accomplished by analyzing crossover events,
which occur with statistical regularity. Crossover events may be tracked using
markers, which are strands of DNA with known sequences at known locations across
the genome. By examining markers spread across chromosomes in hundreds of
families affected by a target disease, crossovers can be detected, allowing the
inheritance of subsections of chromosomes to be correlated with the presence or
absence of disease. As a result, the search for disease genes is effectively
narrowed to specific subsections of particular chromosomes. Because positional
cloning is based on the analysis of disease inheritance patterns, knowledge of
the metabolic pathway involved in a disease is not required.


SEQUANA'S GENE DISCOVERY TECHNOLOGY

            Sequana's proprietary gene discovery technology is based on
positional cloning. Rather than emphasizing the random sequencing of a large
number of genes whose functions are unknown, Sequana is concentrating on rapidly
identifying and characterizing specific genes associated with common diseases.
Sequana has developed an integrated gene discovery technology platform comprised
of distinct modules: DNA collection; genotyping and linkage analysis; physical
mapping; and DNA sequencing and mutation detection. This technology utilizes
high-throughput automated DNA analyzers, sophisticated robotics and advanced
computer systems to collect and analyze genetic information and establish its
relationship to disease, and enables Sequana to pursue a number of gene
discovery programs simultaneously.

            DNA Collection. Positional cloning is based on the analysis of
disease inheritance patterns. Determining such patterns with statistical
significance generally requires large and well-characterized DNA sample
collections. The suitability of a particular sample collection is based on a
number of factors, including accurate diagnosis of the underlying disease,
familial relationships, ethnic homogeneity and similar environmental factors
among patients. The typical size for a collection suitable for positional
cloning ranges from an estimated 2,000 to 5,000 samples; however, there can be
no assurance that the Company will not require substantially more samples to
find genes responsible for common diseases where environmental factors are
significant or genetic factors are complex.

            Sequana actively seeks to identify and obtain exclusive access to
suitable DNA samples through collaborations with academic researchers,
clinicians and health care providers. Under the terms of these collaborations,
the collaborators are responsible for collection of DNA samples from individuals
and Sequana funds the expenses incurred in such collection. To support its gene
discovery programs the Company currently has access to approximately 30,000 DNA
samples through its existing collaborations. The Company believes that
replication of these DNA sample collections by others would be expensive and
time-consuming.

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            Genotyping and Linkage Analysis. Genotyping is the use of markers to
determine the genetic constitution of individual DNA samples and measure the
variation between such samples. Linkage analysis is the study of the genotype
variations between affected and healthy individuals to determine the specific
regions of the genome that may be inherited with, or "linked" to, disease. This
process isolates target disease genes to a genomic region, usually representing
two to three million base pairs, or less than 0.1% of the entire genome.

            Sequana has developed an advanced system to capture and store
genotype information in a computer database for linkage analysis. Sequana has
also developed proprietary genetic marker sets which, together with its
integrated technology platform, significantly increase the throughput of the
genotyping process compared to traditional methods. To date, the Company has
identified several regions containing genes associated with common diseases and
is in the process of further refining these regions and identifying additional
regions linked to common diseases. In November 1995, under the Company's
strategic alliance with Boehringer Ingelheim, the Company received a milestone
payment for identifying a genomic region that the Company believes contains a
gene associated with asthma.

            Physical Mapping. Once the chromosomal region containing the target
disease gene is narrowed to two to three million base pairs, the Company begins
identifying genes in that region. Such a region typically contains 60 to 100
genes. To find the target disease gene, the Company must determine which of the
60 to 100 genes in a given region are associated with the disease state;
typically, only one or a few of these genes will be the target disease genes.
The Company begins this analysis by constructing an overlapping set of DNA
clones that spans the genomic region and by isolating genes in those clones.
Sequana also compares data with public and proprietary databases, which may
allow the Company to focus on those genes most likely to be associated with the
disease state. To date, the Company has used a variety of techniques and
proprietary tools to clone genes that are contained in several regions
associated with certain common diseases. In November 1995, under the Company's
strategic alliance with Boehringer Ingelheim, the Company received a milestone
payment for constructing an overlapping set of DNA clones that spans a genomic
region which the Company believes contains a gene associated with asthma.

            DNA Sequencing and Mutation Detection. Target disease genes
identified through the physical mapping process are then sequenced using samples
from a group of normal, healthy individuals and from a group of individuals with
the target disease. The sequences are statistically analyzed to identify
mutations that may be responsible for the target disease state. Sequana uses
automated instrumentation, together with a variety of molecular biology
techniques and proprietary software developed by Sequana, to identify mutations
rapidly and accurately.

            Sequana has identified several target disease genes and is currently
attempting to identify the corresponding mutations responsible for disease.
Using Sequana's DNA sequencing and mutation detection technology, Sequana,
together with the National Cancer Institute ("NCI"), identified a gene and a
corresponding mutation associated with hereditary melanoma. In addition, the
Company, in collaboration with The Jackson Laboratory, discovered a gene
associated with obesity in mice.


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SEQUANA'S FUNCTIONAL GENOMICS TECHNOLOGY

            Once the Company has identified gene mutations which may be
associated with particular diseases, it seeks to analyze these genes to
determine their specific role in disease. Sequana has developed or acquired
access to a variety of technologies that the Company believes will be useful in
determining gene function, including methods to examine the role of human
disease genes in a variety of model organisms.

            The yeast cell, nematode worm, fruit fly and mouse are
well-developed model organisms and, as a result, the Company believes they are
particularly useful models for the study of human gene function. Each of these
organisms exhibits certain similarities to humans at the genetic, molecular and
cellular levels, and mechanisms that operate in these organisms may also operate
in humans. Nearly all genes known to cause human disease have close counterparts
in one or more of these organisms. By studying gene function in these model
systems, Sequana believes it can achieve a better understanding of the molecular
mechanisms that cause or predispose individuals to common diseases. Using genes
which it discovers, as well as those discovered externally, Sequana seeks to
examine gene function, determine signaling pathways, and identify additional
genes that interact with known disease genes. The Company believes that this
information will enable Sequana and its partners to choose more effective
therapeutic intervention points for many common human diseases. Additionally,
Sequana's use of these functional genomics technologies may provide the Company
with opportunities for target-specific projects aimed at drug discovery.

            Yeast Genetics. Sequana's developing program in yeast genetics uses
this well-characterized genome to examine the function of human genes. Among
other techniques employing this organism, Sequana is using yeast two-hybrid
systems for the study of genes relating to asthma and obesity, among other
diseases.

            Nematode Genetics. Through the acquisition of NemaPharm in October
1996, Sequana gained access to proprietary technologies for the study of gene
function in the nematode worm, or C. elegans, one of the most thoroughly
understood multi-cellular organisms in terms of its anatomy, development,
behavior and genetics. The nematode worm is expected to be the first
multi-cellular organism to be fully sequenced, a task that is scheduled for
completion in early 1998. NemaPharm has applied for patents in the United States
on a proprietary nematode-based screening method. Sequana plans to employ
NemaPharm's technologies to develop animal models of human disease and use such
models to identify potential new therapeutic targets. Using NemaPharm's
proprietary NemaScreen(R) technology, Sequana also plans to develop novel
high-throughput screens for therapeutic leads.

            Drosophila Genetics. Sequana is utilizing Drosophila, or fruit fly,
models to examine gene function and gene expression. The Company believes that
the fruit fly is particularly useful because many human gene families and
signaling pathways are also found in this model organism. Sequana has entered
into consulting agreements with two renowned Drosophila geneticists at the
University of California, San Diego, who serve as scientific advisors to the
Company in the use of Drosophila as a model system. Currently, Sequana is using
this model system to examine the function of certain genes related to obesity.



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            Mouse Genetics. In the area of mouse genetics, Sequana is examining
gene function in transgenic mice using high-precision gene insertion
technologies and high-throughput gene inactivation technologies. The Company
believes that these technologies may offer a superior method for developing
animal models of certain human genetic diseases. Currently, the Company is
utilizing its mouse-related technologies in the study of asthma and obesity.

The Company may license or acquire additional technologies which it believes
could further complement its functional genomics capabilities.


SEQUANA'S BIOINFORMATICS TECHNOLOGY

            Sequana's gene discovery programs create significant challenges in
information management, data analysis, quality control and process optimization.
Sequana has developed a proprietary bioinformatics system that integrates the
enormous amount of information produced by each of the gene discovery modules.
Data is collected by highly automated instrumentation, is stored in proprietary
relational databases and is analyzed by Sequana's scientists using sophisticated
computational tools. In addition, Sequana continuously uses its data to redesign
and improve its systems and analytical techniques and tools to make further gene
discovery efforts more effective and efficient.

            SequaSearch(TM) Data Mining Tools and BioAgent db.(TM) Sequana has
developed proprietary software tools, computer networks, database management
systems and computer algorithms to exploit the genetic information contained in
publicly available databases. The Company's SequaSearch(TM) data mining tools
enable Sequana's scientists to continually monitor these external databases and
identify candidate genes implicated in common diseases or located within
disease-associated DNA regions identified by the Company. Sequana's BioAgent
db(TM) candidate gene database is the repository for information obtained
through the use of both SequaSearch(TM) as well as the Company's gene discovery
technology. The Company believes that the use of Sequana's BioAgent db(TM) may
significantly accelerate the discovery and characterization of many disease
genes and facilitate the identification of potential lead compounds for
pharmaceutical development.


GENE DISCOVERY PROGRAMS

            The Company's initial focus is on discovering and characterizing
disease genes associated with type II diabetes, asthma, osteoporosis, obesity,
schizophrenia, and manic depression, among other common diseases. The
inheritance patterns of many common diseases are very complex, indicating that
such diseases are probably associated with defects in more than one gene.
Sequana believes that these diseases represent large market opportunities for
potential prognostic, diagnostic and therapeutic products because the causes of
such conditions are not well understood, current therapies for such diseases are
generally inadequate for treating the underlying cause of the disease and a
large number of individuals are affected by such diseases. The Company believes
that identifying disease genes and determining their biological function will
provide insights into the fundamental causes of common diseases and may
facilitate the development of novel prognostic, diagnostic and therapeutic
products such as small molecule drugs, recombinant proteins, gene therapy and
antisense therapy. The Company's principle gene discovery programs are
summarized below.



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            Diabetes. Type II diabetes, also known as adult onset or non-insulin
dependent diabetes mellitus ("NIDDM"), is believed to be the result of a
combination of impaired release of insulin into the bloodstream and resistance
of the body to insulin. As in type I diabetes, type II diabetes is characterized
by high levels of glucose in the blood. Complications of the disease include
heart disease, circulatory problems, kidney disease, nerve damage and blindness.
Approximately five percent of the United States population, or 13 million
individuals, is affected by type II diabetes.

            Sequana has entered into a strategic alliance with Glaxo to discover
genes associated with type II diabetes. Through collaborative agreements with
various academic institutions and health care providers and, through its
alliance with Glaxo, Sequana has access to more than 5,000 DNA samples from
individuals and families affected by type II diabetes. The Company is conducting
genotyping and linkage analysis with respect to type II diabetes and has
identified several genetic linkages to areas containing candidate disease genes.
Under the terms of the Company's strategic alliance with Glaxo, Glaxo has the
exclusive right to develop and commercialize therapeutic products based on genes
discovered as a result of the alliance. Sequana retains the rights to diagnostic
products based on genes discovered as a result of the alliance. See
"Business--Strategic Alliances."

            Asthma. Asthma, characterized by generalized airway obstruction, is
estimated to affect five percent of the U.S. population, or approximately 13
million people. The precise causes of asthma are not well understood, and
current treatments for asthma are limited to controlling inflammation or
treating airway constriction through the use of bronchodilators.

            Sequana has established a research collaboration with the Mt. Sinai
Hospital Corporation ("MSHC") in Toronto, Ontario, through which it gained
access to a population of approximately 300 individuals with a 30% incidence of
asthma. These individuals are inhabitants of Tristan da Cunha, an island in the
South Atlantic. The remote location of this island has isolated its inhabitants
from the outside world, offering a unique opportunity for the study of this
disease. All of the inhabitants are closely related through intermarriage, and
anecdotal evidence suggests that one of the island's original settlers suffered
from asthma, resulting in the high incidence of asthma in the current
population. In addition, MSHC has gathered DNA samples from affected families in
the Toronto area and from an extended family of over 150 members that live in a
remote location in China and suffer from a high incidence of asthma. Pursuant to
the research collaboration, the Company is obligated to share with MSHC license
fees, milestone payments and royalties that Sequana receives from third parties.
To date, Sequana has completed genotyping and linkage analysis of DNA samples
from these and other sources, has identified genomic regions which the Company
believes contain genes associated with asthma, has identified candidate disease
genes and is in the process of sequencing and searching for mutations in these
genes.

         The Company has entered into a strategic alliance with Boehringer
Ingelheim in the area of asthma. Under the terms of this strategic alliance,
Boehringer Ingelheim has the exclusive right to develop and commercialize
therapeutic products based on genes discovered as a result of the alliance.
Sequana retains the rights to diagnostic products based on genes discovered as a
result of the alliance. See "Business--Strategic Alliances."

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            Osteoporosis. Osteoporosis is a condition characterized by the loss
of bone mass that generally occurs with aging and is particularly rapid in women
after menopause. Nearly 25 million people suffer from osteoporosis in the United
States. The primary complications of the disease are compression fractures of
the vertebrae and hip fractures. There are a number of therapies for
osteoporosis, but none of them significantly restores functional bone mass.
Early treatment is believed to reduce the severity of the disease; therefore,
the Company believes that early identification of patients predisposed to
osteoporosis presents a significant opportunity.

            Sequana has entered into collaborations with several academic
institutions to collect human DNA samples and bone density information for
osteoporosis research. In addition, Sequana has established a research
collaboration with the Southwest Foundation for Biomedical Research ("SFBR") in
San Antonio, Texas to study osteoporosis in baboons. SFBR studies indicate that
there is a strong inherited component to bone density in baboons. The Company
believes that the genetic analysis of baboons may provide leads to candidate
genes for human studies. Sequana is conducting genotyping and physical mapping
of human and baboon samples and has developed a proprietary genetic marker set
for genotyping in baboons. In addition, the Company is examining potential
candidate human disease genes.

         The Company has entered into a strategic alliance with Corange in the
area of osteoporosis. Under the terms of this strategic alliance, Corange has
exclusive rights to develop and commercialize diagnostic and therapeutic
products for osteoporosis based on genes discovered as a result of such
alliance. See "Business--Strategic Alliances."

            Obesity. Obesity has become one of the most common disorders of
modern society. In the United States alone, approximately 30 million individuals
can be classified as obese. Obesity is associated with a large number of
conditions including type II diabetes, hypertension, high cholesterol levels,
atherosclerosis, ischemic heart disease, osteoarthritis, gall bladder disease
and some forms of cancer. Published research suggests that genetic factors
controlling metabolism and appetite suppression may be involved in obesity. In
February 1996, Glaxo expanded its strategic alliance with the Company in the
area of type II diabetes to include the study of human obesity. In collaboration
with Glaxo and others, Sequana has access to DNA samples from more than 1,000
morbidly obese (more than 30% over ideal weight) individuals.

             Sequana has also entered into a collaboration with The Jackson
Laboratory in Bar Harbor, Maine, to discover the genes responsible for obesity
in two specific mouse strains. In January 1996, the Company and The Jackson
Laboratory announced the discovery of a gene associated with obesity in mice.
The Company plans to use information regarding mouse obesity genes to assist in
isolating human gene counterparts.

            Schizophrenia. Schizophrenia is a form of mental illness
characterized by disturbance in logical thinking, inappropriate emotions,
hallucinations, delusions, catatonic symptoms (exaggerated or severely
suppressed movement), violent behavior, withdrawal from reality or some
combination of these symptoms. Due to the diverse nature of these symptoms,
accurate diagnosis is difficult. Schizophrenia affects approximately one percent
of the worldwide population and usually appears in late adolescence or early
adulthood. Published research suggests that the condition has a strong genetic
component, although environmental factors appear to influence the onset and
severity of the disease. The underlying biochemical mechanisms are diverse and
not well understood. Current treatments for schizophrenia include tranquilizers


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and antipsychotic drugs; electric shock treatment for severe catatonia,
depression, or elation; and psychotherapy.

            Sequana has entered into a collaboration with the State University
of New York at Stony Brook ("SUNY") with regard to schizophrenia. Through the
SUNY collaboration, the Company has access to DNA samples from approximately 400
families affected by schizophrenia. The Company believes that this patient
population is valuable due to its size and to SUNY's utilization of consistent
criteria for the accurate assessment of schizophrenic symptoms. Sequana is
conducting genotyping on the SUNY samples and has established linkage to an area
containing candidate disease genes. Sequana has also entered into collaborations
with other academic institutions to access additional DNA samples as well as
unique physical mapping tools for the candidate gene region.

            Bipolar Disorder. Bipolar disorder is a psychiatric disorder
characterized by mood fluctuations between mania and depression and is estimated
to affect one percent of the United States population, or 2.5 million people.
Sequana has entered into a collaboration with the University of Pittsburgh in
Pittsburgh, Pennsylvania to collect DNA samples from individuals and families
with bipolar disorder. Sequana plans to collect DNA samples from approximately
500 families through this collaboration and the Company has entered into
collaborations with other academic institutions to access additional DNA
samples. Sequana is conducting genotyping on these samples and has established
linkage to a region containing candidate disease genes.

            In an effort to focus its gene discovery efforts on areas which
provide the most significant commercial opportunities, the Company continually
evaluates its ongoing programs in light of the latest market information and
conditions, availability of third-party funding, technological advances and
other factors. As a result of such evaluations, the Company's gene discovery
programs have changed from time to time and the Company anticipates that they
may continue to do so in the future.

            While the Company has used its gene discovery technology to identify
certain genes which it believes are associated with certain diseases, the
Company has identified only a limited number of genes using its technology and
has not fully described the function of any identified disease gene using its
functional genomics and bioinformatics technologies. There can be no assurance
that the Company's positional cloning technology and approach to gene discovery
will enable it to successfully identify and characterize specific genes that
cause or predispose individuals to the complex, polygenic diseases that are the
targets of its gene discovery programs. In addition, there can be no assurance
that the Company's functional genomics and bioinformatics technologies will
enable it to determine the function of any disease gene which it or others may
discover. The Company will be required to dedicate substantial resources over an
extended period to identify and characterize genes which may be implicated in
these disease states. Even if the Company successfully identifies and determines
the function of specific genes, there can be no assurance that its gene
discoveries will lead to the development of commercial products. To date,
relatively few products based upon genes have been developed and commercialized,
and there can be no assurance that the Company and other entities working in
collaboration with the Company will be able to develop commercial prognostic,
diagnostic and therapeutic products based upon the Company's gene discoveries.


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            The Company's positional cloning technology requires the collection
of large numbers of DNA samples from affected individuals, their families and
other suitable populations and, therefore, the availability of such samples is
critical to the Company's ability to discover the genes responsible for common
diseases. The Company is highly dependent upon others for the collection and
supply of the DNA samples used in its research projects. The Company does not
currently have in its possession sufficient DNA samples to support all of its
gene discovery programs. There can be no assurance that the Company will be able
to obtain access to the DNA samples necessary to support its gene discovery
programs and any material lack of availability of such samples would have an
adverse effect on the Company's business.


STRATEGIC ALLIANCES

            An integral component of Sequana's business strategy is to enter
into strategic alliances with major pharmaceutical and biotechnology companies
in order to develop and commercialize products based on information provided by
the Company's gene discovery, functional genomics and bioinformatics
technologies. Such corporate alliances may provide for financial and technical
support during the gene discovery and characterization phase, and may include
up-front fees, research support, milestone payments and royalty payments on
product sales. Entering into strategic alliances enables the Company to focus
its efforts on its gene discovery programs and to leverage the resources and
expertise of its strategic alliance partners in product development. As a
result, the Company avoids incurring the significant expenses required in
connection with the development and commercialization of therapeutic products.
To date, the Company has transferred rights to therapeutic applications of its
gene discoveries to its strategic alliance partners while generally retaining
rights to diagnostic applications for development by the Company or subsequent
licensing to third parties. The Company's existing strategic alliances are
summarized below.

            Glaxo Wellcome Inc. In July 1994, Sequana and Glaxo entered into a
five year strategic alliance in the area of type II diabetes. In February 1996,
this alliance was expanded to include the study of human obesity. Under the
terms of this agreement, Glaxo paid the Company a $1 million up-front fee and is
obligated to make additional ongoing payments for research support. The Company
may receive additional payments upon the achievement of certain milestones and
royalties on sales of therapeutic products which may result from the alliance.
The agreement provides Glaxo with exclusive worldwide rights to develop and
commercialize therapeutic products based upon the Company's gene discoveries in
the areas of diabetes and human obesity. Sequana retains rights to develop and
commercialize diagnostic products based on such gene discoveries. Glaxo has the
right to terminate the agreement (subject to certain notification requirements)
beginning in July 1997, or earlier in the event the Company is acquired by
another pharmaceutical company. There can be no assurance that the Company's
research pursuant to the agreement will be successful in discovering the
targeted genes or that Glaxo will be successful in developing or commercializing
any products based upon the Company's gene discoveries. As a result, there can
be no assurance that any of the future milestone, royalty and other payments
contemplated by the agreement will ever be made.

            In January 1997, the Company entered into a two year strategic
alliance with Glaxo under which Sequana's wholly-owned subsidiary, NemaPharm,
will examine the function of certain human genes using its proprietary C.
elegans technology. Glaxo is obligated to provide payments to the Company for
research support and to make certain additional payments contingent on
identification by the Company of targets


                                                                              11
<PAGE>   12
used by Glaxo in its research programs. The Company may also receive royalties
on sales of products which may result from the alliance. There can be no
assurance that the Company's research pursuant to the agreement will be
successful in identifying targets or, in the event that any such targets are
identified, that products would be successfully developed or commercialized. As
a result, there can be no assurance that any of the future milestone, royalty or
other payments contemplated by the agreement will ever be made.

            Boehringer Ingelheim International GmbH. In June 1995, Sequana
entered into a five year strategic alliance with Boehringer Ingelheim in the
area of asthma. Under the terms of the agreement, Boehringer Ingelheim made a $6
million equity investment in the Company and paid the Company an up-front fee of
$2 million. The Company receives ongoing payments for research support, and may
receive additional payments upon achievement of certain milestones and royalties
on sales of therapeutic products which may result from the alliance. The Company
received $2 million in milestone payments during 1995 in connection with
achieving two research milestones under the agreement. The Company is obligated
to share milestone payments and royalties with MSHC pursuant to the terms of the
Company's collaborative agreement with MSHC. Under the agreement with Boehringer
Ingelheim, Boehringer Ingelheim has exclusive worldwide rights to develop and
commercialize therapeutic products for asthma based on discovered genes. Sequana
retains the right to develop and commercialize diagnostic products based on such
gene discoveries. Boehringer Ingelheim has the right to terminate the agreement
(subject to certain notification requirements) beginning in June 1998, or
earlier in the event the Company is acquired by another pharmaceutical company.
There can be no assurance that the Company's research pursuant to the agreement
will be successful in discovering the targeted asthma genes or that Boehringer
Ingelheim will be successful in developing or commercializing any products based
upon the Company's gene discoveries. As a result, there can be no assurance that
any of the future milestone, royalty and other payments contemplated by the
agreement will ever be made.

            Corange International, Ltd. In June 1995, Sequana and Corange, the
parent corporation of Boehringer Mannheim, entered into a five year strategic
alliance in the area of osteoporosis. Corange made a non-refundable payment of
$1 million to the Company and an investment fund affiliated with Corange made an
equity investment of $1 million in the Company. The Company receives ongoing
payments for research support and may receive additional payments upon
achievement of certain milestones and royalties on sales of diagnostic and
therapeutic products which may result from the alliance. Corange made an
additional $1.25 million equity investment in the Company in both 1995 and 1996.
In addition, Corange is obligated to invest $1.25 million in the Company each
year for the next three years by purchasing shares of common stock at a purchase
price equal to 135% of the per share market price of Sequana's common stock. The
agreement with Corange provides Corange with exclusive worldwide rights to
develop and commercialize diagnostic and therapeutic products based on
osteoporosis genes which may be discovered as a result of the alliance. Corange
has the right to terminate the agreement (subject to certain notification
requirements) beginning in February 1998, or earlier in the event the Company is
acquired by another pharmaceutical company. Upon such termination, the
obligation of Corange to purchase common stock of the Company also terminates.
There can be no assurance that the Company's research pursuant to the agreement
with Corange will be successful in discovering the targeted osteoporosis genes
or that Corange will be successful in developing or commercializing any products
based upon gene discoveries of the Company. As a result, there can be no
assurance that any of the future milestone, royalty or other payments
contemplated by the agreement will ever be made.



                                                                              12
<PAGE>   13
            In October 1994, Genentech, Inc. ("Genentech") made a $2 million
equity investment in the Company. In connection with this investment, the
Company granted certain first negotiation rights to Genentech with respect to
the development and commercialization of recombinant therapeutic or prophylactic
proteins. Such first negotiation rights continue until September 1999 and
require the Company to negotiate commercialization rights with Genentech with
respect to such potential products prior to granting such rights to other
parties or otherwise upon request by Genentech. Genentech has not exercised its
first negotiation rights to date and has waived such rights in connection with
Sequana's existing strategic alliances.

            In January 1997, the Company and Memorial Sloan-Kettering Cancer
Center ("MSK") formed Genos Biosciences, Inc. ("Genos"), a new company focused
on the research and identification of genes and related genetic information of
value in the prognosis, diagnosis and possible treatment of certain common
cancers. The Company and MSK each own 50% of Genos and have committed to
contribute approximately $5 million each to fund its initial operations. The
Company invested $1.2 million in Genos in connection with its formation and
anticipates that Sequana's remaining commitment will be funded during 1997 and
early 1998. In connection with the formation of Genos, the Company sold a
warrant to MSK to purchase 350,000 shares of the Company's common stock
exercisable at a price of $17.38 per share. The Company's Chief Executive
Officer and Chief Financial Officer are members of the Board of Directors of
Genos.

            The Company's strategy for commercialization of its gene discoveries
and related technologies depends upon the formation of various strategic
alliances and licensing agreements. There can be no assurance that the Company
will be able to establish additional strategic alliances or licensing
arrangements that the Company deems necessary to commercialize its technologies,
that any such arrangements will be on terms favorable to the Company, or that
the current or future strategic alliances or licensing arrangements will
ultimately be successful. With respect to current and potential future strategic
alliances and licensing arrangements, the Company will be dependent upon the
expertise and dedication of sufficient resources by these outside parties to
develop and commercialize products based on the Company's discoveries. The
Company's contractual arrangements with its strategic alliance partners do not
obligate them to develop or commercialize genes discovered by the Company and
there can be no assurance that current or future strategic alliance partners
will successfully develop and commercialize products based upon the Company's
discoveries.

PATENTS AND PROPRIETARY RIGHTS

            The Company's commercial success will be dependent in part on its
ability to obtain patent protection on genes, or products based on genes,
discovered by it. The current criteria for obtaining patent protection for genes
whose functions have not been characterized are unclear. The Company's
positional cloning approach to gene discovery is directed at identifying novel
genes and characterizing their function. The Company generally intends to apply
for patent protection for all novel full-length gene sequences identified by the
Company. To date, the Company has filed patent applications for several genes
including genes associated with hereditary melanoma and asthma, as well as a
collection of patent applications associated with mouse obesity (tubby) and
related genes. The Company believes that by filing for additional patent
protection after the function of a gene has been characterized, the likelihood
that the Company will be able to obtain patent protection for such gene is
increased. However, there can be no assurance that the Company will be able to
obtain patent protection for such genes, and even if such patents


                                                                              13
<PAGE>   14
are issued, the scope of the coverage or protection provided by any such patents
is uncertain. In addition, there can be no assurance that any patents, if
issued, will provide protection against any competitors, will provide the
Company with competitive advantages, or will not be challenged by others. In
addition, it is likely that the Company or its strategic alliance partners will
attempt to seek patent protection for products based on genes discovered by the
Company. There can be no assurance that any patent protection can be obtained
for any such products.

            There are an estimated 100,000 genes in the human genome and the
Company believes that virtually all such genes will be identified, albeit
largely without known function, within two years. A number of groups are
attempting to rapidly identify and patent gene fragments and full-length genes
whose functions have not been characterized, as well as fully-characterized
genes. There is substantial uncertainty regarding the patentability of gene
fragments or genes without known function. There have been recent proposals for
review of the appropriateness of patents on gene fragments and genes. The
Congressional Office of Technology Assessment has announced that it is
conducting a review of this area with a particular focus on the patentability of
gene fragments. The United States Patent and Trademark Office initially rejected
a patent application by the National Institutes of Health on certain partial
genes. To the extent any patents issue on such partial or full-length genes, the
risk increases that the potential products of the Company or its strategic
alliance partners may give rise to claims that such products infringe the
patents of others. Such groups could bring legal actions against the Company or
its strategic alliance partners claiming damages and seeking to enjoin drug
screening, clinical testing, manufacturing or marketing of the affected
products. If any such actions are successful, in addition to any potential
liability for damages, the Company or its strategic alliance partners could be
required to obtain a license in order to continue to manufacture or market the
affected products. There can be no assurance that the Company or its strategic
alliance partners would prevail in any such action or that any license required
under any such patent would be made available upon commercially acceptable
terms. The Company believes that there may be significant litigation in the
industry regarding patent and other intellectual property rights. If the Company
becomes involved in such litigation, it could consume a substantial portion of
the Company's management and financial resources.

            The Company also relies on trade secret protection for its
confidential and proprietary information. The Company believes it has developed
proprietary technology for gene discovery and characterization, including
proprietary genetic marker sets, custom software and an integrated
bioinformatics system. The Company has sought patent protection for only limited
aspects of this technology. Additionally, the Company is developing a database
of DNA samples analyzed by it. The Company has taken security measures to
protect its data and is in the process of exploring ways to further enhance the
security for its data. There can be no assurance that such measures will provide
adequate protection for the Company's trade secrets or other proprietary
information. In addition, while the Company has entered into proprietary
information agreements with its employees, consultants and advisors, there can
be no assurance that these agreements will provide meaningful protection for the
Company's proprietary information in the event of unauthorized use or disclosure
of such information. In addition, there can be no assurance that others will not
independently develop substantially equivalent proprietary information and
techniques or otherwise gain access to the Company's trade secrets or disclose
such technology, or that the Company can meaningfully protect its trade secrets.


                                                                              14
<PAGE>   15
COMPETITION

            Competition among entities attempting to identify and characterize
the genes responsible for causing diseases is intense and is expected to
increase. The Company will face competition from pharmaceutical and
biotechnology companies both in the United States and abroad. In addition,
significant research to identify and characterize genes is being conducted by
universities, other non-profit research institutions and United States and
foreign government-sponsored entities. A number of entities are attempting to
identify rapidly and patent randomly sequenced genes, typically without specific
knowledge of the function of such genes. In addition, the Company believes that
certain entities are pursuing a gene identification and characterization and
product development strategy based upon positional cloning. Any one of these
companies or other entities may discover and establish a competitive advantage
in one or more genes which the Company has identified and designated as a
product candidate. Some of these entities have reported gene discoveries,
including discovery of genes implicated in human breast cancer, Alzheimer's
disease and obesity in mice and humans. Other entities may have identified and
characterized other disease genes, which discoveries have not yet been publicly
reported. The Company also faces competition from these and other entities in
gaining access to DNA samples used in its research and development projects.

            The Company believes that its ability to compete is dependent, in
part, upon its ability to create and maintain scientifically advanced
technology, the speed with which it can identify and characterize the genes
involved in targeted complex diseases, its strategic alliance partners' ability
to develop and commercialize pharmaceutical products based upon the Company's
gene discoveries, as well as its ability to attract and retain qualified
personnel, obtain patent protection or otherwise develop proprietary technology
or processes and secure sufficient capital resources for the expected
substantial time period between technological conception and commercial sales of
products based upon the Company's gene discoveries.

            Many of the Company's competitors have substantially greater
research and product development capabilities and financial, scientific,
marketing and human resources than the Company. These competitors may succeed in
identifying and characterizing genes or developing products earlier than the
Company or its strategic alliance partners, obtaining authorization from the FDA
for such products more rapidly than the Company or its strategic alliance
partners, or developing products that are more effective than those proposed to
be developed by the Company or its strategic alliance partners. Any potential
products based on genes identified by the Company will face competition both
from companies developing gene-based products and from companies developing
other forms of treatment for particular diseases targeted by the Company.
Certain of the Company's and its strategic alliance partners' competitors may be
further advanced than the Company in identifying genes and developing potential
products that may compete with potential products of the Company or its
strategic alliance partners. There can be no assurance that research and
development by others will not render the products which the Company or its
strategic alliance partners may seek to develop obsolete or uneconomical or
result in treatments or cures superior to any other therapy developed by the
Company or its strategic alliance partners, or that any therapy developed by the
Company or its strategic alliance partners will be preferred to any existing or
newly developed technologies.


                                                                              15
<PAGE>   16
GOVERNMENT REGULATION

            Regulation by governmental entities in the United States and other
countries will be a significant factor in the production and marketing of any
pharmaceutical products which may be developed by the Company or a strategic
alliance partner of the Company. The nature and the extent to which such
regulation may apply to the Company or its strategic alliance partners will vary
depending on the nature of any such pharmaceutical products. Virtually all of
the Company's or its strategic alliance partners' pharmaceutical products will
require regulatory approval by governmental agencies prior to commercialization.
In particular, human pharmaceutical products are subject to rigorous preclinical
and clinical testing and other approval procedures by the United States Food and
Drug Administration ("FDA") and similar health authorities in foreign countries.
Various federal and, in some cases, state statutes and regulations also govern
or influence the manufacturing, safety, labeling, storage, record keeping and
marketing of such pharmaceutical products. The process of obtaining these
approvals and the subsequent compliance with appropriate federal and foreign
statutes and regulations are time-consuming and require the expenditure of
substantial resources.

            Generally, in order to gain FDA pre-market approval, a company first
must conduct preclinical studies in the laboratory and in animal model systems
to gain preliminary information on an agent's efficacy and to identify any
safety problems. The results of these studies are submitted as a part of an
investigational new drug application ("IND"), which the FDA must review before
human clinical trials of an investigational drug can start. In order to
commercialize any products, the Company or its strategic alliance partner will
be required to sponsor and file an IND and will be responsible for initiating
and overseeing the clinical studies to demonstrate the safety, efficacy and
potency that are necessary to obtain FDA approval of any such products. Clinical
trials are normally done in three phases and generally take two to five years,
but may take longer, to complete. After completion of clinical trials of a new
product, FDA marketing approval must be obtained. If the product is classified
as a new drug, the Company or its strategic alliance partner will be required to
file a new drug application ("NDA") and receive approval before commercial
marketing of the drug. The testing and approval processes require substantial
time and effort and there can be no assurance that any approval will be granted
on a timely basis, if at all. NDAs submitted to the FDA can take, on average,
two to five years to receive approval. If questions arise during the FDA review
process, approval can take more than five years. Even if FDA regulatory
clearances are obtained, a marketed product is subject to continual review, and
later discovery of previously unknown problems or failure to comply with the
applicable regulatory requirements may result in restrictions on the marketing
of a product or withdrawal of the product from the market as well as possible
civil or criminal sanctions. For marketing outside the United States, the
Company will also be subject to foreign regulatory requirements governing human
clinical trials and marketing approval for pharmaceutical products. The
requirements governing the conduct of clinical trials, product licensing,
pricing and reimbursement vary widely from country to country.

            The Company also intends to develop diagnostic products based upon
genes that it identifies. The diagnostic products to be developed by the Company
or its strategic alliance partners are likely to be regulated by the FDA as
devices rather than drugs. The nature of the FDA requirements applicable to such
diagnostic devices depends on their classification by the FDA. A diagnostic
device developed by the Company or a strategic alliance partner would most
likely be classified as a Class III device, requiring pre-market approval.
Obtaining pre-market approval involves the costly and time-consuming process,


                                                                              16
<PAGE>   17
comparable to that for new drugs, of conducting preclinical studies, obtaining
an investigational device exemption to conduct clinical tests, filing a
pre-market approval application, and obtaining FDA approval.

            The Company's research and development activities involve the
controlled use of hazardous materials, chemicals and various radioactive
materials. The Company is subject to federal, state and local laws and
regulations governing the use, storage, handling and disposal of such materials
and certain waste products. Although the Company believes that its safety
procedures for handling and disposing of such materials comply with the
standards prescribed by state and federal laws and 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 liability could exceed the resources of the
Company.

EMPLOYEES

            As of December 31, 1996, the Company had 203 full-time employees, of
whom 53 hold Ph.D. or M.D. degrees and 36 hold other advanced degrees. Of the
Company's total work force, 172 are engaged in research and development
activities and 31 are engaged in business development, finance and
administration. The Company believes that its future success will depend, in
part, on its continuing ability to attract, retain and motivate qualified
scientific, technical and managerial personnel. The Company faces intense
competition in this regard from other companies, research and academic
institutions, government entities and other organizations. None of the Company's
employees is represented by a collective bargaining agreement, nor has the
Company experienced work stoppages. The Company believes that its relations with
its employees are good.

ITEM 2.  PROPERTIES

            The Company's principal administrative offices and research and
development laboratories are located in a research and development office park
in La Jolla, California. The Company currently leases approximately 53,000
square feet in this facility pursuant to a lease which expires in December 2001.
The Company also leases approximately 11,000 of additional space, primarily
research facilities, under leases which expire in 1999. The Company believes
that its facilities will be adequate to support its operations through 1997.
Thereafter, the Company believes that it will be able to secure additional
facilities for its continued operations.

ITEM 3.  LEGAL PROCEEDINGS

            Not applicable.

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

            Not applicable.


                                                                              17
<PAGE>   18
                      EXECUTIVE OFFICERS OF THE REGISTRANT

            The executive officers and key scientific employees of the Company
are as follows:

<TABLE>
<CAPTION>
              NAME               AGE                                POSITION
              ----               ---                                --------
<S>                              <C>         <C>
Kevin J. Kinsella                51          President, Chief Executive Officer and Director

Timothy J. R. Harris, Ph.D.      46          Senior Vice President, Research and Development, Chief Technical Officer
                                                and Director
Carl D. Johnson, Ph.D.           48          Vice President Research, NemaPharm, Inc.

M. Scott Salka                   35          Vice President, Operations and Chief Financial Officer

Alan J. Buckler, Ph.D.           37          Senior Director of Genomics

Lon R. Cardon, Ph.D.             31          Senior Director of Statistical Genetics

Spencer Emtage, Ph.D.            51          Senior Director of Biology

Jay B. Lichter, Ph.D.            35          Senior Director of  Diagnostics
                                                and Pharmacogenetics
</TABLE>

         Kevin J. Kinsella is the founder of the Company and has been a director
since its inception in February 1993. Mr. Kinsella served as the Chairman of the
Board of Directors and acting chief executive of the Company until January 1995,
when he was named President and Chief Executive Officer. Mr. Kinsella also
served as Chief Financial Officer of the Company from January 1995 to September
1995. Mr. Kinsella was previously the Managing General Partner of Avalon
Ventures, a venture capital firm founded by him. Avalon Ventures established
over thirty companies, many of which are in the biopharmaceutical field,
including IMPATH Laboratories, Inc., Metra Biosystems, Inc. and Pharmacopeia,
Inc. Mr. Kinsella founded Aurora Biosciences Corporation, Athena Neurosciences
Inc., NeoRx Corporation, Vertex Pharmaceuticals Inc., Microcide Pharmaceuticals,
Inc. and Landmark Graphics Corporation. He received a B.S. from the
Massachusetts Institute of Technology ("MIT") and an M.A. from the Johns Hopkins
School of Advanced International Studies.

         Timothy J.R. Harris has served as Senior Vice President, Research and
Development, Chief Technical Officer and a director of the Company since January
1994. From March 1989 to December 1993, Dr. Harris served as Director of
Biotechnology of Glaxo Group Research, Ltd., a pharmaceutical company. Prior to
that, Dr. Harris was a Senior Molecular Biologist at Celltech Ltd., a
biotechnology company. He received a B.Sc. in Biochemistry and an M.S. and Ph.D.
in General Virology from the University of Birmingham in England. He is the
author of approximately 60 research papers and inventor on five patent
applications.



                                                                              18
<PAGE>   19
         Carl D. Johnson has served as Vice President, Research of NemaPharm
since the acquisition of NemaPharm by Sequana in October 1996. From 1991 through
September 1996, Dr. Johnson was President and Director of Research of NemaPharm
and was a Visiting Scientist at Massachusetts Institute of Technology. Prior to
that, Dr. Johnson was Director of Genetics of Cambridge NeuroScience, Inc. Dr.
Johnson received a B.S. in Chemistry from the University of Chicago and a Ph.D.
in Biochemistry and Genetics from the California Institute of Technology.

         M. Scott Salka has served as Vice President, Operations and Chief
Financial Officer of the Company since September 1995 and served as Director of
Business Operations of the Company from April 1993 to September 1995. From June
1991 to March 1993, Mr. Salka served as a Financial Analyst for The BF Goodrich
Company, a manufacturer of specialty chemical and aerospace products. From 1986
to August 1990, he was a Financial Analyst for Unisys Corporation, a computer
company. Mr. Salka received a B.S. in Finance from San Diego State University
and an M.S. in Industrial Administration from the Graduate School of Industrial
Administration at Carnegie Mellon University.

         Alan J. Buckler has served as Senior Director of Genomics of the
Company since February 1997 and served as Director of Genomics of the Company
from March 1996 to January 1997. From 1991 to February 1996, Dr. Buckler served
as Assistant Professor, Molecular Neurogenetics Laboratory, Massachusetts
General Hospital. From 1991 through 1995, Dr. Buckler also held various
appointments at Harvard University including, most recently, Assistant Professor
in Neurology. Dr. Buckler developed the technique of exon trapping for the
isolation of genes in cloned DNA and used this technology to find the genes for
neurofibromatosis type 2, Huntington's disease and diastrophic dysplasia. Dr.
Buckler was also involved in the discoveries of the Wilm's tumor and myotonic
dystrophy disease genes. Dr. Buckler received a B.A. in Biology from the
University of Chicago and a Ph.D. in Microbiology from the Boston University
School of Medicine.

            Lon R. Cardon has served as Senior Director of Statistical Genetics
of the Company since February 1997, served as Director of Statistical Genetics
of the Company from August 1995 to January 1997 and has been with the Company
since September 1994. From June 1992 to August 1994, he was a post-doctoral
scholar in Mathematics at Stanford University, with a joint appointment in
Biostatistics at SRI International, a non-profit research institute. While at
Stanford, Dr. Cardon developed novel statistical procedures which he used to
localize a gene believed to be responsible for dyslexia. Dr. Cardon received a
B.A. in Biology/Psychology from the University of Puget Sound and a Ph.D. in
Behavioral Genetics from the University of Colorado, Boulder.

         Spencer Emtage has served as Senior Director of Biology of the Company
since February 1997, and served as Director of Biology of the Company from April
1996 to January 1997. From 1980 to March 1996, Dr. Emtage held a variety of
positions at Celltech, Ltd., most recently Group Leader of Molecular Biology.
Dr. Emtage was involved in cloning genes for Influenza haemagglutinin and
Interferon-beta, developing vectors for gene expression in bacterial and
mammalian cells and in antibody engineering and production. Dr. Emtage received
his B.A. and Ph.D. in Biochemistry from Cambridge University in England.


                                                                              19
<PAGE>   20
            Jay B. Lichter has served as Senior Director of Diagnostics and
Pharmacogenetics of the Company since February 1997 and served as Director of
Scientific Strategy of the Company from September 1995 to January 1997. Prior to
that, he served as Director of Genetics of the Company from August 1993 to
September 1995, and served as Director of Business Strategy from inception to
August 1993. From April 1992 to January 1993, Dr. Lichter was a post-doctoral
fellow at DuPont Merck Pharmaceutical Company. From April 1990 to April 1992,
Dr. Lichter was a post-doctoral fellow in Human Genetics at Yale University. Dr.
Lichter received a B.S. in Biochemistry from the University of Illinois,
Urbana-Champaign and a Ph.D. in Biological Chemistry from the University of
Illinois, Chicago.


                                                                              20
<PAGE>   21
                                     PART II


ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

(a)         Market Information

            The common stock of the Company has been traded on the Nasdaq
            National Market under the Symbol "SQNA" since the Company's initial
            public offering on July 31, 1995. Prior to that time there was no
            public market for the Company's common stock. The following table
            sets forth for the periods indicated the high and low sale prices of
            the common stock.

<TABLE>
<CAPTION>
                                                                    HIGH            LOW
                                                                    ----            ---
<S>                                                              <C>            <C>
                       1996
                        First Quarter                            $  29.50       $  18.00
                        Second Quarter                              24.25          13.25
                        Third Quarter                               19.00          12.75
                        Fourth Quarter                              19.50          14.00

                       1995
                        Third Quarter (from July 31, 1995)          12.50          10.25
                        Fourth Quarter                              24.38          10.50
</TABLE>

(b)         Holders

            The approximate number of holders of record of the Company's common
            stock as of March 1, 1997 was 345.

(c)         Dividends

            The Company has never paid dividends on its common stock and does
            not anticipate paying any such dividends in the foreseeable future.
            The Company currently intends to retain its earnings, if any, for
            the development of its business.


                                                                              21
<PAGE>   22
ITEM. 6  SELECTED CONSOLIDATED FINANCIAL DATA

The following table sets forth certain consolidated financial data with respect
to the Company. The selected consolidated financial data should be read in
conjunction with the consolidated financial statements and related notes
thereto.
<TABLE>
<CAPTION>
                                                                                        PERIOD FROM
                                                                                        FEB. 3, 1993
                                                                                         (INCEPTION)
                                                     YEARS ENDED DECEMBER 31,         THROUGH DEC. 31,
                                               ------------------------------------
                                                 1996          1995          1994          1993
                                               --------      --------      --------      --------
                                                    (In thousands, except per share amounts)
<S>                                            <C>           <C>           <C>           <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenue under strategic alliances              $  9,705      $ 10,762      $  2,389      $     --

Operating expenses:
  Research and development                       26,397        15,138         7,614         2,018
  Charge for acquisition of in-process
    research and development                      3,366            --            --            --
  General and administrative                      5,005         3,078         1,494           356
                                               --------      --------      --------      --------
                                                 34,768        18,216         9,108         2,374
                                               --------      --------      --------      --------
Loss from operations                            (25,063)       (7,454)       (6,719)       (2,374)
Interest income (expense), net                    2,844         1,384            73            (5)
                                               ========      ========      ========      ========
Net loss                                       $(22,219)     $ (6,070)     $ (6,646)     $ (2,379)
                                               ========      ========      ========      ========

Net loss per share (1)                         $  (2.31)     $  (0.92)     $  (2.02)     $  (1.26)
                                               ========      ========      ========      ========

Shares used in computing net
  loss per share                                  9,625         6,578         3,284         1,893
                                               ========      ========      ========      ========
</TABLE>


<TABLE>
<CAPTION>
                                                                   DECEMBER 31,
                                               --------------------------------------------------
                                                 1996          1995          1994          1993
                                               --------      --------      --------      --------
                                                                 (In thousands)

<S>                                            <C>           <C>           <C>           <C>
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and
  investment securities                        $ 52,720      $ 41,338      $ 16,402      $  1,987
Working capital                                  45,820        36,497        15,676           448
Total assets                                     66,093        48,001        21,108         2,728
Loans and capital lease obligations,
  less current portion                            4,524         2,804         2,156            --
Shareholders' equity                             51,849        38,774        17,318         1,039
</TABLE>


----------
(1)  Computed on the basis of net loss per share described in Note 1 of Notes
     to Consolidated Financial Statements.
                                                                              22
<PAGE>   23
ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
           RESULTS OF OPERATIONS

OVERVIEW

            The Company was incorporated in February 1993 and has devoted
substantially all of its resources since that time to the development of an
integrated technology platform for discovering and characterizing genes
associated with common human diseases. The Company believes that identification
of disease genes and determination of their biological function will provide
insights into the fundamental causes of these diseases and may facilitate the
development of novel prognostic, diagnostic and therapeutic products. The
Company has incurred substantial operating losses since inception and, as of
December 31, 1996, had incurred a cumulative net loss of $37.3 million. The
Company anticipates incurring additional losses over at least the next several
years as it expands its gene discovery and functional genomics activities. Such
expansion may result in increases in both research and development and general
and administrative expenses.

            The Company does not anticipate revenues from product sales in the
foreseeable future. The Company's sources of revenue for the next several years
will be payments under existing strategic alliances, license fees, proceeds from
the sale of rights, payments from future strategic alliances and licensing
arrangements, if any, and interest income. Certain payments under strategic
alliances are contingent upon the Company meeting established milestones.
Payments under strategic alliances and licensing arrangements will be subject to
significant fluctuation in both timing and amount and, therefore, the Company's
results of operations for any period may not be comparable to the results of
operations for any other period.

            An integral component of Sequana's business strategy is to enter
into strategic alliances with major pharmaceutical and biotechnology companies
in order to develop and commercialize products based on information provided by
the Company's gene discovery, functional genomics and bioinformatics
technologies. In July 1994, the Company entered into a strategic alliance with
Glaxo to discover disease genes associated with type II diabetes. In February
1996, this alliance was expanded to include the study of human obesity. In June
1995, the Company entered into strategic alliances with Boehringer Ingelheim in
the area of asthma and with Corange in the area of osteoporosis. In January
1997, the Company entered into a strategic alliance with Glaxo in the area of
gene function analysis. Pursuant to the terms of the various agreements, the
Company has granted the strategic alliance partners exclusive worldwide rights
to develop and commercialize therapeutic products which may be discovered as a
result of the alliances. Sequana has retained the right to develop and
commercialize diagnostic products based on such gene discoveries, except in the
case of the Corange agreement. Under the terms of the strategic alliance
agreements, the Company receives ongoing payments for research support, and may
receive payments upon the achievement of certain research and product
development milestones and royalties on the sale of products resulting from the
alliance. Such agreements provide the strategic alliance partners certain rights
of early termination. See "Business--Strategic Alliances."

            The information set forth in this report contains forward-looking
statements, including but not limited to statements concerning the Company's
future capital requirements and the expected time period during which the
Company's existing financial resources will meet such capital requirements, and
business conditions and growth in the biopharmaceutical and pharmaceutical
industries and general economy. The


                                                                              23
<PAGE>   24
Company's actual results could differ materially from those anticipated in these
forward-looking statements as a result of the aforementioned factors, as well as
those set forth elsewhere in this Form 10-K.


RESULTS OF OPERATIONS

            Revenue under strategic alliances totaled $9.7 million in 1996
compared to $10.8 million in 1995 and $2.4 million in 1994. Such revenue is
comprised of ongoing payments for research support and DNA sample collection, as
well as certain up-front and research milestone payments received pursuant to
the Company's strategic alliance agreements. The decrease in revenue in 1996,
relative to 1995, was primarily attributable to up-front payments received in
1995 which were recognized upon the commencement of the Company's strategic
alliances with Boehringer Ingelheim and Corange in June 1995. The increase in
revenue during 1995, relative to 1994, was primarily attributable to the
commencement of these two new strategic alliance agreements.

            Research and development expenses increased to $26.4 million in 1996
from $15.1 million in 1995 and $7.6 million in 1994. Increases in research and
development expenses were primarily attributable to increased costs associated
with expansion of the Company's gene discovery efforts and establishment of a
broad-based functional genomics technology platform. Such costs consisted
primarily of increased personnel expenses, supply costs, and facility and
equipment expenses associated with expansion of the Company's research
organization. Research and development expenses also included costs associated
with the collection of patient information and DNA samples pursuant to
collaborative research agreements. The Company expects to continue expanding its
gene discovery and functional genomics activities in future periods, which is
anticipated to result in additional increases in research and development
expenses.

            In connection with the Company's acquisition of NemaPharm (see Note
2 of Notes to Consolidated Financial Statements), the Company recorded a
non-cash charge for acquired in-process research and development of $3.4 million
during the fourth quarter of 1996. The Company may elect to pursue the
acquisition of additional technologies which it believes could further
complement its gene discovery and functional genomics capabilities.

            General and administrative expenses increased to $5.0 million in
1996 from $3.1 million in 1995 and $1.5 million in 1994. Increases in general
and administrative expenses largely reflect expansion of the Company's
administrative organization to support increased research efforts and business
development activities. Such increases are comprised primarily of costs
associated with the addition of management and support personnel as well as
expenses related to Sequana's status as a public company (commencing in July
1995). General and administrative expenses in 1996 and 1995 also include
amortization of deferred compensation related to certain stock issuances and
option grants. General and administrative expenses are anticipated to increase
in future periods as a result of expansion necessary to support increases in
research and development programs and business development activities.

            Interest income increased significantly during 1996 and 1995,
relative to the prior years, primarily due to higher levels of cash, cash
equivalents and investment securities resulting from public offerings of the
Company's equity securities and, to a lesser degree, funding under the Company's
strategic alliances.

                                                                              24
<PAGE>   25
LIQUIDITY AND CAPITAL RESOURCES

            Since inception, the Company has financed its operations primarily
through public and private offerings of its equity securities (generating net
proceeds of approximately $80.5 million) and cash received pursuant to the
Company's strategic alliances ($25 million). At December 31, 1996, the Company
had cash, cash equivalents and investment securities totaling $52.7 million
compared to $41.3 million at December 31, 1995. The increase in cash, cash
equivalents and investment securities in 1996 is largely attributable to net
proceeds of approximately $30 million raised from the Company's follow-on public
offering in March 1996, which amount was reduced by cash used primarily to
finance the Company's operating activities and its equipment and related
financing activities.

            Through December 31, 1996, the Company had acquired approximately
$12.5 million in furniture and equipment, of which approximately $9.3 million
was financed through capital leases and equipment loans. The Company has
commitments associated with its capital leases, loans and operating leases as
discussed further in Note 6 of Notes to Consolidated Financial Statements. In
addition to these commitments, the Company anticipates that it may invest up to
approximately $3 million in additional equipment during 1997. In October 1996,
the Company entered into a credit agreement with a bank which, subject to
compliance with certain financial covenants and conditions, provides the Company
the ability to finance up to an additional $6 million of capital expenditures or
other working capital requirements through September 1997.

            In January 1997, the Company and Memorial Sloan-Kettering Cancer
Center ("MSK") formed Genos Biosciences, Inc. ("Genos"), a new company focused
on the research and identification of genes and related genetic information of
value in the prognosis, diagnosis and possible treatment of certain common
cancers. The Company and MSK each own 50% of Genos and have committed to
contribute approximately $5 million each to fund its initial operations. The
Company invested $1.2 million in Genos in connection with its formation and
anticipates that Sequana's remaining commitment will be funded during 1997 and
early 1998.

            As of December 31, 1996, the Company's reported net operating loss
carryforwards were approximately $32.1 million and $1.2 million for federal and
state income tax purposes, respectively. If not utilized, the federal and state
tax loss carryforwards will begin to expire in 2008 and 1998, respectively. The
Company's ability to utilize these carryforwards is subject to certain
limitations.

            The Company's future capital requirements and the adequacy of its
available funds will depend on many factors, including progress of its gene
discovery programs, the number and breadth of these programs, achievement of
milestones under strategic alliance arrangements, the decision of the Company to
acquire or develop technologies useful in discovering genes or determining gene
function, the ability of the Company to establish and maintain additional
strategic alliances and licensing arrangements, the progress of the development
and commercialization efforts of the Company's strategic alliance partners,
competing technological and market developments, the costs associated with
collection of patient information and DNA samples, the costs involved in
preparing, filing, prosecuting, maintaining and enforcing patent claims and
other intellectual property rights, the regulatory process and other factors.

                                                                              25
<PAGE>   26
            The Company believes that its existing cash, cash equivalents and
investment securities and anticipated cash flows from its current strategic
alliances will be sufficient to support the Company's operations through 1999.
The Company is actively seeking to establish new strategic alliances with
potential corporate partners, and may seek to raise additional financing through
public or private equity or debt financings or licensing arrangements. No
assurance can be given that additional financing or strategic alliance and
licensing arrangements will be available when needed or that, if available, such
financing or strategic alliance and licensing arrangements will be obtainable on
terms favorable to the Company or its shareholders. To the extent the Company
raises additional capital by issuing equity securities, ownership dilution to
shareholders will result. In the event that adequate funds are not available,
the Company's business may be adversely affected. The Company's forecast of the
period of time through which its financial resources will be adequate to support
its operations and the statements with regard to continued expansion of its gene
discovery and functional genomics activities are forward-looking statements, and
actual results and timing of certain events could vary. The factors described
earlier in this paragraph will impact the Company's future capital requirements
and the adequacy of its available funds which could cause the period of time
through which the Company's financial resources will be adequate to support its
operations to vary from that set forth above.

                                                                              26
<PAGE>   27
ITEM 8.     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                          INDEX TO FINANCIAL STATEMENTS


<TABLE>
<CAPTION>
                                                                                      PAGE
                                                                                      ----

<S>                                                                                    <C>
Report of Ernst & Young LLP, Independent Auditors                                      28

Consolidated Balance Sheets at December 31, 1996 and 1995                              29

Consolidated Statements of Operations for each of the three years
  in the period ended December 31, 1996                                                30

Consolidated Statements of Shareholders' Equity for each of the three years
  in the period ended December 31, 1996                                                31

Consolidated Statements of Cash Flows for each of the three years in the period
  ended December 31, 1996                                                              32

Notes to Consolidated Financial Statements                                             33
</TABLE>

                                                                              27
<PAGE>   28
                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Shareholders
Sequana Therapeutics, Inc.

We have audited the accompanying consolidated balance sheets of Sequana
Therapeutics, Inc. as of December 31, 1996 and 1995, and the related
consolidated statements of operations, shareholders' equity, and cash flows for
each of the three years in the period ended December 31, 1996. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Sequana
Therapeutics, Inc. as of December 31, 1996 and 1995, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1996, in conformity with generally accepted accounting
principles.


                                                     ERNST & YOUNG LLP


San Diego, California
February 13, 1997


                                                                              28
<PAGE>   29
                            SEQUANA THERAPEUTICS, INC.
                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                       DECEMBER 31,
                                                              ------------------------------
                                                                  1996               1995
                                                              ------------      ------------
<S>                                                           <C>               <C>
                             ASSETS
Current assets:
  Cash and cash equivalents                                   $  9,402,958      $ 13,512,688
  Investment securities, available-for-sale                     43,316,733        27,825,023
  Other current assets                                           2,820,355         1,582,053
                                                              ------------      ------------
Total current assets                                            55,540,046        42,919,764
                                                              ------------      ------------
Furniture and equipment, net                                     8,285,305         4,438,611
Other assets                                                     1,737,075           179,482
Notes receivable from officers and employees                       530,844           463,000
                                                              ------------      ------------
                                                              $ 66,093,270      $ 48,000,857
                                                              ============      ============

              LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable and accrued expenses                       $  3,965,475      $  2,775,380
  Deferred revenue                                               3,357,936         2,311,856
  Current portion of loans and capital lease obligations         2,396,523         1,335,720
                                                              ------------      ------------
Total current liabilities                                        9,719,934         6,422,956
                                                              ------------      ------------
Loans and capital lease obligations, less current portion        4,524,311         2,803,612
Commitments
Shareholders' equity:
  Preferred stock, $.001 par value; 5,000,000 shares
    authorized, no shares issued and outstanding                        --                --
  Common stock, $.001 par value; 50,000,000 shares
    authorized, 10,113,243 shares and 8,125,632 shares
    issued and outstanding at December 31, 1996
    and 1995, respectively                                          10,113             8,126
  Additional paid-in capital                                    90,611,609        55,484,707
  Notes receivable from shareholders                              (237,040)         (254,144)
  Deferred compensation                                         (1,220,650)       (1,368,802)
  Accumulated deficit                                          (37,315,007)      (15,095,598)
                                                              ------------      ------------
Total shareholders' equity                                      51,849,025        38,774,289
                                                              ------------      ------------
                                                              $ 66,093,270      $ 48,000,857
                                                              ============      ============
</TABLE>


          See accompanying notes to consolidated financial statements.

                                                                              29
<PAGE>   30
                             SEQUANA THERAPEUTICS, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS



<TABLE>
<CAPTION>
                                                       YEARS ENDED DECEMBER 31,
                                           ------------------------------------------------
                                               1996              1995              1994
                                           ------------      ------------      ------------


<S>                                        <C>               <C>               <C>
Revenue under strategic alliances          $  9,705,048      $ 10,761,731      $  2,388,850

Operating expenses:
  Research and development                   26,396,844        15,138,109         7,614,501
  Charge for acquisition of in-process
    research and development                  3,366,168                --                --
  General and administrative                  5,004,604         3,078,302         1,493,667
                                           ------------      ------------      ------------
                                             34,767,616        18,216,411         9,108,168
                                           ------------      ------------      ------------
Loss from operations                        (25,062,568)       (7,454,680)       (6,719,318)
Other income (expense):
  Interest income                             3,276,968         1,653,312           247,250
  Interest expense                             (433,809)         (269,132)         (174,194)
                                           ------------      ------------      ------------
Net loss                                   $(22,219,409)     $ (6,070,500)     $ (6,646,262)
                                           ============      ============      ============


Net loss per share                         $      (2.31)     $      (0.92)     $      (2.02)
                                           ============      ============      ============

Shares used in computing net
  loss per share                              9,625,286         6,578,412         3,284,390
                                           ============      ============      ============
</TABLE>


          See accompanying notes to consolidated financial statements.

                                                                              30
<PAGE>   31
                           SEQUANA THERAPEUTICS, INC.
                 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                    CONVERTIBLE PREFERRED STOCK                 COMMON STOCK              ADDITIONAL
                                   ------------------------------      -----------------------------        PAID-IN
                                      SHARES            AMOUNT            SHARES            AMOUNT          CAPITAL
                                   ------------      ------------      ------------     ------------     ------------
<S>                                 <C>               <C>                 <C>            <C>              <C>
Balance at January 1, 1994             1,153,975      $      1,154           336,247     $        336     $  3,416,666
Issuance of common stock                      --                --           149,541              150           46,730
Issuance of preferred stock            3,091,785             3,092                --               --       22,899,442
Deferred compensation for
  issuance of stock and options               --                --                --               --          187,345
Amortization of deferred
  compensation                                --                --                --               --               --
Repayment of notes receivable                 --                --                --               --               --
Net loss                                      --                --                --               --               --
                                    ------------      ------------      ------------     ------------     ------------
Balance at December 31, 1994           4,245,760             4,246           485,788              486       26,550,183
Issuance of common stock                      --                --           445,935              446        1,358,223
Issuance of preferred stock              388,889               389                --               --        6,999,606
Issuance of common stock
  in initial public offering                  --                --         2,300,000            2,300       18,631,216
Conversion of preferred stock
  to common stock                     (4,634,649)           (4,635)        4,893,909            4,894             (259)
Deferred compensation for
  issuance of stock and options               --                --                --               --        1,945,738
Amortization of deferred
  compensation                                --                --                --               --               --
Repayment of notes receivable                 --                --                --               --               --
Net loss                                      --                --                --               --               --
                                    ------------      ------------      ------------     ------------     ------------
Balance at December 31, 1995                  --                --         8,125,632            8,126       55,484,707
Issuance of common stock
  in follow-on public offering                --                --         1,700,000            1,700       30,035,106
Issuance of common stock
  in acquisition                              --                --           158,451              158        3,197,907
Issuance of common stock                      --                --            74,445               74        1,268,234
Issuance of common stock
  on exercise of options                      --                --            47,901               48          147,683
Issuance of common stock
  on exercise of warrants                     --                --             6,814                7               (7)
Deferred compensation for
  issuance of stock and options               --                --                --               --          477,979
Amortization of deferred
  compensation                                --                --                --               --               --
Repayment of notes receivable                 --                --                --               --               --
Net loss                                      --                --                --               --               --
                                    ------------      ------------      ------------     ------------     ------------
Balance at December 31, 1996                  --      $         --        10,113,243     $     10,113     $ 90,611,609
                                    ============      ============      ============     ============     ============
</TABLE>


<TABLE>
<CAPTION>
                                       NOTES
                                     RECEIVABLE                                               TOTAL
                                   -    FROM            DEFERRED        ACCUMULATED       SHAREHOLDERS'
                                    SHAREHOLDERS      COMPENSATION        DEFICIT            EQUITY
                                   -------------      ------------      ------------      ------------
<S>                                  <C>               <C>               <C>               <C>
Balance at January 1, 1994           $         --      $         --      $ (2,378,836)     $  1,039,320
Issuance of common stock                  (27,500)               --                --            19,380
Issuance of preferred stock                    --                --                --        22,902,534
Deferred compensation for
  issuance of stock and options                --          (187,345)               --                --
Amortization of deferred
  compensation                                 --             1,137                --             1,137
Repayment of notes receivable               1,749                --                --             1,749
Net loss                                       --                --        (6,646,262)       (6,646,262)
                                     ------------      ------------      ------------      ------------
Balance at December 31, 1994              (25,751)         (186,208)       (9,025,098)       17,317,858
Issuance of common stock                 (229,248)               --                --         1,129,421
Issuance of preferred stock                    --                --                --         6,999,995
Issuance of common stock
  in initial public offering                   --                --                --        18,633,516
Conversion of preferred stock
  to common stock                              --                --                --                --
Deferred compensation for
  issuance of stock and options                --        (1,945,738)               --                --
Amortization of deferred
  compensation                                 --           763,144                --           763,144
Repayment of notes receivable                 855                --                --               855
Net loss                                       --                --        (6,070,500)       (6,070,500)
                                     ------------      ------------      ------------      ------------
Balance at December 31, 1995             (254,144)       (1,368,802)      (15,095,598)       38,774,289
Issuance of common stock
  in follow-on public offering                 --                --                --        30,036,806
Issuance of common stock
  in acquisition                               --                --                --         3,198,065
Issuance of common stock                       --                --                --         1,268,308
Issuance of common stock
  on exercise of options                       --                --                --           147,731
Issuance of common stock
  on exercise of warrants                      --                --                --                --
Deferred compensation for
  issuance of stock and options                --          (477,979)               --                --
Amortization of deferred
  compensation                                 --           626,131                --           626,131
Repayment of notes receivable              17,104                --                --            17,104
Net loss                                       --                --       (22,219,409)      (22,219,409)
                                     ------------      ------------      ------------      ------------
Balance at December 31, 1996         $   (237,040)     $ (1,220,650)     $(37,315,007)     $ 51,849,025
                                     ============      ============      ============      ============
</TABLE>


          See accompanying notes to consolidated financial statements.

                                                                              31
<PAGE>   32
                              SEQUANA THERAPEUTICS, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                      ------------------------------------------------
                                                          1996               1995             1994
                                                      ------------      ------------      ------------
<S>                                                   <C>               <C>               <C>
OPERATING ACTIVITIES:
Net loss                                              $(22,219,409)     $ (6,070,500)     $ (6,646,262)
  Adjustments to reconcile net loss to net cash
    used in operating activities:
      Depreciation and amortization                      2,380,897           943,756           480,418
      Amortization of deferred compensation                626,131           763,144             1,137
      Charge for acquisition of in-process
        research and development and other               3,274,266            77,276            46,374
      Change in operating asset and liabilities,
       net of acquisition:
        Other current assets                            (1,212,022)         (674,501)         (758,156)
        Accounts payable and accrued expenses            1,108,020         2,122,429           381,293
        Deferred revenue                                 1,046,080         2,103,522           208,334

                                                      ------------      ------------      ------------
Net cash used in operating activities                  (14,996,037)         (734,874)       (6,286,862)

INVESTING ACTIVITIES:
Purchases of investment securities                     (52,737,763)      (26,874,478)      (19,645,220)
Sales and maturities of investment securities           37,246,053        14,106,822         4,899,308
Purchases of furniture and equipment                    (2,402,076)         (299,869)         (415,863)
Other assets                                            (1,522,468)           58,468           (68,904)
Notes receivable from employees                            (67,844)          (60,000)         (128,000)

                                                      ------------      ------------      ------------
Net cash used in investing activities                  (19,484,098)      (13,069,057)      (15,358,679)

FINANCING ACTIVITIES:
Issuances of common stock, net                          31,452,845        19,685,738            15,380
Issuance of convertible preferred stock, net                    --         6,999,995        19,537,087
Proceeds from notes payable                              1,000,000                --         2,000,000
Repayments of loans and capital lease obligations       (2,099,544)         (959,691)         (305,748)
Other financing activities                                  17,104               855             1,749

                                                      ------------      ------------      ------------
Net cash provided by financing activities               30,370,405        25,726,897        21,248,468
                                                      ------------      ------------      ------------

Increase (decrease) in cash and cash equivalents        (4,109,730)       11,922,966          (397,073)

Cash and cash equivalents at beginning of year          13,512,688         1,589,722         1,986,795
                                                      ------------      ------------      ------------

Cash and cash equivalents at end of year              $  9,402,958      $ 13,512,688      $  1,589,722
                                                      ============      ============      ============

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid                                         $    421,830      $    269,132      $    145,302
                                                      ============      ============      ============

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND
  FINANCING ACTIVITIES:
Equipment acquired under capital leases and loans     $  3,751,046      $  2,170,135      $  3,151,303
                                                      ============      ============      ============
Conversion of notes payable and advances from
  shareholder to convertible preferred stock          $          -      $          -      $  3,333,333
                                                      ============      ============      ============
Issuance of common stock for notes receivable         $          -      $    229,248      $     27,500
                                                      ============      ============      ============
</TABLE>



          See accompanying notes to consolidated financial statements.

                                                                              32
<PAGE>   33

                           SEQUANA THERAPEUTICS, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1996

1.  ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

  Organization and Business Activity

            Sequana Therapeutics, Inc. ("Sequana" or the "Company") is a
genomics company that uses industrial-scale gene discovery technology and
functional genomics to discover and characterize genes that cause certain common
diseases. The Company's proprietary gene discovery technology is based on
positional cloning, a method that uses statistical analysis of disease
inheritance patterns to isolate disease genes. The Company has ongoing discovery
programs in asthma, diabetes, obesity, osteoporosis, schizophrenia, manic
depression and other disease areas. The Company believes that identification of
disease genes and determination of their biological function will provide
insights into the causes of common diseases and may facilitate the development
of novel prognostic, diagnostic and therapeutic products.

  Principles of Consolidation

            The consolidated financial statements include the accounts of the
Company and its wholly owned subsidiary, NemaPharm, Inc. ("NemaPharm") since the
date of acquisition (see Note 2). All significant intercompany accounts and
transactions have been eliminated in consolidation.

  Cash Equivalents

            The Company considers all highly-liquid investments with maturities
of three months or less when purchased to be cash equivalents.

  Concentration of Credit Risk

            The Company generally invests its excess cash in U.S. government
securities, high credit quality commercial paper, certificates of deposit and
money market accounts. Such investments are made in accordance with the
Company's investment policy which establishes guidelines relative to
diversification and maturities designed to maintain safety and liquidity. These
guidelines are periodically reviewed and modified to take advantage of trends in
yields and interest rates.

  Investment Securities

            The Company classifies its investment securities as
available-for-sale. Such securities are carried at fair value with unrealized
gains and losses, if any, reported as a separate component of shareholders'
equity. The cost of investment securities classified as available-for-sale is
adjusted for amortization of premiums and accretion of discounts to maturity.
Such amortization and accretion is 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.



                                                                              33
<PAGE>   34
  Furniture and Equipment

            Furniture and equipment is stated at cost and depreciated over the
estimated useful lives of the assets (generally four to seven years) on a
straight-line basis. Leasehold improvements are amortized over the shorter of
the lease term or the estimated useful life of the assets. Amortization of
equipment under capital leases is reported with depreciation of furniture and
equipment.

  Research and Development Revenue and Expenses

            Revenue under strategic alliances is recognized as research
activities are performed over the term of the agreements and upon the
achievement of certain milestones. Revenues for cost reimbursement are
recognized as the related costs are incurred. Advance payments received in
excess of amounts earned are classified as deferred revenue. Research and
development costs are expensed as incurred.

  Net Loss Per Share

            Net loss per share is computed using the weighted-average number of
shares outstanding during the periods, as adjusted for the effects of certain
rules of the Securities and Exchange Commission for the periods prior to the
Company's initial public offering ("IPO") in July 1995. Shares issuable upon the
exercise of outstanding stock options and warrants are not reflected for the
periods subsequent to the Company's IPO as their effect is anti-dilutive.

  Stock Options

            Effective January 1, 1996, the Company adopted FASB Statement No.
123, "Accounting for Stock-Based Compensation" (FAS 123). FAS 123 allows
companies to either account for stock-based compensation under the new
provisions of FAS 123 or under the provisions of Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), but
requires pro forma disclosure in the footnotes to the financial statements as if
the measurement provisions of FAS 123 had been adopted. The Company elected to
continue to account for its stock-based compensation in accordance with
provisions of APB 25.

  Asset Impairment

            Effective January 1, 1996, the Company adopted Statement of
Financial Accounting Standard No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of " (FAS 121). FAS
121 requires impairment losses to be recorded on long-lived assets used in
operations when indicators of impairment are present and the estimated
undiscounted cash flows to be generated by those assets are less than the
assets' carrying amount. The adoption of the new standard had no effect on the
Company's financial position or results of operations.

  Reclassifications

            Certain amounts in the prior year financial statements have been
reclassified to conform with the current year classifications.


                                                                              34
<PAGE>   35
  Use of Estimates

            The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
disclosures made in the accompanying notes to the financial statements. Actual
results could differ from those estimates.

2.  ACQUISITION

            On October 15, 1996, the Company acquired all of the outstanding
capital stock of NemaPharm, a drug discovery company, through the issuance of
approximately 158,000 shares of the Company's common stock and options to
acquire 38,000 shares of the Company's common stock. The acquisition was
accounted for under the purchase method and, accordingly, the consolidated
financial statements include the operations of NemaPharm from the date of its
acquisition. The aggregate cost of NemaPharm of approximately $3.4 million was
charged to acquired in-process research and development during 1996. The
operations of NemaPharm had no material effect on the pro forma combined results
of operations of the Company and NemaPharm for the periods preceding the
Company's acquisition.

3.  INVESTMENT SECURITIES

            The estimated fair value of each investment security approximates
cost and, therefore, there are no unrealized gains or losses at December 31,
1996 and 1995. The estimated fair value of the Company's available-for-sale
securities by type is as follows:
<TABLE>
<CAPTION>
                                        DECEMBER 31,
                                ----------------------------
                                    1996             1995
                                    ----             ----
<S>                             <C>              <C>
U.S. government securities      $20,424,631      $12,891,330
Corporate obligations ....       13,896,127        8,845,812
Certificates of deposit ..        8,995,975        6,087,881
                                -----------      -----------
                                $43,316,733      $27,825,023
                                ===========      ===========
</TABLE>


            The estimated fair value of available-for-sale securities by
contractual maturity as of December 31, 1996 is as follows:
<TABLE>
<S>                                  <C>
Due within one year                  $27,287,680
Due after one year                    16,029,053
                                     -----------
                                     $43,316,733
                                     ===========
</TABLE>

4.  FURNITURE AND EQUIPMENT

            Furniture and equipment is comprised of the following:
<TABLE>
<CAPTION>

                                                             DECEMBER 31,
                                                    -------------------------------
                                                        1996               1995
                                                        ----               ----
<S>                                                 <C>                <C>
Office furniture and equipment ...............      $    559,336       $   242,539
Computer and scientific equipment ............        11,318,393         5,751,504
Leasehold improvements .......................           579,976           194,030
                                                    ------------       -----------
                                                      12,457,705         6,188,073
Less accumulated depreciation and amortization        (4,172,400)       (1,749,462)
                                                    ------------       -----------
Furniture and equipment, net .................      $  8,285,305       $ 4,438,611
                                                    ============       ===========
</TABLE>



                                                                              35
<PAGE>   36
            Included in furniture and equipment at December 31, 1996 and 1995,
is equipment under capital leases and loans aggregating $9.3 million and $5.5
million, respectively, all of which is pledged as security pursuant to the
Company's equipment financing agreements. Accumulated amortization with respect
to such equipment totaled $3.7 million and $1.6 million at December 31, 1996 and
1995, respectively.

5.  NOTES RECEIVABLE FROM OFFICERS AND EMPLOYEES

            Notes receivable consist primarily of loans made to certain officers
and employees to facilitate their relocation. Such notes accrue interest at the
applicable federal rate, as adjusted yearly, and are due upon demand. The notes
are secured by approximately 88,000 shares of common stock and options to
purchase 219,000 shares of common stock at December 31, 1996.

6.  LOAN AND LEASE OBLIGATIONS

            The Company leases its facilities under operating leases that
generally provide for annual cost-of-living related increases. Certain equipment
is leased under operating and capital leases. Total rent expense under operating
leases was $2.1 million, $860,000 and $747,000, for the years ended December 31,
1996, 1995 and 1994, respectively.

            In October 1996, the Company entered into a credit agreement with a
bank which, subject to compliance with certain financial covenants and
conditions, may be used by the Company to finance up to $7 million of capital
expenditures or other working capital requirements through September 1997.
Included in loans and capital lease obligations at December 31, 1996 was $1
million of loans obtained pursuant to this agreement. The agreement provides for
equal principal installments over a four-year period commencing in September
1997, along with interest based on Eurodollar rates (7.19% at December 31,
1996).

      Minimum future obligations due under the Company's operating and capital
leases and loans as of December 31, 1996 are as follows:
<TABLE>
<CAPTION>
                                                                             CAPITAL
                                                        OPERATING            LEASES
        YEARS ENDED DECEMBER 31,                         LEASES             AND LOANS
        ------------------------                         ------             ---------
<S>                                                    <C>                 <C>
  1997                                                 $1,784,931          $2,730,391
  1998                                                  1,617,391           2,340,286
  1999                                                  1,490,023           1,702,652
  2000                                                  1,385,155             531,628
  2001                                                  1,426,997             187,500
                                                       ----------         -----------
Total minimum lease payments                           $7,704,497           7,492,457
                                                       ==========
Less amount representing interest                                            (571,623)
                                                                          -----------
Present value of capital lease and loan payments                            6,920,834
Less current portion                                                       (2,396,523)
                                                                          -----------
Long-term obligations under capital leases and loans                      $ 4,524,311
                                                                          ===========
</TABLE>


                                                                              36
<PAGE>   37
7.  SHAREHOLDERS' EQUITY

  Common Stock

            In March 1996, the Company raised net proceeds of $30 million
through a follow-on public offering of its common stock.

            In August 1995, the Company completed its IPO of common stock
providing net proceeds of $18.6 million. Upon the closing of the Company's IPO,
all previously outstanding shares of preferred stock were converted into common
stock. The holders of the common stock issued upon conversion of the preferred
stock remain entitled to certain registration rights with respect to such
shares.

  Deferred Compensation

            The Company has recorded deferred compensation for the difference
between the price per share of certain stock sold and stock options granted and
the deemed fair value of such shares for accounting purposes. Deferred
compensation is amortized to expense over the vesting period of the related
stock and options. The Company recorded deferred compensation of approximately
$1.3 million in connection with the issuance of 208,333 shares of common stock
to the Company's President and Chief Executive Officer (in exchange for a
$187,500 promissory note) and the sale of 86,805 shares of common stock to two
affiliated shareholders for $78,125 in March 1995. The promissory note bears
interest at 7.2%, is secured by the 208,333 shares of common stock and becomes
due and payable upon the occurrence of certain events. Such shares vest over a
four year period, with the unvested shares subject to repurchase by the Company
at the original issue price in the event of this employee's termination.

  Stock Warrants

            At December 31, 1996, the Company had outstanding warrants to
purchase an aggregate of 111,471 shares of the Company's common stock. The
warrants are exercisable at prices ranging from $3 to $24 per share and expire
at various dates through 2005.

   Stock Option Plans

            In April 1994, the Company adopted the 1994 Incentive Stock Plan
(the "Plan"), under which, as amended, 1,063,125 shares of the Company's common
stock were reserved for issuance. The Plan provides for the grant of incentive
stock options to employees and nonstatutory stock options to employees and
consultants. Options under the Plan have a ten-year term and generally vest over
four years. The exercise price of incentive stock options must equal at least
the fair market value on the date of grant, and the exercise price of
nonstatutory stock options is as determined by the Board of Directors.

            During 1995, the Company adopted the 1995 Director Option Plan (the
"Director Plan"), under which, as amended, 225,000 shares of the Company's
common stock were reserved for issuance to all non-employee members of the Board
of Directors. The Director Plan provides for the automatic grant of an option to
purchase shares of the Company's common stock at the time the non-employee joins
the Board of Directors. The options have a ten-year term, an exercise price
equal to the fair market value of the common stock on the date of grant, and
vest over four years.



                                                                              37
<PAGE>   38
At December 31, 1996, options to purchase 75,000 shares of the Company's common
stock were granted and outstanding under the Director Plan with a
weighted-average exercise price of $10.90 per share.

            Pro forma information regarding net loss and net loss per share is
required by FAS 123 and has been determined as if the Company had accounted for
its employee stock options under the alternative fair value method provided for
in FAS 123. The fair value for these options was estimated as of the date of
grant using a Black-Scholes option pricing model with the following
weighted-average assumptions for 1996 and 1995, respectively: risk-free interest
rates of 6.39% and 6.38% volatility factors of the expected market price of the
Company's common stock of 61%, and 33%; and a weighted-average expected life of
the option of 5 years. The weighted-average fair value of options granted during
the year ended December 31, 1996 was $10.06.

            The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. Because the Company's stock options have
characteristics significantly different from those of traded options, and
because changes in highly subjective assumptions can materially affect the fair
value estimate, in management's opinion, the existing models do not necessarily
provide a reliable single measure of the fair value of its stock options.

            For purposes of pro forma disclosure, the estimated fair value of
the options is amortized to expense over the options' vesting period. The
Company's pro forma net loss and pro forma net loss per share totaled
approximately $23.4 million and $2.43 per share, respectively, for the year
ended December 31, 1996. The pro forma results for 1995 were not materially
different than the reported results for the period. The pro forma results are
not likely to be representative of the effects of applying FAS 123 on the
reported net income or loss for future years as these amounts reflect the
expense associated with only one or two years of vesting.

            The following table summarizes stock option activity under the Plan
and related information through December 31, 1996:
<TABLE>
<CAPTION>
                                                     WEIGHTED-
                                                     AVERAGE
                                      NUMBER OF      EXERCISE
                                       OPTIONS        PRICE
                                       -------        -----
<S>                                   <C>            <C>
Granted ........................       208,080       $  .45
Exercised ......................      (123,749)         .33
Cancelled ......................        (1,749)         .31
                                      --------       ------
Outstanding at December 31, 1994        82,582          .61
Granted ........................       291,017         5.57
Exercised ......................       (43,203)        2.07
Cancelled ......................        (7,587)        1.28
                                      --------       ------
Outstanding at December 31, 1995       322,809         4.87
Granted ........................       571,099        15.95
Exercised ......................       (47,901)        3.08
Cancelled ......................       (68,590)        9.02
                                      --------       ------
Outstanding at December 31, 1996       777,417       $12.75
                                      ========       ======
</TABLE>


                                                                              38
<PAGE>   39
            At December 31, 1996, options to purchase an aggregate of 137,624
shares of common stock were exercisable under the Plan at a weighted-average
exercise price of $8.96 per share, and options to purchase 70,855 shares of
common stock were available for future grant.

            The following table summarizes information about stock options
outstanding under the Company's plans at December 31, 1996:
<TABLE>
<CAPTION>
                                  Options Outstanding                         Options Exercisable
                     ------------------------------------------------       -----------------------
                                       Wt. Avg.
    Range of         Number of         Remaining             Wt. Avg.        Number of     Wt. Avg.
Exercise Prices       Options       Contractual Life        Ex. Price         Options     Ex. Price
---------------      ---------      ----------------        ---------        ---------    ---------
<C>                   <C>               <C>                 <C>              <C>          <C>
$   .01 to 3.00       174,254           8.4 years           $    1.63         65,294      $    1.48
  9.00 to 11.00       139,524           8.7 years               10.03         38,064          10.10
 15.25 to 18.50       468,281           9.6 years               16.05         39,716          16.30
 21.00 to 24.12        70,358           9.3 years               21.77         12,245          23.61
----------------      -------           ---------           ---------        -------      ---------
   $.01 to 24.12      852,417           9.2 years           $   12.59        155,319      $    9.13
================      =======           =========           =========        =======      =========
</TABLE>

  Employee Stock Purchase Plan

            During 1995, the Company adopted the 1995 Employee Stock Purchase
Plan (the "Purchase Plan"), under which 200,000 shares of the Company's common
stock were reserved for issuance. The Purchase Plan provides for all eligible
employees to purchase the Company's common stock through payroll deductions at a
price equal to 85% of the lesser of the fair market value per share on the start
date of each overlapping two year offering period or on the date on which each
semi-annual purchase period ends. The Purchase Plan will terminate in May 2005.
As of December 31, 1996, 41,613 shares of common stock have been issued pursuant
to the Purchase Plan.

  Common Stock Reserved for Future Issuance

            Common stock reserved for future issuance is as follows at December
31, 1996:

<TABLE>
<S>                                                   <C>
Outstanding warrants                                    111,471
1994 Incentive Stock Plan                               848,272
1995 Director Option Plan                               225,000
1995 Employee Stock Purchase Plan                       158,387
Other                                                    46,686
                                                      ---------
                                                      1,389,816
                                                      =========
</TABLE>

8.  STRATEGIC ALLIANCES

  Boehringer Ingelheim

            In June 1995, the Company entered into a five year strategic
alliance with Boehringer Ingelheim International GmbH ("Boehringer Ingelheim")
in the area of asthma. Under the terms of the agreement, Boehringer Ingelheim
made a $6 million equity investment in the Company and paid the Company an
up-front fee of $2 million. The Company receives ongoing payments for



                                                                              39
<PAGE>   40
research support, and may receive additional milestone payments and royalties on
the sale of therapeutic products resulting from the alliance. The Company
received $2 million in milestone payments during 1995 in connection with
achieving two research milestones under the agreement. The Company is obligated
to share milestone payments and royalties with a Collaborator. The Company
recognized revenue of $4.1 million and $5.9 million in the years ended December
31, 1996 and 1995, respectively, under this alliance. Boehringer Ingelheim has
the right to terminate the agreement (subject to certain notification
requirements) beginning in June 1998, or earlier in the event the Company is
acquired by another pharmaceutical company.

  Corange

            In June 1995, the Company and Corange International, Ltd.
("Corange"), the parent company of Boehringer Mannheim GmbH, entered into a five
year strategic alliance in the area of osteoporosis. Corange made a
non-refundable payment of $1 million to the Company, and an investment fund
affiliated with Corange made an equity investment of $1 million in the Company.
The Company receives ongoing payments for research support, and may receive
additional milestone payments and royalties on sales of diagnostic and
therapeutic products resulting from the alliance. Corange is also obligated to
purchase $1.25 million in shares of the Company's common stock for each of the
next three years at a purchase price equal to 135% of an average per share
market price. In accordance with the agreement, Corange purchased 37,538 shares
and 102,881 shares of the Company's common stock during 1996 and 1995,
respectively. The Company recognized revenue totaling $2.5 million and $2.0
million in the years ended December 31, 1996 and 1995, respectively, under this
alliance. Corange has the right to terminate the agreement (subject to certain
notification requirements) beginning in February 1998, or earlier in the event
the Company is acquired by another pharmaceutical company.

  Glaxo

            In July 1994, the Company entered into a five year strategic
alliance with Glaxo Wellcome Inc. ("Glaxo") in the area of type II diabetes. In
February 1996, this alliance was expanded to include the study of human obesity.
Under the terms of the agreement, Glaxo paid the Company a $1 million up-front
fee. The Company receives ongoing payments for research support, and may receive
additional milestone payments and royalties on the sale of therapeutic products
resulting from the alliance. The Company received a $500,000 milestone payment
during 1996 in connection with the attainment of a research milestone. The
Company recognized revenue totaling $3.0 million, $2.8 million and $1.4 million
in the years ended December 31, 1996, 1995 and 1994, respectively, under this
alliance. Glaxo has the right to terminate the agreement (subject to certain
notification requirements) beginning in July 1997, or earlier in the event the
Company is acquired by another pharmaceutical company.

            In January 1997, the Company entered into a two year strategic
alliance with Glaxo in the area of gene function analysis. Glaxo is obligated to
provide payments to the Company for research support and to make certain
additional payments contingent on identification by the Company of targets used
by Glaxo in its research programs. The Company may also receive royalties on
sales of products resulting from the alliance.



                                                                              40
<PAGE>   41
  Genentech

            In October 1994, Genentech, Inc. made a $2 million equity investment
in the Company and was granted first negotiation rights with respect to the
development and commercialization of recombinant therapeutic or prophylactic
proteins. The Company retains the ability to license rights to develop
therapeutic or prophylactic proteins as part of any such strategic alliances.

  Collaborative Agreements

            In April 1996, the Company entered into a collaborative agreement
with Aurora Biosciences Corporation ("Aurora"). Under the agreement, the Company
gained access to certain technologies and rights to contract with Aurora for the
application of Aurora's proprietary mammalian cell-based screening technology to
genetic targets selected by the Company. In connection with the agreement, the
Company also made a $1.5 million minority equity investment in Aurora, which
investment is recorded at cost and included in other assets at December 31,
1996. The Company's President and Chief Executive Officer is affiliated with
Avalon Ventures (a founder and shareholder of Aurora) and a shareholder and
member of the Board of Directors of Aurora.

            The Company has entered into various agreements with academic
researchers, clinicians and health care providers (the "Collaborators") to
collect patient information and DNA samples related to the Company's research
activities. Certain of the agreements require the Company to pay royalties or
license fees to the Collaborators in the event the Company sells or licenses
products incorporating any inventions or technology developed under the
agreement. Payments under the agreements totaled approximately $5.3 million,
$5.7 million and $1.5 million for the years ended December 31, 1996, 1995 and
1994, respectively. The Company is obligated to make future payments for the
years 1997 through 1999 of approximately $2.9 million, $1.6 million and
$358,000, respectively, a significant portion of which will be reimbursed under
strategic alliances. Most agreements, however, may be terminated by the Company
with written notice ranging from 30 days to one year without significant
financial penalty.

9.  INCOME TAXES

            At December 31, 1996, the Company had federal and California income
tax net operating loss carryforwards of approximately $32,122,000 and
$1,191,000, respectively. The difference between the federal and California tax
loss carryforwards is primarily attributable to the capitalization of research
and development expenses for California income tax purposes and the fifty
percent limitation on California loss carryforwards.

            The federal and California tax loss carryforwards will begin to
expire in 2008 and 1998, respectively, unless previously utilized. The Company
also has federal and California research tax credit carryforwards of
approximately $972,000 and $349,000, respectively, which will begin to expire in
2008 unless previously utilized.

            Pursuant to Sections 382 and 383 of the Internal Revenue Code,
annual use of the Company's net operating loss and credit carryforwards may be
limited because of cumulative changes in ownership of more than 50% which have
occurred. However, the Company does not believe such limitation will have a
material impact upon the utilization of these carryforwards.


                                                                              41
<PAGE>   42
            Significant components of the Company's deferred tax assets and
liabilities are shown below. A valuation allowance of $14,233,000 has been
recognized to offset the deferred tax assets, as realization of such assets is
uncertain.
<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                        -------------------------------
                                                             1996               1995
                                                             ----               ----
<S>                                                     <C>                <C>
Deferred tax liability--tax over book depreciation      $    298,000       $   247,000
Deferred tax assets:
  Net operating loss carryforwards                        11,313,000         4,946,000
  Research and development credits                         1,199,000           617,000
  Capitalized research and development                     1,822,000           779,000
  Other                                                      197,000           148,000
                                                        ------------       -----------
Total deferred tax assets                                 14,531,000         6,490,000
Valuation allowance for deferred tax assets              (14,233,000)       (6,243,000)
                                                        ------------       -----------
Net deferred tax assets                                      298,000           247,000
                                                        ------------       -----------
Net deferred tax liabilities (assets)                   $       --         $      --
                                                        ============       ===========
</TABLE>


10.  401(K) PROFIT SHARING PLAN

            The Company maintains a 401(k) profit sharing plan which allows
substantially all employees to contribute up to 15% of their salary, subject to
annual limitations. The Board of Directors may, at its sole discretion, approve
Company contributions. To date, there have been no Company contributions under
the plan.

11.  JOINT VENTURE

            In January 1997, the Company and Memorial Sloan-Kettering Cancer
Center ("MSK") formed Genos Biosciences, Inc. ("Genos"), a new company focused
on the research and identification of genes and related genetic information of
value in the prognosis, diagnosis and possible treatment of certain common
cancers. The Company and MSK each own 50% of Genos and have committed to
contribute approximately $5 million each to fund its initial operations. The
Company invested $1.2 million in Genos in connection with its formation and
anticipates that Sequana's remaining commitment will be funded during 1997 and
early 1998. In connection with the formation of Genos, the Company sold a
warrant to MSK to purchase 350,000 shares of the Company's common stock
exercisable at a price of $17.38 per share. The Company's Chief Executive
Officer and Chief Financial Officer are members of the Board of Directors of
Genos.


                                                                              42
<PAGE>   43
ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
          FINANCIAL DISCLOSURE

          Not applicable.

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

            Information concerning the Company's directors is incorporated by
reference from the section captioned "Election of Directors" contained in the
Company's Proxy Statement to be filed in connection with the Annual Meeting of
Shareholders to be held June 24, 1997. Information concerning executive officers
is set forth in Part I of this Form 10-K.

ITEM 11.  EXECUTIVE COMPENSATION

            The information required by this item is incorporated by reference
from the section captioned "Executive Compensation and Other Matters" contained
in the Proxy Statement.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

            The information required by this item is incorporated by reference
from the section captioned "Record Date and Principal Share Ownership" contained
in the Proxy Statement.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

            The information required by this item is incorporated by reference
from the sections captioned "Compensation Committee Interlocks and Insider
Participation" and "Certain Transactions with Management" contained in the Proxy
Statement.


                                     PART IV

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

            (a)(1)  Financial Statements

                    Reference is made to the Index to Financial Statements
                     under Item 8 of this report on Form 10-K.

            (a)(2)  Financial Statement Schedules

                    All schedules have been omitted because they are not
                     required under the related instructions, are
                     inapplicable or because the information required
                     thereby has been included in the financial statements of
                     the Registrant or the notes thereto.

            (a)(3)   Reference is made to Item 14 (c) below for Exhibits
                     required by Item 601 of Regulation S-K including
                     management contracts and compensatory plans and
                     arrangements.





                                                                              43
<PAGE>   44
 (b)   Reports on Form 8-K

          The Company did not file any reports on Form 8-K during the
             quarter ended December 31, 1996.

 (c)  Exhibits

         3.1(1)   Restated Articles of Incorporation of the Registrant

         3.3(2)   Bylaws of the Registrant, as amended to date.

         10.1(2)  Shareholder Rights Agreement, dated October 21, 1994, as
                  amended to date.

         10.2(2)  1994 Incentive Stock Plan

         10.3(2)  1995 Employee Stock Purchase Plan

         10.4(2)  1995 Director Stock Option Plan

         10.5(2)  Form of Indemnification Agreement between the Registrant and
                  its officers and directors.

         10.6(2)  Master Lease Agreement dated November 1, 1993 by and between
                  Comdisco, Inc. and Registrant.

         10.7(2)* Collaborative Research Agreement dated as of July 27, 1994 by
                  and between Registrant and Glaxo, Inc.

         10.8(1)  Expansion Lease by and between Health Science Properties, Inc.
                  and Registrant dated as of November 20, 1995.

         10.9(2)* Collaborative Research Agreement dated as of June 30, 1995 by
                  and between Registrant and Corange International, Ltd.

         10.10(2)*Collaborative Research Agreement dated as of June 12,
                  1995 by and between Registrant and Boehringer Ingelheim
                  International GmbH.

         10.11(2) Employment Agreement dated February 28, 1995 between the
                  Registrant and Kevin J. Kinsella.

         10.12(2) Consulting Agreement dated March 6, 1995 between the
                  Registrant and Irwin Lerner.

         10.13(2) Letter Agreement dated September 7, 1993 between the
                  Registrant and Timothy J.R. Harris.

         10.14(3)*Research Agreement dated as of April 2, 1996 by and between
                  the Registrant and Aurora Biosciences Corporation.

         10.15(4) Merger Agreement and Plan of Reorganization between the
                  Registrant, Sequana Merger Sub, Inc., NemaPharm, Inc. and the
                  Shareholders of NemaPharm, Inc. dated July 19, 1996.

         10.16**  Loan Agreement between the Registrant and The Sumitomo Bank,
                  Limited dated as of October 23, 1996.

         11.1(1)  Computation of net loss per share.

         23.1     Consent of Ernst & Young LLP, Independent Auditors.

         24.1     Power of Attorney (see page 46).

         27.1     Financial Data Schedule.

----------------

*        Confidential treatment has been granted with respect to certain
         portions of this exhibit.

**       Confidential treatment has been requested with respect to certain
         portions of this exhibit.



                                                                              44
<PAGE>   45
(1)      Incorporated by reference to exhibits filed with Registrant's
         Registration Statement on Form S-1 (Reg. No. 333-01226).

(2)      Incorporated by reference to exhibits filed with Registrant's
         Registration Statement on Form S-1 (Reg. No. 33-93460).

(3)      Incorporated by reference to the exhibit of the same number to the
         Registrant's Quarterly Report on Form 10-Q for the Quarter ended June
         30, 1996.

(4)      Incorporated by reference to the exhibit of the same number to the
         Registrant's Quarterly Report on Form 10-Q for the Quarter ended
         September 30, 1996.




                                                                              45
<PAGE>   46
                                   SIGNATURES

            Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, as amended, the Registrant has duly caused this
Report to be signed on its behalf by the undersigned, thereunto duly authorized.

                                           SEQUANA THERAPEUTICS, INC.


                                           BY: /s/ KEVIN J. KINSELLA
                                               --------------------------------
                                                 KEVIN J. KINSELLA
                                                 PRESIDENT AND CHIEF EXECUTIVE
                                                 OFFICER
DATE:  March 25, 1997


                                POWER OF ATTORNEY

            KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Kevin J. Kinsella and M. Scott Salka, and
each of them, his true and lawful attorneys-in-fact and agents, each with full
power of substitution and resubstitution, 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 attorneys-in-fact and agents, and each of them,
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 all
intents and purposes as he might do in person, hereby ratifying and confirming
all that said attorneys-in-fact and agents, or their substitute or substitutes,
or any of them, shall do or cause to be done by virtue hereof.

            PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934,
AS AMENDED, 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/  KEVIN J. KINSELLA         PRESIDENT, CHIEF EXECUTIVE OFFICER AND              MARCH 25, 1997
---------------------------
     KEVIN J. KINSELLA         DIRECTOR (PRINCIPAL EXECUTIVE OFFICER)

/s/  M. SCOTT SALKA            VICE PRESIDENT, OPERATIONS AND CHIEF                MARCH 25, 1997
---------------------------
     M. SCOTT SALKA            FINANCIAL OFFICER (PRINCIPAL ACCOUNTING
                               AND FINANCIAL OFFICER)

/s/  TIMOTHY J.R. HARRIS       SENIOR VICE PRESIDENT, RESEARCH  AND                MARCH 25, 1997
---------------------------
     TIMOTHY J.R. HARRIS       DEVELOPMENT, CHIEF TECHNICAL OFFICER
                               AND DIRECTOR

/s/  IRWIN LERNER              CHAIRMAN OF THE BOARD OF DIRECTORS                  MARCH 25, 1997
---------------------------
     IRWIN LERNER
</TABLE>



                                                                              46
<PAGE>   47
<TABLE>
<CAPTION>
          SIGNATURE                   TITLE                      DATE
          ---------                   -----                      ----
<S>                                  <C>                     <C>
                                     DIRECTOR                MARCH   , 1997
----------------------------
     HOWARD PALEFSKY

/s/  RICHARD DARMAN                  DIRECTOR                MARCH 25, 1997
----------------------------
     RICHARD DARMAN

/s/  THOMAS C. MCCONNELL             DIRECTOR                MARCH 25, 1997
----------------------------
     THOMAS C. MCCONNELL

/s/  THOMAS F. STEPHENSON            DIRECTOR                MARCH 25, 1997
----------------------------
     THOMAS F. STEPHENSON
</TABLE>



                                                                              47
<PAGE>   48
                                  EXHIBIT INDEX


<TABLE>
<CAPTION>
 Exhibit                                                                       Sequentially
 Number       Description of Document                                          Numbered Page
 ------       -----------------------                                          -------------

<S>      <C>                                                                    <C>
3.1(1)   Restated Articles of Incorporation of the Registrant

3.3(2)   Bylaws of the Registrant, as amended to date.

10.1(2)  Shareholder Rights Agreement, dated October 21, 1994, as amended to
         date.

10.2(2)  1994 Incentive Stock Plan

10.3(2)  1995 Employee Stock Purchase Plan

10.4(2)  1995 Director Stock Option Plan

10.5(2)  Form of Indemnification Agreement between the Registrant and its
         officers and directors.

10.6(2)  Master Lease Agreement dated November 1, 1993 by and between Comdisco,
         Inc. and Registrant.

10.7(2)* Collaborative Research Agreement dated as of July 27, 1994 by and
         between Registrant and Glaxo, Inc.

10.8(1)  Expansion Lease by and between Health Science Properties, Inc. and
         Registrant dated as of November 20, 1995.

10.9(2)* Collaborative Research Agreement dated as of June 30, 1995 by and
         between Registrant and Corange International, Ltd.

10.10(2)*Collaborative Research Agreement dated as of June 12, 1995 by and
         between Registrant and Boehringer Ingelheim International GmbH.

10.11(2) Employment Agreement dated February 28, 1995 between the Registrant and
         Kevin J. Kinsella.

10.12(2) Consulting Agreement dated March 6, 1995 between the Registrant and
         Irwin Lerner.

10.13(2) Letter Agreement dated September 7, 1993 between the Registrant and
         Timothy J.R. Harris.

10.14(3)*Research Agreement dated as of April 2, 1996 by and between the
         Registrant and Aurora Biosciences Corporation.

10.15(4) Merger Agreement and Plan of Reorganization between the Registrant,
         Sequana Merger Sub, Inc., NemaPharm, Inc. and the Shareholders of
         NemaPharm, Inc. dated July 19, 1996.

10.16**  Loan Agreement between the Registrant and The Sumitomo Bank, Limited
         dated as of October 23, 1996.

11.1(1)  Computation of net loss per share.

23.1     Consent of Ernst & Young LLP, Independent Auditors.

24.1     Power of Attorney (see page 46).

27.1     Financial Data Schedule.
</TABLE>

----------------

*        Confidential treatment has been granted with respect to certain
         portions of this exhibit.

**       Confidential treatment has been requested with respect to certain
         portions of this exhibit.


                                                                              48
<PAGE>   49
(1)      Incorporated by reference to exhibits filed with Registrant's
         Registration Statement on Form S-1 (Reg. No. 333-01226).

(2)      Incorporated by reference to exhibits filed with Registrant's
         Registration Statement on Form S-1 (Reg. No. 33-93460).

(3)      Incorporated by reference to the exhibit of the same number to the
         Registrant's Quarterly Report on Form 10-Q for the Quarter ended June
         30, 1996.

(4)      Incorporated by reference to the exhibit of the same number to the
         Registrant's Quarterly Report on Form 10-Q for the Quarter ended
         September 30, 1996.

                                                                              49