<PAGE>   1


                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

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

                                    FORM 10-K

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

                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998

                         COMMISSION FILE NUMBER: 0-27406


                              CONNETICS CORPORATION
             (Exact name of registrant as specified in its charter)

                             3400 WEST BAYSHORE ROAD
                           PALO ALTO, CALIFORNIA 94303
                                 (650) 843-2800
               (Address, including zip code and telephone number,
                        of principal executive offices)

       DELAWARE                                        94-3173928
      (State or other jurisdiction of                 (I.R.S. Employer
      incorporation or organization)                  Identification No.)

        SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE

           SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                    COMMON STOCK, $0.001 PAR VALUE PER SHARE
                         PREFERRED SHARE PURCHASE RIGHTS

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

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period than the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days.  YES [X]   NO [ ]

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

The aggregate market value of the voting stock held by non-affiliates of the
registrant as of February 26, 1999 was approximately $103,667,000. There were
21,173,668 shares of Common Stock issued and outstanding as of February 26,
1999.


                       DOCUMENTS INCORPORATED BY REFERENCE

Part III of this report incorporates information by reference from the
definitive proxy statement for the Annual Meeting of Stockholders to be held on
May 19, 1999.


<PAGE>   2
                                     PART I

ITEM 1.        BUSINESS

        Special Note: The Company desires to take advantage of the "safe harbor"
provisions of the Private Securities Litigation Reform Act of 1995.
Specifically, the Company wishes to alert investors and other readers that the
following discussion contains certain forward-looking statements that involve
risks and uncertainties. The Company's actual results or events may differ
significantly from the results contemplated by the forward-looking statements.
These factors could in the future affect, and in the past have affected, the
Company's actual results and could cause the Company's results for future years
or quarters to differ materially from those expressed in any forward looking
statements made by or on behalf of the Company. These factors should be
considered carefully in addition to the other information presented in this
report.

THE COMPANY

Connetics Corporation ("Connetics" or the "Company") is focused on the
acquisition, development and commercialization of marketed and late-stage
products. The Company's product and commercial focus is initially targeted at
rheumatology and dermatology, two specialty medical markets. These commercially
attractive markets have large patient populations yet relatively small physician
treating groups. U.S. dermatologists and rheumatologists write prescriptions
each year exceeding $5.0 billion. The Company's goal is to leverage these
markets by commercializing novel products to meet currently unmet medical needs
and employing focused and highly trained sales staff. Connetics currently
markets Ridaura(R) (auranofin), a treatment for rheumatoid arthritis, and
ACTIMMUNE(R) (interferon gamma-1b), a treatment for chronic granulomatous
disease (beginning January 1999). On March 1, 1999 Connetics received clearance
from the FDA to begin marketing Luxiq(TM) (betamethasone valerate) Foam, 0.12%,
a product to treat corticosteroid-responsive scalp dermatoses. Connetics has
several other products in development: ConXn(R) (recombinant human relaxin H2)
("relaxin"), targeting scleroderma, organ fibrosis, and infertility; and
OLUX(TM) (clobetasol propionate) Foam, 0.05%, a novel formulation for the
treatment of severe scalp dermatoses; and interferon gamma (through its
wholly-owned subsidiary, InterMune Pharmaceuticals, Inc.) for the treatment of
certain congenital, infectious and other diseases.

        The Company is subject to the uncertainties and risks associated with
any young company focused on pharmaceutical product development. The Company has
experienced operating losses every year since its incorporation, and expects to
incur additional losses over the next few years. The losses are expected to
fluctuate from period to period based on timing of product revenues, clinical
material purchases, possible acquisitions of new products and technologies,
scale-up activities and clinical activities. The time required by the Company to
reach profitability is uncertain and there can be no assurance that the Company
will ever be able to generate revenue from its products now under development or
achieve profitability on a sustainable basis.

        The Company was incorporated in the State of Delaware on February 8,
1993. In May 1997, the Company's stockholders approved a change of the Company's
name from "Connective





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Therapeutics, Inc." to "Connetics Corporation." The "C with interlocking
hemisphere" logo (used alone and with the Company's name), "Connetics", "ConXn",
and "Ridaura" are registered trademarks of the Company, and "Luxiq" and "OLUX"
are trademarks of the Company. All other tradenames and trademarks appearing in
this report are the property of their respective holders.

        The Company's principal executive offices are located at 3400 West
Bayshore Road, Palo Alto, California 94303. Its telephone number is (650)
843-2800. The Company maintains an internet website at http://www.connetics.com.

CONNETICS' STRATEGY

The key elements of the Company's strategy include:

o    Develop a Commercial Organization Targeting Specialty Markets and Novel
     Therapies. The Company is targeting its initial commercial activities at
     the dermatology and rheumatology markets, which can be served by a focused,
     specialized marketing organization. Scalp psoriasis and skin dermatoses,
     the target indications for the Company's foam products, are treated
     primarily by dermatologists. Scleroderma, ConXn's lead indication, and
     rheumatoid arthritis, treated by Ridaura, are primarily treated by
     rheumatologists. The Company's strategy is to target its marketing
     activities to the approximately 7,000 dermatologists and 3,000
     rheumatologists practicing in the United States. Because dermatologists and
     rheumatologists are primarily concentrated in major metropolitan areas, the
     Company believes these physician groups can be accessed efficiently by a
     relatively small sales force.

o    In-License Development Stage and Currently Marketed Products. The Company
     expects to continue to in-license and acquire rights to late-stage
     development products and currently marketed products in the areas of
     dermatology and rheumatology. Increasing consolidation in the
     pharmaceutical and biotechnology industries and continuing changes in the
     health care system are changing the way therapeutic products are developed
     and marketed. As a result, the Company believes there are opportunities to
     in-license or acquire additional products that pharmaceutical companies are
     not developing or promoting, or that do not fit in the present business
     strategy of such companies. The Company believes that this strategy can
     result in accelerated development and commercialization of novel products
     to treat diseases, while minimizing the Company's exposure to the risks
     inherent in drug discovery and basic research.

o    Use Corporate Partnerships to Pursue Additional Markets. In its strategic
     markets, the Company's goal is to retain commercial rights to its products
     in the United States and to enter into corporate partnerships with respect
     to additional market segments in North America and international markets.
     This strategy will allow the Company to pursue additional therapeutic
     markets, offset near-term development costs and enter international
     markets. To date, the Company has entered into two strategic relationships
     (one each with a European and a Japanese company) for its relaxin program.





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        Future product acquisitions, if any, may require substantial additional
funds (1) for the initial acquisition of rights to these products, (2) for the
steps necessary to obtain FDA approval for the product and (3) to market, sell
and distribute the product successfully. In addition, if the newly-acquired
product is already approved for commercialization, the Company will likely be
assuming the marketing, sale and distribution of such product, which may require
the Company to recruit a substantial number of qualified employees to perform
these functions. If the Company is unable to hire a sufficient number of
employees with the appropriate levels of experience, or if the Company is unable
to effectively manage the integration of any newly-acquired products into the
Company's product line, the Company's business, financial condition and results
of operations could be materially and adversely affected. Finally, any
newly-acquired products may not achieve the marketing or therapeutic success
expected of it by the Company, industry analysts or others at the time of
acquisition.

RELAXIN

        The Company has exclusive rights to develop and commercialize human
recombinant relaxin (ConXn). See "Collaborative Relationships: Relaxin," below.
Relaxin is a naturally occurring protein that is known to promote remodeling of
connective tissues. Connective tissues are components of the body that form
structural or binding elements such as skin, joints, ligaments and lining of
organs. Organs of the body such as lungs, kidneys and skin function normally in
part because of the precise arrangement of specialized cells within a connective
tissue framework. Connective tissue undergoes constant turnover through a normal
remodeling process that normally keeps the amount of connective tissue, which is
95% collagen, in balance. When this balance is broken, as in the case of certain
chronic diseases, the result can lead to excessive formation of or destruction
of connective tissue, resulting in serious disease. The most severe forms of
these diseases cause painful disfigurement, disability and, in certain cases,
death.

        Scleroderma. As an example, the overproduction of collagen can result in
a severe fibrotic disorder called scleroderma. The Company is developing relaxin
for the treatment of scleroderma, a serious disease involving the uncontrolled
formation of connective tissue. Scleroderma is characterized by thickening and
hardening of the skin and internal organs, including the heart, lungs, kidneys
and gastrointestinal tract and generally afflicts women in their child-bearing
years. Scleroderma can cause extensive disfigurement and quality of life
impairment, making it impossible for afflicted patients to carry out the most
routine daily functions. Approximately 300,000 individuals, primarily women,
suffer from various forms of this disease, with approximately 70,000 having
systemic sclerosis, and in some cases diffuse scleroderma. In the United States,
scleroderma is primarily treated by rheumatologists. Currently there is no cure
for this often fatal disease, and few therapies ease the pain and suffering of
scleroderma patients. Current therapies are directed toward alleviating the
symptoms of the disease, not the underlying cause.

        In 1997, the Company completed a Phase II trial for relaxin in patients
with scleroderma. The results of the 64-patient Phase II trial showed that
administration of relaxin caused a statistically significant reduction in skin
score (a measure of skin thickening) and a trend toward improvement in
eleven other disease parameters. Based partly on the results of the Phase





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II trial and an earlier Phase I/II trial for scleroderma, the Company believes
that relaxin may have a beneficial effect on connective tissue turnover and may
provide a treatment for scleroderma. The Company initiated a 200-patient pivotal
trial of relaxin for scleroderma in February 1999. The Company has also
conducted a preclinical animal study that demonstrated Relaxin's potential
ability to inhibit pulmonary (lung) fibrosis and is conducting preclinical
studies with relaxin in liver and cardiac fibrosis, and infertility.

        The Company has been granted Orphan Drug Status for ConXn for treatment
of progressive systemic sclerosis, a severe form of scleroderma. In the United
States, the Orphan Drug Act of 1983 provides incentives to drug manufacturers to
develop and manufacture products for the treatment of rare diseases, currently
defined as diseases that affect fewer than 200,000 individuals in the United
States, or for a disease that affects more than 200,000 individuals in the
United States where the sponsor does not realistically anticipate its product
becoming profitable. Under the Orphan Drug Act, a manufacturer of a designated
orphan product can seek certain tax benefits, and the holder of the first FDA
approval of a designated orphan product will be granted a seven-year period of
marketing exclusivity for that product for the orphan indication. While the
marketing exclusivity of an orphan drug would prevent other sponsors from
obtaining approval of the same product for the same indication, it would not
prevent other types of products from being approved for the same use. The U.S.
Congress has considered and may consider in the future, legislation that would
restrict the duration of the market exclusivity of an orphan drug and, thus,
there can be no assurance that the benefits of the existing statute will remain
in effect.

        Organ Fibrosis. In addition to scleroderma, the Company believes that
ConXn may have potential in treating organ-specific fibroses, such as cardiac
and pulmonary fibrosis. Scarring of the heart is the cause of much of the
impairment in cardiac function that occurs in atherosclerosis, in hypertension,
or following a heart attack. Because ConXn is believed to stimulate new blood
vessel growth, as well as promoting the breakdown of fibrotic (scarred or
hardened) tissue, it may provide a dual mechanism for improving function of the
scarred heart. Cardiovascular diseases remain the leading cause of morbidity 
and mortality in the United States, where approximately 13 million people 
suffer from heart disease, and 800,000 new heart attacks occur annually. 
Current therapies include angiotensin-converting enzyme (ACE) inhibitors. 
Pulmonary fibrosis represents a group of diseases associated with chronic 
inflammation and scarring in the walls of the alveoli in the lungs. Impairment 
of lung function and in many cases, death occurs as consequences. Approximately 
144,000 individuals who suffer from pulmonary fibrosis are treated by 
pulmonologists and oncologists. Current therapies consist of corticosteroids 
and cytotoxic drugs, such as cyclophosphamide, which are largely ineffective.

        Infertility. Infertility is a serious problem that affects approximately
one in seven couples in the United States. The Company and collaborators have
accumulated data indicating that relaxin may be involved in stimulating new
blood vessel formation in the lining of the uterus, and that the increase in
blood flow may enhance embryonic implantation and pregnancy success. Relaxin
therapy may be useful in the treatment of infertility in the area of assisted
reproductive technologies, including in vitro fertilization. The Company has
begun a development program for relaxin in the treatment of infertility.



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FOAM PRODUCTS

        Luxiq(TM). The Company has an exclusive license to develop and market a
foam formulation of betamethasone valerate, a dermatology therapy, in North
America. Connetics' tradename for the product is Luxiq(TM). The product has been
approved for sale in the United Kingdom and is being marketed in the U.K. by a
company affiliated with Medeva PLC. Under the terms of an exclusive license
agreement with Soltec Research Pty Ltd., the Company will pay a licensing fee to
Soltec, plus royalties on future sales of products, if any, arising from the
licensed technology. The Company also has an exclusive option on Soltec's foam
formulation for the delivery of other compounds. In August 1997, the Company
announced that results from its Phase III clinical trial with Luxiq demonstrated
statistically significant improvement over both placebo and betamethasone lotion
for the treatment of scalp psoriasis, a condition that affects over three
million persons in the United States. On February 28, 1999, the FDA approved the
Company's New Drug Application ("NDA") to market Luxiq for relief of the 
inflammatory and pruritic manifestations of corticosteroid-responsive
dermatoses of the scalp.

        Betamethasone valerate is a mid-potency corticosteroid currently
marketed in the U.S. The unique foam formulation has been shown to liquefy when
applied to the body, enabling rapid penetration of active dermatologic agent.
This formulation is designed to be easier to apply and less messy than currently
marketed scalp lotions and gels. In addition, the ease of use and patient
acceptability may enhance patient compliance. 

        Psoriasis and other Scalp Dermatoses. Psoriasis, a chronic, recurrent
dermatologic disease characterized by inflammation and thickening of the skin,
is estimated to affect six million people in the United States. Scalp psoriasis,
a distinct manifestation of psoriasis, is a serious problem for more than sixty
percent of psoriatics. Patients with scalp psoriasis suffer from various degrees
of erythema, scaling and itching associated with the disease, and the disease
course typically involves periods of remission followed by acute exacerbations.
Luxiq is also suitable for treating other dermatoses of the scalp, including
eczema and seborrheic dermatitis.

        OLUX(TM). Following its development progress with Luxiq, in January
1998, the Company entered into an agreement with Soltec Research Pty Ltd., and
exercised an option to exclusively develop and market clobetasol propionate, a
super high-potency corticosteroid currently marketed in the United States in
other formulations. The foam formulation is expected to be sold under Connetics'
trademark "OLUX." OLUX uses a foam formulation similar to Luxiq, whereby it
remains a foam at room temperature and then liquefies when applied to the body,
facilitating the delivery of the active dermatologic agent. 

        During the quarter ended September 30, 1998, the Company completed
treatment in a Phase III clinical trial of OLUX intended for the treatment of
severe scalp psoriasis and other corticosteroid-responsive dermatoses of the
scalp. The Phase III trial was a multicenter, randomized, double-blind study of
approximately 190 scalp psoriasis patients which compared OLUX to a currently
approved clobetasol solution and to placebo during a two week


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treatment regimen. Endpoints for the trial included changes in the clinical
signs of psoriasis: plaque thickness, scaling, erythema (redness), and the
global response to treatment as judged by the investigator. Decreases in itching
and the patient's assessment of improvement were also evaluated. In November
1998, the Company announced that the outcome of the trial was positive and that
the Company anticipates filing an NDA in 1999.

        If the Company were unable to commence clinical trials as planned,
complete the clinical trials or demonstrate the safety and efficacy of its
products, the Company's business, financial condition and results of operations
would be materially and adversely affected. Even if a product from the Company's
research and development programs or any other therapeutic product is
successfully developed according to plans, there can be no assurance it will be
approved by the FDA on a timely basis or at all.

RIDAURA

        Ridaura(R). In December 1996, the Company acquired the exclusive U.S.
and Canadian rights to Ridaura (auranofin), from SmithKline Beecham Corporation
and affiliated entities ("SmithKline"). Ridaura is an oral formulation of a gold
salt (auranofin). Ridaura, which is classified as a disease-modifying
antirheumatic drug ("DMARD"), is an established therapy for rheumatoid
arthritis. Ridaura has been shown to slow joint destruction and the progression
of rheumatoid arthritis. The drug is currently indicated for adults with active
rheumatoid arthritis who are not responsive to, or are intolerant of, treatment
with non-steroidal anti-inflammatory drugs. The primary patents for Ridaura
expired in 1989 and 1992; the absence of patent protection for Ridaura means
that the Company will be unable to assert patent infringement claims against a
third party marketing the same product under a different trade name, which could
have a material adverse effect on the Company's business, financial condition,
and results of operations.

        Rheumatoid arthritis. Rheumatoid arthritis is a chronic autoimmune
disease in which the body's immune system attacks the connective tissue in the
joints, resulting in progressive, systemic and painful inflammation and erosion
of the joints. In advanced phases of the disease, symptoms include severe pain,
body disfigurement and loss of mobility. It is estimated that between one and
two percent of the worldwide adult population, including over two million
individuals in the United States, suffer from rheumatoid arthritis and about
one-half of these will progress to severe disease. Women are three times more
susceptible than men. Current treatment for rheumatoid arthritis uses a
combination of drugs and physical and occupational therapy in an attempt to
prevent further joint damage. No current therapy cures the disease and often its
progression cannot be stopped. Rheumatoid arthritis is primarily treated by
rheumatologists.

        Connetics began marketing Ridaura through its own sales force in
mid-1997. Through agreements with SmithKline, customer orders and distribution
for the product was managed by SmithKline through 1997 and SmithKline will
manufacture and supply Ridaura (in final finished package form) to the Company
through December 2001. The Company has an agreement with





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CORD Logistics, Inc. ("CORD"), based in Nashville, Tennessee, to manage the
distribution of Ridaura.

        In December 1997, the Company sold the Canadian rights to Ridaura to,
and entered a supply agreement with, Pharmascience, Inc., a Canadian
corporation, for a net consideration of $1,300,000.

T-CELL RECEPTOR ("TCR") PROGRAM

        Autoimmune Disorders. Connective tissue can be destroyed by various 
T cell-mediated autoimmune diseases. Autoimmune diseases are generally believed 
to result from an inappropriate response of the immune system. The immune system
is the body's major biological defense mechanism, first distinguishing antigens
(foreign substances) from the body's tissue and then eliminating a wide variety
of disease-causing pathogens, such as bacteria and viruses. A major component of
this system is T cells. In many autoimmune diseases, these T cells go awry and
attack the body's healthy tissues. There is mounting evidence that these
disease-causing T cells are concentrated at the disease site, where they
initiate signals leading to tissue destruction. The mechanism responsible for
causing these T cells to attack healthy tissue has, for the most part, not been
identified. Autoimmune diseases can attack virtually any tissue or organ of the
body, are often debilitating and can be fatal.

        The Company holds certain patents to a TCR vaccine technology for the
treatment of autoimmune diseases. TCR vaccines are being developed to help the
body elicit an immune response against disease-causing agents. Specifically, TCR
vaccines are injected into the patient to elicit a heightened immune response
against the T-cells thought to cause autoimmune disease. These vaccines elicit a
"regulatory immune response" by increasing the number of regulatory T-cells that
produce anti-inflammatory cytokines. While the results of pilot clinical studies
using TCR vaccines for the treatment of rheumatoid arthritis and multiple
sclerosis were encouraging, the Company has suspended most of its activity with
respect to TCR, to permit it to focus its resources on products closer to
market.

        XOMA. In June 1994, Connetics entered into an agreement with Xoma
pursuant to which the Company acquired additional TCR vaccine technology and
patent rights. This agreement obligates the Company to make certain milestone
payments and to pay certain royalties on sales of TCR vaccine products. The
Company's failure to meet certain milestones may result in the acquisition by
XOMA of a co-exclusive royalty-free license to the TCR vaccine technology or in
certain circumstances the reversion of the asset to Xoma.

        Arthur A. Vandenbark, Ph.D. (Veterans Administration Medical Center,
Portland, Oregon). In July 1994, the Company entered into a Research
Collaboration and Assignment Agreement with Dr. Vandenbark, the inventor of the
patent rights acquired from XOMA, to establish a framework for a scientific
collaboration relating to the development of the TCR Peptide vaccines. The
agreement, which has been extended through March 31, 2000, provides that the
Company continue to fund the collaborative research, gives the Company access to
future inventions and know-how, and obligates the Company to make certain
royalty payments on sales





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of products not already covered by the XOMA Agreement. In addition, the Company
entered into consulting agreements with Dr. Vandenbark and Dr. Halina Offner,
which have also been extended, and in connection with the agreements granted
each of them options to purchase the Company's Common Stock, which vest upon the
achievement of certain milestones.

        Molecular Medicine Research Institute ("MMRI"). In October 1996, the
Company entered into a Laboratory Services Agreement with MMRI directed research
relating to relaxin and TCR peptides. The agreement provides funding for MMRI to
conduct the research on behalf of the Company and also has provisions covering
intellectual property arising from the directed research and other discoveries
relating to the Company's areas of interest. The current agreement expires in
June 1999.

INTERFERON GAMMA

        Interferon gamma. Interferon gamma-1b is one of a family of proteins
involved in the regulation of the immune system and has been shown to reduce the
frequency and severity of certain infections. Interferon gamma is approved by
the FDA for the reduction in frequency and severity of infections associated
with a rare immune disease, known as chronic granulomatous disease ("CGD"). In
December 1995, Genentech and Connetics entered into an agreement with respect to
interferon gamma pursuant to which the Company acquired exclusive development
and marketing rights in the United States for dermatologic indications. In May
1998, Genentech and the Company terminated the agreement and entered into a new
license agreement (the "Genentech Gamma License") that granted the Company an
exclusive license under certain patent rights and know-how to ACTIMMUNE(R)
(interferon gamma-1b) for the treatment of infections in CGD and several
additional indications (non-cancer dermatological diseases; infectious diseases;
infections in osteopetrosis; pulmonary fibrosis; and asthma) in the United
States. The parties also entered into a Supply Agreement under which Genentech
will manufacture and supply interferon gamma, in bulk product or finished
product form.

        The Company has formed a subsidiary corporation, InterMune
Pharmaceuticals, Inc. to further develop and commercialize interferon gamma.
Clinical studies are underway evaluating interferon gamma's role as a potential
therapy for infections associated with osteopetrosis, for atypical mycobacterial
infections, and as a treatment for multiple-drug resistant tuberculosis.

        Osteopetrosis. Osteopetrosis is a life-threatening, congenital disorder
in which overgrowth of bony structures leads to blindness, deafness and
increased susceptibility to infection. There are currently no effective
treatments for this disease. InterMune is in discussions with the FDA about
whether a BLA can be filed on existing data generated in the course of a
physician-sponsored Phase II study, or whether the FDA would request results
from the ongoing Phase III study. Depending on the outcome of those discussions,
a BLA could be submitted as early as the third quarter of 1999.

        Multiple Drug-Resistant Tuberculosis. Results from a recent, open-label
trial in five patients with severe, advanced mycobacterium tuberculosis (MDR-TB)
showed that treatment with aerosolized interferon-gamma was well tolerated and 
provided encouraging results. An open-label pilot





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study, conducted under a physician-sponsored IND has been completed. A
multi-center Phase II trial sponsored by the NIH is ongoing. InterMune
anticipates initiating a Phase III trial in 1999.

        Other Potential Indications. In ongoing clinical studies conducted at
the NIH, and in other preclinical studies, interferon gamma has shown
preliminary results of efficacy for treatment of non-HIV immunocompromised
patients with mycobacterial infection, and in the treatment of a wide range of
fungal diseases.

        Early-stage clinical trials conducted by independent investigators in
collaboration with Genentech showed preliminary results indicating that
interferon gamma may be efficacious in the treatment of keloids, which are
unsightly, painful, elevated scars resulting from collagen overproduction. The
Company has concluded a Phase II clinical trial for the treatment of keloids,
with inconclusive results, and the Company is not presently pursuing development
of interferon gamma for dermatological indications. In addition, in August 1997,
the Company announced results from a Phase III trial of interferon gamma for the
treatment of atopic dermatitis that indicated that the product did not show an
acceptable therapeutic response with respect to the primary clinical endpoint,
and the Company suspended plans to submit a BLA for the treatment of atopic
dermatitis.

COLLABORATIVE RELATIONSHIPS: RELAXIN

        As part of its business strategy, the Company has entered into and
continues to explore strategic collaborative relationships (including licensing
agreements) and consulting agreements with leading researchers and institutions
working in its fields of interest, to complement its internal research efforts
and provide access to technologies that may expand its existing portfolio.

        Genentech. In September 1993, Genentech and Connetics entered into a
license agreement (the "September 1993 Agreement") pursuant to which Connetics
obtained exclusive worldwide rights to relaxin (excluding reproductive
indications and the territories of Japan, Korea and the Republic of China). The
September 1993 Agreement was amended in July 1994 to modify the Company's right
to sublicense the relaxin technology and to expand the Company's rights to
include reproductive indications on a co-exclusive basis with Genentech. In
April 1996, the Company acquired rights to Japan, Korea and the Republic of
China from Genentech, thereby giving the Company worldwide rights to the
technology. The September 1993 Agreement with its amendments is referred to as
the "Genentech Relaxin License."

        Under the Genentech Relaxin License, Connetics also has rights to future
developments regarding relaxin, and the Company is obligated to pay royalties on
licensed product sales. In addition, Genentech received an equity position in
the Company. The September 1993 Agreement also includes certain technology
transfer, supply, and intellectual property provisions, and includes provisions
requiring the Company to meet certain milestones and make payments for supplies.
Failure to timely achieve designated milestones may result in termination of the
Genentech Relaxin License by Genentech and a license on a non-exclusive basis to
Genentech of relaxin technology developed by the Company.





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        Florey Institute. The Genentech Relaxin License includes rights licensed
to Genentech from the Howard Florey Institute of Experimental Physiology and
Medicine in Melbourne, Australia (the "Florey Institute"). In January 1998, the
Company negotiated an agreement with the Florey Institute that will provide for
the Company to pay royalties directly to the Florey Institute (rather than
through Genentech) and for such royalty payments to be restructured. Under the
agreement, the Company would provide approximately $125,000 of annual research
funding to the Florey Institute for a five-year period (which could terminate
earlier upon the date of the first sale of a relaxin product by Connetics or its
partner), and the Florey Institute would receive a royalty on Connetics' sales
of relaxin products and a portion of revenues received from corporate partners.

        Medeva. In January 1999, Connetics entered into a development,
commercialization and supply agreement for ConXn(R) with Medeva PLC of the
United Kingdom. Under the terms of the agreement, Medeva will pay certain fees,
development support and milestone payments. Medeva will be responsible for all
development and commercialization activities in Europe and will pay royalties on
sales in Europe. Medeva paid $8.0 million upon closing, including a $4.0 million
development fee and a $4.0 million equity investment, and will pay up to $17.0
million of milestone payments based upon development progress in the U.S. and
Europe, and $5 million for the development and approval of each indication in
Europe in addition to scleroderma. In addition, Medeva will pay half of the U.S.
development costs up to $1.0 million per quarter (for an estimated total of
$10.0 million) and share U.S. co-promotion rights with Connetics for up to five
years. Medeva will purchase relaxin materials from Connetics.

        Suntory. In April 1998, Connetics entered into a license agreement with
Suntory Pharmaceuticals for the development and marketing of ConXn in Japan.
Under the terms of the agreement, Suntory agreed to pay approximately $14
million in license fees and milestone payments. Suntory will be responsible for
all development and commercialization expenses in Japan and will pay royalties
on sales in Japan for the treatment of scleroderma. The deal included a $1.6
million license fee and future potential milestone payments based upon
development progress in the U.S. and Japan. Suntory will purchase relaxin
materials from Connetics. Connetics retained the rights to all other indications
in Japan.

        Medical University of South Carolina (Christian Schwabe, Ph.D.). In
April 1995, the Company entered into a Collaborative Research Agreement with the
Medical University of South Carolina to establish a collaborative research
program expanding upon an existing consulting relationship with Dr. Christian
Schwabe in the area of relaxin research, including the biology, receptors,
synthesis and activities of relaxin, the genes encoding relaxin, relaxin
peptides, analogs and related compounds. The agreement provides funding for
collaborative research, gives the Company access to future inventions and
know-how, and obligates the Company to make certain royalty payments on sales of
products covered by licensed patents. The Company declined to renew the
Agreement in 1998 but continues to make payments in connection with the
intellectual property rights.







                                       10
<PAGE>   12


PATENTS AND PROPRIETARY RIGHTS

        The Company's success will depend in part on the ability of Connetics
and its licensors to obtain patent protection for the Company's products and
processes, to preserve its trade secrets, and to operate without infringing the
proprietary rights of third parties. The Company owns, controls or has
exclusively licensed pending applications and/or issued patents worldwide
relating to the technology of all three of its major programs as well as
technology in the earlier stages of research.

        The Company's relaxin patent portfolio covers the composition of matter
(proteins and DNA), analogs and closely related compositions, formulations,
methods of manufacture and methods of treatment, including issued patents in the
U.S, and various international equivalents and pending applications. The issued
relaxin patents will expire at various times between 2003 and 2012. The
Company's TCR vaccine patent portfolio also includes pending applications in the
U.S., and corresponding international patents and applications, relating to
compositions of matter (peptides, peptide analogs, peptide fragments, and
antibodies), formulations, methods of treatment, diagnostic methods, and methods
of preparing/isolating protective T cells, most of which expire in 2010, with
one issued U.S. patent expiring in 2014. The Company's interferon gamma patent
portfolio includes issued U.S. patents and other pending applications relating
to the composition of matter, formulations and methods of treatment, which do
not begin to expire until 2009.

        There has been increasing litigation in the biomedical, biotechnology
and pharmaceutical industries with respect to the manufacture, use and sale of
new therapeutic products that are the subject of conflicting patent rights. The
validity and breadth of claims in biomedical/pharmaceutical/biotechnology
patents involve complex factual and legal issues for which no consistent policy
has emerged, and therefore are highly uncertain. Moreover, the patent laws of
foreign countries differ from those of the U.S. and the degree of protection, if
any, afforded by foreign patents may be different. In Europe, a third party
appeal is pending from an opposition to a patent application concerning relaxin
DNA; the original opposition was successfully defended by the Company's
licensor. No assurance can be given that any of the Company's or its licensors'
patent applications will issue as patents or that any such issued patents will
provide competitive advantage to the Company or will not be successfully
challenged or circumvented by its competitors. In addition, others may hold or
receive patents or file patent applications that contain claims having a scope
that covers products or processes made, used or sold by the Company. If any
claims of third-party patents were upheld as valid and enforceable with respect
to a product or process made, used or sold by the Company, Connetics could be
prevented from practicing the subject matter claimed in such patents or could be
required to obtain licenses or redesign its products or processes to avoid
infringement and could be liable to pay damages. There can be no assurance that
such licenses would be available or, if available, would be on commercially
reasonable terms, or that the Company would be successful in any attempt to
redesign its products or processes to avoid infringement.

        Connetics has been awarded a U.S. patent covering its proprietary TCR
vaccine technology. The Company is aware that third parties have also obtained
patents relating to TCR





                                       11
<PAGE>   13

vaccines technology, including U.S. patents issued to Immune Response
Corporation in 1997 and 1998. With regard to such patents as are known to the
Company and its patent counsel, the Company believes such patents' claims would
be found either invalid or not infringed if asserted against the Company's
proposed TCR vaccines. The Company has filed an opposition to a European patent
claiming compositions for use in treating multiple sclerosis, covering certain
TCR V beta peptides disclosed for treating multiple sclerosis in the Company's
own, earlier-filed application; another opposition has been filed against this
patent by an independent party. The Company has been advised that a separate
opposition has been filed to one of the Company's European patents. The Company
is also aware of other pending third party patent applications which, if issued,
might be asserted against the Company's TCR vaccines and products or processes
as planned to be made, used or sold by the Company. Even if the Company's patent
counsel render advice that the Company's products and processes do not infringe
any valid claim under third party patents relating to the TCR vaccines
technology, neither they nor the Company can assure that no third party will
commence litigation to enforce such patents, or that the Company will not incur
substantial expenses or that it will prevail in any patent litigation. A
judgment adverse to the Company in any such patent interference, litigation or
other proceeding could materially adversely affect the Company's business,
financial condition and results of operations with respect to the TCR
development program, and its expense may be substantial whether or not the
Company is successful.

        Connetics also relies on trade secrets and proprietary know-how. The
Company requires each of its employees, consultants and advisors to execute a
confidentiality agreement providing that all proprietary information developed
or made known to the individual during the course of the relationship will be
kept confidential and not used or disclosed to third parties except in specified
circumstances. The agreements also provide that all inventions conceived by an
employee (or consultant or advisor to the extent appropriate for the services
provided) during the course of the relationship shall be the exclusive property
of the Company, other than inventions unrelated to the Company and developed
entirely on the individual's own time. There can be no assurance, however, that
these agreements will provide meaningful protection or adequate remedies for
misappropriation of the Company's trade secrets in the event of unauthorized use
or disclosure of such information.

MARKETING AND SALES

        The Company's business strategy is to retain marketing rights for
products in the areas of dermatology and rheumatology in the United States. The
Company believes that a large, general sales and marketing infrastructure is not
required to effectively and successfully maximize the commercial potential of
products directed toward focused, specialty markets. The Company is targeting
its initial commercial activities at dermatologists and rheumatologists, which
can be served by a focused and specialized marketing organization. As of
March 26, 1999, the Company had a marketing and sales operation comprising 47
people, of whom 40 are sales representatives. The Company expects to expand the
sales force as it prepares to launch additional products. Outside the United
States, the Company's strategy is to establish development, marketing and
distribution agreements with pharmaceutical companies.


                                       12
<PAGE>   14

MANUFACTURING

        The Company currently has no manufacturing facilities for clinical or
commercial production of any of its products, nor does the Company intend to
develop such capabilities in the near future. The Company contracts with
independent sources to manufacture its products, which enables the Company to
focus on product and clinical development strengths, minimize fixed costs and
capital expenditures, and gain access to advanced manufacturing process
capabilities. TCR vaccines are manufactured for the Company by American Peptide
Company and Multiple Peptide Systems. Ridaura is manufactured by SmithKline (in
final finished package form) under an agreement with an initial term through
December 2001. Luxiq and OLUX are currently manufactured for Connetics by CCL
Pharmaceuticals. Interferon gamma is manufactured by Genentech and Parke-Davis.

        Relaxin has been manufactured for Connetics under contract with four
outside vendors: BASF Bioresearch Corp. for fermentation, Scios, Inc. for
purification, Chesapeake Biological Laboratory for filling and Tektagen, Inc.
for testing. Effective December 1, 1998, the Company entered into a long-term
agreement with Boehringer Ingelheim Austria GmbH (formerly Bender + Co. GmbH)
for the scale-up and manufacture of relaxin for clinical and commercial uses.

        The Company's strategy is to continue to use manufacturing agreements
for the production of its current and future products. If the Company were
unable to contract for manufacturing capabilities on acceptable terms, the
Company's ability to conduct preclinical and human clinical testing would be
adversely affected, resulting in the delay of submission of products for
regulatory approval and initiation of new development programs, which in turn
could impair materially the Company's competitive position and the possibility
of the Company achieving profitability. In addition, some materials used in the
Company's products may be available only from sole suppliers. Although neither
the Company nor its contract manufacturers has experienced difficulty acquiring
materials for the manufacture of its products for clinical trials, no assurance
can be given that interruptions in supplies will not occur in the future, which
could have a material adverse effect on the Company's ability to manufacture its
products.

COMPETITION

        The biopharmaceutical industry is highly competitive. Other products and
therapies currently exist on the market or are under development that could
compete directly with some of the products that the Company is marketing, or
seeking to develop and market. The Company believes that there are numerous
pharmaceutical and biotechnology companies and academic research groups
throughout the world engaged in research and development efforts with respect to
therapeutic products targeted at diseases or conditions addressed by the
Company. Connetics believes that competitive factors in its industry include
scientific and technological expertise, managerial competence in identifying and
pursuing product in-licensing and acquisition opportunities, operational
competence in developing, protecting, manufacturing and marketing products and
obtaining timely regulatory agency approvals, and financial resources.





                                       13

<PAGE>   15

        The Company intends to compete on the basis of the quality and
exclusivity of its products, combined with the effectiveness of its marketing
and sales efforts. Competing successfully will depend on the Company's continued
ability to attract and retain skilled and experienced personnel, to develop and
secure the rights to pharmaceutical products and compounds and to exploit these
products and compounds commercially prior to the development of competitive
products by others. The Company expects that there will be continued competition
for highly qualified scientific, technical and managerial personnel.

        There can be no assurance that the Company's products, even if
successfully tested and developed, will be adopted by physicians over such other
products, or that the Company's products will offer an economically feasible
alternative to existing modes of therapy where they exist. In addition, a number
of companies have received FDA approval in 1998 for new products and therapies
to address diseases involving connective tissue, particularly in the field of
rheumatoid arthritis, and the number of the Company's competitors in these
markets could increase. It is uncertain what impact, if any, the introduction of
new products will have on the Company's existing or future product revenues. The
Company intends to compete on the basis of the effectiveness, quality and
exclusivity of its products, combined with the effectiveness of its marketing
and sales efforts. There can be no assurance that other products and therapies
will not be developed that will either render the Company's proposed products
obsolete or will have advantages outweighing those of the products and therapies
that the Company is seeking to develop.

        With regard to Ridaura, there are numerous products on the market, and
under development, for the treatment of rheumatoid arthritis. There can be no
assurance that Ridaura will continue to be utilized by physicians over other
rheumatoid arthritis products, or that Ridaura will continue to offer a
cost-effective alternative to competing therapies. In addition, although the
Company believes that there will be a continued role for products such as
Ridaura, the market for rheumatoid arthritis will likely change based upon new
product introductions, which could have a material adverse effect on the
Company's sales of Ridaura.

        Many of the Company's existing or potential competitors, particularly
large pharmaceutical companies, have substantially greater financial, technical
and human resources than the Company. In addition, many of these competitors
have more collective experience than the Company in undertaking preclinical
testing and human clinical trials of new pharmaceutical products and obtaining
regulatory approvals for therapeutic products. Accordingly, the Company's
competitors may succeed in obtaining FDA approval for products more rapidly than
the Company. See "Government Regulation."

GOVERNMENT REGULATION

        FDA Regulation and Product Approval. The biotech industry is subject to
regulation by the FDA under the Food Drug and Cosmetic Act and by similar
agencies outside of the United States. It is expected that all of the Company's
pharmaceutical products will require regulatory approval by governmental
agencies prior to commercialization. In particular, human pharmaceutical
therapeutic products are subject to rigorous preclinical and clinical testing
and





                                       14
<PAGE>   16

other approval procedures by the FDA in the United States and similar health
authorities in foreign countries. Labeling and promotional activities are
subject to scrutiny by the FDA. 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.
Noncompliance with applicable requirements can result in, among other things,
warning letters, fines, injunctions, penalties, recall or seizure of products,
total or partial suspension of production, denial or withdrawal of approval, and
criminal prosecution. Accordingly, ongoing 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 that the Company has or
may develop. 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.

        Before obtaining regulatory approvals for the commercial sale of any of
its products under development, the Company must demonstrate through preclinical
studies and clinical trials that the product is safe and efficacious for use in
the target indication for which approval is sought. The results from preclinical
studies and early clinical trials may not be predictive of results that will be
obtained in later-stage testing and there can be no assurance that the Company's
future clinical trials will demonstrate the safety and efficacy of any products
or will result in approval to market products. A number of companies in the
biotechnology industry have suffered significant setbacks in advanced clinical
trials, even after promising results from earlier trials.

        Generally, in order to obtain FDA approval for a new therapeutic agent,
a company first must conduct preclinical studies in the laboratory and in animal
model systems to gain preliminary information on the agent's efficacy and to
identify any safety problems. "Preclinical" studies include toxicity,
pharmacokinetic and efficacy testing in vitro and in animals and chemical or
biological formulation work in preparation for submission of the necessary data
to comply with applicable regulations prior to the commencement of human
testing. 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. The Company has
filed and will continue to be required to sponsor and file INDs and will be
responsible for initiating and overseeing the clinical studies to demonstrate
the safety and efficacy that are necessary to obtain FDA approval of its
products.

        Clinical trials are normally done in various phases and generally take
two to five years, but may take longer, to complete. The rate of completion of
the Company's clinical trials is dependent upon, among other factors, the rate
of patient enrollment. Patient enrollment is a function of many factors,
including the size of the patient population, the nature of the protocol, the
proximity of patients to clinical sites and the eligibility criteria for the
study. Delays in planned patient enrollment may result in increased costs and
delays, which could have a material adverse effect on the Company. "Phase I
trials" generally involve administration of a product to a small number of
persons to determine safety, tolerance and pharmacokinetic characteristics.
"Phase I/II trials" generally involve administration of a product to a small
number of persons who have the targeted disease to determine safety, tolerance
and pharmacokinetic characteristics





                                       15
<PAGE>   17

and/or to obtain preliminary evidence of efficacy. "Phase II trials" generally
involve administration of a product to a limited number of patients with a
particular disease to determine dosage, efficacy and safety. "Phase III trials"
generally examine the clinical efficacy and safety in an expanded patient
population at multiple clinical sites. At least one such trial is required (but
usually two are required) for FDA approval to market a drug.

        After completion of clinical trials of a product, the Company will be
required to file an NDA, if the product is classified as a new drug, or a BLA,
if the product is classified as a biologic, and receive FDA approval before
commercial marketing of the product. 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 and BLAs can take between one and
two years to be reviewed by the FDA, and can take longer if significant
questions arise during the review process. While recent legislative and
regulatory initiatives have focused on the need to reduce FDA review and
approval times, the ultimate impact of such initiatives on the Company's
products cannot be certain. In addition, delays or rejections may be encountered
based upon changes in FDA policy during the period of product development and
FDA regulatory review of each submitted new drug application or biologic license
application. Similar delays may also be encountered in other countries. There
can be no assurance that even after such time and expenditures, regulatory
approval will be obtained for any products developed by the Company. If
regulatory approval of a product is granted, such approval may entail
limitations on the indicated uses for which the product may be marketed.

        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, recalls, seizures, injunctions or criminal sanctions. For marketing
outside the United States, the Company will also be subject to foreign
regulatory requirements governing human clinical trials, manufacturing 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.

        Third Party Reimbursement and Health Care Reform. The commercial success
of the Company's products will be substantially dependent upon the availability
of government or private third-party reimbursement for the use of such products.
There can be no assurance that Medicare, Medicaid, health maintenance
organizations and other third-party payers will authorize or otherwise budget
such reimbursement. Such governmental and third party payers are increasingly
challenging the prices charged for medical products and services. There can be
no assurance that the Company's products, once marketed, will be viewed as
cost-effective or that reimbursement will be available to consumers or will be
sufficient to allow the Company's products to be marketed on a competitive
basis. Furthermore, federal and state regulations govern or influence the
reimbursement to health care providers of fees and capital equipment costs in
connection with medical treatment of certain patients. The Company cannot
predict the likelihood of passage of federal and state legislation related to
health care reform or lowering pharmaceutical costs. To the extent that these or
other proposals or reforms have a material adverse effect on the Company's
ability to secure funding for its development or on the business,





                                       16
<PAGE>   18

financial condition and profitability of other companies that are prospective
collaborators for certain of the Company's product candidates, the Company's
ability to develop or commercialize its product candidates may be adversely
affected. In certain foreign markets pricing of prescription pharmaceuticals is
already subject to government control. Continued significant changes in the U.S.
or foreign health care systems could have a material adverse effect on the
Company's business.

        Environmental Regulation. 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, federal, and local 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. The Company could be required to incur significant
costs to comply with environmental laws and regulations as its research
activities are increased, and if that were to happen there can be no assurance
that the Company's operations, business and future profitability will not be
adversely affected.

INDUSTRY ADVISORS

        Connetics uses various advisors to provide expertise and critical review
of its programs. For advice on and review of its current and long-term
scientific planning, research and development, the Company has contracts with a
number of distinguished scientists and clinicians with expertise in biologic
processes and diseases that involve the connective tissues of the body. The list
of scientific advisors includes the following individuals, all of whom are
recognized as leading authorities in their fields:

<TABLE>
<CAPTION>
Name                               Position
----                               --------
<S>                                <C>
Edward P. Amento, M.D.             Consultant, Molecular Medicine Research, Inc.

Eugene A. Bauer, M.D.              Dean, Stanford University School of Medicine

Yueh-Hsiu Chien, Ph.D.             Assistant Professor, Stanford University School of Medicine

Arthur Z. Eisen, M.D               Professor, Washington University School of Medicine, Barnes
                                   Hospital

Philip C. Hanawalt, M.D.           Professor of Biological Sciences and Dermatology, Stanford
                                   University and Stanford University School of Medicine

Gerald T. Nepom, M.D., Ph.D.       Director, Virginia Mason Research Center Professor,
                                   University of Washington School of Medicine, Seattle

Brian Seed, Ph.D.                  Professor, Harvard Medical School
                                      (Massachusetts General Hospital)
</TABLE>

        Each advisor has entered into an agreement with the Company covering the
terms of his position. Each advisor provides services on an as-needed basis.
Three of the advisors have





                                       17
<PAGE>   19

entered into separate agreements with the Company covering additional
consultation above and beyond their activities as advisors. Certain advisors
hold options to purchase or have purchased Common Stock of the Company. In
addition, scientific advisors receive a fee for attending any advisory board
meeting and are reimbursed for out-of-pocket expenses incurred in attending each
meeting. All of the scientific advisors are employed by institutions other than
the Company and may have commitments to, or consulting or advisory agreements
with, other entities that may limit their availability to the Company.

        For its preclinical and clinical development programs the Company has
established relationships with several contract research organizations and
practicing physicians.

PRODUCT LIABILITY AND INSURANCE

        The Company faces an inherent business risk of exposure to product
liability claims in the event that the use of its technology or potential
products is alleged to have resulted in adverse effects. Such claims, even if
successfully defended by the Company, could injure the Company's reputation.
While the Company has taken, and intends to continue to take, what it believes
are appropriate precautions to minimize exposure to product liability claims,
there can be no assurance that it will avoid liability. The Company believes
that it possesses product liability and general liability and certain other
types of insurance customarily obtained by business organizations of its type.
The Company intends to maintain insurance against product liability risks
associated with the testing, manufacturing and marketing of its products.
However, there can be no assurance that it will be able to obtain such insurance
in the future, or that if obtained, such insurance will be sufficient.
Consequently, a product liability claim or other claims with respect to
uninsured liabilities or in excess of insured liabilities could have a material
adverse effect on the business or financial condition of the Company.

POTENTIAL EFFECTS OF GUARANTEE OF VALUE OF SHARES ISSUED TO GENENTECH

        Pursuant to the Genentech Gamma License, the Company issued Genentech
380,048 shares of common stock valued at $2.0 million in May 1998. Pursuant to a
December 1998 amendment to the Genentech Gamma License, the total value of the
shares issued to Genentech is required to be $4.0 million on or before December
15, 1999. The Company has the right to issue additional shares to Genentech at
any time before December 15, 1999, in order to meet this obligation. If the
future value of such shares is less than $4.0 million at December 15, 1999, and
the Company has not yet issued additional shares to Genentech, the Company would
have to either issue additional shares or pay cash to Genentech to make up the
difference. In addition, pursuant to the Genentech Relaxin License, the Company
is entitled to pay certain amounts in cash or equity at the Company's choice. A
payment of $683,500, originally due in September 1998, has been extended to
April 1, 1999, and it is the Company's current intention to issue stock to
Genentech to cover that obligation.

        If the Company is required to issue additional shares to Genentech, that
issuance will have a dilutive impact on the other stockholders of the Company.
As a result, the market price of





                                       18
<PAGE>   20

the Company's Common Stock could be adversely affected, and if the Company
becomes profitable, the Company net income per share could be decreased in
future periods.

IMPACT OF YEAR 2000

        Certain currently installed computer systems and software programs were
written to accept only two digit entries in the date fields rather than four
digit entries. In particular, some of the Company's older computer programs were
written using two digits rather than four to define the applicable year and as a
result, those computer programs that have time-sensitive software may recognize
a date using "00" as the year 1900 rather than the year 2000. Beginning in the
year 2000, these date code fields will need to accept four digit entries to
distinguish 21st century dates from 20th century dates or they could cause a
system failure or miscalculations causing disruptions of operations, including,
among other things, a temporary inability to process transactions, send
invoices, or engage in similar normal business activities. As a result, during
the next year, computer systems and/or software used by many companies,
including Connetics, may need to be upgraded to comply with such "Year 2000"
requirements. The Company presently believes that with modifications or
replacement of existing software and certain hardware, the Year 2000 Issue can
be mitigated. However, if such modifications and upgrades are not made, or are
not completed by the end of 1999, the Year 2000 Issue could have a material
impact on the operations of the Company.

        In particular, if the Company does not complete any additional phases,
the progress of the Company's research and development projects could be
delayed. In addition, disruptions in the economy generally resulting from Year
2000 issues may also have a material adverse effect on the Company's results of
operations, and the amount of potential liability and lost revenue cannot be
reasonably estimated at this time. For more information on the Company's plans
to address the Year 2000 issue, see Item 7, "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Impact of Year
2000."

        The Company currently has no contingency plan in place in the event it
does not complete all phases of the Year 2000 program. The Company plans to
evaluate the status of completion in March 1999 and determine whether such a
plan is necessary.

EMPLOYEES

        The Company is dependent on the principal members of its scientific and
management staffs (including Thomas G. Wiggans, President and Chief Executive
Officer), the loss of whose services might impede the achievement of development
objectives. The Company does not maintain "key person" insurance on any of these
individuals. In addition, the Company's potentially rapid growth and expansion
into areas and activities requiring additional expertise, such as clinical
trials, governmental approvals, manufacturing, sales and marketing, will
increase burdens on the Company's management, operational and financial
resources. These demands are expected to require an increase in management and
scientific personnel and the development of additional expertise by existing
management personnel. Recruiting and retaining management, operational personnel
and qualified scientific personnel to perform research and development work in
the future will be critical to the Company's success. Although the Company
believes it





                                       19
<PAGE>   21

will continue to be successful in attracting and retaining skilled and
experienced management and operational and scientific personnel, there can be no
assurance that the Company will be able to attract and retain such personnel on
acceptable terms given the competition for such personnel among numerous
pharmaceutical and biotechnology companies, universities and other institutions.

        As of December 31, 1998, the Company had 84 full-time employees. Of the
full-time employees, 31 were engaged in, or directly support, the Company's
research and development activities, and 48 were in general administrative and
marketing and sales positions. InterMune had an additional five full-time
employees at December 31, 1998. The Company and InterMune also use the services
of various consultants. The Company considers relations with its employees to be
good. None of the Company's employees is covered by a collective bargaining
agreement.


ITEM 2.        PROPERTIES

        Connetics currently leases approximately 23,500 square feet of
laboratory and office space at 3400 West Bayshore Road in Palo Alto, California.
The Company leases this space under a master lease agreement that commenced in
August 1996 and which will expire in July 1999 with a renewal option that, if
exercised, would extend the term of the lease to the year 2001. The Company
currently pays base monthly rent of $48,670 for this space and has the right to
use this space for laboratory research and development, storage and
distribution, offices, marketing and other related uses. Effective January 1,
1999, the Company leases an additional 13,464 square feet of office space at
3294 West Bayshore Road in Palo Alto, California. Beginning February 1, 1999,
the Company will pay a base monthly rent for this space of approximately $16,605
for two months, and $24,908 for the next ten months, increasing to approximately
$26,255 thereafter. In addition, through March 31, 1999, the Company leases
approximately 3,100 square feet of office space at 2483 East Bayshore Road, in
Palo Alto, California at a base monthly rent of $9,576. The Company does not
intend to renew the East Bayshore lease. The Company believes that its existing
facilities are adequate to meet its requirements for the near term and that
additional space will be available on commercially reasonable terms if needed.


ITEM 3.        LEGAL PROCEEDINGS

        Connetics knows of no material litigation or proceeding pending or
threatened to which the Company is, or may become, a party.

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

        No matters were submitted to a vote of security holders during the
fourth quarter of 1998.










                                       20

<PAGE>   22


                                     PART II


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

        The Company's Common Stock is traded on the Nasdaq National Market under
the symbol "CNCT." The following table sets forth for the periods indicated the
low and high closing sale prices for the Company's Common Stock.

<TABLE>
<CAPTION>
                                                1997                    1998
                                          ----------------        ---------------
                                           High       Low          High      Low
                                          -----      -----        ------    -----
           <S>                            <C>        <C>          <C>       <C>  
           First Quarter                  $8.00      $6.63        $5.313    $3.00
           Second Quarter                 $7.88      $6.00        $6.00     $3.375
           Third Quarter                  $9.50      $3.50        $4.375    $2.75
           Fourth Quarter                 $4.25      $2.56        $5.875    $2.25
</TABLE>

        On February 26, 1999, the last reported sale price of the Common Stock
on the Nasdaq National Market was $9.125 per share. As of that date, there were
approximately 215 stockholders of record of the Common Stock.

        The Company has never declared or paid cash dividends on its Common
Stock. The Company currently intends to retain all available funds for use in
its business, and does not anticipate paying any cash dividends in the
foreseeable future.
















                                       21

<PAGE>   23

ITEM 6.        SELECTED FINANCIAL DATA 

        The following selected consolidated financial data has been derived from
the Company's audited consolidated financial statements. This historical data
should be read in conjunction with the Company's consolidated Financial
Statements and the related notes thereto and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" appearing in Item 7
of this Form 10-K.

<TABLE>
<CAPTION>
(In thousands, except per share amounts)                                Years Ended December 31,
                                                        ---------------------------------------------------
                                                          1998       1997       1996       1995      1994
                                                        --------   --------   --------   --------   -------
<S>                                                     <C>        <C>        <C>        <C>        <C>    
Statement of Operations Data:
Revenues:
  Product revenues                                      $  7,473   $  6,803   $    428   $     --   $    --
  License revenues                                         1,648         --         --         --        --
                                                        --------   --------   --------   --------   -------
Total revenues                                             9,121      6,803        428         --        --

Operating costs and expenses:
   Cost of product revenues                                1,374      1,149         --         --        --
   License amortization                                    6,720      7,124        594
   Research and development                               11,446     17,162     13,161      8,271     6,436
   Selling, general and administrative                    11,680      8,966      5,434      2,113     1,317
   Charge for pre-FDA approved product rights              4,000         --         --         --        --
                                                        --------   --------   --------   --------   -------
Total operating costs and expenses                        35,220     34,401     19,189     10,384     7,753

Loss from operations                                     (26,099)   (27,598)   (18,761)   (10,384)   (7,753)

Gain on sale of license rights                                --        525         --         --        --
Interest income (expense), net                              (496)      (862)       247         12       (97)
                                                        --------   --------   --------   --------   -------
Net loss                                                $(26,595)  $(27,935)  $(18,514)  $(10,372)  $(7,850)
                                                        ========   ========   ========   ========   ======= 

Basic and diluted net loss per share(1)                 $  (1.61)  $  (2.69)  $  (2.71)  $  (2.34)       --
Shares used to calculate basic and diluted
   net loss per share(1)                                  16,533     10,412      6,825      4,434        --

Balance Sheet Data:
Cash, cash equivalents and short-term investments       $ 23,020   $ 14,346   $ 24,554   $  9,023   $ 1,287
Working capital                                           12,464      6,687     14,904      5,844      (979)
Total assets                                              31,394     31,068     47,922     11,796     2,901
Current portion of capital lease obligations,
   capital loans and long-term debt                          582      2,746      2,408      1,259       233
Current portion of notes payable and other liabilities     6,822      2,884         --         --        --
Non-current portion of capital lease obligations,
   capital loans and long-term debt                        4,002        649      3,062      4,933       829
Other long-term liabilities and notes payable(2)           3,781      9,666     10,858      3,467     2,643
Redeemable convertible preferred stock                        --        600      2,000         --        --
Total stockholders' equity (net capital deficiency)       12,452     10,809     21,800         63    (2,919)
</TABLE>


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

(1)  Earnings per share amounts prior to 1997 have been restated as required to
     comply with Statement of Financial Accounting Standards No. 128, "Earnings
     Per Share" (SFAS 128) and Staff Accounting Bulletin No. 98 ("SAB 98"). See
     Notes 1 and 13 of Notes to Consolidated Financial Statements.

(2)  See Note 5 of Notes to Consolidated Financial Statements for a description
     of the Company's other long-term liabilities.






                                       22
<PAGE>   24


ITEM 7.        MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
               AND RESULTS OF OPERATIONS


The following discussion should be read in conjunction with the Consolidated
Financial Statements and Notes filed with this Report.

OVERVIEW

        The Company acquires, develops and markets products in the areas of
rheumatology and dermatology. The Company acquired the U.S. and Canadian rights
to Ridaura(R) (auranofin), a treatment for rheumatoid arthritis, from SmithKline
Beecham Corporation and related entities ("SmithKline") in December 1996, and in
December 1997 the Company re-sold its Canadian rights to Ridaura. In March 1999,
the Company received marketing clearance from the U.S. Food and Drug
Administration ("FDA") to sell Luxiq(TM) (betamethasone valerate) Foam, 0.12%,
for the treatment of scalp dermatoses. The Company's products under development
include OLUX(TM) (clobetasol propionate 0.05%) for the treatment of severe scalp
dermatoses; ConXn(R) (relaxin) for the treatment of scleroderma, infertility and
organ fibrosis; interferon gamma for the treatment of certain congenital,
infectious and other diseases; and T-cell receptor ("TCR") peptide vaccines for
the treatment of multiple sclerosis and rheumatoid arthritis. There can be no
assurance that any of the Company's potential products will be successfully
developed, receive the necessary regulatory approvals or be successfully
commercialized.

        The Company has financed its operations primarily through the sale and
issuance of equity securities. Additional cash has been received in connection
with product revenue, license agreements and certain credit financing
arrangements. In January 1999, the Company entered into a collaborative
arrangement with a corporate partner whereby the Company was paid $4.0 million
in cash and received $4.0 million in equity investment upon closing of the
agreement, and will receive future payments based on milestones and development
activities (see Note 15 of Notes to Consolidated Financial Statements). To date,
while a majority of expenditures have been for research and development
activities, the Company has also increased its sales and marketing expenditures
due to the promotion efforts of Ridaura. The Company has incurred operating
losses since its inception and had an accumulated deficit of $92.5 million at
December 31, 1998. The Company will require additional funds to continue the
development of its products and to fund operating losses that are expected for
the next few years. Ridaura is the only product the Company currently has on the
market.

RESULTS OF OPERATIONS

        The Company's product revenues, derived from the sales of Ridaura, were
$7.5 million, $6.8 million and $0.4 million for the years ended December 31,
1998, 1997 and 1996, respectively. In December 1997, the Company sold the
Canadian rights to Ridaura to Pharmascience, Inc., a Canadian corporation
("Pharmascience"). Revenue on a pro forma basis to reflect the disposition of
Ridaura rights in Canada for the year 1997 was $6.5 million. The $0.7 million
($1.0 million on a pro forma basis) increase in revenue in 1998 over 1997 was
the result of increased promotional efforts by the Company's sales and marketing
organization and a





                                       23
<PAGE>   25

product price increase. The Company had no revenue for the first eleven months
in 1996 as all of its products were in the development stage. The $6.4 million
increase in revenue in 1997 over 1996 was the result of having one full year of
Ridaura sales. Although revenue from Ridaura increased from 1997 to 1998, there
can be no assurance that the Company will be able to market and sell Ridaura
successfully or that Ridaura revenues will equal or exceed those achieved in
1997 and 1998. In particular, increased competition from new products to treat
rheumatoid arthritis could impact Ridaura sales and, as a result, the Company's
financial condition and results of operations could be materially and adversely
affected.

        In connection with an agreement with Suntory Pharmaceuticals, a division
of Suntory Limited of Osaka Japan, for ConXn for the treatment of scleroderma,
the Company also recorded $1.6 million in licensing revenue in 1998.

        Pursuant to agreements between SmithKline and the Company, SmithKline
will manufacture and supply Ridaura in final package form through December 2001.
SmithKline also managed distribution of the product, with no additional
consideration, through December 1997, at which time CORD Logistics, Inc.
("CORD") began managing customer orders and distribution of Ridaura. The
Company's distribution costs are currently estimated to be approximately three
percent of net revenue.

        The Company's cost of product sales includes the cost of Ridaura
purchases from SmithKline, a percentage royalty based on product sales, and
distribution costs from CORD. For the years ending December 31, 1998 and 1997,
the Company recorded $1.4 million and $1.1 million in cost of product sales, and
$6.7 million and $7.1 million in amortization expense associated with the
acquisition of product rights to Ridaura, respectively. The Company determined
the useful life of the asset to be three years based on information regarding
products in the Company's development pipeline, competitive products, the
off-patent position of Ridaura and expected future revenues from Ridaura sales.
The increase of $0.3 million in product cost in 1998 over 1997 was the direct
result of increased unit sales and the decrease of $0.4 million in amortization
expense was the result of the Company's sale of its Canadian rights to Ridaura
in 1997. No product costs were recorded for 1996 as the Company was still in
development stage without any revenue generating product and there was no cost
associated with the Ridaura revenue the Company recognized in December 1996.

        Research and development expenses were $11.4 million, $17.2 million and
$13.2 million for the years ended December 31, 1998, 1997 and 1996,
respectively. The $5.8 million decrease in research and development expenses in
1998 over 1997 was primarily due to lower clinical trial activity. In 1998, the
Company's clinical trial activities consisted of an open label trial of ConXn
for the treatment of scleroderma, a Phase II clinical trial of interferon gamma
for the treatment of keloids, a Phase III clinical trial of OLUX and contract
manufacturing scale-up expenses associated with Luxiq. The $4.0 million increase
in research and development expenses in 1997 over 1996 was primarily due to the
Phase III clinical trial of interferon gamma for the treatment of atopic
dermatitis, the Phase II clinical trial of ConXn for the treatment of
scleroderma, the Phase III clinical trial of Luxiq for the treatment of scalp
psoriasis, the Phase I/II clinical trial of TCR peptide vaccines for the
treatment of multiple sclerosis and the Phase II clinical trial of interferon
gamma for the treatment of keloids, all of which commenced after June 1996.





                                       24
<PAGE>   26

Research and development expenses are expected to increase in future periods due
to the initiation of an expected pivotal trial of ConXn for the treatment of
scleroderma, commencement of relaxin manufacturing scale-up activities,
anticipated clinical trials of interferon gamma for the treatment of
osteopetrosis, multiple drug resistant tuberculosis and other indications, and
possible acquisition and development of new technologies and products.

        Selling, general and administrative expenses were $11.7 million, $9.0
million and $5.4 million for the years ended December 31, 1998, 1997 and 1996,
respectively. The increase of $2.7 million in expenses from 1998 over 1997 was
primarily due to increased activities of an established sales and marketing
organization including the hiring of additional sales staff in the third quarter
and costs associated with the promotion and marketing of Ridaura, increases in
business development expenses, and the hiring of additional personnel in the
general and administrative functions. The increase of $3.6 million in expenses
from 1997 over 1996 was primarily due to the establishment of a new sales and
marketing organization, costs associated with re-launching Ridaura, increases in
personnel in the general and administrative functions, and legal expenses
associated with operating as a public company. Selling, general and
administrative expenses are expected to continue to increase primarily due to
further staffing up of the sales organization, costs associated with marketing
Ridaura and potential commercialization of additional products.

        Pursuant to the interferon gamma license agreement with Genentech in May
1998 (see Note 5 of Notes to Consolidated Financial Statements), the Company
recorded a $4.0 million non-cash license fee charge in 1998. The Company
determined that the realizability of the license is largely uncertain as it
relates to a pre-FDA approved product and is dependent on additional research
and development of interferon gamma, and as a result, has expensed the full
purchase amount. There were no license fee charges in 1997 or 1996.

        In December 1997, the Company entered into an agreement with
Pharmascience, whereby the Company sold its Canadian rights to Ridaura for a net
consideration of $1.3 million. The book value of the Canadian rights to Ridaura
at December 31, 1997 was approximately $775,000 and accordingly, the Company
recognized a gain of $525,000 from the transaction. The Company had no similar
transactions in 1998 or 1996.

        Interest income was $0.8 million, $0.9 million and $1.2 million for the
years ended December 31, 1998, 1997 and 1996, respectively. The decrease in
interest income in 1998 over 1997 was due to lower average cash and investment
balance resulting from cash used in operations, debt obligations and
approximately $3.6 million principal and interest payments to SmithKline for
rights to Ridaura, offset in part by two private placements that raised a total
of $22.7 million. The decrease in interest income in 1997 over 1996 was also the
result of lower cash and investment balances due to increases in operating
expenses and a $3.0 million payment to SmithKline for rights to Ridaura.
Interest earned in the future will depend on the Company's funding cycles and
prevailing interest rates. Interest expense was $1.3 million, $1.7 million and
$0.9 million for the years ended December 31, 1998, 1997 and 1996, respectively.
The decrease of $0.4 million in interest expense in 1998 from 1997 was due to
lower imputed interest expense ($519,000 in 1998 compared to $830,000 in 1997)
attributable to a non-interest bearing $11.0 million promissory note payable to
SmithKline as partial consideration for the rights to Ridaura,





                                       25
<PAGE>   27

and lower interest expense associated with lower balances outstanding for
obligations under capital leases, loans and notes payable. The decrease was
offset in part by approximately $471,000 in accrued interest payable pursuant to
the amended repayment terms of the SmithKline note (see Note 5 of Notes to
Consolidated Financial Statements). The increase of $0.8 million in interest
expense in 1997 over 1996 was due to imputed interest expense of $1.1 million
attributable to the non-interest bearing $11.0 million promissory note payable
to SmithKline, offset in part by lower interest expense associated with lower
balances outstanding for obligations under capital leases and loans, and notes
payable.

        The Company incurred net losses of $26.6 million, $27.9 million and
$18.5 million for the years ended December 31, 1998, 1997 and 1996,
respectively. Other than the $4.0 million licensing charge in connection with
the license of interferon gamma (discussed above), the decrease of $1.3 million
in net losses in 1998 from 1997 was primarily due to a decrease of approximately
$5.8 million in development activities, lower amortization costs due to the sale
of Canadian rights to Ridaura, lower interest expense and an additional $1.6
million in licensing revenue in connection with the agreement with Suntory
Pharmaceuticals for ConXn. These decreases were offset in part by higher
selling, general and administrative expenses. The increase of $9.4 million in
net loss in 1997 over 1996 was primarily due to a higher level of product
development activities and Ridaura-related sales and marketing expenses,
amortization costs and imputed interest expenses, offset in part by revenues
generated from the sale of Ridaura. The Company expects to incur additional
losses over the next few years and losses are expected to fluctuate from period
to period based on timing of product revenues, clinical material purchases,
possible acquisitions of new products and technologies, scale-up activities and
clinical activities.

LIQUIDITY AND CAPITAL RESOURCES

        The Company has financed its operations to date primarily through
private sales of equity securities, proceeds from its initial public offering in
February 1996 and six self-managed financings, two in 1996, two in 1997 and two
in 1998. At December 31, 1998, cash, cash equivalents and short-term investments
totaled $23.0 million, an increase of $8.7 million from $14.3 million at
December 31, 1997. In 1998, the Company has generated cash of $24.2 million
through private sales of the Company's common stock ($22.7 million) and an
up-front license fee payment from Suntory Limited ($1.5 million, net of
international withholding tax). In January 1999, the Company received a $4.0
million up-front development fee and $4.0 million in equity investment from a
collaborative arrangement with a corporate partner (see Note 15 of Notes to
Consolidated Financial Statements).

        Cash used in operations in 1998 was $12.0 million compared with $23.6
million in 1997 and $10.4 million in 1996. The 1998 net loss was affected by a
number of charges that did not use cash, including a $4.0 million charge for the
write-off of technology licensed in exchange for common stock, $6.7 million of
amortization expense and $0.5 million of imputed interest expense associated
with the acquisition of Ridaura. Cash outflow for the year was primarily for
operating activities and approximately $3.6 million in principal and interest
payments to SmithKline. The 1997 net loss was also affected by a number of
charges that did not use cash, including $7.1 million of amortization expense
and $1.1 million imputed interest expense





                                       26
<PAGE>   28

associated with the acquisition of Ridaura that were offset in part by a $0.5
million gain recognized from the sale of Ridaura Canadian rights. In addition,
the increase in net loss of $9.4 million from 1997 over 1996 was due to higher
expenses associated with clinical trials and sales and marketing activities. The
cash outflow from operations also included a $3.0 million payment to SmithKline
for rights to Ridaura in January 1997, offset by $4.8 million cash generated
from Ridaura product sales (net of product costs). Other than non-cash
depreciation and deferred compensation expenses, cash outflow in 1996 was
primarily for operating activities. Receivables at December 31, 1998 were $0.5
million as compared with $1.5 million for the same period in 1997, attributable
to a shorter collection cycle as product sales in 1998 are made direct to
wholesalers with payment terms of 2% discount if paid in 30 days. In 1997, the
Company's sole customer was SmithKline, which in turn distributed Ridaura under
a Transitional Services Agreement with the Company. Payment terms under this
arrangement were on a quarterly basis.

        Investing activities, other than changes in the Company's short-term
investments, consumed $0.5 million in cash during 1998, compared with $0.6
million during 1997 and $3.5 million during 1996. Cash outlays in 1998 included
$176,000 for equipment expenditures required for operations and $308,000 for
fulfillment of obligations under the equity and asset purchase agreements with
SmithKline (see Note 5 of Notes to Consolidated Financial Statements). Cash
outlays in 1997 included a $1.0 million payment to SmithKline and equipment and
leasehold improvements expenditures of $0.9 million due to headcount growth,
offset in part by $1.3 million cash generated from the sale of the Canadian
rights to Ridaura. Cash outlays in 1996 included a $3.0 million up-front payment
to SmithKline for the acquisition of Ridaura rights and $0.5 million in capital
expenditures.

        Cash proceeds from financing activities in 1998 were $21.1 million
compared with $13.9 million in 1997 and $29.4 million in 1996. The Company
raised $22.7 million through private sales of its common stock and $4.0 million
in a bank loan in 1998. In 1997, the Company generated $16.1 million cash
primarily from sales of its common stock compared with $32.6 million cash
generated primarily from its initial public offering and a private financing in
1996. The Company also financed $0.3 million of its equipment expenditures
through a capital loan arrangement in 1997 and 1996. Cash proceeds in 1998, 1997
and 1996 were offset by $2.8 million, $2.5 million and $1.2 million in payments
on obligations under capital leases and loans, respectively, and principal
payments of $3.2 million to SmithKline in 1998.

        Working capital increased by $5.8 million to $12.5 million at December
31, 1998 from $6.7 million at December 31, 1997. The increase was primarily due
to a higher cash balance as a result of the $22.7 million raised by the Company
through equity sales and $4.0 million bank loan, offset by the reclassification
of the note payable due to SmithKline in 1999 from long term to current
liabilities. In April 1998, the Company restructured its payment obligations
under the promissory note to SmithKline such that the note previously to be
fully paid by January 1999 is now due throughout 1999 and to be fully paid by
April 2000 (see Note 5 of Notes to Consolidated Financial Statements). The
decrease of working capital to $6.7 million at December 31, 1997 from $14.9
million at December 31, 1996 was the result of lower cash, cash equivalents and
short-term investments, the reclassification of long-term capital loans, debt
and note payable to current liabilities, offset in part by lower accounts
payable, lower accrued





                                       27
<PAGE>   29

expenses and a higher receivable balance. The decrease in accounts payable and
accrued process development expenses of $3.3 million was partially due to
payments of $3.0 to SmithKline and $0.7 million for interferon gamma material
associated with the Phase III clinical trial.

        At December 31, 1998, the Company had an aggregate of $15.2 million in
future obligations of principal payments under capital leases, loans, long-term
debt and other obligations, of which $7.4 million is to be paid before December
31, 1999.

        The Company has an equity line agreement with an investor that may
potentially provide the Company access to capital through sales of its common
stock. The three-year equity line became available on June 26, 1998. During the
three year term, if the stock meets certain volume restrictions and trades above
$10.00, then up to $500,000 would be drawn against the equity line approximately
every three months in exchange for the sale of stock at an approximate minimum
price of $10.00 (see Note 6 of Notes to Consolidated Financial Statements).

        The Company believes that its existing cash and cash equivalents,
short-term investments, cash generated from Ridaura revenues, and financings,
including cash received through the collaborative arrangements with a corporate
partner in January 1999, will be sufficient to fund the Company's operating
expenses, debt obligations and capital requirements through early 2000. The
Company's future capital uses and requirements depend on numerous factors,
including the progress of its research and development programs, the progress of
clinical testing, the time and costs involved in obtaining regulatory approvals,
the cost of filing, prosecuting, and enforcing patent claims and other
intellectual property rights, competing technological and market developments,
the ability of the Company to establish other collaborative arrangements, the
level of product revenues, the possible acquisition of new products and
technologies, and the development of commercialization activities. Therefore
such capital uses and requirements may increase in future periods. As a result,
the Company will require additional funds prior to reaching profitability and
may attempt to raise additional funds through equity or debt financings,
collaborative arrangements with corporate partners or from other sources. Other
than the equity line agreement discussed above, the Company currently has no
commitments for any additional financings, and there can be no assurance that
additional funding will be available for the Company to finance its ongoing
operations on acceptable terms, if at all. The inability to obtain sufficient
funds could require the Company to delay, scale back or eliminate some or all of
its research and product development programs, to limit the marketing of its
products or to license to third parties the rights to commercialize products or
technologies that the Company would otherwise seek to develop and market itself.

IMPACT OF YEAR 2000

        Many computer systems and software applications were not designed to
handle dates beyond the year 1999, and therefore will need to be modified prior
to year 2000 in order to remain functional. As for many other companies, the
year 2000 issue poses a potential risk for Connetics and as a result, computer
systems and/or software used by many companies, including Connetics, may need to
be upgraded to comply with such "Year 2000" requirements.





                                       28
<PAGE>   30

        The Company has completed an assessment of its core business information
systems and related business processes used in its operations, most of which are
provided by outside suppliers. To date the Company has completed testing and
upgrading of approximately 74% of its information technology systems and expects
to have all remaining systems upgraded by March 31, 1999. The Company is
approximately 67% complete with the testing and upgrading of its operating
equipment and expects the process to be fully completed by June 30, 1999. The
Company has on-line access to its third party distribution service system that
includes customer orders, billing, shipping and inventory management. This
vendor has made its distribution system Year 2000 compliant, and the Company
converted to the compliant system in November, 1998.

        The Company's reliance on key suppliers, and therefore on the proper
functioning of their information systems and software, is increasing, and there
can be no assurance that another company's failure to address year 2000 issues
might not have an adverse effect on the Company. The Company has initiated
formal communications with each of its significant suppliers and customers to
determine the extent of its vulnerability to those third parties' failure to
remediate their own Year 2000 issues. The Company has requested that third party
vendors represent their products and services to be Year 2000 compliant and that
they have a program to test for Year 2000 compliance. However, the response of
those third parties is beyond the Company's control.

        Management of the Company is in the process of evaluating the need for
contingency plans with respect to Year 2000 requirements. The necessity of any
contingency plan must be evaluated on a case-by-case basis and will vary
considerably in nature depending on the Year 2000 issue it may need to address.
However, there can be no assurance that the Company may be able to solve all
potential Year 2000 issues, and if the Company fails to correct a material Year
2000 problem, its normal business activities and operations could be
interrupted. Such interruptions could have a material adverse affect on the
Company's results of operations, liquidity and financial condition. To date,
Year 2000 costs are not considered by the Company to be material to its
financial condition. The Company has incurred and expensed approximately $15,500
and currently estimates that, in order to complete Year 2000 compliance, the
Company will be required to incur total expenditures of approximately $50,000.

FORWARD-LOOKING STATEMENTS

        The Private Securities Litigation Reform Act of 1995 (the "Act")
provides a safe harbor for forward-looking statements made by or on behalf of
the Company. This report contains statements that are "forward-looking." All
statements that express expectations, beliefs, intentions or future strategies,
including possible development or future market launching of therapeutic
products; ability to raise funds to finance ongoing operations; possible
acquisition of new products and technologies; and "Year 2000" compliance
efforts, are forward-looking statements within the meaning of the Act. These
statements are made on the basis of management's views and assumptions, as of
the time the statements are made, regarding future events and business
performance. There can be no assurance, however, that management's expectations
will necessarily come to pass.





                                       29

<PAGE>   31

        Factors that may affect forward-looking statements. A wide range of
factors could materially affect future developments and performance, including
the following:

o    The Company is at an early stage of development and is subject to
     uncertainties associated with product development and market acceptance.
     Several of the Company's products are in clinical and preclinical
     development or are pending approval by the FDA, and no revenues were
     generated from products until December 1996. There can be no assurance that
     products under development will be safe and effective, approved by the FDA,
     produced in commercial quantities at reasonable costs or will gain
     satisfactory market acceptance.

o    The Company has a limited operating history and is subject to the
     uncertainties and risks associated with any new business. The Company has
     experienced operating losses every year since its incorporation and expects
     to incur additional losses over the next few years. Losses are expected to
     fluctuate from period to period based on timing of product revenues,
     clinical material purchases, possible acquisitions of new products and
     technologies, scale-up activities and clinical activities. The time for the
     Company to reach profitability is uncertain and there can be no assurance
     that the Company will ever be able to generate revenue from its products
     now under development or achieve profitability on a sustained basis.

o    There are risks related to the management of the marketing and sales of the
     Company's products. The Company's success depends in part on its ability to
     effectively manage the distribution of its products and to market and sell
     its products successfully. Future revenues from sales are uncertain as the
     Company is subject to patent risks and competition from new products.

o    The Company's future capital uses and requirements depend on numerous
     factors, including costs associated with the research, development,
     clinical testing and obtaining regulatory approvals of products in its
     pipeline; enforcing patent claims and intellectual property rights;
     acquisition of new products and technologies; commercialization activities
     and the ability to establish collaborative arrangements. Such requirements
     may increase in the future and the Company may attempt to raise additional
     funds through equity or debt financings, collaborative arrangements or from
     other sources. Future financings could have a dilutive effect on the
     Company's stockholders.

o    A key element of the Company's strategy is to in-license or acquire
     additional marketed or late-stage development products, which involve
     risks. A portion of the funds needed to acquire, develop and market any new
     products may come from the Company's existing cash which will result in
     fewer resources available to its current products and clinical programs.
     There can be no assurance that the Company will be able to raise additional
     funding to finance such acquisitions. In addition, the Company may have to
     recruit additional qualified employees to manage the development,
     marketing, sale and distribution of newly acquired products. There can be
     no assurance that newly acquired products will achieve the marketing or
     therapeutic success expected of them by the Company, industry analysts or
     others at the time of acquisition.





                                       30
<PAGE>   32

o    Clinical trials are inherently unpredictable and there can be no assurance
     that the Company will be able to commence any future trials, successfully
     complete them once started, meet development schedules or obtain product
     approval by the FDA on a timely basis if at all. The Company has limited
     experience in conducting preclinical and clinical trials, and delays in
     planned patient enrollment may result in increased costs and delays, which
     could have a material adverse effect on the Company's results of
     operations.

o    The Company's success will depend in part on its ability to preserve its
     trade secrets, to operate without infringing the proprietary rights of
     third parties, and to obtain patent protection for its products and
     processes. Products or processes made, used or sold by the Company may be
     covered by patents held by third parties that could prevent the Company
     from practicing the subject matter, require it to obtain licenses or
     redesign its products or processes to avoid infringement. The patent
     positions can be highly uncertain and involve complex legal and factual
     questions. Accordingly, the breadth of such claims cannot be predicted.
     Patent disputes are frequent and the Company could in the future be
     involved in material patent litigation.

o    The Company's products for research, preclinical testing and sale have been
     supplied by collaborators and contract manufacturing companies. The Company
     currently has no manufacturing facilities nor does it intend to develop
     such capabilities in the near future. The failure of any of the Company's
     contract manufacturers to provide products for clinical testing or to
     manufacture products on a commercial scale on a timely basis will have a
     material adverse effect on the Company's results of operations.

        This list of factors that may affect future performance and the accuracy
of forward-looking statements is illustrative, but by no means exhaustive.
Accordingly, all forward-looking statements should be evaluated with the
understanding of their inherent uncertainty.





















                                       31

<PAGE>   33

ITEM 7A.       QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company has supply contracts with Boehringer Ingelheim Austria GmbH (for a
product under research and development) and CCL Pharmaceuticals Ltd. in the U.K.
(for a product to be marketed in 1999). As payments under these contracts are
payable in local currency, the Company's financial results could be affected by
changes in foreign currency exchange rates. The Company has a bank loan that is
sensitive to movement in interest rates. Interest income from the Company's
investments is sensitive to changes in the general level of U.S. interest rates,
particularly since the majority of its investments are in short-term
instruments. Due to the nature of its short-term investments, the Company has
concluded that there is no material market risk exposure. Therefore, no
quantitative tabular disclosures are required.

ITEM 8.        FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

The following Financial Statements are filed as part of this Report:

<TABLE>
<CAPTION>
                                                                                PAGE
                                                                                ----
        <S>                                                                      <C>
        Report of Ernst & Young LLP, Independent Auditors.....................   33
        Consolidated Balance Sheets...........................................   34
        Consolidated Statements of Operations.................................   35
        Consolidated Statement of Stockholders' Equity........................   36
        Consolidated Statements of Cash Flows.................................   37
        Notes to Consolidated Financial Statements............................   38
</TABLE>










                                       32

<PAGE>   34


                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS


To the Board of Directors and Stockholders of Connetics Corporation

        We have audited the accompanying consolidated balance sheets of
Connetics Corporation as of December 31, 1998 and 1997, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

        In our opinion, the consolidated financial statements referred to above
present fairly, in all material aspects, the consolidated financial position of
Connetics Corporation at December 31, 1998 and 1997, and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.




                                            ERNST & YOUNG LLP


Palo Alto, California
January 13, 1999











                                       33

<PAGE>   35


                              CONNETICS CORPORATION
                           CONSOLIDATED BALANCE SHEETS
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)


<TABLE>
<CAPTION>
                                                                                         YEARS ENDED DECEMBER 31,
                                                                                         ------------------------
                                                                                            1998          1997
                                                                                          ---------     --------
<S>                                                                                       <C>           <C>     
                                        ASSETS
Current assets:
  Cash and cash equivalents                                                               $  14,708     $  8,452
  Short-term investments                                                                      8,312        5,894
  Accounts receivable, net                                                                      485        1,527
  Other current assets                                                                          118          158
                                                                                          ---------     --------
          Total current assets                                                               23,623       16,031

Property and equipment, net                                                                   1,128        1,663
Notes receivable from related parties                                                           379          333
Deposits and other assets                                                                       104          160
Licensed assets and product rights                                                            6,160       12,881
                                                                                          ---------     --------
                                                                                          $  31,394     $ 31,068
                                                                                          =========     ========
         

                         LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable                                                                        $   1,229     $  1,492
  Accrued liabilities                                                                           879        1,100
  Accrued process development expenses                                                          644          586
  Accrued payroll and related expenses                                                        1,003          536
  Current portion of notes payable and other liabilities                                      6,822        2,884
  Current portion of capital lease obligations, capital loans and long-term debt                582        2,746
                                                                                          ---------     --------
          Total current liabilities                                                          11,159        9,344

Non-current portion of capital lease obligations, capital loans and long-term debt            4,002          649
Other long-term liabilities                                                                   3,781        9,666
Redeemable convertible preferred stock, Series A                                                 --          600

Commitments
Stockholders' equity:
  Preferred stock, $0.001 par value:
     5,000,000 shares authorized; redeemable convertible preferred stock, Series A,
     shares issued and outstanding:  none in 1998 and 60 in 1997; and preferred stock,
     none issued or outstanding in 1998 and 1997                                                 --           --
  Common stock, $0.001 par value, and additional paid-in capital:
     50,000,000 shares authorized; shares issued and outstanding: 20,577,067 in 1998
     and 13,244,164 in 1997                                                                 105,285       77,518
  Notes receivable from stockholders                                                            (65)         (75)
  Deferred compensation, net                                                                   (302)        (763)
  Accumulated deficit                                                                       (92,469)     (65,873)
  Accumulated other comprehensive income                                                          3            2
                                                                                          ---------     --------
            Total stockholders' equity                                                       12,452       10,809
                                                                                          ---------     --------
                                                                                          $  31,394     $ 31,068
                                                                                          =========     ========
</TABLE>


          See accompanying Notes to Consolidated Financial Statements.





                                       34
<PAGE>   36


                              CONNETICS CORPORATION
                      CONSOLIDATED STATEMENTS OF OPERATIONS
               (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)


<TABLE>
<CAPTION>
                                                                  YEARS ENDED DECEMBER 31,
                                                       ---------------------------------------------
                                                           1998             1997             1996
                                                       ------------     ------------     -----------
<S>                                                    <C>              <C>              <C>        
Revenues:
   Product                                             $      7,473     $      6,803     $       428
   License                                                    1,648               --
                                                       ------------     ------------     -----------
Total revenues                                                9,121            6,803             428

Operating costs and expenses:
  Cost of product revenues                                    1,374            1,149              --
  License amortization                                        6,720            7,124             594
  Research and development                                   11,446           17,162          13,161
  Selling, general and administrative                        11,680            8,966           5,434
  Charge for pre-FDA approved product rights                  4,000               --              --
                                                       ------------     ------------     -----------
Total operating costs and expenses                           35,220           34,401          19,189

Loss from operations                                        (26,099)         (27,598)        (18,761)

Interest income                                                 808              860           1,190
Gain on sale of license rights                                   --              525              --
Interest expense                                             (1,304)          (1,722)           (943)
                                                       ------------     ------------     -----------
Net loss                                               $    (26,595)    $    (27,935)    $   (18,514)
                                                       ============     ============     ===========

Basic and diluted net loss per share                   $      (1.61)    $      (2.69)    $     (2.71)
Shares used to calculate basic and diluted net loss
  per share                                              16,532,544       10,412,039       6,824,668
</TABLE>


          See accompanying Notes to Consolidated Financial Statements.





                                       35
<PAGE>   37
                              CONNETICS CORPORATION
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                                                                                 
                                                                             CONVERTIBLE         COMMON STOCK AND                
                                                                           PREFERRED STOCK ADDITIONAL PAID IN CAPITAL   NOTES
                                                                           SHARES   AMOUNT   SHARES        AMOUNT     RECEIVABLE 
                                                                           ------   ------  --------     ---------    ---------- 
<S>                                                                         <C>             <C>          <C>          <C>        
Balances at December 31, 1995                                               3,965   $  4         909      $ 21,426     $   (134)
Issuance of common stock at IPO, net                                           --     --       2,500        24,521           --  
Conversion of preferred stock into common stock at IPO                     (3,965)    (4)      3,965             4           --  
Common stock issued under stock option and purchase plans                      --     --          63           118           --  
Issuance of common stock warrants                                              --     --          10            --           --  
Common stock issued pursuant to private placement, net                         --     --         972         5,930           --  
Common stock issued to SmithKline for asset purchase                           --     --         638         9,000           --  
Payment of notes receivable                                                    --     --          --            --           59  
Deferred compensation from stock incentive program, net of amortization        --     --          --             8           --  
Comprehensive loss:
   Net loss                                                                    --     --          --            --           --  
   Unrealized loss on investments                                              --     --          --            --           --  

Comprehensive loss                                                             --     --          --            --           --  
                                                                           ------     --    --------     ---------     --------  
Balances at December 31, 1996                                                  --     --       9,057        61,007          (75) 
                                                                           ------     --    --------     ---------     --------  
Common stock issued under stock option and purchase plans                      --     --         185           187           --  
Common stock issued pursuant to private placements, net                        --     --       3,560        15,894           --  
Conversion of Series A preferred stock and accrued dividends                   --     --         442         1,521           --  
Amendment to guaranteed market value of common                                 --     --          --        (1,000)          --  
    stock issued to SmithKline
Deferred compensation from stock incentive program, net of amortization        --     --          --           (91)          --  
Comprehensive loss:
   Net loss                                                                    --     --          --            --           --  
   Unrealized loss on investments                                              --     --          --            --           --  

Comprehensive loss                                                             --     --          --            --           --  
                                                                           ------     --    --------     ---------     --------  
Balances at December 31, 1997                                                  --     --      13,244        77,518          (75) 
                                                                           ------     --    --------     ---------     --------  
Common stock issued under stock option and purchase plans                      --     --         337           513           --  
Conversion of Series A preferred stock and accrued dividends                   --     --         251           604           --  
Common stock issued pursuant to private placements, net                        --     --       5,330        22,671           --  
Issuance of common stock and amendment to guaranteed market value
    of  common stock issued to SmithKline                                      --     --       1,038          (308)          --  
Common stock issued pursuant to license agreements                             --     --         382         4,010           --  
Payment of notes receivable and repurchase of common stock                     --     --          (5)          (14)          10  
Deferred compensation from stock incentive program, net of amortization        --     --          --           291           --  
Comprehensive loss:
   Net loss                                                                    --     --          --            --           --  
   Unrealized gain on investments                                              --     --          --            --           --  

Comprehensive loss                                                             --     --          --            --           --  
                                                                           ------     --    --------     ---------     --------  
Balances at December 31, 1998                                                  --     --      20,577     $ 105,285     $    (65) 
                                                                           ======     ==    ========     =========     ========  
</TABLE>

<TABLE>
<CAPTION>
                                                                                                       ACCUMULATED
                                                                                                          OTHER
                                                                            DEFERRED     ACCUMULATED  COMPREHENSIVE
                                                                          COMPENSATION     DEFICIT     INCOME(LOSS)       TOTAL
                                                                          ------------   -----------  -------------     --------
<S>                                                                         <C>           <C>            <C>             <C>
Balances at December 31, 1995                                                $(1,933)      $(19,300)      $     --      $     63
Issuance of common stock at IPO, net                                              --             --             --        24,521
Conversion of preferred stock into common stock at IPO                            --             --             --            --
Common stock issued under stock option and purchase plans                         --             --             --           118
Issuance of common stock warrants                                                 --             --             --            --
Common stock issued pursuant to private placement, net                            --             --             --         5,930
Common stock issued to SmithKline for asset purchase                              --             --             --         9,000
Payment of notes receivable                                                       --             --             --            59
Deferred compensation from stock incentive program, net of amortization          618             --             --           626
Comprehensive loss:
   Net loss                                                                       --        (18,514)            --       (18,514)
   Unrealized loss on investments                                                 --             --             (3)           (3)
                                                                                                                         --------
Comprehensive loss                                                                --             --             --       (18,517) 
                                                                             -------       --------       --------      --------
Balances at December 31, 1996                                                 (1,315)       (37,814)            (3)       21,800
                                                                             -------       --------       --------      --------
Common stock issued under stock option and purchase plans                         --             --             --           187
Common stock issued pursuant to private placements, net                           --             --             --        15,894
Conversion of Series A preferred stock and accrued dividends                      --           (124)            --         1,397
Amendment to guaranteed market value of common                                    --             --             --        (1,000)
    stock issued to SmithKline
Deferred compensation from stock incentive program, net of amortization          552             --             --           461
Comprehensive loss:
   Net loss                                                                       --        (27,935)            --       (27,935)
   Unrealized gain on investments                                                 --             --              5             5
                                                                                                                         --------
Comprehensive loss                                                                --             --             --       (27,930)
                                                                             -------       --------       --------      --------
Balances at December 31, 1997                                                   (763)       (65,873)             2        10,809
                                                                             -------       --------       --------      --------
Common stock issued under stock option and purchase plans                         --             --             --           513
Conversion of Series A preferred stock and accrued dividends                      --             (1)            --           603
Common stock issued pursuant to private placements, net                           --             --             --        22,671
Issuance of common stock and amendment to guaranteed market value
    of  common stock issued to SmithKline                                         --             --             --          (308)
Common stock issued pursuant to license agreements                                --             --             --         4,010
Payment of notes receivable and repurchase of common stock                        --             --             --            (4)
Deferred compensation from stock incentive program, net of amortization          461             --             --           752
Comprehensive loss:
   Net loss                                                                       --        (26,595)            --       (26,595)
   Unrealized gain on investments                                                 --             --              1             1
                                                                                                                         --------
Comprehensive loss                                                                --             --             --       (26,594)
                                                                             -------       --------       --------      --------
Balances at December 31, 1998                                                $  (302)      $(92,469)      $      3      $ 12,452
                                                                             =======       ========       ========      ========
</TABLE>

          See accompanying Notes to Consolidated Financial Statements


                                       36
<PAGE>   38


                              CONNETICS CORPORATION
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)


<TABLE>
<CAPTION>
                                                                                         YEARS ENDED DECEMBER 31,
                                                                                    --------------------------------
                                                                                      1998        1997        1996
                                                                                    --------    --------    --------
<S>                                                                                 <C>         <C>         <C>      
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss                                                                            $(26,595)   $(27,935)   $(18,514)
Adjustments to reconcile net loss to net cash used by operating activities:
  Depreciation and amortization                                                        7,488       7,911       1,237
  Technology acquired in exchange for note payable and other
     long-term liability                                                               4,010          --          --
  Amortization of deferred compensation                                                  752         461         626
  Accrued interest on notes payable                                                      519       1,107          --
  Gain on sale of Canadian rights to Ridaura                                              --        (525)         --
  Changes in assets and liabilities:
    Accounts receivable                                                                1,042      (1,099)       (428)
    Current and other assets                                                              18         (17)        690
    Accounts payable                                                                    (263)     (2,687)      3,738
    Accrued liabilities                                                                1,038        (809)      2,203
                                                                                    --------    --------    --------
Net cash used by operating activities                                                (11,991)    (23,593)    (10,448)
                                                                                    --------    --------    --------

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments                                                  (10,969)    (12,152)    (21,650)
Sales and maturities of short-term investments                                         8,552      16,263      11,648
Capital expenditures                                                                    (176)       (865)       (461)
Sale of Canadian rights to Ridaura                                                        --       1,300          --
Payment for licensed assets and product rights                                          (308)     (1,000)     (3,000)
                                                                                    --------    --------    --------
Net cash (used in) provided by investing activities                                   (2,901)      3,546     (13,463)
                                                                                    --------    --------    --------

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds (payments) from bank loans                                                    4,000          --          --
Payment of notes payable                                                              (3,200)         --      (2,205)
Proceeds from capital loans and long-term debt                                            --         333         323
Payments on obligations under capital leases and capital loans                        (2,836)     (2,470)     (1,244)
Proceeds from issuance of redeemable preferred stock                                      --          --       2,000
Proceeds from issuance of preferred and common stock, net                             23,184      16,081      30,569
                                                                                    --------    --------    --------
Net cash provided by financing activities                                             21,148      13,944      29,443
                                                                                    --------    --------    --------
Net change in cash and cash equivalents                                                6,256      (6,103)      5,532
Cash and cash equivalents at beginning of period                                       8,452      14,555       9,023
                                                                                    --------    --------    --------
Cash and cash equivalents at end of period                                          $ 14,708    $  8,452    $ 14,555
                                                                                    ========    ========    ========

SUPPLEMENTARY INFORMATION:
Interest paid                                                                       $    698    $    615    $  1,062

INVESTING AND FINANCING ACTIVITIES:
Assets acquired under capital leases                                                $     --    $     --    $    199
Deferred compensation related to stock options, purchase rights and purchase plan   $    387    $     --    $    145
Issuance of common stock for licensed assets and product rights                     $  4,010    $     --    $  9,000
Issuance of note payable for  licensed assets and product rights                    $     --    $     --    $  9,375
Preferred dividends on redeemable preferred stock, series A                         $      1    $    124    $     --
Conversion of redeemable preferred stock, series A and preferred dividend
  into common stock                                                                 $    604    $  1,521    $     --
</TABLE>


                 See accompanying Notes to Consolidated Financial Statements.





                                       37
<PAGE>   39

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                DECEMBER 31, 1998

1.      ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

        Organization

        Connetics Corporation (the "Company") was incorporated in the State of
Delaware on February 8, 1993. In May 1997, the Company's stockholders approved a
change of the Company's name from "Connective Therapeutics, Inc." to "Connetics
Corporation." References in this section to historical results include the
Company's results when it was known as "Connective Therapeutics, Inc." From its
inception the Company has principally been involved in research and development
of therapeutics for diseases that involve connective tissues of the body,
obtaining financing, recruiting personnel, securing operating facilities, and
pursuing business development opportunities. In December 1996, the Company
acquired exclusive U.S. and Canadian rights to Ridaura(R), a disease modifying
anti-rheumatic drug, from SmithKline Beecham Corporation and related entities
("SmithKline"). Ridaura is the first product the Company commercialized and it
signified the beginning of the Company's transition from purely product
development to a revenue based sales and marketing company. In December 1997,
the Company submitted a New Drug Application (an "NDA") with the FDA to market
Luxiq(TM) (a foam formulation of the dermatologic drug, betamethasone valerate)
in North America. In 1998, the Company formed a wholly-owned subsidiary
corporation, InterMune Pharmaceuticals, Inc., to further develop and market
certain patent rights and know-how to interferon gamma in the United States
through an exclusive license from Genentech, Inc. (see Note 5). As of December
31, 1998, the Company had no products from its development programs available
for sale. There can be no assurance that any of the Company's potential products
will be successfully developed, receive the necessary regulatory approvals or be
successfully commercialized. Accordingly, the Company's ability to continue its
research and development activities is dependent upon the ability of management
to obtain substantial additional financing.

        Liquidity and Financial Viability

        In the course of its development activities, the Company has sustained
continuing operating losses and expects such losses to continue for the next few
years. The Company's future capital uses and requirements depend on numerous
factors, including the progress of its research and development programs, the
progress of clinical and advanced-stage clinical testing, the time and costs
involved in obtaining regulatory approvals, the cost of filing, prosecuting, and
enforcing patent claims and other intellectual property rights, competing
technological and market developments, the ability of the Company to establish
collaborative arrangements, the level of product revenues, the possible
acquisition of new products and technologies, and the development of
commercialization activities. Therefore, such capital uses and requirements may
increase in future periods. As a result, the Company will require substantial
additional funds prior to reaching profitability and plans to continue to
finance its operating activities with a combination of stock sales, payments
from corporate partnering arrangements, product revenue, bank loans and/or debt
financing. The inability to obtain sufficient funds may require the





                                       38
<PAGE>   40

Company to delay, scale back or eliminate some or all of its research and
product development programs, limit the marketing of its products, or license to
third parties the rights to commercialize products or technologies that the
Company would otherwise seek to develop and market itself.

        Principles of Consolidation

        The consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiary corporation, InterMune Pharmaceuticals,
Inc. Material intercompany balances and transactions have been eliminated.

        Cash, Cash Equivalents and Short-term Investments

        Cash and cash equivalents consist of cash on deposit with banks and
money market instruments with original maturity of 90 days or less. Investments
with maturities beyond three months at the date of acquisition and that mature
within one year from the balance sheet date are considered to be short-term
investments. Cash equivalents and short-term investments are carried at fair
value, with unrealized gains and losses, net of tax, reported as a separate
component of stockholders' equity. The cost of securities sold is based on the
specific identification method.

        Management of the Company believes it has established guidelines for
investment of its excess cash relative to diversification and maturities that
maintain safety and liquidity.

        Fair Value of Financial Instruments

        The carrying amount of cash, cash equivalents and short-term
investments, accounts receivable, notes receivable from related parties, current
liabilities, notes payable, and long-term lease obligations, loans and debt are
considered to be representative of their respective fair values.

        Property and Equipment

        Property and equipment is stated at cost and depreciated using the
straight-line method over the useful lives of the assets, generally three to
five years. Assets acquired under capital lease arrangements are amortized over
the shorter of the estimated useful lives or the lease term.

        Research and Development

        Research and development costs are charged to expense as incurred.

        Revenue Recognition

        Revenues from product sales are recognized upon shipment, net of
allowances for estimated returns, rebates and chargebacks. The Company is
obligated to accept from customers the return of pharmaceuticals that have
reached their expiration date. The Company has not experienced significant
returns of expired product since its acquisition of U.S. and Canadian





                                       39
<PAGE>   41

rights to Ridaura in December 1996. License revenue under collaborative
agreements is recognized when earned under the terms of the agreement and when
performance obligations have been met and related payments are receivable and
non-refundable.

        Income Taxes

        Income taxes are accounted for under the asset and liability method
where deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled.

        Net Loss Per Share

        In fiscal 1997, the Company adopted Statement of Financial Accounting
Standards No. 128, "Earnings Per Share" (SFAS 128). This statement requires the
presentation of basic and diluted net income or loss per share. Basic net loss
per common share is computed using the weighted average number of common shares
outstanding during the period. Diluted net loss per share is computed using the
weighted average of common and diluted equivalent shares outstanding during the
period. All historical earnings per share amounts have been restated to conform
to the provisions of this statement (see Note 13).

        Use of Estimates

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

        Disclosure about Segments of an Enterprise and Related Information

        Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and
Related Information" (SFAS 131). SFAS 131 establishes standards for the way that
public business enterprises report information about operating segments in
annual financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports. SFAS 131 also
establishes standards for related disclosures about products and services,
geographic areas, and major customers. SFAS 131 is effective beginning in the
Company's year ended December 31, 1998. The Company operates solely in one
segment, the development and commercialization of therapeutics for diseases that
involve connective tissues of the body, and therefore there is no impact to the
Company's financial statements of adopting SFAS 131. For the year ended December
31, 1998, all of the Company's sales were to customers in the United States. For
the year ended December 31, 1997, sales to customers outside the United States
(principally in Canada) were $353,000.





                                       40
<PAGE>   42

2.      CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

The following is a summary of available-for-sale investments (in thousands):


<TABLE>
<CAPTION>
                                                                December 31, 1998
                                                   --------------------------------------------
                                                                 Gross      Gross
                                                   Amortized  Unrealized  Unrealized  Estimated
                                                      Costs      Gains       Loss     Fair Value
                                                   ---------  ----------  ----------  ----------
    <S>                                             <C>            <C>       <C>       <C>     
    Corporate bonds                                 $  4,017       $ 3       $ (3)     $  4,017
    Commercial paper                                  15,638         3         --        15,641
    Certificate of deposits                              520        --         --           520
    Money market funds                                   391        --         --           391
                                                    --------       ---       ----      --------
          Total                                       20,566         6         (3)       20,569
    Less amount classified as cash equivalents       (12,255)       (2)        --       (12,257)
                                                    --------       ---       ----      --------
    Total short-term investments                    $  8,311       $ 4       $ (3)     $  8,312
                                                    ========       ===       ====      ========
</TABLE>


<TABLE>
<CAPTION>
                                                                December 31, 1997
                                                   --------------------------------------------
                                                                 Gross      Gross
                                                   Amortized  Unrealized  Unrealized  Estimated
                                                      Costs      Gains       Loss     Fair Value
                                                   ---------  ----------  ----------  ----------
    <S>                                             <C>            <C>       <C>       <C>     
    Corporate bonds                                 $  3,824       $ 1       $--       $  3,825
    Commercial paper                                   1,947        --         --         1,947
    Certificate of deposits                            2,068         1         --         2,069
    Money market funds                                 3,582        --         --         3,582
                                                    --------       ---       ----      --------
          Total                                       11,421         2         --        11,423
    Less amount classified as cash equivalents        (5,529)       --         --        (5,529)
                                                    --------       ---       ----      --------
          Total short-term investments              $  5,892       $ 2       $--       $  5,894
                                                    ========       ===       ====      ========
</TABLE>

        The net unrealized holding gain (loss) on available-for-sale investments
included as a separate component of stockholders' equity at December 31, 1998
and 1997 totaled $1,000 and $2,000, respectively. The gross realized gains on
sales of available-for-sale investments for the years ended December 31, 1998
and 1997 totaled $398,000 and $442,000, respectively, and gross realized losses
for the same periods totaled $53,000 and $78,000, respectively. Realized gains
and losses were calculated based on the specific identification method.





                                       41
<PAGE>   43

3.      PROPERTY AND EQUIPMENT

        Property and equipment consists of the following (in thousands):

<TABLE>
<CAPTION>
                                                             December 31,
                                                        ---------------------
                                                          1998          1997
                                                        -------       -------
    <S>                                                 <C>           <C>    
    Laboratory equipment                                $ 1,889       $ 1,779
    Computer equipment                                      546           501
    Furniture and fixtures                                  417           397
    Leasehold improvements                                  730           729
                                                        -------       -------
                                                          3,582         3,406
    Less accumulated depreciation and amortization       (2,454)       (1,743)
                                                        -------       -------
    Property and equipment, net                         $ 1,128       $ 1,663
                                                        =======       =======
</TABLE>

        Property and equipment includes assets under capitalized leases at
December 31, 1998 and 1997 of approximately $1,005,000. Accumulated amortization
related to leased assets was approximately $945,000 and $831,000 at December 31,
1998 and 1997, respectively. There were no new capitalized leases for the year
ended December 31, 1998.

4.      NOTES RECEIVABLE FROM RELATED PARTIES

        At December 31, 1998 and 1997, the Company held notes receivable from
officers of the Company totaling $379,000 and $333,000, respectively. These
notes, which bear interest at rates ranging from 5.5% to 8.5% annually, are
collateralized by certain personal assets of the officers and are generally due
and payable within three to five years.

5.      RESEARCH AND LICENSE AGREEMENTS

        Product Rights

        In December 1996, the Company entered into an agreement with SmithKline
under which the Company acquired exclusive United States and Canadian rights to
Ridaura, a disease modifying antirheumatic drug. That agreement was amended on
November 13, 1997, December 18, 1997, and April 29, 1998. The agreement,
together with its amendments, is referred to as the "SKB Agreement." Under the
SKB Agreement, the Company paid $3.0 million in cash in January 1997, issued a
non-interest bearing $11.0 million promissory note payable due in two
installments ($6.0 million and $5.0 million in January 1998 and January 1999,
respectively), issued 637,733 shares of common stock with a guaranteed value of
$9.0 million at December 31, 1997, and is obligated to pay up to $6.0 million in
royalty payments based on future product sales, for a potential aggregate
consideration of up to $29.0 million. The $11.0 million promissory note was
discounted at inception using an imputed interest rate of 11% and total imputed
interest expense attributable to these payments is $1.6 million. The original
amount of the discounted note, $9.4 million, has been included in current and
other long-term liabilities with imputed interest being amortized over the
original term of the note. The Company determined the useful life of this asset
to be three years and has recorded amortization expense of $6.7 million, $7.1
million and $0.6 million for the years ended December 31, 1998, 1997 and 1996,
respectively. Accumulated amortization at December 31, 1998 and 1997 were $14.4





                                       42
<PAGE>   44

million and $7.7 million, respectively. In December 1997, the Company sold its
Canadian rights to Ridaura to Pharmascience, Inc., a Canadian corporation
("Pharmascience"), for a net consideration of $1.3 million. The original total
purchase price of $21.4 million that has been capitalized was adjusted by the
book value of the Canadian rights of approximately $775,000 to $20.6 million.

        The SKB Agreement allows the Company to defer the principal payments of
$11.0 million (originally due in January 1998 and January 1999 as discussed
above) to SmithKline as follows:

<TABLE>
<CAPTION>
        Due Date             Amount                   Due Date             Amount 
        --------             ------                   --------             -------
        <S>                  <C>                      <C>                  <C>
        April 1, 1998        $1,000,000               April 1, 1999        $  800,000
        July 1, 1998         $1,100,000               July 1, 1999         $  800,000
        October 1, 1998      $1,100,000               October 1, 1999      $  700,000
        January 4, 1999      $2,500,000               January 3, 2000      $1,500,000
                                                      April 1, 2000        $1,500,000
</TABLE>

        The Company is required to pay interest at prime rate plus 2% per year
on the principal amount outstanding of $5.7 million from January 1, 1998 through
January 4, 1999, and interest at prime rate plus 3% per year on the principal
amount outstanding of $5.3 million from January 5, 1999 through April 1, 2000.
The Company paid SmithKline $3.6 million in principal and interest in 1998 and
$2.6 million in principal and interest on January 4, 1999. As of December 31,
1998, the Company has classified principal and accrued interest on this note of
$4.9 million in the current portion of notes payable and other liabilities and
$3.0 million in other long-term liabilities.

        Pursuant to the SKB Agreement as amended, the guaranteed value of the
common stock was revised from $9.0 million to $8.0 million based on the fair
market value of the Company's common stock on April 1, 1998, with a maximum of
1,675,512 shares to be issued in total. In consideration of the amendment, the
Company paid SmithKline $1.0 million on December 31, 1997. As of April 1, 1998,
the aggregate fair market value of the shares previously issued under the
agreement was less than $8.0 million and, as a result, the Company issued
1,037,779 shares of its common stock and additional cash consideration of
approximately $308,000 to SmithKline in fulfillment of the Company's obligation
to issue equity to SmithKline under the SKB Agreement.

        Under a related Supply Agreement, SmithKline will manufacture and supply
Ridaura, in final package form, to the Company for an initial term through
December 2001. Under the Supply Agreement with Pharmascience, the Company,
through its relationship with SmithKline or other future vendors, will supply
Ridaura exclusively in Canada to Pharmascience.

        License Agreements

        In September 1993, the Company entered into an agreement with Genentech,
Inc. ("Genentech"), which was subsequently amended in July 1994, for an
exclusive right to make, use and sell certain products arising from recombinant
human relaxin ("relaxin") in a defined





                                       43
<PAGE>   45

field and territory in exchange for Series A preferred stock that was issued in
September 1994. The Company charged the value of the preferred stock to research
and development expense in 1993. In addition, the Company charged $684,000 to
expense in 1994 for the purchase of research materials and payment of technology
transfer costs under the agreement. This amount, payable in the form of cash or
equity, was originally due on September 30, 1998, but by letter agreement dated
September 22, 1998, was amended to be due on April 1, 1999, and has been
included in the current portion of notes payable and other liabilities. The
Company is required to pay interest on the amount outstanding at an annual rate
of 7.5% and will also pay to Genentech royalties on sales of products arising
from relaxin, if any. In April 1996, the Company acquired worldwide rights to
relaxin from Genentech.

        In June 1996, the Company entered into an exclusive License Agreement
with Soltec Research Pty Ltd. ("Soltec"), to develop and market a foam
formulation of the dermatologic drug, betamethasone valerate, in North America.
Under the terms of the Agreement, the Company will pay $75,000, of which $35,000
was paid in 1996, $22,500 was paid in January 1998, and the balance upon FDA
approval, in licensing fees to the Soltec (based on certain milestones) plus
royalties on future sales of products, if any, arising from the licensed
technology. The Company also has an exclusive option on Soltec's foam
formulation for the delivery of other compounds.

        In December 1995, the Company entered into a license agreement with
Genentech to acquire exclusive development and marketing rights to interferon
gamma in the United States for dermatologic indications. In May 1998, Genentech
and the Company amended the agreement in its entirety, entering into a new
license agreement that granted the Company an exclusive license under certain
patent rights and know-how to ACTIMMUNE(R) (interferon gamma) for the treatment
of chronic granulomatous disease ("CGD") and several additional indications
(non-cancer dermatological diseases, infectious diseases, osteopetrosis,
pulmonary fibrosis and asthma) in the United States. Under the terms of the
agreement, the Company issued Genentech 380,048 shares of its common stock
valued at $2.0 million at the time of closing with a guaranteed value of $4.0
million at the second closing date, originally set as December 28, 1998. In the
event that the value of the initial shares issued is less than $4.0 million, the
Company will either issue additional shares or pay cash to Genentech. On
December 28, 1998, the Company amended the second closing date to any time on or
before December 15, 1999. The Company will also be required to pay Genentech
certain development and commercialization milestones and royalties on sales. The
parties also entered into a Supply Agreement under which Genentech will
manufacture and supply interferon gamma, in bulk product or finished product,
with a termination date on the earlier of May 5, 2001 or the date on which a
third party manufacturer, approved by the parties, enters into a supply
agreement with the Company. Because the realizability of the license is largely
uncertain as it relates to a pre-FDA approved product and is dependent on
additional research and development related to interferon gamma, the Company
recorded a $4.0 million non-cash license fee charge.

        Agreement with Xoma

        In June 1994, the Company entered into a Technology Acquisition
Agreement with Xoma Corporation to purchase all rights to TCR vaccines
technology and for the exclusive right to





                                       44
<PAGE>   46

make, use and sell certain products pursuant to a sublicense agreement in
exchange for the issuance of two promissory notes totaling $2.2 million which
were repaid in February 1996. In addition to this note, the Company has accrued
additional consideration of $500,000 (included in other long-term liabilities),
which is payable by the Company upon the earlier of the achievement of
commencement of Phase III clinical trials for a product involving the licensed
technology, or six years from the date of the agreement. An additional
$1,000,000 will be payable by the Company upon FDA approval of a product
involving the licensed technology, and including royalties based on future
product sales. However, while the results of pilot clinical studies using TCR
vaccines for the treatment of rheumatoid arthritis and multiple sclerosis were
encouraging, the Company has suspended most of its activity in 1998 with respect
to TCR, to permit it to focus its resources on products closer to market. The
Company is evaluating its options, and intends to reach a decision regarding the
TCR program before the due date of the additional $500,000.

        Development, Commercialization and Supply Agreement

        In April 1998, the Company entered into a development, commercialization
and supply agreement with Suntory Pharmaceuticals, a division of Suntory Limited
of Osaka, Japan, for ConXn(R) for the treatment of scleroderma. Under the terms
of the agreement, Suntory will pay approximately $14.0 million in license fees
and milestone payments to the Company, be responsible for all development and
commercialization expenses in Japan, and pay royalties on sales in Japan for the
treatment of scleroderma. The Company has retained rights to all other
indications in Japan for ConXn. Suntory will purchase relaxin materials from the
Company and make milestone payments based upon development progress in the
United States and Japan. On April 30, 1998, Suntory paid an up-front license fee
of $1.5 million (net of $165,000 international withholding tax) to the Company.

6.      FINANCING ARRANGEMENTS

        Long-Term Debt

        On December 21, 1995, the Company entered into a term Loan and Security
Agreement (the "First Term Loan") with a bank consortium (the "Lenders") under
which the Company borrowed $5.0 million at the interest rate of 13% per year. In
connection with the First Term Loan, the Company issued a warrant to purchase
73,071 shares of Common Stock at an exercise price of $5.78 per share,
exercisable at any time through December 2002. In conjunction with the First
Term Loan, the Company granted the Lenders a first security interest in its
corporate assets. At December 31, 1998, the loan was paid in full.

        On September 24, 1998, the Company entered into a term Loan and Security
Agreement (the "Second Term Loan") with a bank (the "Lender"), which was
modified on December 22, 1998, under which the Company borrowed $4.0 million.
The Second Term Loan bears interest at prime rate plus 1.25% with interest only
payments for the first twelve months (through September 23, 1999), and to be
repaid thereafter in forty-eight (48) equal monthly installments of principal
plus accrued interest. On the first anniversary of the loan, the Company has the
right to elect whether the aggregate Second Term Loan outstanding will bear
interest at (i) a floating rate





                                       45
<PAGE>   47

equal to prime rate plus 1.25% or (ii) a fixed rate equal to 4.5 percentage
points above the yield of the 48 month Treasury Bill (fixed at the time of
election). In conjunction with the Second Term Loan, the Company granted the
Lender a first priority security interest in its presently existing intellectual
property collateral, as defined in the loan documents. Covenants governing the
Second Term Loan require the maintenance of certain financial ratios, and if the
Company does not meet the covenants during the loan period, a restricted cash
pledge must be made against 100% of the outstanding loan balance.

        Structured Equity Line Flexible Financing

        On December 2, 1996, the Company entered into a Structured Equity Line
Flexible Financing Agreement (the "Equity Line") with Kepler Capital LLC
("Kepler") that allows the Company to access up to $25 million through sales of
its Common Stock. The Equity Line, originally to be made available on or before
December 1, 1997, became available on June 26, 1998 and will remain open until
June 2001. During any 90-day period within the three year term, if the Company's
stock meets certain volume restrictions and trades above $10.00, then up to
$500,000 would be drawn against the Equity Line in exchange for the sale of
stock at an approximate minimum price of $10.00. The purchase price will be
subject to a maximum discount of 15%. As a commitment fee to Kepler for keeping
the equity line available, the Company has issued a warrant to purchase 250,000
shares of Common Stock (see Note 11). To date, the Company has not drawn down
any amount against the Equity Line.

7.      CAPITAL LEASE OBLIGATIONS AND CAPITAL LOANS

        The Company has capital lease and capital loan credit lines outstanding
totaling $1,364,000 at December 31, 1998. Under the terms of a master lease
agreement, ownership of the leased equipment reverts to the Company at the end
of the lease term.

        As of December 31, 1998, future minimum lease payments under capital
leases and principal payments on capital loans are as follows:

   
<TABLE>
<CAPTION>
                                                                  CAPITAL      CAPITAL
                                                                  LEASES        LOANS
                                                                  -------      -------
                                                                     (IN THOUSANDS)
    <S>                                                             <C>         <C> 
    Year ending December 31:
      1999.....................................................     $ 79        $225
      2000.....................................................       54         168
      2001.....................................................       39          --
      Thereafter ..............................................       --          --
                                                                    ----        ----
    Total minimum lease and principal payments, respectively...      172        $393
    Less amount representing interest .........................       22
                                                                    ----
    Present value of future payments ..........................      150
    Less current portion of capital lease obligations .........       66
                                                                    ----
    Non-current portion of capital lease obligations ..........     $ 84
                                                                    ====
</TABLE>
    

        The obligations under the capital leases and loans are secured by the
leasehold improvements and equipment financed, bear interest at fixed rates of
approximately 8% to 19% and are payable in monthly installments through
September 2001.





                                       46
<PAGE>   48

8.      OPERATING LEASES

        The Company leases two facilities under non-cancelable operating leases,
which expire in July 1999, with an option to extend the term of the lease for
one additional period of two years, and in March 1999, respectively. The Company
does not intend to extend the term of the lease expiring in March 1999. In
November 1998, the Company entered into a non-cancelable operating lease on a
third facility with a lease commencement date of January 1, 1999 and expiration
date of January 31, 2002. The future minimum rental payments under the leases
are as follows (in thousands):

<TABLE>
    <S>                                                               <C>   
    Years ending December 31:
    1999 .........................................................    $  627
    2000 .........................................................       314
    2001 .........................................................       315
    2002 .........................................................        26
                                                                      ------
                                                                      $1,282
                                                                      ======
</TABLE>

        The Company recognizes rent expenses on a straight-line basis over the
term of each lease. Rent expense under operating leases was approximately
$687,000, $639,000 and $425,000 for the years ended December 31, 1998, 1997 and
1996, respectively.

9.      NOTES RECEIVABLE FROM STOCKHOLDERS

        At December 31, 1998 and 1997, the Company held $65,000 and $75,000,
respectively, in notes receivable from certain stockholders for the purchase of
the Company's common stock. These notes bear interest at rates ranging from 6%
to 7% annually and are secured by the shares of common stock held by the
borrowers. The notes are due and payable, together with any unpaid interest, no
later than either the fourth or fifth anniversary of the note, or, for certain
of these notes, within 30 days of termination of employment with the Company. In
June 1998, one note was paid in full including accrued interest.

10.     REDEEMABLE CONVERTIBLE PREFERRED STOCK

        In December 1996, the Company issued 200 shares of 7% Series A
Redeemable Convertible Preferred Stock ("Series A Redeemable Preferred Stock"),
par value $0.001 per share, in a Regulation S offering at a per share price of
$10,000 with a mandatory redemption date of December 4, 1999. The Series A
Redeemable Preferred Stock had provisions for dividends and principal to be
converted into common stock according to a formula. As of January 31, 1998, all
200 shares of Series A Redeemable Preferred Stock plus accrued dividends of
$125,000 had been converted to 693,393 shares of common stock with a value of
$2,125,000.

11.     STOCKHOLDERS' EQUITY

        The Company is authorized to issue two classes of shares, common stock
(Common Stock) and preferred stock (Preferred Stock), each with par value of
$0.001 per share. Prior to the Company's initial public offering, two series of
Preferred Stock, Series A and B were issued.





                                       47
<PAGE>   49

In connection with the initial public offering of the Company's common stock in
February 1996, each previously outstanding share of preferred stock (an
aggregate of 3,965,137 shares) was converted into one share of common stock and
all previously authorized preferred stock was eliminated. The Company's
Certificate of Incorporation was restated to delete all references to Series A
and B of Preferred Stock, and to authorize a new class of 5,000,000 shares of
Preferred Stock.

        Warrants

        In July 1995, the Company issued warrants to purchase 18,395 shares of
Series B Preferred Stock at an exercise price of $4.89 per share pursuant to a
capital lease and capital loan agreement. Each such warrant was converted into a
warrant for the purchase of one share of common stock and such warrants are
exercisable any time through July 2002.

        In connection with a Master Bridge Loan Agreement with certain
stockholders of the Company in December 1995, the Company issued warrants that
expire in December 2000 to purchase a total of 22,727 shares of common stock at
an exercise price of $11.00 per share. Also in December 1995, in connection with
a loan and security agreement with a bank consortium, the Company issued
warrants, which expire in December 2002, to purchase 73,071 shares of common
stock at an exercise price of $5.78 per share.

        In conjunction with the Company's issuance of 200 shares of Series A
Redeemable Preferred Stock in December 1996 (see Note 10), warrants were issued
that allow the holders to purchase up to 20,000 shares of the Company's common
stock at an exercise price of $7.43 per share, with an expiration date of
December 4, 2001.

        In conjunction with the Equity Line (see Note 6), the Company issued a
warrant on January 2, 1997 to purchase 250,000 shares of common stock at an
exercise price of $8.25 per share. The warrant is exercisable over a period of 5
years from date of issuance. On each of the first, second and third
anniversaries of the beginning of the commitment period, the Company will issue
an additional five-year warrant exercisable for a number of shares based on the
amount of equity line still available to the Company.

        In conjunction with the Company's issuance of 1,810,000 shares in May
1997 to certain private investors, warrants were issued to purchase 905,000
shares of the Company's common stock at an exercise price of $9.08 per share.
These warrants will expire May 15, 2001.

        In January 1998, the Company issued a warrant to a third party to
purchase 6,000 shares of common stock at an exercise price of $6.00 per share as
partial compensation for services rendered to the Company in connection with a
private placement of the Company's Common Stock on December 15, 1997.

        Common Stock

        The Company has the right to repurchase, at the original issue price per
share, certain shares of common stock issued to employees, consultants,
investors and founders. This right generally expires ratably over a period of
time not greater than five years, in accordance with





                                       48
<PAGE>   50

terms determined by the Board of Directors. At December 31, 1998 and 1997,
outstanding shares of 389 and 36,202, respectively, were subject to repurchase
at an original issue price of $0.45 per share, including shares issued pursuant
to stock purchase rights under the 1994 Stock Plan (see Note 12).

        Dividend Restrictions

        The Company's loan agreement with a bank lender prohibits the Company
from declaring or paying a dividend without the bank's prior written consent.

        Common Shares Reserved for Future Issuance

        The Company has reserved shares of common stock as follows:

<TABLE>
<CAPTION>
                                                          DECEMBER 31,
                                                   -------------------------
                                                     1998            1997
                                                   ---------       ---------
    <S>                                            <C>             <C>      
    1994 Stock Plan ........................       2,150,495       1,706,467
    1995 Employee Stock Purchase Plan ......         289,538          46,147
    1995 Directors Stock Option Plan .......         250,000         150,000
    1998 Supplemental Stock Plan ...........         500,000              --
    Non-plan stock options outstanding .....          38,863          38,863
    Common stock warrants ..................       1,295,193       1,289,193
                                                   ---------       ---------
                                                   4,524,089       3,230,670
                                                   =========       =========
</TABLE>

12.     STOCK PLANS

        1994 Stock Plan

        The Company's 1994 Stock Plan (the "Plan") authorizes the Company's
Board of Directors (the "Board") to grant incentive stock options, non-statutory
stock options, and stock purchase rights for up to 2,600,000 shares of common
stock.

        The options under this Plan expire no later than ten years from the date
of grant. The exercise price of the incentive stock options, non-statutory stock
options and options granted to 10% shareholders shall be at least 100%, 85%, and
110%, respectively, of the fair value of the stock subject to the option on the
grant date. The price for shares purchased pursuant to stock purchase rights by
10% shareholders shall be at least 100% of the fair market value of the stock on
the date of grant.

        The options generally become exercisable at such times as determined by
the Board, but in no event at a rate of less than 20% per year for a period of
five (5) years from date of grant. Shares granted under the Plan pursuant to
stock purchase rights are generally subject to repurchase by the Company at the
original issue price per share. The Company's right to repurchase these shares
generally expires ratably over a period of time not greater than five years.





                                       49
<PAGE>   51

        1995 Director Stock Option Plan

        The 1995 Director Stock Option Plan (the "Directors' Plan") was adopted
by the Board in December 1995. A total of 250,000 shares of Common Stock have
been reserved for issuance under the Directors' Plan. The Directors' Plan
provides for the grant of non-statutory stock options to non-employee directors
of the Company.

        The Directors' Plan provides that each person who first becomes a
non-employee director of the Company shall be granted a non-statutory stock
option to purchase 30,000 shares of Common Stock (the "First Option") on the
date on which the optionee first becomes a non-employee director of the Company.
Thereafter, on the date of each annual meeting of the Company's stockholders,
each non-employee director shall be granted an additional option to purchase
7,500 shares of Common Stock (a "Subsequent Option") if, on such date, he or she
has served on the Board for at least six months.

        The Directors' Plan provides that the First Option shall become
exercisable in installments as to 25% of the total number of shares subject to
the First Option on each of the first, second, third and fourth anniversaries of
the date of grant of the First Option; each Subsequent Option shall become
exercisable in full on the first anniversary of the date of grant of that
Subsequent Option. The exercise price of all stock options granted under the
Directors' Plan shall be equal to the fair market value of a share of the
Company's Common Stock on the date of grant of the option. Options granted under
the Directors' Plan have a term of ten years. At December 31, 1998, 165,000
shares had been granted under the Directors' Plan and outstanding at a weighted
average price of $6.07, with 85,000 shares available for future grants.

        1998 Supplemental Stock Plan

        On November 5, 1998, the Board approved a new 1998 Supplemental Stock
Plan (the "Supplemental Plan") that provides the Board the authority to grant
non-statutory stock options to employees and consultants for up to 500,000
shares of common stock. Officers and directors of the Company are not eligible
for grants under the Supplemental Plan.

        The options under this Plan expire no later than ten years from the date
of grant. The exercise price of the non-statutory stock options shall be at
least 100% of the fair value of the stock subject to the option on the grant
date. The options generally become exercisable at such times as determined by
the Board, but in no event at a rate of less than 20% per year for a period of
five (5) years from date of grant.

        Non-Plan Stock Options

        The Company may from time to time grant options outside one of its
qualified plans ("Non Plan Stock Options"). As of December 31, 1998, a total of
64,612 Non Plan Stock Options were granted. At December 31, 1998, 38,863 shares
were outstanding at a weighted average price of $4.74 per share.

        Activity under the Plan, the Directors' Plan, Supplemental Stock Plan
and Non-Plan Stock Options is summarized as follows:





                                       50
<PAGE>   52

<TABLE>
<CAPTION>
                                                        OUTSTANDING OPTIONS
                                           -----------------------------------------
                                              SHARES                       WEIGHTED
                                           AVAILABLE FOR    NUMBER OF     AVG. PRICE
                                               GRANT          SHARES      PER SHARE
                                           -------------    ---------     ----------
<S>                                          <C>             <C>          <C>     
Balance, December 31, 1995 ...........        297,841         956,102      $   0.71
  Additional shares authorized .......        300,989              --            --
  Options granted ....................       (196,540)        196,540      $   8.76
  Options exercised ..................             --         (62,302)     $   0.45
  Shares repurchased .................         10,717              --      $   0.45
  Options canceled ...................         57,154         (57,154)     $   0.45
                                              -------       ---------
Balance, December 31, 1996 ...........        470,161       1,033,186      $   2.04
  Additional shares authorized .......        500,000              --            --
  Options granted ....................       (865,023)        904,635      $   6.15
  Options exercised ..................             --        (147,629)     $   0.67
  Shares repurchased .................             --              --            --
  Options canceled ...................         58,349         (58,349)     $   4.64
                                              -------       ---------
Balance, December 31, 1997 ...........        163,487       1,731,843      $   4.33
  Additional shares authorized .......      1,225,000              --            --
  Options granted ....................     (1,033,000)      1,033,000      $   3.68
  Options exercised ..................             --        (185,328)     $   0.80
  Shares repurchased .................          4,356              --      $   0.44
  Options canceled ...................        247,135        (247,135)     $   5.27
                                              -------       ---------
Balance, December 31, 1998 ...........        606,978       2,332,380      $   4.22
                                              =======       =========
</TABLE>

        The following table summarizes information concerning outstanding and
exercisable options at December 31, 1998:

<TABLE>
<CAPTION>
                               OPTIONS OUTSTANDING                 OPTIONS EXERCISABLE
                     -------------------------------------       ----------------------
                                    WEIGHTED-
                                      AVG.
                                    REMAINING     WEIGHTED                     WEIGHTED
                                   CONTRACTUAL      AVG.                         AVG.  
 RANGE OF             NUMBER OF     LIFE (IN      EXERCISE       NUMBER OF     EXERCISE
 EXERCISE PRICE        SHARES        YEARS)         PRICE         SHARES         PRICE
 --------------      ----------    -----------    --------       ---------     --------
<S>                     <C>            <C>           <C>          <C>             <C>  
 $0.44 - $ 2.22         480,502        6.73          $0.62        353,725         $0.66
 $2.56 - $ 3.88         672,250        6.36          $3.51         28,547         $3.63
 $4.00 - $ 4.31         477,563        8.99          $4.11         71,071         $4.23
 $4.50 - $ 7.13         516,275        8.30          $6.74        233,696         $7.02
 $7.50 - $11.00         185,790        7.55          $9.34        115,612         $9.60
                     ----------        ----          -----        -------         -----
 $0.44 - $11.00       2,332,380        7.50          $4.22        802,651         $4.22
</TABLE>

        For the years ended December 31, 1998 and 1997, the Company recorded
deferred compensation expense for the difference between the exercise price and
the deemed fair value of the Company's common stock, related to shares issued
pursuant to stock purchase rights and options granted in 1996 and 1995. These
options were granted to provide additional incentives to retain management and
key employees. This deferred compensation expense is being amortized over the
related vesting period, generally a 48-month period.





                                       51
<PAGE>   53

        1995 Employee Stock Purchase Plan

        The Company's 1995 Employee Stock Purchase Plan (the "Purchase Plan")
was adopted by the Board in December 1995. A total of 500,000 shares of Common
Stock has been reserved for issuance under the Purchase Plan. The Purchase Plan
is administered by the Compensation Committee of the Board. Employees (including
officers and employee directors) of the Company, or of any majority owned
subsidiary designated by the Board, are eligible to participate if they are
employed by the Company or any such subsidiary for at least 20 hours per week
and more than 5 months per year. The Purchase Plan permits eligible employees to
purchase Common Stock through payroll deductions, which may not exceed 15% of an
employee's compensation, at a price equal to the lower of 85% of the fair market
value of the Company's Common Stock at the beginning or end of the offering
period. During 1998 and 1997, 156,609 and 53,853 shares, respectively, had been
issued under the plan and 289,538 shares were reserved for future issuance as of
December 31, 1998.

        Pro Forma Information

        The Company adopted Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" (SFAS 123), in 1996. In accordance
with the provisions of SFAS 123, the Company applies APB Opinion No. 25 and
related interpretations in accounting for its stock option plans and,
accordingly, does not recognize compensation cost. If the Company had elected to
recognize compensation cost based on the fair value of the options granted at
grant date and including stock purchases under the Purchase Plan as prescribed
by SFAS 123, net loss and net loss per share would have been increased to the
pro forma amounts indicated in the table below:

<TABLE>
<CAPTION>
        (In thousands except per share amounts)      1998          1997          1996
                                                  ---------     ---------     --------- 
        <S>                                       <C>           <C>           <C>       
        Net loss - as reported .................  $ (26,595)    $ (27,935)    $ (18,514)
        Net loss - pro forma ...................  $ (27,964)    $ (29,287)    $ (19,339)
        Net loss per share - as reported........  $   (1.61)    $   (2.69)    $   (2.71)
        Net loss per share - pro forma..........  $   (1.69)    $   (2.81)    $   (2.83)
</TABLE>

        The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted average
assumptions:

   
<TABLE>
<CAPTION>
                                                    Stock Option Plans           Stock Purchase Plan
                                                -------------------------     -------------------------  
                                                 1998      1997      1996      1998     1997       1996
                                                -----     -----     -----     -----     -----     -----  
        <S>                                     <C>       <C>       <C>       <C>       <C>       <C>  
        Expected  stock price  volatility....   90.0%     60.0%     60.0%     76.6%     60.0%     60.0%
        Risk-free interest rate .............    4.74%     5.77%     5.91%     5.05%     5.63%     5.48%
        Expected life (in years) ............    3.8       4.1       3.6       0.5       0.5       0.5
        Expected dividend yield .............    0.0%      0.0%      0.0%      0.0%      0.0%      0.0%
</TABLE>
    

        The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options that have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions, including the expected stock price
volatility. Because the Company's options have characteristics significantly





                                       52
<PAGE>   54
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in the opinion
of management, the existing models do not necessarily provide a reliable single
measure of the fair value of its options. The weighted average fair value of
options granted during 1998 and 1997 was $2.44 and $3.12 per share,
respectively.

        The effects on pro forma disclosures of applying SFAS 123 are not likely
to be representative of the effects on pro forma disclosures of future years.

        1997 Stockholder Rights Plan

        In May 1997, the Company adopted a stockholder rights plan (the "Rights
Plan") that provides existing stockholders with the right to purchase one
one-thousandth of a share of the Company's Series B Participating Preferred
Stock, $0.001 par value, at an exercise price of $49 per one one-thousandth of a
preferred share in the event of certain changes in the Company's ownership. The
Company will be entitled to redeem the rights at $0.01 per right at any time on
or before the tenth day following acquisition by a person or group of 15% or
more of the Company's common stock. The Rights Plan may serve as a deterrent to
certain abusive takeover tactics that are not in the best interest of
stockholders. At December 31, 1998, 90,000 shares were designated under the
Rights Plan and no shares were issued and outstanding.


                                       53
<PAGE>   55
13. EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted earnings per
share:

<TABLE>
<CAPTION>
    (In thousands except per share amounts)                           1998         1997         1996
                                                                    --------     --------     -------- 
    <S>                                                             <C>          <C>          <C>      
    Numerator:
       Net loss                                                     $(26,595)    $(27,935)    $(18,514)
       Preferred stock dividends                                          (1)        (124)          --
                                                                    --------     --------     -------- 
       Numerator  for basic and  diluted  earnings  per share --
        loss to common stockholders                                  (26,596)     (28,059)     (18,514)

    Denominator:
       Denominator  for basic and diluted  earnings per share --
        weighted-average shares                                       16,533       10,412        6,825
    Basic and diluted net loss per share                            $  (1.61)    $  (2.69)    $  (2.71)
                                                                    ========     ========     ======== 
</TABLE>

Options to purchase 2,332,380 shares of common stock at exercise prices ranging
from $0.44 to $11.00 and warrants to purchase 1,295,193 shares of common stock
at exercise prices ranging from $4.89 to $11.00 were outstanding during 1998 but
were not included in the computation of diluted earnings per share as their
effect would be antidilutive.

14.     INCOME TAXES

        As of December 31, 1998, the Company had federal and state net operating
loss carryforwards of approximately $75,700,000 and $14,900,000, respectively.
The Company also had federal and California research and development tax credit
carryforwards of approximately $2,400,000 and $1,400,000, respectively. The
federal net operating loss and credit carryforwards will expire at various dates
beginning in the year 2008 through 2018, if not utilized. The state of
California net operating losses will expire at various dates beginning in 1999
through 2003, if not utilized.

        Utilization of the Company's net operating loss carryforwards and
credits may be subject to an annual limitation due to the "change in ownership"
provisions of the Internal Revenue Code of 1986 and similar state provisions.
The annual limitation may result in the expiration of net operating losses and
credits before utilization.

        Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets for financial reporting and
the amount used for income tax purposes.






                                       54
<PAGE>   56


        Significant components of the Company's deferred tax assets for federal
and state income taxes are as follows:

<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                     ----------------------
                                                       1998          1997
                                                     --------      --------
                                                         (IN THOUSANDS)
    <S>                                              <C>           <C>     
    Deferred tax assets
      Net operating loss carryforward ..........     $ 26,600      $ 21,000
      Capitalized research and development .....        3,100         2,400
      Research credit ..........................        3,300         1,900
      Other - Net ..............................        2,500           600
                                                     --------      --------
      Total Deferred Tax Assets ................       35,500        25,900
      Valuation allowance ......................      (35,500)      (25,900)
                                                     --------      --------
    Net deferred tax assets ....................     $     --      $     --
                                                     ========      ========
</TABLE>

        Due to the Company's lack of earnings history, the net deferred tax
assets have been fully offset by a valuation allowance. The net valuation
allowance increased by $9,600,000 and $11,400,000 for the fiscal years ended
December 31, 1998 and 1997, respectively.

15. SUBSEQUENT EVENT

        In January 1999, the Company entered into a development,
commercialization and supply agreement with Medeva PLC of the United Kingdom
("Medeva") for certain therapeutic indications pertaining to relaxin. Under the
terms of the agreement, Medeva paid $8.0 million upon closing which included a
$4.0 million development fee and a $4.0 million equity investment, and will pay
$17.0 million of milestone payments based upon development progress in the U.S.
and Europe and $5.0 million for the development and approval of each indication
in Europe in addition to scleroderma. Medeva is responsible for all development
and commercialization activities in Europe and is required to pay royalties on
sales in Europe. Medeva will reimburse the Company for 50% of its product
development costs in the U.S. up to a maximum of $1.0 million per quarter for an
estimated total of $10.0 million. Medeva also agreed to share U.S. co-promotion
rights with the Company for up to five years, and will also purchase relaxin
materials from the Company.

16. EVENTS SUBSEQUENT TO DATE OF AUDITORS' REPORT

        In February 1999, the Board approved, and recommended that the Company's
stockholders approve, a new 2000 Stock Plan (the "2000 Plan"). Initially, an
amount equal to three percent (3%) of shares issued and outstanding on December
31, 1999 will be authorized and available for future grants under the 2000 Plan.
Each year thereafter, on the first day of each new calendar year, the number of
shares available shall be increased (with no further action needed by the Board
or the stockholders) by a number of shares equal to the lesser of 3% of the
number of shares of common stock outstanding on the last preceding business day,
or an amount determined by the Board. Upon adoption by the stockholders of the
2000 Plan, the 1994 Plan and the Supplemental Plan will be terminated.

        On March 2, 1999, the Company announced that the Food and Drug
Administration granted marketing clearance to Luxiq(TM) (betamethasone valerate)
Foam, 0.12%, a novel foam formulation for relief of the inflammatory and
pruritic manifestations of corticosteroid-responsive dermatoses of the scalp.



                                       55
<PAGE>   57


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

There have been no disagreements with the independent public accountants on
accounting and financial disclosure.


                                    PART III

ITEM 10.       DIRECTORS AND EXECUTIVE OFFICERS OF CONNETICS

        The information required by this Item 10 regarding directors of the
Company is incorporated into this item by reference to the information set forth
under "Election of Directors" and "Further Information Concerning the Board of
Directors" in the Company's definitive Proxy Statement ("1999 Proxy Statement")
to be filed with the Securities and Exchange Commission and relating to the
Company's annual meeting of stockholders to be held May 19, 1999.

The officers of the Company are:

<TABLE>
<CAPTION>
NAME                               AGE                    POSITION
----                               ---                    --------
<S>                                <C>  <C>
Thomas G. Wiggans                  47   President, Chief Executive Officer and Director

W. Scott Harkonen, M.D             47   Sr. Vice President, Product Development and
                                        Operations
Robert G. Lederer                  54   Sr. Vice President, Commercial Operations

John L. Higgins                    29   Vice President, Finance and Administration and
                                        Chief Financial Officer
Katrina J. Church                  37   Vice President, Legal Affairs, Corporate
                                        Counsel and Secretary
Ernst H. Rinderknecht, Ph.D.       51   Vice President, Process Science and
                                        Manufacturing
</TABLE>


Thomas G. Wiggans has served as President, Chief Executive Officer and as a
director of the Company since July 1994. From February 1992 to April 1994, Mr.
Wiggans served as President and Chief Operating Officer of CytoTherapeutics, a
biotechnology company. From 1980 to February 1992, Mr. Wiggans served in various
positions at Ares-Serono Group, a pharmaceutical company, including President of
its U.S. pharmaceutical operations and Managing Director of its U.K.
pharmaceutical operations. From 1976 to 1980 he held various sales and marketing
positions with Eli Lilly & Co., a pharmaceutical company. He is currently a
director of the Biotechnology Industry Organization, and Chairman of its
Emerging Company Section. He was also President of the Board of Directors of the
Association of Biotechnology Companies. Mr.





                                       56
<PAGE>   58

Wiggans received his B.S. degree in Pharmacy from the University of Kansas and
his M.B.A. from Southern Methodist University.

W. Scott Harkonen has served as Senior Vice President, Product Development and
Operations of the Company since September 1995, and as President of InterMune
Pharmaceuticals, Inc., a wholly-owned subsidiary of the Company, since June
1998. From March 1991 to August 1995, Dr. Harkonen served as Vice President of
medical and regulatory affairs at Univax Biologics, Inc., a biotechnology
company. From May 1989 to February 1991, he served as Vice President, medical
and regulatory affairs at Scios Nova, Inc., a biotechnology company. He is
currently a director of Planet Biotechnology, a privately-owned
biopharmaceutical company. He received his B.A. and M.D. from the University of
Minnesota and M.B.A. from the University of California, Berkeley.

Robert G. Lederer joined the Company as Senior Vice President, Marketing and
Sales in July 1998, and his title was changed to Senior Vice President,
Commercial Operations in January 1999. Before joining the Company, Mr. Lederer
spent 15 years with Serono Laboratories, most recently as the Executive Vice
President for Business Operations. He joined Serono in 1983, and held various
positions within the sales organization, including Executive Vice President of
Serono's Infertility Business Unit from 1994 to 1997. Before joining Serono, Mr.
Lederer held sales and management positions with Becton Dickinson and Genovese
Drugs. Mr. Lederer received his B.A. from St. John's University in New York.

John L. Higgins has served as Vice President, Finance and Administration and
Chief Financial Officer since September 1997. From August 1994 to September
1997, he was a member of the management team at BioCryst Pharmaceuticals, Inc.,
a pharmaceutical company, serving most recently as Executive Vice President of
Corporate Development. From July 1992 to July 1994, Mr. Higgins was a member of
the health care banking team of Dillon, Read & Co. Inc., an investment banking
firm. While at Dillon, Read, he focused on financing and advisory assignments
for biotechnology and managed care companies. He received his A.B. in Economics
from Colgate University.

Katrina J. Church has served as Vice President, Legal Affairs and Corporate
Counsel since June 1998, and as Secretary since September 1998. Prior to joining
the Company, Ms. Church served as Vice President, General Counsel of VISX,
Incorporated, a medical device company, from January 1995 through June 22, 1998,
as Corporate Counsel from June 1991 through December 1994, and as Secretary from
May 1994 until June 22, 1998. Before joining VISX in 1991, Ms. Church practiced
law with the firm Hopkins & Carley in San Jose, California. Ms. Church received
her J.D. from the New York University School of Law, and her A.B. from Duke
University.

Ernst H. Rinderknecht has served as Vice President, Process Sciences and
Manufacturing of the Company since September 1994. From 1980 to September 1994,
Dr. Rinderknecht worked at Genentech in various positions, since 1987 as Staff
Scientist. He received his M.S. from the Swiss Federal Institute of Technology
(ETH) and Ph.D. in Biochemistry from the University of Zurich, Switzerland.






                                       57
<PAGE>   59

ITEM 11.       EXECUTIVE COMPENSATION

The information required by this Item 11 regarding compensation of Connetics'
directors and executive officers is incorporated into this item by reference
(except to the extent allowed by Item 402(a)(8) of Regulation S-K) to the 1999
Proxy Statement section entitled "Executive Compensation and Related
Information."

ITEM 12.       SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this Item 12 regarding beneficial ownership of the
Common Stock by certain beneficial owners and by management of the Company is
incorporated into this item by reference to the 1999 Proxy Statement section
entitled "Common Stock Ownership of Certain Beneficial Owners and Management."

ITEM 13.       CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this Item 13 regarding certain relationships and
related transactions with management of the Company is incorporated into this
item by reference to the 1999 Proxy Statement section entitled "Certain
Relationships and Related Transactions."


                                     PART IV

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

(A)     1.     Financial Statements. See Index to Consolidated Financial
               Statements at Item 8 on Page 32 of this Report.

        2.     Financial Statement Schedules. Financial statement schedules are
               omitted because they are not applicable or are not required as
               the information required to be set forth therein is included in
               the financial statements or notes thereto.

        3.     The Exhibits filed as a part of this Report are listed in the
               Index to Exhibits.

(B)     REPORTS ON FORM 8-K. No reports on Form 8-K were filed during the fourth
        quarter of 1998.

(C)     EXHIBITS.  See Index to Exhibits.

(D)     FINANCIAL STATEMENT SCHEDULES.  See Item 14(a)(2), above.








                                       58

<PAGE>   60

                                   SIGNATURES


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



                                           Connetics Corporation
                                           a Delaware corporation



                                           By: /s/ JOHN L. HIGGINS              
                                              ----------------------------------
                                              John L. Higgins
                                              Vice President, Finance and
                                              Administration and Chief Financial
                                              Officer

Date:  March 30, 1999


                                POWER OF ATTORNEY

        Each person whose signature appears below constitutes and appoints
Thomas G. Wiggans and John L. Higgins, and each of them, his attorneys-in-fact,
each with the power of substitution, for him in any and all capacities, to sign
any amendments to this Report on Form 10-K, and to file the same, with exhibits
thereto and other documents in connection therewith with the Securities and
Exchange Commission, granting to said attorneys-in-fact, or his substitute or
substitutes, the power and authority to 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 or could do in person, hereby ratifying and
confirming all that each of said attorneys-in-fact, or his substitute or
substitutes, may do or cause to be done by virtue hereof.

        Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons in the capacities and
on the dates indicated.

<TABLE>
<CAPTION>
SIGNATURE                                           TITLE                      DATE
---------                                           -----                      ----
<S>                                  <C>                                   <C>
PRINCIPAL EXECUTIVE OFFICER:

/s/  THOMAS G. WIGGANS               President, Chief Executive Officer    March 30, 1999
-------------------------------                 and Director
Thomas G. Wiggans
</TABLE>




                                       59
<PAGE>   61

<TABLE>
<CAPTION>
SIGNATURE                                           TITLE                      DATE
---------                                           -----                      ----
<S>                                  <C>                                   <C>
PRINCIPAL FINANCIAL AND
ACCOUNTING OFFICER:

/s/  JOHN L. HIGGINS                     Vice President, Finance and       March 30, 1999
-------------------------------      Administration and Chief Financial
John L. Higgins                                   Officer


CHAIRMAN OF THE BOARD:

/s/  G. KIRK RAAB                                 Director                 March 30, 1999
-------------------------------
G. Kirk Raab


ADDITIONAL DIRECTORS:

/s/  ALEXANDER E. BARKAS                          Director                 March 30, 1999
-------------------------------
Alexander E. Barkas

/s/  EUGENE A. BAUER                              Director                 March 30, 1999
-------------------------------
Eugene A. Bauer

/s/  BRIAN H. DOVEY                               Director                 March 30, 1999
-------------------------------
Brian H. Dovey

/s/  JOHN C. KANE                                 Director                 March 30, 1999
-------------------------------
John C. Kane

/s/  THOMAS D. KILEY                              Director                 March 30, 1999
-------------------------------
Thomas D. Kiley

/s/ KENNETH B. PLUMLEE                            Director                 March 30, 1999
-----------------------------
Kenneth B. Plumlee

/s/ JOSEPH J. RUVANE, JR.                         Director                 March 30, 1999
-----------------------------
Joseph J. Ruvane, Jr.
</TABLE>







                                       60
<PAGE>   62

                              CONNETICS CORPORATION
                                INDEX TO EXHIBITS
                                  [Item 14(c)]


<TABLE>
<CAPTION>
EXHIBIT
NUMBER       DESCRIPTION
-------      -----------
<S>          <C>
3.1*         Form of Amended and Restated Certificate of Incorporation
             (previously filed as an exhibit to the Company's Form S-1
             Registration Statement No. 33-80261)

3.2*         Form of Bylaws (previously filed as an exhibit to the Company's
             Form S-1 Registration Statement No. 33-80261)

3.3*         Certificate of Designation of 7% Redeemable Convertible Preferred
             Stock, Series A of Connective Therapeutics, Inc., as filed with the
             Delaware Secretary of State on December 4, 1996 (previously filed
             as an exhibit to the Company's Report on Form 8-K dated December 4,
             1996)

3.4*         Amendment to the Company's Amended and Restated Certificate of
             Incorporation, as filed with the Delaware Secretary of State on May
             15, 1997, changing the Company's name to Connetics Corporation
             (previously filed as an exhibit to the Company's Report on Form 8-K
             dated May 23, 1997)

3.5*         Certificate of Designation of Rights, Preferences and Privileges of
             Series B Participating Preferred Stock, as filed with the Delaware
             Secretary of State on May 15, 1997. Reference is made to Exhibit
             4.2.

4.1          Form of Common Stock Certificate

4.2*         Preferred Shares Rights Agreement, dated as of May 20, 1997,
             between the Company and U.S. Stock Transfer Corporation, including
             the Certificate of Designation of Rights, Preferences and
             Privileges of Series B Participating Preferred Stock, the form of
             Rights Certificate and the Summary of Rights attached thereto as
             Exhibits A, B and C, respectively (previously filed as an exhibit
             to the Company's Registration Statement on Form 8-A filed on May
             23, 1997)

10.1*        Form of Indemnification Agreement with the Company's directors and
             officers (previously filed as an exhibit to the Company's Form S-1
             Registration Statement No. 33-80261)

10.2(M)*     1994 Stock Plan, as amended, and form of Option Agreement
             (previously filed as an exhibit to Post-Effective Amendment No. 1
             to the Company's Form S-8 Registration Statement No. 333-04985)

10.3(M)*     1995 Employee Stock Purchase Plan, as amended, and form of
             Subscription Agreement (previously filed as an exhibit to
             Post-Effective Amendment No. 1 to the Company's Form S-8
             Registration Statement No. 333-04985)

10.4(M)*     1995 Directors' Stock Option Plan and form of Option Agreement
             (previously filed as an exhibit to the Company's Form S-1
             Registration Statement No. 33-80261)

10.5*        Third Amended and Restated Registration Rights Agreement dated
             February 14, 1995 among the registrant and certain security holders
             of the registrant and Amendments Nos. 1 and 2 thereto dated May 31,
             1995 and September 28, 1995 (previously filed as an exhibit to the
             Company's Form S-1 Registration Statement No. 33-80261)

10.6+*       License Agreement dated September 27, 1993, between Genentech, Inc.
             and the Company, Amendment dated July 14, 1994, and side letter
             agreement dated November 17, 1994 (previously filed as an exhibit
             to the Company's Form S-1 Registration Statement No. 33-80261)

10.7*        Assignment and Assumption Agreement, dated June 3, 1994, by and
             between the Company and XOMA Corporation (previously filed as an
             exhibit to the Company's Form S-1 Registration Statement No.
             33-80261)
</TABLE>





                                       61
<PAGE>   63

<TABLE>
<CAPTION>
EXHIBIT
NUMBER       DESCRIPTION
-------      -----------
<S>          <C>
10.8+*       Technology Acquisition Agreement dated June 3, 1994 by and between
             the Company and XOMA Corporation, and License Agreement dated
             February 27, 1990 by and between Arthur A. Vandenbark, Ph.D. and
             XOMA Corporation (previously filed as an exhibit to the Company's
             Form S-1 Registration Statement No. 33-80261)

10.9+*       Agreement on Interferon Gamma-1B dated December 8, 1995 by and
             between the Company and Genentech, Inc. (previously filed as an
             exhibit to the Company's Form S-1 Registration Statement No.
             33-80261)

10.11*       Business Loan Agreement, dated July 18, 1995, between the Company,
             Silicon Valley Bank and MMC/GATX Partnership No. 1 (previously
             filed as an exhibit to the Company's Form S-1 Registration
             Statement No. 33-80261)

10.12+*      Research Collaboration and Assignment Agreement, dated July 1,
             1994, between the Company and Dr. Arthur A. Vandenbark (previously
             filed as an exhibit to the Company's Form S-1 Registration
             Statement No. 33-80261)

10.13*       Consulting Agreement dated November 17, 1993 between the Company
             and Brian Seed (previously filed as an exhibit to the Company's
             Form S-1 Registration Statement No. 33-80261)

10.14*       Consulting Agreement dated November 17, 1993 between the Company
             and Eugene Bauer (previously filed as an exhibit to the Company's
             Form S-1 Registration Statement No. 33-80261)

10.15(M)*    Employment Agreement dated June 9, 1994 between the Company and
             Thomas Wiggans (previously filed as an exhibit to the Company's
             Form S-1 Registration Statement No. 33-80261)

10.16(M)*    Loan Agreements between the Company and Thomas Wiggans dated July
             15, 1994 and August 1, 1994 (previously filed as an exhibit to the
             Company's Form S-1 Registration Statement No. 33-80261)

10.17(M)*    Letter Agreement with G. Kirk Raab dated October 1, 1995
             (previously filed as an exhibit to the Company's Form S-1
             Registration Statement No. 33-80261)

10.18*       Facility Master Lease between the Company and Renault & Handley
             dated February 9, 1994 (previously filed as an exhibit to the
             Company's Form S-1 Registration Statement No. 33-80261)

10.19*       Loan and Security Agreement dated December 21, 1995 by and among
             the Company, Silicon Valley Bank and MMC/GATX Partnership No. 1
             (previously filed as an exhibit to the Company's Form S-1
             Registration Statement No. 33-80261)

10.20+*      Agreement on Relaxin Rights in Asia dated April 1, 1996 between the
             Company and Mitsubishi Chemical Corporation (previously filed as an
             exhibit to the Company's Quarterly Report on Form 10-Q for the
             fiscal quarter ended June 30, 1996)

10.21+*      Soltec License Agreement dated June 14, 1996 (previously filed as
             an exhibit to the Company's Quarterly Report on Form 10-Q for the
             fiscal quarter ended June 30, 1996)

10.22(M)*    Form of Directors and Officers Change in Control Agreement
             (previously filed as an exhibit to the Company's Quarterly Report
             on Form 10-Q for the fiscal quarter ended September 30, 1996)

10.23*       Common Stock Purchase Agreement, dated December 4, 1996 by and
             among the Company and certain investors (previously filed as an
             exhibit to the Company's Report on Form 8-K dated December 4, 1996)

10.24*       Registration Rights Agreement, dated December 4, 1996 by and among
             the Company and certain investors (previously filed as an exhibit
             to the Company's Report on Form 8-K dated December 4, 1996)
</TABLE>





                                       62
<PAGE>   64

<TABLE>
<CAPTION>
EXHIBIT
NUMBER       DESCRIPTION
-------      -----------
<S>          <C>
10.25*       Securities Purchase Agreement, dated December 4, 1996 by and among
             the Company and a certain purchaser (previously filed as an exhibit
             to the Company's Report on Form 8-K dated December 4, 1996)

10.26*       Warrant, dated December 4, 1996 between the Company and a certain
             purchaser (previously filed as an exhibit to the Company's Report
             on Form 8-K dated December 4, 1996)

10.27+*      Asset Purchase Agreement dated December 2, 1996 between the
             Company, SmithKline Beecham Corporation, SmithKline Beecham Pharma
             Inc., SmithKline Beecham Properties, Inc. and SmithKline Beecham
             Inter-American Corporation (previously filed as an exhibit to the
             Company's Report on Form 8-K dated January 15, 1997)

10.28*       Stock Issuance Agreement dated December 31, 1996 between the
             Company and SmithKline Beecham Properties, Inc (previously filed as
             an exhibit to the Company's Report on Form 8-K dated January 15,
             1997)

10.29*       Secured Promissory Note dated December 31, 1996 issued to
             SmithKline Beecham Corporation (previously filed as an exhibit to
             the Company's Report on Form 8-K dated January 15, 1997)

10.30*       Security Agreement dated December 31, 1996 between the Company and
             SmithKline Beecham Corporation (previously filed as an exhibit to
             the Company's Report on Form 8-K dated January 15, 1997)

10.31+*      Supply Agreement dated December 31, 1996 between the Company and
             SmithKline Beecham Corporation (previously filed as an exhibit to
             the Company's Report on Form 8-K dated January 15, 1997)

10.32*       Structured Equity Line Flexible Financing Agreement dated January
             2, 1997 between the Company and Kepler Capital LLC (previously
             filed as an exhibit to the Company's Annual Report on Form 10-K for
             the fiscal year ended December 31, 1996)

10.33*       Registration Rights Agreement dated January 2, 1997 between the
             Company and Kepler Capital LLC (previously filed as an exhibit to
             the Company's Annual Report on Form 10-K for the fiscal year ended
             December 31, 1996)

10.34(M)*    Form of Notice of Stock Option Grant to G. Kirk Raab for stock
             option issued in January 1997 (previously filed as an exhibit to
             Post-Effective Amendment No. 1 to the Company's Form S-8
             Registration Statement No. 333-04985)

10.35*       Common Stock and Warrant Purchase Agreement dated May 15, 1997 by
             and among the Company, Genentech, Inc. and certain investors
             (previously filed as an exhibit to the Company's Form S-3
             Registration Statement No. 333-21941)

10.36*       Registration Rights agreement dated May 15, 1997 by and among the
             Company and certain investors (previously filed as an exhibit to
             the Company's Form S-3 Registration Statement No. 333-21941)

10.37*       Form of Common Stock Purchase Warrant issued to certain investors
             on May 15, 1997 (previously filed as an exhibit to the Company's
             Form S-3 Registration Statement No. 333-21941)

10.38(M)*    Secured Loan Agreement dated October 30, 1997 between the Company
             and W. Scott Harkonen (previously filed as an exhibit to the
             Company's Form S-1 Registration Statement No. 333-41195)

10.39*       Amendment dated November 13, 1997 to Secured Promissory Note dated
             December 31, 1996 issued to SmithKline Beecham Corporation
             (previously filed as an exhibit to the Company's Form S-1
             Registration Statement No. 333-41195)

10.40*       Letter Agreement dated November 26, 1997 between the Company and
             Gerard Klauer Mattison & Co., Inc. (previously filed as an exhibit
             to the Company's Form S-1 Registration Statement No. 333-41195)
</TABLE>





                                       63
<PAGE>   65

<TABLE>
<CAPTION>
EXHIBIT
NUMBER       DESCRIPTION
-------      -----------
<S>          <C>
10.41*       Omnibus Agreement with SmithKline Beecham Corporation and related
             entities dated December 18, 1997 (previously filed as an exhibit to
             the Company's Form S-1 Registration Statement No. 333-41195)

10.42*       Canadian Asset Purchase Agreement with Pharmascience, Inc. dated
             December 19, 1997 (previously filed as an exhibit to the Company's
             Form S-1 Registration Statement No. 333-41195)

10.43*       Supply Agreement with Pharmascience, Inc. dated December 19, 1997
             (previously filed as an exhibit to the Company's Form S-1
             Registration Statement No. 333-41195)

10.44*+      License Agreement dated January 1, 1998 between the Company and
             Soltec Research Pty Limited (previously filed as an exhibit to the
             Company's Annual Report on Form 10-K for the fiscal year ended
             December 31, 1997)

10.45+*      Agreement on Relaxin dated January 19, 1998 by and between the
             Company and Howard Florey Institute of Experimental Physiology and
             Medicine (previously filed as an exhibit to the Company's Annual
             Report on Form 10-K for the fiscal year ended December 31, 1997)

10.46*       Common Stock Purchase Agreement dated April 10, 1998 by and among
             the Company and certain investors (previously filed as Exhibit 10.1
             to the Company's Report on Form 8-K dated May 6, 1998)

10.47*       Registration Rights Agreement dated April 10, 1998 by and among the
             Company and certain investors (previously filed as an exhibit to
             the Company's Report on Form 8-K dated May 6, 1998)

10.48*+      Agreement dated as of April 23, 1998 between the Company and 
             Suntory Limited (previously filed as Exhibit 10.1 to the Company's
             Report on Form 10-Q for the quarter ended June 30, 1998)

10.49*+      Second Omnibus Agreement with SmithKline Beecham Corporation and
             related entities dated April 28, 1998 (previously filed as an
             exhibit to the Company's Current Report on Form 8-K filed May 6,
             1998)

10.50*+      License Agreement dated as of May 5, 1998 between the Company and
             Genentech, Inc. (previously filed as Exhibit 10.2 to the Company's
             Report on Form 10-Q for the quarter ended June 30, 1998)

10.51*+      Supply Agreement dated as of May 5, 1998 between the Company and
             Genentech, Inc. (previously filed as Exhibit 10.3 to the Company's
             Report on Form 10-Q for the quarter ended June 30, 1998)

10.52*       Stock Purchase Agreement dated May 5, 1998 between the Company and
             Genentech, Inc. (previously filed as Exhibit 10.4 to the Company's
             Form S-3 Registration Statement No. 333-69055)

10.53*       Common Stock Purchase Agreement dated November 20, 1998 by and
             among the Company and certain investors (previously filed as
             Exhibit 10.1 to the Company's Form S-3 Registration Statement No.
             333-69055)

10.54*       Registration Rights Agreement dated November 20, 1998 by and among
             the Company and certain investors (previously filed as Exhibit 10.2
             to the Company's Form S-3 Registration Statement No. 333-69055)

10.55(M)     Secured Loan Agreement and associated documents dated January 9,
             1998, between the Company and John L. Higgins

10.56(M)     Letter of Employment dated July 1, 1998 from the Company to Robert
             G. Lederer

10.57(M)     Loan Agreement and associated documents dated August 21, 1998,
             between the Company and Robert G. Lederer

10.58        Loan and Security Agreement between Silicon Valley Bank and the
             Company dated September 24, 1998, as modified December 22, 1998
             pursuant to a Loan Modification Agreement
</TABLE>





                                       64
<PAGE>   66

<TABLE>
<CAPTION>
EXHIBIT
NUMBER       DESCRIPTION
-------      -----------
<S>          <C>
10.59(M)     Restricted Common Stock Purchase Agreement dated November 5, 1998
             between the Company and Kirk Raab

10.60(M)     1998 Supplemental Stock Plan

10.61        Industrial Building Lease dated November 20, 1998, by and between
             the Company and West Bayshore Associates, a general partnership, et
             al.

10.62(C)     Relaxin Scale-up and Bulk Supply Agreement effective as of December
             1, 1998, by and between the Company and Bender + Co. Ges.m.b.H.

10.63        Amendment No. One to License Agreement, effective December 28,
             1998, between the Company and Genentech

10.64        Amendment No. One to Stock Purchase Agreement, effective December
             28, 1998, between the Company and Genentech

10.65(C)     Relaxin Development, Commercialization and License Agreement dated
             January 11, 1999 by and between the Company and Medeva
             Pharmaceuticals, Inc.

10.66        Common Stock Purchase Agreement, dated January 11, 1999, by and
             between the Company and Medeva PLC

10.67        Registration Rights Agreement, dated January 11, 1999 by and
             between the Company and Medeva PLC

21.1         Subsidiaries

23.1         Consent of Ernst & Young LLP, Independent Auditors

24.1         Power of Attorney (see page 60-)

27.1         Financial Data Schedule (EDGAR filed version only)
</TABLE>

--------

*     Previously filed.

(M)   This item is a management compensatory plan or arrangement required to be
      listed as an exhibit to this form pursuant to Item 601(a)(10)(iii) of
      Regulation S-K.

(C)   The Company has omitted certain portions of this Exhibit and has requested
      confidential treatment of such portions from the SEC.

+     Confidential treatment has been requested and granted for certain portions
      of this Exhibit.






                                       65