<PAGE>   1
                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549


                                    FORM 10-K

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

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997,

                                       OR

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

              For the Transition period from _________ to_________.



                         COMMISSION FILE NUMBER: 0-27406

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


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

3400 WEST BAYSHORE ROAD, PALO ALTO, CALIFORNIA                 94303
   (Address of principal executive offices)                  (zip code)

       Registrant's telephone number, including area code: (650) 843-2800

        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 was approximately $48,113,852 as of February 27, 1998, based upon
the closing sale price on the Nasdaq National Market reported for such date.
Shares of Common Stock held by each officer and director and by each person who
owns 5% of more of the outstanding Common Stock have been excluded in that such
persons may be deemed to be affiliates. This determination of affiliate status
is not necessarily a conclusive determination for other purposes.

        There were 13,515,509 shares of Registrant's Common Stock issued and
outstanding as of February 27, 1998.

        The "C with interlocking hemisphere" logo (used alone and with the
Company's name), "Connetics", "ConXn(R)", "Ridaura(R)" and "Betamousse(TM)" are
trademarks of the Company. All other tradenames and trademarks appearing in this
Prospectus are the property of their respective holders.

                       DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates information by reference from the definitive proxy
statement for the Annual Meeting of Stockholders to be held on May 22, 1998.


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                                     PART I


ITEM 1. BUSINESS

        Special Note: The following discussion contains certain forward-looking
statements that involve risks and uncertainties that could cause actual results
or events to differ materially from those projected in such forward-looking
statements. Potential risks and uncertainties include, without limitation, those
factors below under the heading "Additional Factors That May Affect Future
Results."

Connetics Corporation ("Connetics" or 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."

The Company is focused on the development and commercialization of therapeutics
to address serious diseases involving the connective tissues of the body.
Connective tissues are components of the body that form structural or binding
elements such as skin, joints, ligaments and lining of organs, and form the
three-dimensional structure that allows cells to function normally. The diseases
or conditions initially addressed by the Company include scleroderma, rheumatoid
arthritis, psoriasis, multiple sclerosis, and keloids; many of these fall within
the broad category of autoimmune diseases. Patients suffering from these
conditions experience a variety of chronic problems depending on the particular
condition, including hardening of the skin and internal organs, severe scarring,
lack of mobility and extensive rashes and lesions. The most severe of these
diseases cause painful disfigurement, disability and, in certain cases, death.
The Company estimates that over five million Americans suffer from its targeted
diseases in their various forms, with over five billion dollars spent annually
on treatments that are mostly palliative in nature. The Company has several
products in development addressing these disease indications: ConXn(R)
(recombinant human relaxin H2) ("relaxin"), betamethasone valerate quick break
foam ("betamethasone mousse"), clobetasol propionate quick break foam
("clobetasol mousse"), T cell receptor peptide therapeutic vaccines ("TCR
vaccines"), and gamma interferon (1b) ("gamma interferon"). In December 1996,
the Company acquired the exclusive U.S. rights to Ridaura(R) (auranofin), an
approved disease modifying antirheumatic drug approved for sale, from SmithKline
Beecham Corporation and affiliated entities ("SmithKline).

Relaxin

Relaxin is a naturally occurring protein that is known to promote remodeling of
connective tissues. The Company is developing relaxin for the treatment of
scleroderma, as well as other connective tissue diseases. Scleroderma, a
disorder characterized by thickening and hardening of the skin and internal
organs, 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.
This disease affects over 300,000 individuals in the United States and, in its
severe form (known as systemic sclerosis, which affects approximately 70,000
individuals in the U.S.), has a five-year mortality rate of 50%-70%. Research by
two of the Company's founders and their colleagues has shown that relaxin can
inhibit excessive connective tissue formation and promote connective tissue
remodeling. Results from several clinical trials in individuals with systemic
sclerosis indicated that continuous administration of relaxin was well
tolerated, without any serious drug-related adverse effects. In June 1997, the
Company announced results of a 64 patient Phase II clinical trial which showed
that administration of relaxin caused a statistically significant reduction in
skin score (a measure of disease progression) and a trend toward improvement in
eleven other disease parameters. Thus, relaxin may have a 


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beneficial effect on connective tissue turnover and may provide a treatment for
scleroderma. The Company has met with the U.S. Food and Drug Administration
(FDA), and based on that meeting, plans to begin a pivotal trial of relaxin in
1998. 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.

Betamethasone Mousse

The Company has an exclusive license to develop and market betamethasone mousse
(a quick break foam formulation of the dermatologic drug, betamethasone
valerate) in North America. The product has been approved for sale in the United
Kingdom and is being marketed in the U.K. by Evans Medical Ltd. In August 1997,
the Company announced that results from its Phase III clinical trial with
betamethasone mousse 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. In
December 1997, the Company submitted a New Drug Application (NDA) with the FDA
to market the product for use in all steroid-responsive dermatoses, including
psoriasis, The NDA has been accepted for filing by the FDA.

Clobetasol Mousse

Following its development progress with betamethasone mousse, the Company is
now developing a second mousse product, clobetasol mousse. Clobetasol mousse is
a quick break foam formulation of clobetasol propionate, a super high potency
corticosteriod. In January 1998, the Company acquired exclusive rights to
develop and market the drug in North America. The Company intends to initiate a
Phase III trial for the treatment of severe psoriasis and skin dermatoses during
1998.

TCR Vaccines

The Company is developing TCR vaccines for the treatment of autoimmune diseases.
Connetics has two TCR vaccines product programs in development for multiple
sclerosis and rheumatoid arthritis. These diseases collectively disable over two
million people nationwide, with combined annual treatment costs exceeding two
billion dollars. Results from early clinical trials designed to assess the
immunogenicity of TCR vaccines in multiple sclerosis suggest that a number of
patients achieved the desired immune response to the vaccine and that the
vaccine was well tolerated. The Company is also conducting a pilot clinical
study using TCR vaccines for the treatment of rheumatoid arthritis.

Gamma Interferon

Gamma interferon is one of a family of proteins involved in the regulation of
the immune system and has been shown to inhibit the production of collagen, the
primary component of connective tissue. Gamma interferon is approved by the FDA
and marketed by Genentech, Inc. ("Genentech") for a rare, serious immune
disease, known as chronic granulomatous disease (CGD). The Company is developing
gamma interferon for the treatment of keloids, which are unsightly, painful,
elevated scars resulting from collagen overproduction. The Company is currently
conducting a Phase II clinical trial for the treatment of keloids. In August
1997, the Company also announced results from a Phase III trial of gamma
interferon 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. As a result, the Company suspended plans to submit a
biological license application for gamma interferon for the treatment of atopic
dermatitis. Full 


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analysis of the data from the trial was completed in December 1997 where areas
of drug activity were seen, and as a result, the Company is evaluating further
development opportunities for gamma interferon.

Ridaura(R)

In December 1996, the Company acquired the exclusive U.S. and Canadian rights to
Ridaura (auranofin), a disease modifying antirheumatic drug, from SmithKline.
Ridaura is an established therapy for rheumatoid arthritis, an autoimmune
disease that afflicts one to two percent of adult Americans (approximately three
million people), mostly women. Under its agreement with SmithKline, the Company
acquired all U.S. and Canadian rights, title and interest to Ridaura, including
intellectual property rights, along with related assets such as customer lists,
contracts, product files and unfilled customer orders. Although the primary
patents for Ridaura expired in 1989 and 1992, the Company intends to use the
other valuable intellectual property rights and assets acquired in connection
with its marketing of the product in the United States. Connetics began
marketing Ridaura through in its own sales force in mid-1997. Through agreements
with SmithKline, customer orders and distribution for the product were managed
by SmithKline through 1997 and SmithKline will manufacture and supply Ridaura in
final finished package form to the Company for an initial term of five years.
The Company has established a relationship with CORD Logistics, Inc. ("CORD"), a
distribution company located in Nashville, Tennessee and has been shipping
Ridaura through CORD since December 15, 1997. In December 1997, the Company sold
the Canadian rights to Ridaura to, and entered into a supply agreement with,
Pharmascience Inc., a Canadian company, for a net consideration of $1,300,000.

Corporate Strategy

The Company's strategy is to: (i) focus on the treatment of serious and chronic
diseases involving connective tissues caused by inflammation, abnormal
remodeling and autoimmune disorders, (ii) target its initial commercial
activities at rheumatologists and dermatologists, which can be effectively
served by focused and specialized sales and marketing activities, (iii) expand
its existing product portfolio and pursue early commercialization opportunities
by in-licensing other therapeutically related products that are already marketed
or in late stage clinical development, (iv) pursue earlier stage opportunities
in the field of connective tissue disorders with high potential, (v) leverage
its product development and commercialization expertise by pursuing additional
specialized diseases and markets, (vi) utilize corporate partnerships to pursue
new business opportunities and overseas licensing of the Company's products in
development and (vii) minimize drug discovery costs, manufacturing costs and
capital requirements.

BACKGROUND

Connective tissue is composed of cells (such as fibroblasts) and the
extracellular matrix (such as collagen-containing fibers) produced by these
cells. Organs of the body such as lungs, kidneys and skin function normally in
part because of the precise three-dimensional arrangement of specialized cells
within a connective tissue framework. Alterations in this framework affect organ
function.

DISEASES INVOLVING CONNECTIVE TISSUE

Inflammation

Inflammation is a natural response to tissue injury and is necessary for normal
healing. During normal wound healing, tissue repair follows an orderly
progression of immune cell infiltration, new blood vessel formation and
connective tissue deposition and remodeling. Under abnormal conditions,
inappropriate 


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regulation of the immune cells results in either local or widespread tissue
injury. Many disorders associated with inflammation occur in response to an
unknown stimulus that misdirects the inflammation process against normal tissue.
This lack of appropriate regulation generally results in chronic, progressive
disease conditions that may ultimately lead to dysfunction or destruction of the
affected organ system.

Abnormal Remodeling

Connective tissue undergoes constant turnover through a normal remodeling
process that links the breakdown of the collagen-based extracellular matrix with
the synthesis of new collagen. The body's ability to regulate this process
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 the increase in or breakdown of collagen. Both
excessive formation or destruction of connective tissue can result in serious
disease. There is currently no approved therapy that has been documented to have
significant beneficial effect on the clinical course of abnormal remodeling.

As an example, the overproduction of collagen can result in severe systemic
disorders, such as scleroderma and pulmonary fibrosis, keloid formation and
hypertrophic scarring. Scleroderma is one of the most serious diseases involving
the uncontrolled formation of connective tissue. Approximately 300,000
individuals, primarily women, suffer from various forms of this disease, with
approximately 70,000 having severe or systemic sclerosis, otherwise known as
diffuse scleroderma. In its most severe form, the disease has a five year
mortality rate in 50-70% of cases. 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. Pulmonary fibrosis represents a group of diseases associated with
chronic inflammation and increase in fibrotic tissue in the walls of the
alveolar spaces in the lung. Ultimately, these diseases result in scarring of
lung tissue, impairment of lung function, and in many cases, death.
Approximately 144,000 individuals suffer from pulmonary fibrosis. Pulmonary
fibrosis is primarily treated by pulmonologists, oncologists and
rheumatologists. Keloids and hypertrophic scars are abnormal healing responses
that occur in the skin, resulting in large, painful, elevated scars that are
unattractive in appearance. There are approximately 300,000 patients treated by
dermatologists and plastic surgeons for keloids every year.

Autoimmune Disorders

Connective tissue can also 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.

For example, rheumatoid arthritis is an autoimmune disease that attacks the
connective tissue in the joints. Rheumatoid arthritis is a chronic disease in
which the body's immune system leads to an attack on synovial tissue, resulting
in progressive, painful inflammation and destruction of the joints. In advanced
stages of the disease, symptoms include severe pain, body disfigurement and loss
of mobility. It is estimated that between one and two percent of the adult U.S.
population, or more than two million individuals, have 


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rheumatoid arthritis. Women are three times more susceptible than men. No
current therapy cures the disease and often its progression cannot be stopped.
The efficacy of currently used drugs tends to be directly correlated with
systemic toxicity. Rheumatoid arthritis is primarily treated by rheumatologists.

CONNETICS STRATEGY

The key elements of the Company's strategy include:

-   Focus on the Treatment of Serious and Chronic Diseases Involving Connective
    Tissue. The Company's products and technologies are initially focused on the
    treatment of diseases involving connective tissues caused by inflammation,
    abnormal remodeling and autoimmune disorders. These diseases include serious
    skin and skin structure diseases such as psoriasis, scleroderma, organ
    fibroses, rheumatoid arthritis, multiple sclerosis and keloids. Although
    individually these diseases have been the subject of many research programs,
    no concentrated effort has been aimed at the market segment as a whole,
    representing significant and currently underserved therapeutic market
    opportunities.

-   Develop a Marketing Organization Targeting Rheumatologists and
    Dermatologists. The Company is targeting its initial commercial activities
    at rheumatologists and dermatologists, which can be served by a focused,
    specialized marketing organization. Scalp psoriasis and skin dermatoses,
    betamethasone mousse's target indications, and keloids, gamma interferon's
    lead indication, are treated primarily by dermatologists. Scleroderma,
    ConXn's lead indication, and rheumatoid arthritis, treated by Ridaura, are
    primarily treated by rheumatologists. With the acquisition of rights to
    Ridaura the Company was able to enter the U.S. rheumatology market in
    December 1996. The Company's strategy is to target its marketing activities
    to the approximately 3,000 rheumatologists and 7,000 dermatologists
    practicing in the United States. In addition, because rheumatologists and
    dermatologists are primarily concentrated in major metropolitan areas, they
    can be effectively served by a relatively small sales force.

-   In-License Development Stage and currently Marketed Products. The Company
    expects to continue to in-license and acquire rights to development products
    and currently marketed products in the areas of rheumatology and
    dermatology. To date, the Company has in-licensed both relaxin and gamma
    interferon from Genentech, and has acquired rights to TCR vaccines
    technology primarily from Genentech and XOMA Corporation. In addition, the
    Company has acquired exclusive license rights to betamethasone and
    clobetasol mousse and the mousse delivery technology from Soltec Research
    Pty Ltd., and exclusive U.S. rights to Ridaura from SmithKline. 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 significant opportunities to in-license or acquire
    additional products from pharmaceutical companies that are not being
    developed or optimally promoted by these companies or do not fit in the
    present business strategy of such companies, or from research and academic
    institutions. The Company believes it is well-positioned to expand its
    product portfolio by licensing such products because of its market focus,
    complementary products in development and relevant management experience in
    product development and marketing. The Company believes that this strategy
    can result in accelerated development and commercialization of novel
    products to treat serious diseases involving connective tissue at
    significantly lower capital requirements than most biotechnology companies
    while minimizing the Company's exposure to the risks inherent in drug
    discovery and basic research.

-   Leverage Product Development and Commercialization Expertise. The Company is
    leveraging its product pipeline by developing its products for multiple
    indications. The Company believes certain of 


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    its products can be developed for significant markets and high-value
    opportunities in addition to its primary markets. An example of leveraging a
    product is the development of ConXn for scleroderma, organ fibrosis and
    infertility. To target such uses, the Company plans to either retain such
    products in-house or license them to third parties.

-   Utilize Corporate Partnerships to Pursue Additional Markets. In its
    strategic markets, the Company plans 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. The Company is pursuing collaborative relationships
    to provide funding and consulting support for the Company's research and
    development programs and to assist in the clinical and regulatory
    development and commercialization of specific products outside of the United
    States.

-   Minimize Drug Discovery and Manufacturing Costs. The Company has sought to
    minimize the costs of drug discovery and manufacturing by in-licensing
    later-stage development and currently marketed products, outsourcing
    manufacturing and utilizing research collaborators and consultants. To date,
    the Company's clinical supplies have been manufactured by third parties on a
    contract basis. The Company also initially intends to use third parties for
    the manufacture of its commercial products, including Ridaura, which is
    being manufactured for the Company by SmithKline through December 2001. The
    Company believes it will be able to minimize costly infrastructure by
    continuing to use external resources where appropriate.

PRODUCT DEVELOPMENT

The Company has products in various stages of development as illustrated in the
table below:

<TABLE>
<CAPTION>
PRODUCT                          INDICATION                            DEVELOPMENT STATUS
-------                          ----------                            ------------------

<S>                              <C>                                   <C>
Betamethasone Mousse             Psoriasis                             NDA filed
Clobetasol Mousse                Severe Psoriasis / Skin Dermatoses    Pivotal Trial (scheduled to begin in 1998)
ConXn(R)                         Scleroderma                           Pivotal Trial (scheduled to begin in 1998)
                                 Organ Fibrosis                        Pre-clinical
                                 Infertility                           Pre-clinical
TCR Peptide Vaccine              Multiple Sclerosis                    Phase I/II
                                 Rheumatoid Arthritis                  Phase I
Gamma Interferon                 Keloids                               Phase II
</TABLE>


Betamethasone Mousse Program

In June 1996, the Company signed an agreement with Soltec Research Pty Ltd.
which granted Connetics an exclusive license to develop and market betamethasone
mousse in North America. The product is being marketed in the United Kingdom by
Evans Medical Ltd., a division of Medeva PLC. Betamethasone mousse is a
quick-break foam formulation of betamethasone valerate, a mid-potency
corticosteroid currently marketed in the U.S. The 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 


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acceptability may enhance patient compliance. The U.S. market for mid-potency
corticosteriods is estimated to be $200 million per year.

Psoriasis. 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. In a comparative
clinical trial of betamethasone mousse against placebo in scalp psoriasis
patients in the U.K., patients treated with betamethasone mousse showed
statistically significant improvement in erythema (redness), scaling and plaque
thickness. The product was well tolerated and no adverse systemic effects were
observed.

In August 1997, the Company announced results from its Phase III clinical trial
of betamethasone mousse. The results demonstrated statistically significant
improvement over both placebo and a currently marketed betamethasone lotion for
the treatment of scalp psoriasis. The 190-patient, placebo-controlled,
randomized, double-blind, multi-center Phase III study demonstrated that
patients treated with betamethasone mousse, administered twice-daily for 28
days, experienced a statistically significant improvement over patients in the
groups treated with betamethasone lotion, or placebo, in all endpoints,
including erythema (redness of the skin), plaque thickness and scaling. In
addition, study investigators completed a physicians global assessment which
showed that overall, approximately 67% of patients treated with the mousse
formulation had complete or almost complete clearance of symptoms compared with
46% for lotion and 19% for placebo in an intent to treat analysis. Both
betamethasone mousse and lotion were generally well tolerated. The Company
submitted a New Drug Application (NDA) with the FDA to market the product for
use in all steroid-responsive dermatoses, including psoriasis, in December 1997.
The NDA has been accepted for filing by the FDA.

Clobetasol Mousse Program

In January 1998, the Company entered into an agreement with Soltec Research Pty
Ltd., and exercised an option to exclusively develop and market clobetasol
mousse in North America. Clobetasol mousse is a quick break foam formulation of
clobetasol propionate, a super high-potency corticosteriod currently marketed in
the United States. Clobetasol mousse utilizes a drug formulation similar to the
Company's betamethasone mousse product, whereby it remains a foam at room
temperature and then liquefies when applied to the body, facilitating the
delivery of active dermatologic agent. The Company plans to begin a Phase III
clinical trial of this product in 1998 for the treatment of severe psoriasis and
skin dermatoses. The U.S. market for high and super high potency corticosteriods
is estimated to be $300 million per year.

ConXn Development Program

ConXn is a naturally occurring peptide hormone that promotes remodeling of
connective tissues. Research by two of the Company's founders and their
colleagues has shown that ConXn can inhibit excessive connective tissue
formation and promote connective tissue remodeling through at least three
mechanisms: inhibiting the production of collagen by fibroblasts, increasing the
production of collagenase (the enzyme that breaks down collagen) and decreasing
the production of TIMP (a protein that blocks collagenase action). These results
have been confirmed by in vitro studies and in vivo animal models of human
disease. ConXn can now be produced in significant quantities by outside
contractors using the Company's recombinant manufacturing techniques. Connetics
is currently developing the recombinant form of ConXn 


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for use in the treatment of scleroderma and other fibrotic conditions, including
various organ fibroses and in vitro fertilization.

Scleroderma. Scleroderma, also called systemic sclerosis in its advanced stages,
is a generalized disorder of connective tissue characterized clinically by
thickening and fibrosis of the skin and internal organs, including the heart,
lungs, kidneys and gastrointestinal tract. Although the underlying cause of this
disease is unknown, the overproduction and accumulation of collagen and other
extracellular matrix proteins in skin and other organs often leads to severe and
painful disfigurement, quality of life impairment, dysfunction of vital organs
and death. There are in excess of 300,000 individuals suffering from
scleroderma, of which approximately 70,000 have the most severe form. In the
most severe form, the disease has a five-year mortality rate of 50-70%. There
are no effective treatments for this disease; current therapies are directed
toward alleviating the symptoms of the disease, not the underlying cause.

In 1995, the Company completed a Phase I/II clinical trial for recombinant human
ConXn in patients with scleroderma. This study examined the safety and
pharmacokinetics of continuous subcutaneous infusion of ConXn for 28 days at
five different dose levels compared to placebo. Thirty patients with a history
of at least two years with systemic sclerosis were enrolled in a randomized,
double-blind, placebo-controlled trial. Administration of ConXn was well
tolerated through 28 days at all dose levels. In addition, during global
assessments performed at the end of the study, ten of 20 patients receiving
ConXn reported improvement versus two of ten patients receiving placebo. No
serious adverse events were observed and no patients dropped out of the study.
These safety and pharmacokinetic observations support continued clinical
evaluation of ConXn for the treatment of scleroderma.

In June 1997, the Company announced results from its Phase II clinical trial.
The double-blind, placebo-controlled study involved 64 patients randomized into
one of two treatment groups (25 or 100 ug/kg/day), or placebo. In the group
receiving a dose of 25 ug/kg/day, statistical significance was found in skin
score improvement, the primary clinical endpoint, and positive trends were seen
in eleven other parameters. As suggested by previous studies, the higher dose
had no effect on the treatment group compared to placebo. Based upon these
results, and a meeting with the FDA, the Company plans to begin a pivotal trial
of ConXn for the treatment of scleroderma in 1998.

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 ConXn may have
potential in treating organ fibroses, such as pulmonary fibrosis. Pulmonary
fibrosis, also known as interstitial lung disease, represents a group of
diseases associated with chronic inflammation and excessive production of
collagen in the walls of the alveolar spaces in the lung. Approximately 144,000
individuals in the United States 


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suffer from this disease. In the case of idiopathic pulmonary fibrosis the
underlying cause of the fibrosis is unknown, while other cases may be associated
with another disease process, such as scleroderma, or due to exposure to toxic
drugs or environmental agents. Current therapy for pulmonary fibrosis consists
of corticosteroids and cytotoxic drugs such as cyclophosphamide, which, when
utilized, are largely ineffective.

Infertility. Infertility is a serious problem that affects approximately one in
seven couples in the United States. The Company and external collaborators
recently accumulated data indicating that relaxin may be involved in encouraging
new blood vessel growth in the uterine lining and that this increased blood flow
enhances conception success. Furthermore, higher levels of relaxin expression in
preclinical studies are correlated with successful pregnancy and term delivery.
Relaxin therapy may therefore be useful in the treatment of infertility in in
vitro fertilization procedures, as well as in natural and other artificial
reproductive cycles. The Company plans to continue its assessment of these data,
and if promising, begin a development program for relaxin use in in vitro
fertilization.

T-Cell Receptor ("TCR") Peptide Development Program

The Company is also developing TCR peptide vaccines to arrest the autoimmune
disease process. As with other therapeutic vaccines, TCR technology is being
developed to help the body elicit an immune response against disease-causing
agents. In the case of autoimmune diseases, the disease-causing agents are
believed to be pathogenic T-cells. TCR vaccines are based upon the CDR2 of
pathogenic T-cells and 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 which produce anti-inflammatory cytokines. Connetics has two
TCR vaccine programs in development, one for multiple sclerosis and one for
rheumatoid arthritis.

Multiple Sclerosis. Multiple sclerosis is an autoimmune disease of the central
nervous system that results from damage to myelin, a substance that encircles
and insulates nerve fibers. Multiple sclerosis can result in impaired mobility,
visual impairment, slurred speech, poor bladder control, sexual dysfunction and,
ultimately, confinement to a wheelchair. Approximately 270,000 persons suffer
from multiple sclerosis in the United States. The cost of treatment in the
United States alone is expected to grow to $1.7 billion worldwide by 1999. None
of the currently available treatments address the underlying cause of the
disease.

In January 1998, the Company reported results from a multi-center Phase I/II
clinical testing of TCR peptide vaccines for the treatment of multiple
sclerosis. The Phase I/II study involved 106 patients with multiple sclerosis.
The trial evaluated safety and immunogenicity of the Company's proprietary TCR
vaccine being developed to elicit a heightened immune response against the
pathogenic T-cells believed to cause multiple sclerosis. Preliminary results
from this study indicate that administration of the TCR vaccine was safe and
well tolerated following three months of treatment. The response rate for TCR
vaccinated patients was similar to the response rate observed for TCR vaccinated
patients in previous studies. In this Phase I/II study, the response rate of
vaccine treated patients was approximately double the response rate of placebo
treated patients.

Rheumatoid Arthritis. Rheumatoid arthritis is a chronic disease in which the
body's immune system attacks synovial tissue in joints, resulting in
progressive, systemic and painful inflammation and erosion of joints. In
advanced phases of the disease, symptoms include severe pain, body disfigurement
and loss of mobility. The cause of rheumatoid arthritis is unknown, though
environmental toxins, certain pathogens and genetic factors have been
implicated. It is estimated that between one and two percent of the 


                                      -10-
<PAGE>   11
worldwide adult population, including approximately three 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.
None of these therapies stops progression completely or reverses the damage.

At the tissue level, there is mounting evidence to suggest that T-cells present
at the sites of inflammation cause fibroblast dysfunction that leads to
destruction of the joint capsule. Company investigators have analyzed the
frequency of T-cells with certain types of receptors in patients with rheumatoid
arthritis. Through such studies the Company has identified peptides which mimic
these receptors and which may be useful as therapeutic vaccines. Company
investigators and their collaborators have performed parallel studies in animal
models of arthritis in which disease relevant T cells with specific receptor
configurations have been defined. Therapeutic vaccines based upon the relevant
protein sequences were produced and demonstrated to control the disease process.
Based on these studies, in 1997 the Company initiated a pilot clinical trial of
TCR Vaccines for rheumatoid arthritis.

As part of its TCR vaccines research program, Connetics has established a
methodology for identifying and isolating disease-causing T cells, which the
Company may use to develop additional products based on its TCR vaccine
technology to treat diseases such as inflammatory bowel disease, psoriasis and
type I diabetes. The TCRs from relevant T cells are analyzed and the resulting
amino acid sequence information is used to chemically synthesize therapeutic
vaccine peptides. The Company believes that these TCR peptides can be
administered to the patient as a disease-specific immune booster to halt the
progress of the autoimmune disease. The Company further believes that, because
TCR peptides selectively inhibit only certain T cells, side effects resulting
from general, non-specific immunosuppression can be avoided.

Gamma Interferon Development Program

Gamma interferon is a member of a family of proteins involved in the regulation
of the immune system, and has been shown to be effective in the treatment of
certain immune-mediated diseases. Gamma interferon is an FDA licensed product,
manufactured and marketed by Genentech for an orphan disease, chronic
granulomatous disease (CGD). Gamma interferon also has been shown to inhibit the
production of IgE (a type of antibody) and collagen. The Company is developing
gamma interferon for use in the treatment of keloids.

Keloids are abnormal healing responses caused by excess collagen production, and
typically occur in the skin of susceptible individuals resulting in large,
painful, elevated scars which are usually unattractive in appearance. There are
approximately 300,000 patients treated by dermatologists and plastic surgeons
for keloids every year. Although existing therapies are potentially efficacious,
recurrence after therapy is frequent.

In vitro studies have shown that gamma interferon can inhibit collagen synthesis
and production. Early-stage clinical trials conducted by independent
investigators in collaboration with Genentech have shown preliminary results
indicating that gamma interferon may be efficacious in the treatment of keloids
and hypertrophic scars. Based on in vitro and clinical information, the Company
is conducting a 40 patient Phase II clinical trial to demonstrate the efficacy
of gamma interferon therapy in patients with keloids.

In August 1997, the Company announced the results from its Phase III clinical
trial of gamma interferon for the treatment of atopic dermatitis. Analysis of
the trial did not show an acceptable therapeutic response with respect to the
primary clinical endpoint - a composite clinical severity index based upon
erythema, 


                                      -11-
<PAGE>   12
papulation (swelling) and excoriation (scratch marks). As a result, the Company
announced that it has suspended plans to submit a Biological License Application
(BLA) for gamma interferon for the treatment of atopic dermatitis. Further
analysis of the data from the trial suggested evidence of drug activity for
certain endpoints. The Company is currently evaluating additional development
opportunities for gamma interferon.

MARKETED PRODUCT

On December 31, 1996, the Company acquired the exclusive U.S. and Canadian
rights to Ridaura from SmithKline. Ridaura is an oral formulation of a gold salt
(auranofin). Also classified as a disease-modifying antirheumatic drug
("DMARD"), 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.

Rheumatoid arthritis. Rheumatoid arthritis is an autoimmune disease that
afflicts one to two percent of adult Americans (approximately 3 million
patients), with women three times more susceptible than men. It is characterized
by inflammation of synovial tissues with joint pain, swelling and stiffness.
Although autoimmune arthritis can afflict children and adolescents, the
incidences of clinical illness is greatest among those aged 40 to 60 years.
Rheumatoid arthritis is an extremely disabling disease that carries a high
degree of morbidity.

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 established a relationship with CORD, a
distribution company located in Nashville, Tennessee and has been shipping
Ridaura through CORD since December 15, 1997.

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.

COLLABORATIVE RELATIONSHIPS

The Company's initial technologies were licensed from Genentech and XOMA. As
part of its business strategy, the Company has entered into and continues to
explore strategic collaborative relationships 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
complement and expand its existing portfolio. The Company is seeking
collaborative agreements with pharmaceutical companies as sources of additional
products and as partners for the development and marketing of existing products.
See "-- Connetics Strategy," "-- Marketing and Sales."

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), including rights
licensed to Genentech from the Howard Florey Institute of Experimental
Physiology and Medicine in Melbourne, Australia (the "Florey Institute").
Connetics also has rights to future developments regarding relaxin. 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. The Company is 


                                      -12-
<PAGE>   13
responsible for meeting certain milestones and making payments for supplies
provided under the September 1993 Agreement. Failure to timely achieve
designated milestones may result in termination of the agreement by Genentech
and a license on a non-exclusive basis to Genentech of relaxin technology
developed by the Company. In July 1994, Genentech and Connetics amended the
September 1993 Agreement to clarify the Company's right to sub-license the
relaxin technology, subject to a right of first offer held by Genentech, which
expired in January 1998. The Company's rights to relaxin were expanded 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.

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. In addition, the Company is engaged
in discussions with a number of pharmaceutical companies regarding development,
marketing and sales alliances for ConXn for the European and Asian markets.
There can be no assurance that any of the agreements described in this paragraph
will be consummated on a timely basis, or at all.

In December 1995, Genentech and Connetics entered into an agreement with respect
to gamma interferon pursuant to which the Company acquired exclusive development
and marketing rights in the United States for dermatologic indications. This
Agreement includes supply provisions on the part of Genentech and obligates the
Company to pay for such supply, providing for a profit margin and an allowance
for the Company's expenses in developing and marketing the product.

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 with the right to sublicense.

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 three-year scientific
collaboration relating to the development of the TCR Peptide vaccines. The
agreement, which was renewed in June 1997 for another two year term, provides
that the Company pays the Portland Veterans Affairs Research Foundation in order
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 of products not already covered by the XOMA Agreement. In
addition, the Company granted to Dr. Vandenbark options to purchase the
Company's Common Stock, which vest upon the achievement of certain milestones.

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 


                                      -13-
<PAGE>   14
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.

Soltec. In June 1996, the Company entered into an exclusive License Agreement
with Soltec Research Pty Ltd. to develop and market betamethasone mousse (a
quick break foam formulation of the dermatologic drug, betamethasone valerate)
in North America. Under the terms of the agreement, 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 mousse system for the delivery of other compounds and, in
January 1998, exercised such option for clobetasol propionate, a super high
potency topical steroid.

Molecular Medicine Research Institute ("MMRI"). In October 1996, the Company
entered into a Laboratory Services Agreement with MMRI covering two years of
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.

SmithKline. In December 1996, the Company entered into an agreement with
SmithKline under which the Company acquired exclusive United States rights to
Ridaura. Through agreements with SmithKline, customer orders and distribution
for the product were managed by SmithKline through 1997 and SmithKline will
manufacture and supply Ridaura (in final finished package form) to the Company
through December 2001. Distribution of Ridaura is conducted by CORD on the
Company's behalf.

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., a granted patent in Europe, and various international equivalents in
addition to other applications that remain pending. The issued relaxin patents
will expire at various times between 2003 and 2012. The Company's TCR vaccine
patent portfolio 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. Issued international patents (Europe, Australia and Israel)
expire in 2010, an issued U.S. patent expires in 2014 and patents issuing on the
pending U.S. and international applications would expire at various times
beginning in 2010. Extensions may be available for certain key patents in the
U.S. and Europe (subject to statutory changes before product approval). The
Company's gamma interferon 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. See
"Collaborative Relationships."

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 


                                      -14-
<PAGE>   15
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, therefore, 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. In the event that any claims of third-party patents are upheld as valid
and enforceable with respect to a product or process made, used or sold by the
Company, the Company 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.

In March 1997, the Company announced that the United States Patent and Trademark
Office had awarded the Company a patent (U.S. Patent Number 5,614,192) covering
TCR peptides and functional derivatives encompassing the second complementarity
determining region (CDR2) as compositions of matter, formulations (including
peptide cocktails) and methods of treatment of T-cell mediated diseases. In
January 1998, the Company announced that a patent in Europe was granted for the
same claims.

The Company has become aware that third parties have obtained patents generally
relating to TCR Vaccines technology, including a U.S. patent issued to Immune
Response Corporation on March 18, 1997. 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 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 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. If such patents were successfully asserted, the Company could be
required to obtain licenses or redesign its TCR Vaccines products or processes
to avoid infringement and could be liable to pay damages, or could be prevented
from commercializing TCR Vaccines. 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. 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. Moreover, patent applications in
the U.S. are maintained in secrecy until issue, and publication of discoveries
in the scientific or patent literature often lag behind actual discoveries, so
the Company cannot be certain that it is aware of all potentially relevant
pending applications and it is not possible to predict with any certainty the
scope of claims that could issue from such a third party's pending application.
The Company anticipates that an interference will be declared between one or
more of its TCR Peptide technology patent applications and those of one or more
of its competitors including the above-referenced patent of Immune Response
Corporation to determine priority of invention, which could result in
substantial cost to the Company even if the eventual outcome is favorable. It is
not possible to know in advance the invention dates that such other parties may
be able to prove, so the Company cannot 


                                      -15-
<PAGE>   16
know whether its or its licensors' inventors are the first for inventions
covered by their pending patent applications or that it or its licensors were
the first to file patent applications for such inventions. 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 operation, 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 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 rheumatology and dermatology 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 in the changing health care market, and in particular products directed
toward focused, specialty markets. The Company is targeting its initial
commercial activities at rheumatologists and dermatologists, which can be served
by a focused and specialized marketing organization. The Company has commenced
marketing and sales operations with the deployment of its initial 14 sales
representatives. This sales organization will market the Company's in-licensed
and internally developed products. The Company expects to expand the sales force
as it prepares to launch additional products. With regard to Ridaura, the
Company had a transitional services agreement with SmithKline which ended
December 31, 1997 whereby SmithKline performed order entry, packaging, shipping,
invoicing and credit and collection services for Ridaura on behalf of the
Company. The Company transitioned these functions on December 15, 1997 to CORD
Logistics, Inc.

Outside the United States, the Company's strategy is to establish development,
marketing and distribution agreements with pharmaceutical companies. The Company
is engaged in discussions with a number of pharmaceutical companies regarding
development, marketing and sales alliances for both ConXn and its TCR vaccine
products for the European and Asian markets, although there can be no assurance
that any such alliances will be consummated.

As of December 31, 1997, the Company had 18 employees devoted to marketing and
sales.

MANUFACTURING

The Company contracts with independent sources to manufacture its products,
which enables the Company to focus on its product and clinical development
strengths, minimize fixed costs and capital expenditures, and gain access to
advanced manufacturing process capabilities. Gamma interferon is manufactured by
Genentech and Parke-Davis. ConXn has been manufactured for Connetics under
contract with four outside vendors: BASF Bioresearch Corp. for fermentation,
Scios Nova, Inc. for purification, Chesapeake Biological Laboratory for filling
and Tektagen, Inc. for testing. TCR vaccines are manufactured by 


                                      -16-
<PAGE>   17
American Peptide Company and Multiple Peptide Systems. The Company is in
discussions with additional manufacturers who can supply ConXn and TCR vaccines
for clinical and commercial uses. Ridaura is manufactured by SmithKline (in
final finished package form) under an agreement with an initial term through
December 2001. Betamathasone mousse is manufactured for Connetics by CCL
Pharmaceuticals.

The Company's strategy is to continue to use manufacturing agreements for the
production of its current and future products.

COMPETITION

The biopharmaceutical industry is highly competitive. 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. In particular, with respect to TCR Vaccines, the
Company is aware that other companies and research institutions are engaged in
research and development efforts and are in various stages of clinical trials
with respect to rheumatoid arthritis and other autoimmune diseases. 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. 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 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. (See Additional Factors that May Affect Future Results - "Competition
and Technological Change")

GOVERNMENT REGULATION

FDA Regulation and Product Approval. Regulation by governmental entities in the
United States and other countries will be a significant factor in the production
and marketing of any pharmaceutical products which are or may be developed by
the Company. 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 other approval
procedures by the FDA in the United States and similar health authorities in
foreign countries. Various federal and, in some cases, state statutes and
regulations also govern or influence the manufacturing, safety, labeling,
storage, record keeping and marketing of such pharmaceutical products. The
process of obtaining these approvals and the subsequent compliance with
appropriate federal and foreign statutes and regulations are time-consuming and
require the expenditure of substantial resources.

Generally, in order to 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 


                                      -17-
<PAGE>   18
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 three phases and generally take two to five years, but may take longer,
to complete. "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 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 a new drug application ("NDA"), if the product is classified as a new
drug, or a biologic license application ("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. While the Company will endeavor to secure expedited review and approval
when possible, 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. If questions arise
during the FDA review process, approval can take more than five years. Even if
FDA regulatory clearances are obtained, a marketed product is subject to
continual review, and later discovery of previously unknown problems or failure
to comply with the applicable regulatory requirements may result in restrictions
on the marketing of a product or withdrawal of the product from the market,
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 under development 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. If the Company succeeds in bringing one or more of its development
products to market, there can be no assurance that such products 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. In response to concerns
about the rising costs of advanced medical technologies, the current
administration of the federal government has in the past publicly stated its
desire to reform health care, including the possibility of price controls and
revised reimbursement policies; while the administration is no longer pursuing
major initiatives, there can be no assurance that any future actions taken by
the administration with regard to health care reform will not have a material
adverse effect on the Company. If any actions are taken by the administration,
such actions could adversely affect the prospects for future sales of the
Company's products. Further, 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 


                                      -18-
<PAGE>   19
business, 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.

Given recent government initiatives directed at lowering the total cost of
health care throughout the United States, it is likely that the United States
Congress and state legislatures will continue to focus on health care reform and
the cost of prescription pharmaceuticals, as well as on the reform of the
Medicare and Medicaid systems. The Company cannot predict the likelihood of
passage of federal and state legislation related to health care reform or
lowering pharmaceutical costs. 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. There can be no assurance that the Company will not be required to
incur significant costs to comply with environmental laws and regulations as its
research activities are increased or that the operations, business and future
profitability of the Company will not be adversely affected by current or future
environmental laws and regulations.

SCIENTIFIC ADVISORY BOARD AND OTHER ADVISORS

Connetics utilizes 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 established a Scientific
Advisory Board ("SAB") consisting of distinguished scientists and clinicians
with expertise in biologic processes and diseases that involve the connective
tissues of the body. All of the individuals on the SAB are recognized as leading
authorities in their fields.

The members of the SAB are as follows:

<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 member of the SAB has entered into an agreement with the Company covering
the terms of his position as a member of the SAB. Each member provides services
on an as-needed basis. Three members 


                                      -19-
<PAGE>   20
of the SAB have entered into separate agreements with the Company covering
additional consultation above and beyond their activities as SAB members.
Certain SAB members hold options to purchase or have purchased Common Stock of
the Company. In addition, members of the SAB receive a fee of $1,000 for
attending any SAB meeting and are reimbursed for out-of-pocket expenses incurred
in attending each meeting. All members of the SAB 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.

Employees

The Company had 72 full-time employees at December 31, 1997, of which 35 are
engaged in, or directly support, the Company's research and development
activities. The Company also uses outside consultants. The Company considers
relations with its employees to be good. None of the Company's employees is
covered by a collective bargaining agreement.


ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS

         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 important
factors, as well as other 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.

DEVELOPMENT STAGE COMPANY; UNCERTAINTY OF PRODUCT DEVELOPMENT AND MARKET
ACCEPTANCE

From its inception until its acquisition of Ridaura in December 1996, Connetics
was a development stage company. Except for Ridaura, all of the Company's
products are in clinical or preclinical development, and no revenues were
generated from products until December 1996, when the Company recognized
$428,000 in December product in connection with the Ridaura acquisition. To
date, the Company's resources have been primarily dedicated to the research and
development of products that the Company has in-licensed from Genentech and
others. Although the Company believes it has the expertise to develop and
commercialize such products, any or all of the Company's products may fail to be
effective or prove to have undesirable and unintended side effects or other
characteristics that may prevent their development or regulatory approval, or
limit their commercial use. For instance, in August 1997 the Company announced
results from a Phase III trial of gamma interferon for the treatment of atopic
dermatitis. The results indicated that the product did not show an acceptable
therapeutic response with respect to the primary clinical endpoint, and as a
result, the Company suspended plans to submit a biological license application
for gamma interferon for the treatment of atopic dermatitis.

There can be no assurance that the Company, or its collaborative partners, will
be permitted to undertake human clinical trials for any of their development
products not currently in clinical trials or, if permitted, that such products
will be demonstrated to be safe and effective. In addition, there can be no
assurance that any of the Company's products under development will obtain
approval from the FDA or equivalent 


                                      -20-
<PAGE>   21
foreign authorities for any indication or that an approved compound will be
capable of being produced in commercial quantities at reasonable costs and
successfully marketed. Products, if any, resulting from the Company's research
and development programs are not expected to be commercially available within
the next year. Even if such products become commercially available, there can be
no assurance that the Company will be able to gain satisfactory market
acceptance for such products.

LIMITED OPERATING HISTORY; HISTORY OF LOSSES; UNCERTAINTY OF FUTURE
PROFITABILITY

Due to its limited operating history, the Company is subject to the
uncertainties and risks associated with any new business. Having no
commercialized products until the December 1996 Ridaura acquisition, the Company
has experienced operating losses every year since its incorporation. Net losses
for the fiscal years ended December 31, 1997, 1996 and 1995 were $27.9 million,
$18.5 million and $10.4 million, respectively, and the Company had an
accumulated deficit of $65.9 million at December 31, 1997. The Company expects
to incur increasing operating losses for the next few years and the amount of
net losses and the time required by the Company to reach profitability are
uncertain. 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.

UNPREDICTABILITY OF CONDUCTING PRECLINICAL AND CLINICAL TRIALS

The Company is conducting a Phase I clinical trial of TCR Vaccines for the
treatment of rheumatoid arthritis and a Phase II trial of gamma interferon for
keloids. In addition, in 1998 the Company intends to commence a pivotal trial of
ConXn for the treatment of scleroderma and a Phase III trial of clobetasol
mousse for the treatment of severe psoriasis and skin dermatoses. There can be
no assurance that the Company will be able to successfully complete its ongoing
clinical trials or commence any future trials. In addition, there can be no
assurance that the Company will meet its development schedule for any of its
products in development. 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. For instance, in August
1997 the Company announced results from a Phase III trial of gamma interferon
for the treatment of atopic dermatitis. The results indicated that the product
did not show an acceptable therapeutic response with respect to the primary
clinical endpoint, and as a result, the Company suspended plans to submit a
biological license application for gamma interferon for the treatment of atopic
dermatitis. 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.

In addition, because the Company will, in a number of cases, rely on its
contractual rights to access data collected by others in phases of its clinical
trials, the Company is dependent on the continued satisfaction by such parties
of their contractual obligations to provide such access and cooperate with the
Company in the execution of successful filings with the FDA. There can be no
assurance that the FDA will permit such reliance. If the Company were unable to
rely on clinical data collected by others, the Company may be required to repeat
clinical trials, which could significantly delay commercialization, and require
significantly greater capital.

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


                                      -21-
<PAGE>   22
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.

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.

FUTURE CAPITAL REQUIREMENTS AND UNCERTAINTY OF FUTURE FUNDING; DILUTIVE AND
OTHER EFFECTS OF EQUITY LINE AGREEMENT

The Company expects that its current cash and cash equivalents, short-term
investments, cash generated from the sale of Ridaura and funds available under
its capital loan will be sufficient to fund the Company's operations through the
fourth quarter of 1998. The development of the Company's products (other than
Ridaura) will require the commitment of substantial resources to conduct the
time-consuming research and development, clinical studies and regulatory
activities necessary to bring any potential medical product to market and to
establish production, marketing and sales capabilities. The Company will need to
raise substantial additional funds for these purposes. The Company may seek such
additional funding through collaborative arrangements and through public or
private financings, including equity financings. Any additional equity
financing, if available, will be dilutive to stockholders and any debt
financing, if available, may restrict the Company's ability to pay dividends on
its capital stock or the manner in which the Company conducts its business.
Under the terms of an equity line agreement, the Company has secured an equity
line that potentially allows the Company to raise up to $25 million from a
certain institutional investor over a three-year period beginning on December 1,
1997; however, this equity line is currently unavailable to the Company since
the Company does not currently meet a requirement that the trading price for its
Common Stock be at least $7.00 per share. Other than this equity line, the
Company currently has no commitments for any additional financings and there can
be no assurance that any such financings will be available to the Company or
that adequate funds for the Company's operations, whether from financial
markets, collaborative or other arrangements with corporate partners or from
other sources, will be available when needed or on terms attractive to the
Company. The inability to obtain sufficient funds may 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 third
parties the rights to commercialize products or technologies that the Company
would otherwise seek to develop and market itself.

While the equity line arrangement discussed above may help provide the Company
with additional future financing, the sale of shares thereunder will have a
dilutive impact on other stockholders of the Company. As a result, the market
price of the Company's Common Stock could be materially and adversely affected,
and if the Company is profitable, the Company's net income per share could be
materially decreased in future periods. In addition, the shares to be issued
under the Equity Line Agreement will be issued at a discount (of up to 15%) to
the then-prevailing market price of the Company's Common Stock. These discounted
sales could have an immediate adverse effect on the market price of the
Company's Common Stock. The Company also has an obligation to register the
shares to be issued under the equity line before the start of the commitment
period; therefore, the shares sold under the Equity Line Agreement will
generally be eligible for immediate resale, which could further adversely affect
the Company's stock price. 


                                      -22-
<PAGE>   23
Finally, the equity line arrangement will not be available to the Company if its
trading price remains below $7.00 per share and certain other pricing conditions
are not met, which could require the Company to seek funds from other sources
(with the attendant risk factors set forth in the preceding paragraph).

As a commitment fee to the equity line investor, the Company has issued a
five-year warrant exercisable for 250,000 shares of Common Stock at an exercise
price of $8.25 per share. On each of the first, second, and third anniversaries
of the beginning of the equity line commitment period, the Company will issue
the equity line investor an additional five-year warrant exercisable for a
number of shares based on the amount of the equity line unused by the Company in
the preceding year (up to a maximum of 25,000 shares if the Company has not
drawn any amount under the equity line during the year and decreasing to zero to
the extent the Company has drawn down up to $8.33 million during the year). The
Company is obligated to file a registration statement covering the resale of the
shares issuable upon the exercise of such additional warrants. The issuance and
exercise of any such additional warrants would have a dilutive effect on the
Company's stockholders and could have an adverse effect on the Company's stock
price, as could the resale of the shares acquired thereunder.

POTENTIAL FLUCTUATIONS IN OPERATING RESULTS

The Company had no revenues from products from its inception until December
1996, when it recognized $428,000 in December product revenues from Ridaura. For
the year ended December 31, 1997, the Company recognized $6.8 million in product
revenue from Ridaura which was below the Company's preliminary projections at
the time of its acquisition of Ridaura. As Ridaura generates additional revenue,
there can be no assurance that growth in Ridaura revenue will be achieved, that
current revenue levels will be maintained, or that the Company will ever be
profitable on a quarterly or annual basis in the future. As noted above, the
Company expects to incur quarterly and annual operating losses for at least the
next several years. The Company's quarterly and annual operating results may
fluctuate significantly in the future depending on such factors as the timing
and shipment of significant Ridaura orders, if any, changes in pricing policies
by the Company and its competitors, the timing and market acceptance of any new
products introduced by the Company, the mix of distribution channels through
which Ridaura and other products (if any) are sold, and the Company's inability
to obtain sufficient supplies for its products. In response to competitive
pressures or new product introductions, the Company may take certain pricing or
other actions that could materially and adversely affect the Company's operating
results.


MANAGEMENT OF RIDAURA PRODUCT; UNCERTAINTY OF FUTURE RIDAURA REVENUES;
OFF-PATENT STATUS OF RIDAURA

The Company's success will depend in part on its ability to manage the marketing
and sales of Ridaura. SmithKline's management of the Company's distribution
operations ended December 31, 1997. The Company has established a relationship
with CORD, a distribution company located in Nashville, Tennessee and has been
shipping Ridaura through CORD since December 15, 1997; however, there can be no
assurance that such relationship will be successful. If CORD is unable to
distribute Ridaura in an effective manner or if the Company is unable to
maintain sufficient personnel with the appropriate levels of experience to
manage this function, the Company's business, financial condition and results of
operations could be materially and adversely affected. In addition, there can be
no assurance that the Company's Ridaura revenues will equal or exceed those
achieved by SmithKline over the last several years. The Company's Ridaura
revenues for the year ending December 31, 1997 were below the Company's
preliminary projections at the time of acquisition. If the Company is not able
to market and sell Ridaura successfully, the Company's business, financial
condition and results of operations could be 


                                      -23-
<PAGE>   24
materially and adversely affected. Furthermore, the primary patents for Ridaura
expired in 1989 and 1992; therefore, 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.

POTENTIAL EFFECTS OF GUARANTEE OF VALUE OF SHARES ISSUED TO SMITHKLINE

In connection with its acquisition of U.S. and Canadian rights to Ridaura in
December 1996, the Company issued 637,733 shares of Common Stock to SmithKline
Beecham Properties, Inc. ("SKB"). Pursuant to a December 1997 amendment to the
Company's original agreement with SKB, the total value of the shares issued to
SKB is required to be $8.0 million on April 1, 1998; to achieve such value, the
Company may be obligated to issue additional shares to SKB on such date (up to a
maximum of 1,672,512 total shares, including those originally issued), or may
repurchase a portion of the originally-issued shares to reduce the market value
of the remaining shares to $8.0 million. In the event the Company is required to
issue a substantial number of additional shares to SKB, such issuance will have
a dilutive impact on the other stockholders of the Company. As a result, the
market price of the Company's Common Stock could be materially and adversely
affected, and if the Company becomes profitable, the Company net income per
share could be materially decreased in future periods. In addition, SKB
currently owns approximately 4.8% of the Company's outstanding shares of Common
Stock. An additional issuance of a substantial number of shares to SKB would
increase SKB's ownership percentage and give SKB increased influence in matters
requiring a stockholder vote, such as electing directors or approving a merger
or sale of the Company. Given the Company's current stock price, it is likely
that the Company will need to issue additional shares to SKB on April 1, 1998 to
achieve the $8.0 million value.

Under the rules of the Nasdaq Stock Market, a second issuance to SKB cannot
result in SKB receiving more than 19.9% or more of the Company's outstanding
Common Stock as of December 30, 1996. Due to the Company's current stock price
and the Nasdaq rules, there is a material likelihood that the Company will be
unable to issue the full amount of shares otherwise issuable to SKB, and as a
result, under the Company's amended agreement with SKB, the Company would be
obligated to increase the amount of deferred royalty-based payments owed to SKB
for Ridaura product sales (currently capped at $6 million) by the cash value of
the unissuable shares. In addition, the Company's royalty rate for Ridaura sales
would increase on sales over a certain level. Such changes could divert the
Company's available liquid resources away from the Company's operations and
development programs, which could have a material adverse effect on the
Company's business and its results of operations.

POSSIBLE FUTURE PRODUCT ACQUISITIONS

A significant part of the Company's overall strategy is to in-license or acquire
additional marketed or late stage development products in its targeted
therapeutic areas. The 1996 acquisitions of rights to Betamethasone mousse and
Ridaura reflect this strategy. Future product acquisitions, if any, may require
substantial additional funds (i) for the initial acquisition of rights to these
products and (ii) for the steps necessary to obtain FDA approval for the product
and to market, sell and distribute the products successfully. A portion of the
funds needed to acquire, develop and market any new products may come from the
Company's existing cash and short-term investments; in such case, fewer
resources will be available to the Company's current products and clinical
programs, which could have a material adverse effect on the Company's business,
financial conditions and results of operations. Alternatively, the Company may
seek to raise substantial additional funds for new product acquisitions.


                                      -24-
<PAGE>   25
As discussed above under "Future Capital Requirements and Uncertainty of Future
Funding," the Company may seek such additional funding through collaborative
arrangements and through public or private financings, including equity
financings. Any additional equity financing, if available, may be dilutive to
stockholders and any debt financing, if available, may restrict the Company's
ability to pay dividends on its capital stock or the manner in which the Company
conducts business. In addition, any acquisition of rights to additional products
that are not presently approved by the FDA will require the commitment of
substantial resources to conduct the research development, clinical studies and
regulatory activities necessary to bring such potential product to market. If
the newly-acquired product is already approved for sale, the Company will likely
assume the marketing and sale 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. (See "--
Management of Ridaura Acquisition; Uncertainty of Future Ridaura Revenues;
Off-Patent Status of Ridaura")

UNCERTAINTIES OF REGULATORY APPROVAL; GOVERNMENT REGULATION

The production and marketing of the Company's products and its ongoing research
and development activities are subject to regulation by numerous governmental
authorities in the United States and other countries. Prior to marketing, any
drug developed by the Company must undergo rigorous preclinical and clinical
testing and an extensive regulatory approval process mandated by the FDA and
equivalent foreign authorities. These processes can take a number of years and
require the expenditure of substantial resources. The Company is also subject to
regulations under the food and drug statutes and regulations of the State of
California.

Obtaining such approvals and completing such testing is a costly and
time-consuming process and approval may not be ultimately obtained. The length
of the FDA review period varies considerably as does the amount of preclinical
and clinical data required to demonstrate the safety and efficacy of a specific
product. The Company may also decide to replace the compounds in testing with
modified or optimized compounds, thus extending the testing process. 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 product 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. Further, even if such regulatory approval is
obtained, the FDA will require post-marketing reporting and may require
surveillance programs to monitor the usage or side effects of each drug product.
A marketed product, its manufacturer and its manufacturing facilities are
subject to continual review and periodic inspections, and later discovery of
previously unknown problems with a product, manufacturer or facility may result
in restrictions on such product or manufacturer, potentially including
withdrawal of the product from the market. In addition, a failure to comply with
FDA requirements for manufacturing, labeling, advertising, recordkeeping or
reporting of adverse events and other information may result in enforcement
actions including, but not limited to, recalls, seizures, injunctions and
criminal prosecution.

Government regulation in the United States or in foreign countries may delay
marketing of the Company's potential products for years, may impose costly
procedures upon the Company and may furnish a 


                                      -25-
<PAGE>   26
competitive advantage to larger companies that may compete with the Company.
There can be no assurance that FDA or other regulatory approval for any products
developed by the Company will be granted on a timely basis or at all. A delay in
obtaining or a failure to obtain such approvals would adversely affect the
marketing of any potential products developed by the Company and the Company's
liquidity and capital resources. The FDA regulatory process periodically goes
under substantial review and revision, and as a result, government regulation
may become more or less restrictive in the future.

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.

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, therefore, 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 a 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. In the event that any claims of third-party patents are upheld as valid
and enforceable with respect to a product or process made, used or sold by the
Company, the Company 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 U.S. Patent No. 5,614,192 covering its proprietary
TCR vaccines technology. The Company has become aware that third parties have
also obtained patents relating to TCR vaccines technology, including a U.S.
patent issued to Immune Response Corporation on March 18, 1997. 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 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 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. If such patents were
successfully asserted, the Company could be required to obtain licenses or
redesign its TCR vaccines products or processes to avoid infringement and could
be liable to pay damages, or could be prevented from commercializing TCR
vaccines. 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 


                                      -26-
<PAGE>   27
avoid infringement. 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. Moreover, patent applications in the U.S. are
maintained in secrecy until issue, and publication of discoveries in the
scientific or patent literature often lag behind actual discoveries, so the
Company cannot be certain that it is aware of all potentially relevant pending
applications and it is not possible to predict with any certainty the scope of
claims that could issue from such a third party's pending application. The
Company anticipates that an interference will be declared between one or more of
its TCR vaccine technology patent applications and those of one or more of its
competitors including the above-referenced patent to Immune Response Corporation
to determine priority of invention, which could result in substantial cost to
the Company even if the eventual outcome is favorable. It is not possible to
know in advance the invention dates that such other parties may be able to
prove, so the Company cannot know whether its or its licensors' inventors are
the first for inventions covered by their pending patent applications or that it
or its licensors were the first to file patent applications for such inventions.
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 operation, 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.

DEPENDENCE ON CONTRACT MANUFACTURERS AND SUPPLIERS

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's products for research and
preclinical testing have been supplied by collaborators and contract
manufacturing companies. 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. TCR vaccines are manufactured for the Company by
American Peptide Company and Multiple Peptide Systems. The Company is in
discussions with additional manufacturers who can supply Relaxin and TCR
vaccines for clinical and commercial uses. Ridaura is manufactured by SmithKline
(in final finished package form) under an agreement with an initial term through
December 2001. Betamethasone mousse and clobetasol mousse are manufactured for
Connetics by CCL Pharmaceuticals. Gamma interferon is manufactured by Genentech
and Parke-Davis. If the Company is unable to contract for manufacturing
capabilities on acceptable terms, the Company's ability to conduct preclinical
and human clinical testing will 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 


                                      -27-
<PAGE>   28
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.
There can also be no assurance that the Company will be able to manufacture any
of its products on a commercial scale or at a competitive cost or in sufficient
quantities. The Company currently is seeking additional clinical and commercial
suppliers. There is no assurance that additional suppliers will be engaged by
the Company or that the current manufacturers of relaxin can supply sufficient
clinical quantities. Failure to obtain sufficient clinical or commercial
quantities of relaxin or other products at acceptable terms would have a
material adverse impact on the Company's attempts to complete its clinical
trials, and obtain approval for and commercialize its products.

COMPETITION AND TECHNOLOGICAL CHANGE

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. 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 are
currently seeking to develop 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. 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.

PRODUCT LIABILITY AND AVAILABILITY OF 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 


                                      -28-
<PAGE>   29
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.

DEPENDENCE ON KEY PERSONNEL

The Company is dependent on the principal members of its scientific and
management staffs (including Thomas G. Wiggans, its 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. 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 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.

UNCERTAINTY OF PHARMACEUTICAL PRICING AND REIMBURSEMENT; HEALTH CARE REFORM AND
RELATED MATTERS

The levels of revenues and profitability of pharmaceutical companies may be
affected by the continuing efforts of governmental and third party payors to
contain or reduce the costs of health care through various means. In both the
United States and elsewhere, sales of prescription pharmaceuticals are dependent
in part on the availability of reimbursement to the consumer from third party
payors, such as government, employers and private insurance plans. Third party
payors are increasingly seeking to reduce the costs of medical products and
services and looking for improved cost/benefit relationships from the products
and services they buy. If the Company or one of its potential marketing or
strategic alliance partners succeeds in bringing one or more products based upon
the Company's technology to the market, there can be no assurance of market
acceptance of the Company's products or that these products will be considered
cost-effective and that reimbursement to the consumer will be available or will
be sufficient to allow the Company or its partner to sell such products on a
competitive basis. Any inability of the Company or its potential partners to
sell products developed using the Company's technology or in-licensed by the
Company on a competitive basis would have a material adverse effect on the
Company's business.

ENVIRONMENT AND CONTROLLED USE OF HAZARDOUS MATERIALS

The Company is subject to federal, state and local laws and regulations
governing the use, generation, manufacture, storage, discharge, handling and
disposal of certain materials and wastes used in its operations, some of which
are classified as "hazardous." There can be no assurance that the Company will
not be required to incur significant costs to comply with environmental laws and
regulations as its research activities are increased or that the operations,
business and future profitability of the Company will not be adversely affected
by current or future environmental laws and regulations. Although the Company
believes that its safety procedures for handling and disposing materials comply
with such laws and regulations, the risk of accidental contamination or injury
from these materials cannot be eliminated. In 


                                      -29-
<PAGE>   30
the event of such an accident, the Company could be held liable for any damages
that result and any such liability could exceed the resources of the Company.

EFFECT OF CERTAIN ANTI-TAKEOVER PROVISIONS

The Company's Board of Directors has the authority to issue up to 5,000,000
shares of undesignated Preferred Stock and to determine the rights, preferences,
privileges and restrictions of such shares without further vote or action by the
Company's stockholders. The rights of the holders of Common Stock will be
subject to, and may be adversely effected by, the rights of the holders of any
Preferred Stock that may be issued in the future. The issuance of Preferred
Stock could have the effect of making it more difficult for third parties to
acquire a majority of the outstanding voting stock of the Company. In April
1997, the Company's Board of Directors adopted a stockholder rights plan, which
entitles existing stockholders of the Company to certain rights (including the
right to purchase shares of Preferred Stock) in the event of an acquisition of
15% or more of the Company's outstanding common stock, or an unsolicited tender
offer for such shares. The existence of the rights plan could delay, prevent, or
make more difficult a merger or tender offer or proxy contest involving the
Company.

In addition, certain provisions of the Company's charter documents, including a
provision eliminating the ability of stockholders to take actions by written
consent, and of Delaware law could delay or make difficult a merger, tender
offer or proxy contest involving the Company. Further, the Company's stock
option and purchase plans generally provide for the assumption of such plans or
substitution of an equivalent option of a successor corporation or,
alternatively, at the discretion of the Board of Directors, exercise of some or
all of the option stock, including non-vested shares, or acceleration of vesting
of shares issued pursuant to stock grants, upon a change of control or similar
event.

POSSIBLE VOLATILITY OF STOCK PRICE; LACK OF DIVIDENDS

Prior to February 1996 there was no public market for the Common Stock of the
Company. There can be no assurance that an active trading market will continue
to be sustained or that the market price of the Common Stock will not decline
below the its present market price. The market prices for securities of
biotechnology companies have been highly volatile. Announcements regarding the
results of regulatory approval filings, clinical studies or other testing,
technological innovations or new commercial products by the Company or its
competitors, government regulations, developments concerning proprietary rights
or public concern as to safety of technology have historically had, and are
expected to continue to have, a significant impact on the market prices of the
stocks of biotechnology companies. For instance, in August 1997, the Company's
trading price dropped approximately 46.7% the day the Company announced negative
results from its Phase III clinical trial of gamma interferon for the treatment
of atopic dermatitis. The trading price of the Common Stock could also be
subject to significant fluctuations in response to variations in operating
results. In addition, the Company has never paid cash dividends on its capital
stock and does not anticipate paying cash dividends in the foreseeable future,
but instead intends to retain future earnings for reinvestment in its business.
The Company's credit agreement requires the approval of the Company's bank to
declare or pay cash dividends.


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 


                                      -30-
<PAGE>   31
exercised, would extend the term of the lease to the year 2001. The Company
currently pays base monthly rent of $45,825 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. The Company also leases
approximately 3,100 square feet of office space at 2483 East Bayshore Road, in
Palo Alto, California. The Company leases this space under an agreement that
expires March 31, 1999. The Company currently pays base monthly rent of $9,300
for this space. 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

    Connective 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

    None.



EXECUTIVE OFFICERS OF THE COMPANY

    The executive officers of the Company, and their ages as of December 31,
1997, are as follows:

<TABLE>
<CAPTION>
NAME                                                AGE   POSITION
----                                                ---   --------

<S>                                                 <C>   <C>                                               
Thomas G. Wiggans...........................        46    President, Chief Executive Officer and Director
W. Scott Harkonen, M.D......................        45    Sr. Vice President, Product Development and Operations
Richard J. Hammel, Ph.D.....................        54    Vice President, Commercial Development
John L. Higgins ............................        27    Vice President, Finance and Administration and Chief
                                                          Financial Officer
David A. Lowin .............................        43    Vice President, Intellectual Property, Chief Patent
                                                          Counsel and Assistant Secretary
Ernst H. Rinderknecht, Ph.D ................        50    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 a member of the
governing body of its emerging company section. He was also President of the
Board of Directors of the Association of Biotechnology Companies. Mr. 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. From March 1991 to August 1995,
Dr. Harkonen served as Vice 


                                      -31-
<PAGE>   32
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.

Richard J. Hammel has served as Vice President, Commercial Development of the
Company since September 1995. From September 1993 to September 1995, he served
at Matrix Pharmaceutical, Inc., a biotechnology company, as Vice President of
Business Development, Sales and Marketing. From March 1992 to September 1995,
Dr. Hammel served as a Senior Consultant to Marketing Corporation of America, a
marketing company. From 1986 to March 1992, he served at Glaxo, Inc., a
pharmaceutical company, most recently as Director of Business Development. He
received a B.S., M.S. and Ph.D. from the University of Minnesota.

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 a B.A. in Economics
from Colgate University, where he serves on the Board of Trustees.

David A. Lowin has served as Vice President, Intellectual Property and Chief
Patent Counsel of the Company since January 1995 and Assistant Secretary of the
Company since July 1995. From 1982 to January 1995, Mr. Lowin served at Syntex
Corporation, a pharmaceutical company, as Assistant Director of the Patent Law
Department. From 1979 to 1982, he served as an associate at Owen, Wickersham &
Erickson. He received a B.A. from Hobart College and a J.D. from the Franklin
Pierce Law Center, where he serves on the Intellectual Property Law Advisory
Committee.

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.

Each executive officer serves at the sole discretion of the Board of Directors.


                                      -32-
<PAGE>   33
                                     PART II

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

The Company's Common Stock commenced trading on the Nasdaq National Market under
the symbol CNCT on February 1, 1996. The price per share reflected in the table
below represents the range of low and high closing sale prices for the Company's
Common Stock as reported in the Nasdaq National Market for the quarters
indicated.

<TABLE>
<CAPTION>
FISCAL YEAR ENDED DECEMBER 31, 1997                                              HIGH          LOW
                                                                                 ----          ---
<S>                                                                              <C>          <C>  
    First Quarter...........................................................     $8.00        $6.63
    Second Quarter..........................................................     $7.88        $6.00
    Third Quarter...........................................................     $9.50        $3.50
    Fourth Quarter..........................................................     $4.25        $2.56

FISCAL YEAR ENDED DECEMBER 31, 1996                                              HIGH          LOW
                                                                                 ----          ---
    First Quarter...........................................................    $11.25        $8.00
    Second Quarter..........................................................    $11.00        $7.75
    Third Quarter...........................................................    $10.25        $5.75
    Fourth Quarter..........................................................    $ 8.75        $6.50
</TABLE>


The Company had approximately 187 stockholders of record as of February 27,
1998, including several holders who are nominees for an undetermined number of
beneficial owners.

The Company has never paid cash dividends on its capital stock. The Company
currently anticipates that it will retain all available funds for use in the
operation and expansion of its business, and does not anticipate paying any cash
dividends in the foreseeable future. The Company must obtain the approval of its
bank before declaring or paying dividends.


                                      -33-
<PAGE>   34
ITEM 6: SELECTED FINANCIAL DATA (IN THOUSANDS, EXCEPT SHARE AND PER SHARE
AMOUNTS)

The following table presents selected financial data of the Company. This
historical data should be read in conjunction with the attached 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>
                                                                                                                 Period from  
                                                                                                                  inception   
                                                                                                                  (February   
                                                                           December 31,                          8, 1993) to  
                                                     ---------------------------------------------------------   December 31, 
                                                         1997           1996           1995           1994           1993
                                                     ------------   ------------   ------------   ------------   ------------
<S>                                                  <C>            <C>            <C>            <C>            <C>       
Statement of Operations Data:
Product revenues                                     $      6,803   $        428   $       --     $       --     $       --

Operating costs and expenses:
   Cost of product revenues                                 1,149           --             --             --             --
   License amortization                                     7,124            594           --             --
   Research and development                                17,162         13,161          8,271          6,436            836
   General and administrative                               8,966          5,434          2,113          1,317            240
                                                     ------------   ------------   ------------   ------------   ------------
Total operating costs and expenses                         34,401         19,189         10,384          7,753          1,076

Loss from operations                                      (27,598)       (18,761)       (10,384)        (7,753)        (1,076)

Gain on sale of license rights                                525           --             --             --             --
Interest income (expense), net                               (862)           247             12            (97)            (2)

                                                     ============   ============   ============   ============   ============
Net loss                                             $    (27,935)  $    (18,514)  $    (10,372)  $     (7,850)  $     (1,078)
                                                     ============   ============   ============   ============   ============

Basic and diluted net loss per share(1)              $      (2.69)  $      (2.71)
Shares used to calculate basic and diluted net loss
   per share(1)                                        10,412,039      6,824,668

Pro forma basic and diluted net loss per share(1)                                  $      (2.34)          --             --
Shares used to calculate pro forma basic and
   diluted net loss per share(1)                                                      4,434,299           --             --

Balance Sheet Data:
Cash, cash equivalents and short-term investments    $     14,346   $     24,554   $      9,023   $      1,287   $        729
Working capital                                             6,687         14,904          5,844           (979)          (147)
Total assets                                               31,068         47,922         11,796          2,901            930
Current portion of capital lease obligations,
   capital loans and long-term debt                         2,746          2,408          1,259            233           --
Current portion of notes payable and other                  2,884           --             --             --             --
   liabilities
Non-current portion of capital lease obligations,
   capital loans and long-term debt                           649          3,062          4,933            829             13
Other long-term liabilities and notes payable(2)            9,666         10,858          3,467          2,643           --
Redeemable convertible preferred stock                        600          2,000           --             --             --
Total stockholders' equity (net capital deficiency)        10,809         21,800             63         (2,919)           (60)
</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 Financial Statements

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


                                      -34-
<PAGE>   35
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

                     MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS


The following discussion contains, in addition to historical information,
certain forward looking statements that involve risks and uncertainties. The
Company's actual results could differ materially from the results anticipated in
these forward looking statements. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed below as well as
those discussed above under the heading "Additional Factors That May Affect
Future Results".

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

OVERVIEW

Connetics Corporation 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. Under
a related Transitional Services Agreement, customer orders and distribution for
Ridaura were managed by SmithKline through 1997. The Company's products under
development include betamethasone mousse for the treatment of scalp psoriasis
and other dermatoses; clobetasol mousse for the treatment of severe dermatoses;
ConXn(R) (relaxin) for the treatment of scleroderma, other fibrotic disorders
and infertility; T-cell receptor (TCR) peptide vaccines for the treatment of
multiple sclerosis and rheumatoid arthritis; and gamma interferon for the
treatment of keloids. The Company's stockholders approved a change of the
Company's name from "Connective Therapeutics, Inc." to "Connetics Corporation"
at its annual meeting in May 1997.

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
certain credit financing arrangements. To date, a majority of the Company's
expenditures have been for research and development activities. The Company has
incurred operating losses since its inception and had an accumulated deficit of
$65.9 million at December 31, 1997. The Company will require additional funds to
continue the development of its products and to fund operating losses which are
expected for the next few years. Other than Ridaura, the Company does not expect
any of its products to be commercialized within the next year.

RESULTS OF OPERATIONS

The Company's revenues, derived from the sales of Ridaura, were $6.8 million and
$0.4 million for the years ended December 31, 1997 and 1996, respectively. The
Company had no revenue in 1995, or for the first eleven months in 1996, as all
of its products were in development stage. Revenues from Ridaura sales in 1997
were somewhat below the Company's preliminary projections at the time of its
acquisition of Ridaura. 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 by SmithKline prior to the Company's 


                                      -35-
<PAGE>   36
acquisition of the product and, as a result, the Company's financial condition
and results of operations could be materially and adversely affected.

Under Transitional Services and Supply agreements between SmithKline and the
Company, entered into in conjunction with the acquisition of Ridaura, SmithKline
will manufacture and supply Ridaura in final package form through December 2001
and has managed distribution of the product, with no additional consideration
for performing such services, through December 1997. The Company has established
a distribution arrangement with CORD Logistics, Inc. ("CORD") under which CORD
will manage customer orders and distribution of Ridaura and any other future
products of the Company. CORD began distributing Ridaura for the Company on
December 15, 1997 and, as a result, the Company incurred distribution costs of
$45,000 which included a one time program implementation start-up fee in
December. Future 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 year ending December 31, 1997, the Company recorded $1.1
million in cost of product sales and $7.1 million in amortization expense
associated with the acquisition of product rights to Ridaura (the Company has
determined the useful life of the asset to be three years based on information
regarding products currently in the Company's development pipeline, competitive
products, the off-patent position of Ridaura and expected future revenues from
Ridaura sales). No product costs were recorded for the years ending December 31,
1996 and 1995 as the Company was still in development stage without any revenue
generating product. There was no cost associated with the Ridaura revenue the
Company recognized in December 1996.

Research and development expenses were $17.2 million, $13.2 million and $8.3
million for the years ended December 31, 1997, 1996 and 1995, respectively. The
$4.0 million increase in research and development expenses in fiscal 1997 over
fiscal 1996 was primarily due to the 555 patient Phase III clinical trial of
gamma interferon for the treatment of atopic dermatitis, the 64 patient Phase II
clinical trial of ConXn for the treatment of scleroderma, the 190 patient Phase
III clinical trial of betamethasone mousse for the treatment of scalp psoriasis,
the 106 patient Phase I/II clinical trial of TCR peptide vaccines for the
treatment of multiple sclerosis and the 40 patient Phase II clinical trial of
gamma interferon for the treatment of keloids, all of which commenced subsequent
to June 1996. The increase in research and development expenses in fiscal 1996
over fiscal 1995 was primarily attributable to significant increases in
personnel staffing particularly related to clinical development, commencement of
the clinical trials associated with gamma interferon, ConXn and TCR peptide
vaccines as listed above, and increased outside services required to support
operations. The factors contributing to increases in spending were partially
offset by decreases in technology acquisition costs from $0.9 million in fiscal
1995, to $35,000 and none for fiscal 1996 and 1997, respectively. Although the
Company has currently suspended any material further activities associated with
gamma interferon for the treatment of atopic dermatitis due to less than
acceptable therapeutic response with respect to the primary clinical endpoint,
research and development expenses may continue to increase in future periods due
to continued expansion of development activities, including progression in
advanced-stage clinical trials, and possible acquisition of new technologies and
products.

Selling, general and administrative expenses were $9.0 million, $5.4 million and
$2.1 million for the years ended December 31, 1997, 1996 and 1995, respectively.
The increase of $3.6 million in expenses from fiscal 1996 to 1997 was primarily
due to the establishment of a new sales and marketing organization, costs
associated with the re-launching of Ridaura, increases in personnel in the
general and administrative functions, and legal expenses associated with
operating as a public company. The increase of $3.3 million in expenses from
fiscal 1995 to 1996 was primarily due to increased support costs associated with


                                      -36-
<PAGE>   37
operating as a public company (including costs related to strengthening the
senior management team), professional fees and expenses associated with the
acquisition of Ridaura and other business development expenses. Selling, general
and administrative expenses are expected to continue to increase primarily due
to increased staffing of the sales organization, costs associated with marketing
Ridaura and possible launching of new acquired products.

On December 18, 1997, the Company entered into a Canadian Asset Purchase
Agreement and a Supply Agreement with Pharmascience, Inc., a Canadian
corporation, 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 sale of Ridaura Canadian rights to
Pharmascience, Inc. in 1997.

Interest income was $0.9 million, $1.2 million and $0.4 million for the years
ended December 31, 1997, 1996 and 1995, respectively. The decrease in interest
income in fiscal 1997 over fiscal 1996 was the result of lower cash and
investment balances due to increase in operating expenses and a $3.0 million
payment to SmithKline for rights to Ridaura. The increase in fiscal 1996 over
fiscal 1995 was due to higher invested cash balances from proceeds of the
Company's initial public offering and two private placements of equity
securities. Interest earned in the future will depend on Company funding cycles
and prevailing interest rates. Interest expense increased to $1.7 million for
the year ended December 31, 1997, from $0.9 million and $0.4 million for the
same periods in 1996 and 1995, respectively. The increase of $0.8 million
interest expense in fiscal 1997 over fiscal 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 as partial consideration of the
acquisition of U.S. and Canadian rights to Ridaura, offset in part by lower
interest expense associated with lower balances outstanding for obligations
under capital leases and loans, and notes payable. The increase of $0.5 million
from fiscal 1996 over fiscal 1995 was due to increased balances outstanding for
obligations under capital leases and loans, and notes payable.

The Company incurred net losses of $27.9 million, $18.5 million and $10.4
million for the years ended December 31, 1997, 1996 and 1995, respectively. The
increase of $9.4 million in net loss in fiscal 1997 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 increase in net loss of
$8.1 million from fiscal 1996 over fiscal 1995 was primarily due to the
Company's development stage activities. 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 four self-managed financings, two in December 1996, one in May 1997 and one
in December 1997. At December 31, 1997, cash, cash equivalents and short-term
investments totaled $14.3 million, a decrease of $10.3 million from $24.6
million at December 31, 1996.

Cash used in operations in 1997 was $23.6 million compared with $10.4 million in
1996. The fiscal 1997 net loss was 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 associated with the acquisition of Ridaura. The impact
of these charges was somewhat offset by a $0.5 million gain recognized from the
sale of Ridaura Canadian 


                                      -37-
<PAGE>   38
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).
Receivables at December 31, 1997 were $1.5 million as compared with $0.4 million
for the same period in 1996 due to increased sales of Ridaura.

Investing activities, other than changes in the Company's short-term
investments, consumed $0.6 million in cash during fiscal 1997, compared with
$3.6 million during fiscal 1996. Cash outlays in 1997 included a $1.0 million
payment to SmithKline in consideration of the omnibus amendment to the asset
purchase agreement in December, 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 proceeds from financing activities in 1997 was $13.9 million compared with
$29.4 million in 1996. In 1997, the Company generated $16.1 million cash
primarily from the sales of its common stock in May and December 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, and at December 31,
1997, had approximately $0.6 million available for additional borrowings under
the same loan. Cash proceeds were offset by $2.5 million in payments on
obligations under capital leases and loans.

Working capital decreased by $8.2 million to $6.7 million at December 31, 1997
from $14.9 million at December 31, 1996. The decrease was the result of lower
cash, cash equivalents and short-term investments, the now current portion of
capital loans and long-term debt, and the current portion of the note payable
due to SmithKline in 1998 for rights to Ridaura, offset in part by lower
accounts payable, lower accrued expenses due to the winding down of clinical
trial activities, lower accrued process development expenses and 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 gamma interferon material associated with the
Phase III clinical trial.

At December 31, 1997, the Company had an aggregate of $15.9 million in future
obligations of principal payments under capital leases, loans, long-term debt
and other obligations, of which $5.6 million is due in 1998. On November 13,
1997, the Company amended the repayment terms of its non-interest bearing $11.0
million promissory note with SmithKline. The amendment allows the Company to
defer the first $6.0 million installment payment, originally due in January
1998, to April 1998, October 1998 and January 1999 with payments of $1.0
million, $1.5 million and $3.5 million, respectively. The Company is required to
pay interest on the principal amount outstanding of the $6.0 million from
January 1, 1998 through January 4, 1999 at prime rate plus 2%. The second
installment payment of $5.0 million under the note, also due January 1999,
remains unchanged. On December 18, 1997, the Company added an omnibus amendment
to the equity and asset purchase agreements with SmithKline. The amendment
adjusts the November 13, 1997 amended payments from $1.5 million and $3.5
million to $1.0 million and $4.0 million in October 1998 and January 1999,
respectively. All other payment terms pertaining to the November 13, 1997
amendment remain unchanged. (See Note 5 of Notes to Financial Statements)

The Company has a Structured Equity Line Flexible Financing Agreement (the
"Equity Line Agreement") with Kepler Capital LLC ("Kepler") that allows the
Company to access up to $25 million through sales of its Common Stock. The
equity line is available for a three-year period beginning on December 1, 1997.
The Equity Line Agreement provides that the Company can, at its option, obtain
from $500,000 to 


                                      -38-
<PAGE>   39
$2,000,000 at any one time through a sale of its Common Stock to Kepler, subject
to the satisfaction of certain conditions, including registration of shares for
resale, minimum volume requirements, and a minimum trading price of $7.00 per
share over a specified period. In addition, the Company must sell $500,000 of
its Common Stock from time to time if the price per share exceeds $10.00 and
minimum volume requirements are met. Since the Company's trading price is
currently below the $7.00 minimum price requirement, the Company is presently
unable to draw under the equity line. (See Note 6 of Notes to Financial
Statements)

The Company believes that its existing cash and cash equivalents, short-term
investments, cash generated from Ridaura revenues and funds available under the
capital loan will be sufficient to fund the Company's operating expenses, debt
obligations and capital requirements through 1998. 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 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 (which is presently unavailable), 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 may 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 third parties the rights to commercialize products
or technologies that the Company would otherwise seek to develop and market
itself.

IMPACT OF YEAR 2000

The "Year 2000 Issue" is the result of certain computer programs being written
using two digits rather than four to define the applicable year. 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. This 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.

Based on a recent assessment, the Company presently believes that with
modifications and upgrades to existing software, the Year 2000 Issue will not
pose significant operational problems for its computer systems. However, if such
modifications and upgrades are not made, or are not completed timely, the Year
2000 Issue could have an impact on the operations of the Company. The total Year
2000 project cost is estimated at less than $50,000.

The Company has begun initiating formal communications with its significant
service providers and suppliers to determine the extent to which the Company's
interface systems are vulnerable to those third parties' failure to remediate
their own Year 2000 Issues. However, there can be no guarantee that the systems
of other companies on which the Company's systems rely will be timely converted
and would not have an adverse effect on the Company's systems.


                                      -39-
<PAGE>   40
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See Item 14(a) for an index to the consolidated financial statements and
supplementary financial information that are attached hereto.

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

Not applicable.


                                    PART III

Certain information required by Part III is omitted from this report because the
Company will file a definitive proxy statement within 120 days after the end of
its fiscal year pursuant to Regulation 14A (the "Proxy Statement") for its
annual meeting of shareholders to be held May 22, 1998 and the information
included therein is incorporated herein by reference.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information with respect to directors of the Company and the Chairman of the
Company's Board of Directors is incorporated by reference from the information
under the caption "Election of Directors--Nominees" in the Company's Proxy
Statement.

Information as to the Company's executive officers appears at the end of Part I
of this report.

ITEM 11. EXECUTIVE COMPENSATION

Incorporated by reference from the information under the caption "Executive
Compensation and Related Information" in the Company's Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Incorporated by reference from the information under the caption "Common Stock
Ownership of Certain Beneficial Owners and Management" in the Company's Proxy
Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Incorporated by reference from the information under the caption "Certain
Relationships and Related Transactions" in the Company's Proxy Statement.


                                      -40-
<PAGE>   41
                                     PART IV

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



(a) The following documents are filed as part of this Report:

    1.  Financial Statements and Report of Ernst & Young LLP, Independent
        Auditors

            Report of Ernst & Young LLP, Independent Auditors.

            Consolidated Balance Sheet at December 31, 1997 and 1996.

            Consolidated Statements of Operations Years ended December 31, 1997,
            1996 and 1995.

            Consolidated Statement of Shareholders' Equity - Three years ended
            December 31, 1997.

            Consolidated Statements of Cash Flows Years ended December 31, 1997,
            1996, and 1995.

            Notes to Consolidated Financial Statements.

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.  Exhibits (numbered in accordance with Item 601 of Regulation S-K)

Exhibits

3.1(1)      Form of Amended and Restated Certificate of Incorporation.
3.2(1)      Form of Bylaws.
3.3(5)      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.
3.4(11)     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.
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(1)      Form of Common Stock Certificate.
4.2(12)     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.


                                      -41-
<PAGE>   42
10.1(1)     Form of Indemnification Agreement with the Company's directors and
            officers.
10.2(7)*    1994 Stock Plan, as amended, and form of Option Agreement.
10.3(7)*    1995 Employee Stock Purchase Plan, as amended, and form of
            Subscription Agreement.
10.4(1)*    1995 Directors' Stock Option Plan and form of Option Agreement.
10.5(1)     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.
10.6(1)(2)  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.
10.8(1)     Assignment and Assumption Agreement, dated June 3, 1994, by and
            between the Company and XOMA Corporation.
10.9(1)(2)  Technical Collaboration and Manufacturing Agreement, dated May 24,
            1994, by and between the Company and Scios Nova Inc.
10.10(1)(2) 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.
10.11(1)(2) Agreement on Interferon Gamma-1B dated December 8, 1995 by and
            between the Company and Genentech, Inc.
10.12(1)    Equipment Lease Line, dated May 31, 1994 with Lease Management
            Services, Inc.
10.13(1)    Business Loan Agreement, dated July 18, 1995, between the Company,
            Silicon Valley Bank and MMC/GATX Partnership No. 1.
10.14(1)(2) Research Collaboration and Assignment Agreement, dated July 1, 1994,
            between the Company and Dr. Arthur A. Vandenbark.
10.17(1)    Consulting Agreement dated November 17, 1993 between the Company and
            Brian Seed.
10.18(1)    Consulting Agreement dated November 17, 1993 between the Company and
            Eugene Bauer.
10.19(1)    Employment Agreement dated June 9, 1994 between the Company and
            Thomas Wiggans.
10.20(1)    Loan Agreements between the Company and Thomas Wiggans dated July
            15, 1994 and August 1, 1994.
10.21(1)    Letter Agreement with G. Kirk Raab dated October 1, 1995.
10.23(1)    Facility Master Lease between the Company and Renault & Handley
            dated February 9, 1994.
10.26(1)    Loan and Security Agreement dated December 21, 1995 by and among the
            Company, Silicon Valley Bank and MMC/GATX Partnership No. 1.
10.27(3)(2) Agreement on Relaxin Rights in Asia dated April 1, 1996 between the
            Company and Mitsubishi Chemical Corporation (Exhibits A and B to
            Exhibit 10.27 have been previously filed as Exhibit 10.6 above.
            Confidential treatment has been granted as to certain portions of
            Exhibit 10.6 by the SEC).
10.28(3)(2) Soltec License Agreement dated June 14, 1996.
10.29(4)    Laboratory Services Agreement dated October 24, 1996.
10.30(4)    Agreement with Dr. Edward Amento dated October 24, 1996.
10.31(4)    Form of Directors and Officers Change in Control Agreement
10.32(5)    Common Stock Purchase Agreement, dated December 4, 1996 by and among
            the Company and certain investors.
10.33(5)    Registration Rights Agreement, dated December 4, 1996 by and among
            the Company and certain investors.
10.34(5)    Securities Purchase Agreement, dated December 4, 1996 by and among
            the Company and a certain purchaser.
10.35(5)    Warrant, dated December 4, 1996 between the Company and a certain
            purchaser.
10.36(6)(2) 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.
10.37(6)    Stock Issuance Agreement dated December 31, 1996 between the Company
            and SmithKline Beecham Properties, Inc.
10.38(6)    Secured Promissory Note dated December 31, 1996 issued to SmithKline
            Beecham Corporation.


                                      -42-
<PAGE>   43
10.39(6)    Security Agreement dated December 31, 1996 between the Company and
            SmithKline Beecham Corporation.
10.40(6)(2) Supply Agreement dated December 31, 1996 between the Company and
            SmithKline Beecham Corporation.
10.42(8)    Structured Equity Line Flexible Financing Agreement dated January 2,
            1997 between the Company and Kepler Capital LLC.
10.43(8)    Registration Rights Agreement dated January 2, 1997 between the
            Company and Kepler Capital LLC.
10.44(9)    Common Stock and Warrant Purchase Agreement dated May 15, 1997 by
            and among the Company, Genentech, Inc. and certain investors.
10.45(9)    Registration Rights agreement dated May 15, 1997 by and among the
            Company and certain investors.
10.46(9)    Form of Common Stock Purchase Warrant issued to certain investors on
            May 15, 1997.
10.47(7)*   Form of Notice of Stock Option Grant to G. Kirk Raab for stock
            option issued in January 1997.
10.48(10)   Secured Loan Agreement dated October 30, 1997 between the Company
            and W. Scott Harkonen.
10.49(10)*  Letter Agreement with Cynthia M. Butitta dated September 22, 1997.
10.50(10)   Amendment dated November 13, 1997 to Secured Promissory Note dated
            December 31, 1996 issued to SmithKline Beecham Corporation.
10.51(10)   Letter Agreement dated November 26, 1997 between the Company and
            Gerard Klauer Mattison & Co., Inc.
10.52(10)*  Letter Agreement with John L. Higgins dated August 25, 1997.
10.53(10)   Omnibus Agreement with SmithKline Beecham Corporation and related
            entities dated December 18, 1997.
10.54(10)   Canadian Asset Purchase Agreement with Pharmascience, Inc. dated
            December 19, 1997.
10.55(10)   Supply Agreement with Pharmascience, Inc. dated December 19, 1997.
10.56**     Agreement on Relaxin dated January 19, 1998 by and between the
            Company and Howard Florey Institute of Experimental Physiology and
            Medicine. 
10.57**     License Agreement dated January 1, 1998 between the Company and
            Soltec Research Pty Limited.
23.1        Consent of Ernst & Young LLP, Independent Auditors.
24.1        Power of Attorney (see page 46).
27.1        Financial Data Schedule (EDGAR filed version only).

----------

*       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.
**      The Company has omitted certain portions of this Exhibit and has
        requested confidential treatment of such portions from the SEC.
1.      Incorporated by reference from an exhibit filed with the Company's
        Registration Statement on Form S-1 (File No. 33-80261) declared
        effective by the Securities and Exchange Commission (the "SEC") on
        January 31, 1996.
2.      Certain portions of this Exhibit were granted confidential treatment
        pursuant to an order from the SEC.
3.      Incorporated by reference from an exhibit to the Company's Quarterly
        Report on Form 10-Q (File No. 0-27406) filed with the SEC for the fiscal
        quarter ended June 30, 1996.
4.      Incorporated by reference from an exhibit to the Company's Quarterly
        Report on Form 10-Q (File No. 0-27406) filed with the SEC for the fiscal
        quarter ended September 30, 1996.
5.      Incorporated by reference from an exhibit to the Company's Report on
        Form 8-K (File No. 0-27406) dated December 4, 1996.
6.      Incorporated by reference from an exhibit to the Company's Report on
        Form 8-K (File No. 0-27406) dated January 15, 1997.
7.      Incorporated by reference from an exhibit filed with Post-Effective
        Amendment No. 1 to the Company's Registration Statement on Form S-8
        (File No. 333-04985) filed with the SEC on June 30, 1997.
8.      Incorporated by reference from an exhibit filed with the Company's
        Annual Report on Form 10-K (File No. 0-27406) for the fiscal year ended
        December 31, 1996.


                                      -43-
<PAGE>   44
9.      Incorporated by reference from an exhibit filed with the Company's
        Registration Statement on Form S-3 (File No. 333-21941) filed with the
        SEC on July 3, 1997.
10.     Incorporated by reference from an exhibit filed with the Company's
        Registration Statement on Form S-1 (File No. 333-41195) declared
        effective by the SEC on December 15, 1997.
11.     Incorporated by reference from an exhibit filed with the Company's
        Current Report on Form 8-K (File No. 0-27406) filed on May 23, 1997.
12.     Incorporated by reference from an exhibit filed with the Company's
        Registration Statement on Form 8-A (File No. 0-27406) filed on May 23,
        1997.


(b)     REPORTS ON FORM 8-K

        No Reports on Form 8-K were filed during the three months ended December
31, 1997.


                                      -44-
<PAGE>   45
                                   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 in the City of Palo Alto,
California on this 20th day of March 1998.

     CONNETICS CORPORATION


     By: /s/      JOHN L. HIGGINS

     John L. Higgins

     Vice President, Finance and Administration and
     Chief Financial Officer


                                      -45-
<PAGE>   46
                                POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Thomas G. Wiggans and John L. Higgins, jointly
and severally, his attorneys-in-fact, each with the power of substitution, for
him in any and all capacities, to sign any amendments to this Report on Form
10-K, and to file the same, with exhibits thereto and other documents in
connection therewith with the Securities and Exchange Commission, hereby
ratifying and confirming all that 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>
    /s/ THOMAS G. WIGGANS        President, Chief Executive Officer and
-------------------------------  Director (Principal Executive Officer)    March 11, 1998
      Thomas G. Wiggans              

     /s/ JOHN L. HIGGINS         Vice President, Finance and
-------------------------------  Administration and Chief Financial
       John L. Higgins           Officer (Principal Financial
                                 and Accounting Officer)                   March 19, 1998

      /s/ G. KIRK RAAB           Chairman of the Board of
-------------------------------  Directors                                 March 11, 1998 
        G. Kirk Raab                

  /s/ ALEXANDER E. BARKAS        Director
-------------------------------
      Alexander E. Barkas                                                  March 18, 1998

     /s/ EUGENE A. BAUER         Director
-------------------------------
         Eugene A. Baue                                                    March 13, 1998

      /s/ BRIAN H. DOVEY         Director
-------------------------------
        Brian H. Dovey                                                     March 19, 1998

       /s/ JOHN C. KANE         Director
-------------------------------
        John C. Kane                                                       March 16, 1998

     /s/ THOMAS D. KILEY         Director
-------------------------------
       Thomas D. Kiley                                                     March 19, 1998

   /s/ KENNETH B. PLUMLEE        Director
-------------------------------
     Kenneth B. Plumlee                                                    March 19, 1998

 /s/ JOSEPH J. RUVANE, JR.       Director
-------------------------------
    Joseph J. Ruvane, Jr.                                                  March 19, 1998
</TABLE>


                                      -46-
<PAGE>   47
                             CONNETICS CORPORATION
                         INDEX TO FINANCIAL STATEMENTS


Report of Ernst & Young LLP, Independent Auditors................   F-2
Balance Sheets...................................................   F-3
Statements of Operations.........................................   F-4
Statements of Stockholders' Equity...............................   F-5
Statements of Cash Flows.........................................   F-6
Notes to Financial Statements....................................   F-7


                                      F-1
<PAGE>   48
                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS


To the Board of Directors and Stockholders of Connetics Corporation

        We have audited the accompanying balance sheets of Connetics Corporation
as of December 31, 1997 and 1996, and the related statements of operations,
stockholders' equity, and cash flows for each of the three years in the period
ended December 31, 1997. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

        In our opinion, the financial statements referred to above present
fairly, in all material aspects, the financial position of Connetics Corporation
at December 31, 1997 and 1996, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 1997, in
conformity with generally accepted accounting principles.


                                     ERNST & YOUNG LLP
Palo Alto, California
January 15, 1998


                                      F-2
<PAGE>   49
                              CONNETICS CORPORATION
                                 BALANCE SHEETS
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)


<TABLE>
<CAPTION>
                                                                                     YEARS ENDED DECEMBER 31,
                                                                                     ------------------------
                                                                                         1997       1996
                                                                                       --------   --------
<S>                                                                                  <C>          <C>     

                                             ASSETS
Current assets:
  Cash and cash equivalents                                                            $  8,452   $ 14,555
  Short-term investments                                                                  5,894      9,999
  Accounts receivable                                                                     1,527        428
  Other current assets                                                                      158        124
                                                                                       --------   --------
          Total current assets                                                           16,031     25,106

Property and equipment, net                                                               1,663      1,484
Notes receivable from related parties                                                       333        301
Deposits and other assets                                                                   160        250
Licensed assets and product rights                                                       12,881     20,781
                                                                                       --------   --------
                                                                                       $ 31,068   $ 47,922
                                                                                       ========   ========
                               LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable                                                                     $  1,492   $  4,179
  Accrued liabilities                                                                     1,100      2,023
  Accrued process development expenses                                                      586      1,198
  Accrued payroll and related expenses                                                      536        394
  Current portion of notes payable and other liabilities (note 5)                         2,884       --
  Current portion of capital lease obligations, capital loans and long-term debt          2,746      2,408
                                                                                       --------   --------
          Total current liabilities                                                       9,344     10,202

Non-current portion of capital lease obligations, capital loans and long-term debt          649      3,062
Other long-term liabilities (note 5)                                                      9,666     10,858
Redeemable convertible preferred stock, Series A                                            600      2,000

Commitments
Stockholders' equity:
  Preferred stock, $0.001 par value:
     5,000,000 shares authorized; redeemable convertible preferred stock, Series
     A, shares issued and outstanding: 60 in 1997 and 200 in 1996; and preferred
     stock, none issued or outstanding in 1997 and 1996                                      --         --
  Common stock, $0.001 par value, and additional paid-in capital:
     50,000,000 shares authorized; shares issued and outstanding:  13,249,410 in 1997
     and 9,057,393 in 1996                                                               77,566     61,004
  Notes receivable from stockholders                                                        (75)       (75)
  Deferred compensation, net                                                               (763)    (1,315)
  Accumulated deficit                                                                   (65,873)   (37,814)
  Treasury stock, at cost:  5,246 shares in 1997                                            (46)      --
                                                                                       --------   --------
Total stockholders' equity                                                               10,809     21,800
                                                                                       --------   --------
                                                                                       $ 31,068   $ 47,922
                                                                                       ========   ========
</TABLE>


                 See accompanying notes to financial statements.


                                      F-3
<PAGE>   50
                              CONNETICS CORPORATION
                            STATEMENTS OF OPERATIONS
               (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)


<TABLE>
<CAPTION>
                                                               YEARS ENDED DECEMBER 31,
                                                      ------------------------------------------
                                                          1997           1996           1995
                                                      ------------   ------------   ------------
<S>                                                   <C>            <C>            <C>       

Product revenues                                      $      6,803   $        428   $       --

Operating costs and expenses:
  Cost of product revenues                                   1,149           --             --
  License amortization                                       7,124            594           --
  Research and development                                  17,162         13,161          8,271
  Selling, general and administrative                        8,966          5,434          2,113
                                                      ------------   ------------   ------------
Total operating expenses                                    34,401         19,189         10,384

Interest income                                                860          1,190            405
Gain on sale of license rights                                 525           --             --
Interest expense                                            (1,722)          (943)          (393)
                                                      ------------   ------------   ------------
Net loss                                              $    (27,935)  $    (18,514)  $    (10,372)
                                                      ============   ============   ============

Basic and diluted net loss per share                  $      (2.69)  $      (2.71)
Shares used to calculate basic and diluted net
loss per share                                          10,412,039      6,824,668

Pro forma basic and diluted net loss per share                                      $      (2.34)
Shares used to calculate pro forma basic and diluted
net loss per share                                                                     4,434,299
</TABLE>


                 See accompanying notes to financial statements.


                                      F-4
<PAGE>   51
                              CONNETICS CORPORATION
                       STATEMENTS OF STOCKHOLDERS' EQUITY
                                 (IN THOUSANDS)


<TABLE>
<CAPTION>
                                                                       CONVERTIBLE                COMMON STOCK AND
                                                                     PREFERRED STOCK         ADDITIONAL PAID IN CAPITAL    
                                                                  SHARES         AMOUNT         SHARES        AMOUNT       
                                                                 --------       --------       --------      --------      
<S>                                                              <C>            <C>         <C>              <C>           
                                                                                                              
Balances at December 31, 1994                                       1,343       $      1            866      $  6,105      

Issuance of series B preferred stock, net of issuance costs         2,622              3           --          12,787      
Issuance of common stock under stock option plans                    --             --               43            19      
Deferred compensation related to certain options and stock
   purchase rights granted to employees and consultants,             --             --             --           2,265      
   net of amortization
Issuance of warrants                                                 --             --             --             250      
Net loss                                                             --             --             --            --        
                                                                 --------       --------       --------      --------      
Balances at December 31, 1995                                       3,965              4            909        21,426      
                                                                 --------       --------       --------      --------      

Issuance of common stock in initial public offering
   ("IPO"), net of issuance costs of $2,981                          --             --            2,500        24,521      
Conversion of preferred stock into common stock in
   conjunction with IPO in February                                (3,965)            (4)         3,965             4      
Issuance of common stock under stock option and purchase plans       --             --               63           118      
Issuance of common stock warrants                                    --             --               10          --        
Issuance of common stock pursuant to private placement,
   net of issuance costs                                             --             --              972         5,930      
Issuance of common stock upon asset purchase from
   SmithKline Beecham                                                --             --              638         9,000      
Payment of notes receivable                                          --             --             --            --        
Deferred compensation related to certain options and stock
   purchase rights granted to employees and consultants,    
   net of amortization                                               --             --             --               8      
Unrealized loss on investments                                       --             --             --              (3)     
Net loss                                                             --             --             --            --        
                                                                 --------       --------       --------      --------      
Balances at December 31, 1996                                        --             --            9,057        61,004      
                                                                 ========       ========       ========      ========      

Issuance of common stock under stock option and purchase         
   plans                                                             --             --              190           233      
Issuance of common stock pursuant to private placement,
   net of issuance costs                                             --             --            1,810        10,886      
Issuance of common stock pursuant to public offering, net
   of issuance costs                                                 --             --            1,750         5,008      
Conversion of redeemable preferred stock, Series A and
   preferred dividends                                               --             --              442         1,521      
Reduction of guaranteed market value of shares issued
   pursuant to asset purchase agreement with  SmithKline         
   Beecham                                                           --             --             --          (1,000)     
Repurchase of officer's common stock                                 --             --             --            --        
Amortization and reversal of deferred compensation                   --             --             --             (91)     
Unrealized gain on investments                                       --             --             --               5      
Net loss                                                             --             --             --            --        
                                                                 --------       --------       --------      --------      
Balances at December 31, 1997                                        --         $   --           13,249      $ 77,566      
                                                                 ========       ========       ========      ========      
</TABLE>

<TABLE>
<CAPTION>
                                                                 
                                                                    NOTES       DEFERRED       ACCUMULATED     
                                                                 RECEIVABLE   COMPENSATION       DEFICIT       
                                                                 ----------   ------------     -----------     
<S>                                                              <C>          <C>              <C>             
                                                                 
Balances at December 31, 1994                                     $    (97)      $   --         $ (8,928)      

Issuance of series B preferred stock, net of issuance costs            (28)          --             --         
Issuance of common stock under stock option plans                       (9)          --             --         
Deferred compensation related to certain options and stock
   purchase rights granted to employees and consultants,              --           (1,933)          --         
   net of amortization
Issuance of warrants                                                  --             --             --         
Net loss                                                              --             --          (10,372)      
                                                                  --------       --------       --------       
Balances at December 31, 1995                                         (134)        (1,933)       (19,300)      
                                                                  --------       --------       --------       

Issuance of common stock in initial public offering
   ("IPO"), net of issuance costs of $2,981                           --             --             --         
Conversion of preferred stock into common stock in
   conjunction with IPO in February                                   --             --             --         
Issuance of common stock under stock option and purchase plans        --             --             --         
Issuance of common stock warrants                                     --             --             --         
Issuance of common stock pursuant to private placement,
   net of issuance costs                                              --             --             --         
Issuance of common stock upon asset purchase from
   SmithKline Beecham                                                 --             --             --         
Payment of notes receivable                                             59           --             --         
Deferred compensation related to certain options and stock
   purchase rights granted to employees and consultants,    
   net of amortization                                                --              618           --         
Unrealized loss on investments                                        --             --             --         
Net loss                                                              --             --          (18,514)      
                                                                  --------       --------       --------       
Balances at December 31, 1996                                          (75)        (1,315)       (37,814)      
                                                                  --------       --------       --------       

Issuance of common stock under stock option and purchase         
   plans                                                              --             --             --         
Issuance of common stock pursuant to private placement,
   net of issuance costs                                              --             --             --         
Issuance of common stock pursuant to public offering, net
   of issuance costs                                                  --             --             --         
Conversion of redeemable preferred stock, Series A and
   preferred dividends                                                --             --             (124)      
Reduction of guaranteed market value of shares issued
   pursuant to asset purchase agreement with  SmithKline         
   Beecham                                                            --             --             --         
Repurchase of officer's common stock                                  --             --             --         
Amortization and reversal of deferred compensation                    --              552           --         
Unrealized gain on investments                                        --             --             --         
Net loss                                                              --             --          (27,935)      
                                                                  --------       --------       --------       
Balances at December 31, 1997                                     $    (75)      $   (763)      $(65,873)      
                                                                  ========       ========       ========       
</TABLE>


<TABLE>
<CAPTION>
                                                                 
                                                                     TREASURY STOCK
                                                                  SHARES         AMOUNT          TOTAL
                                                                 --------       --------       --------
<S>                                                              <C>            <C>            <C>     
                                                                 
Balances at December 31, 1994                                        --         $   --         $ (2,919)

Issuance of series B preferred stock, net of issuance costs          --             --           12,762
Issuance of common stock under stock option plans                    --             --               10
Deferred compensation related to certain options and stock
   purchase rights granted to employees and consultants,             --             --              332
   net of amortization
Issuance of warrants                                                 --             --              250
Net loss                                                             --             --          (10,372)
                                                                 --------       --------       --------
Balances at December 31, 1995                                        --             --               63
                                                                 --------       --------       --------

Issuance of common stock in initial public offering
   ("IPO"), net of issuance costs of $2,981                          --             --           24,521
Conversion of preferred stock into common stock in
   conjunction with IPO in February                                  --             --             --
Issuance of common stock under stock option and purchase plans       --             --              118
Issuance of common stock warrants                                    --             --             --
Issuance of common stock pursuant to private placement,
   net of issuance costs                                             --             --            5,930
Issuance of common stock upon asset purchase from
   SmithKline Beecham                                                --             --            9,000
Payment of notes receivable                                          --             --               59
Deferred compensation related to certain options and stock
   purchase rights granted to employees and consultants,    
   net of amortization                                               --             --              626
Unrealized loss on investments                                       --             --               (3)
Net loss                                                             --             --          (18,514)
                                                                 --------       --------       --------
Balances at December 31, 1996                                        --             --           21,800
                                                                 --------       --------       --------

Issuance of common stock under stock option and purchase         
   plans                                                             --             --              233
Issuance of common stock pursuant to private placement,
   net of issuance costs                                             --             --           10,886
Issuance of common stock pursuant to public offering, net
   of issuance costs                                                 --             --            5,008
Conversion of redeemable preferred stock, Series A and
   preferred dividends                                               --             --            1,397
Reduction of guaranteed market value of shares issued
   pursuant to asset purchase agreement with  SmithKline         
   Beecham                                                           --             --           (1,000)
Repurchase of officer's common stock                                   (5)           (46)           (46)
Amortization and reversal of deferred compensation                   --             --              461
Unrealized gain on investments                                       --             --                5
Net loss                                                             --             --          (27,935)
                                                                 --------       --------       --------
Balances at December 31, 1997                                          (5)      $    (46)      $ 10,809
                                                                 ========       ========       ========
</TABLE>


                 See accompanying notes to financial statements.


                                      F-5
<PAGE>   52
                              CONNETICS CORPORATION
                            STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)


<TABLE>
<CAPTION>
                                                                                        YEARS ENDED DECEMBER 31,
                                                                                 --------------------------------------
                                                                                   1997           1996           1995
                                                                                 --------       --------       --------
<S>                                                                              <C>            <C>            <C>      
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss                                                                         $(27,935)      $(18,514)      $(10,372)
Adjustments to reconcile net loss to net cash used by operating activities:
  Depreciation and amortization                                                     7,911          1,237            393
  Technology acquired in exchange for note payable and other
     long-term liability                                                             --             --              855
  Amortization of deferred compensation                                               461            626            332
  Accrued interest on notes payable                                                 1,107           --             --
  Gain on sale of Canadian rights to Ridaura                                         (525)          --             --
  Changes in assets and liabilities:
    Accounts receivable                                                            (1,099)          (428)          --
    Current and other assets                                                          (17)           690           (731)
    Accounts payable                                                               (2,687)         3,738           (117)
    Accrued liabilities                                                              (809)         2,203            843
                                                                                 --------       --------       --------
Net cash used by operating activities                                             (23,593)       (10,448)        (8,797)
                                                                                 --------       --------       --------

Cash flows from investing activities:
Purchases of short-term investments                                               (12,152)       (21,650)        (7,560)
Sales and maturities of short-term investments                                     16,263         11,648          7,560
Capital expenditures                                                                 (865)          (461)          (400)
Sale of Canadian rights to Ridaura                                                  1,300           --             --
Payment for licensed assets and product rights                                     (1,000)        (3,000)          --
                                                                                 --------       --------       --------
Net cash used in investing activities                                               3,546        (13,463)          (400)
                                                                                 --------       --------       --------

Cash flows from financing activities:
Proceeds (payments) from bank loans                                                  --             --             (750)
Payment of notes payable                                                             --           (2,205)          --
Proceeds from capital loans and long-term debt                                        333            323          5,230
Payments on obligations under capital leases and capital loans                     (2,470)        (1,244)          (319)
Proceeds from issuance of redeemable preferred stock                                 --            2,000           --
Proceeds from issuance of preferred and common stock, net                          16,081         30,569         12,772
                                                                                 --------       --------       --------
Net cash provided by financing activities                                          13,944         29,443         16,933
                                                                                 --------       --------       --------
Net change in cash and cash equivalents                                            (6,103)         5,532          7,736
Cash and cash equivalents at beginning of period                                   14,555          9,023          1,287
                                                                                 --------       --------       --------
Cash and cash equivalents at end of period                                       $  8,452       $ 14,555       $  9,023
                                                                                 ========       ========       ========

SUPPLEMENTARY INFORMATION:
Interest paid                                                                    $    615       $  1,062       $    274

INVESTING AND FINANCING ACTIVITIES:
Assets acquired under capital leases                                             $   --         $    199       $    171
Issuance of warrants                                                             $   --         $   --         $    250
Deferred compensation related to stock options and purchase rights               $   --         $    145       $  2,265
Issuance of common stock for licensed assets and product rights purchased
  from SmithKline Beecham                                                        $   --         $  9,000       $   --
Issuance of note payable for  licensed assets and product rights purchased
  from SmithKline Beecham                                                        $   --         $  9,375       $   --
Preferred dividends on redeemable preferred stock, series A                      $    124       $   --         $   --
Conversion of redeemable preferred stock, series A and preferred
  dividends into common stock                                                    $  1,521       $   --         $   --
</TABLE>


                 See accompanying notes to financial statements.


                                      F-6
<PAGE>   53
                              CONNETICS CORPORATION


                          NOTES TO FINANCIAL STATEMENTS

                                DECEMBER 31, 1997


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 until December 1996, the Company was in the development stage,
principally 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. On December 31, 1996, the Company acquired exclusive U.S. and
Canadian rights to Ridaura(R), a disease modifying antirheumatic drug, from
SmithKline Beecham Corporation and related entities ("SmithKline"). Ridaura is
the first product the Company markets and it signifies the beginning of the
Company's transition from purely product development to a revenue based sales
and marketing company. The Company has no products from its current development
programs available for sale and does not expect to have any within the next
year. 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 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 (which is presently unavailable) (see Note 6), 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 may 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 third parties the rights to commercialize products or
technologies that the Company would otherwise seek to develop and market itself.


                                      F-7
<PAGE>   54
        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

        Statement of Financial Accounting Standards No. 107, "Disclosures About
Fair Value of Financial Instruments," requires that fair values be disclosed for
most of the Company's financial instruments. The carrying amount of cash, cash
equivalents and short-term investments, accounts receivable, 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 which have
reached their expiration date. The Company has not experienced significant
returns of expired product since its acquisition of U.S. and Canadian rights to
Ridaura in December 1996. In 1997, the Company's sole customer was SmithKline
who in turn distributed Riduara under a Transitional Services Agreement with the
Company. At December 31, 1997, the Company had accounts receivable from
SmithKline on an uncollateralized basis of $1.6 million. These amounts were paid
in full in February 1998.

        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.


<PAGE>   55
        Net loss per share

        In February 1997, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share"
(SFAS 128), which requires the Company to simplify the calculation of earnings
per share ("EPS") and achieve comparability with the recently issued
International Accounting Standard No. 33, "Earnings Per Share." Statement 128
replaced the calculation of primary and fully diluted earnings per share with
basic and diluted earnings per share. Unlike primary earnings per share, basic
earnings per share excludes any dilutive effects of options, warrants and
convertible securities. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. All earnings per share
amounts for all periods presented have been restated, where appropriate, to
conform to the Statement 128 requirements (see Note 13).

        Basic and diluted loss per share for 1995 have been retroactively
restated to apply the requirements of Staff Accounting Bulletin No. 98, issued
by the SEC in February 1998 ("SAB 98"). Under SAB 98, certain shares of common
stock and options and warrants to purchase shares of common stock issued at
prices substantially below the per share price of shares sold in the Company's
initial public offering previously included in the computation of shares
outstanding pursuant to Staff Accounting Bulletin Nos. 55, 64 and 83 are now
excluded from the computation.

        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.

        New accounting standards

        In June 1997, the Financial Accounting Standards Board issued Statement
No. 130, "Reporting Comprehensive Income" (SFAS 130), and Statement No. 131,
"Disclosures about Segments of an Enterprise and Related Information" (SFAS
131). The Company is required to adopt these Statements in fiscal 1998. SFAS 130
establishes new standards for reporting and displaying comprehensive income and
its components. SFAS 131 requires disclosure of certain information regarding
operating segments, products and services, geographic areas of operation and
major customers. Adoption of these Statements is expected to have no impact on
the Company's financial position, results of operations or cash flows.

2.  CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS:

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

<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>


<PAGE>   56
<TABLE>
<CAPTION>
                                                                   December 31, 1996
                                                  ------------------------------------------------------
                                                                    Gross        Gross
                                                   Amortized     Unrealized    Unrealized     Estimated
                                                     Costs          Gains         Loss        Fair Value
                                                  ----------     ----------    ----------     ----------
<S>                                               <C>            <C>           <C>            <C>       
Corporate bonds ............................      $    9,802     $        2    $       (5)    $    9,799
Commercial paper ...........................           8,269           --            --            8,269
Certificate of deposits ....................           5,021           --            --            5,021
Money market funds .........................              14           --            --               14
                                                  ----------     ----------    ----------     ----------
      Total ................................          23,106              2            (5)        23,103
Less amount classified as cash equivalents .         (13,104)          --            --          (13,104)
                                                  ----------     ----------    ----------     ----------
Total short-term investments ...............      $   10,002     $        2    $       (5)    $    9,999
                                                  ==========     ==========    ==========     ==========
</TABLE>


        The net unrealized holding gain (loss) on available-for-sale investments
included as a separate component of stockholders' equity at December 31, 1997
and 1996 totaled $2,000 and $(3,000), respectively. The gross realized gains on
sales of available-for-sale investments for the years ended December 31, 1997
and 1996 totaled $442,000 and $543,000, respectively and gross realized losses
for the same periods totaled $78,000 and $289,000, respectively. Realized gains
and losses were calculated based on the specific identification method.

3.  PROPERTY AND EQUIPMENT:

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

<TABLE>
<CAPTION>
                                                         December 31,
                                                    ---------------------
                                                      1997          1996
                                                    -------       -------
<S>                                                 <C>           <C>    
Laboratory equipment .........................      $ 1,779       $ 1,357
Computer equipment ...........................          501           288
Furniture and fixtures .......................          397           224
Leasehold improvements .......................          729           672
                                                    -------       -------
                                                      3,406         2,541
Less accumulated depreciation and amortization       (1,743)       (1,057)
                                                    -------       -------
Property and equipment, net ..................      $ 1,663       $ 1,484
                                                    =======       =======
</TABLE>

        Property and equipment includes assets under capitalized leases at
December 31, 1997 and 1996 of approximately $1,005,000. Accumulated amortization
related to leased assets was approximately $831,000 and $559,000 at December 31,
1997 and 1996, respectively. There were no new capitalized leases for the twelve
months ended December 31, 1997.

4.  NOTES RECEIVABLE FROM RELATED PARTIES

        At December 31, 1997 and 1996, the Company held notes receivable from
officers of the Company totaling $333,000 and $301,000, respectively. These
notes, which bear interest at rates ranging from 6.0% to 8.5% annually, are
collateralized by certain personal assets of the officers and are generally due
and payable within three to five years.


<PAGE>   57
5.  RESEARCH AND LICENSE AGREEMENTS:

        Licensed Assets and 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. Under the Asset Purchase
Agreement, the Company paid $3.0 million in cash in January 1997, issued a
non-interest bearing $11.0 million promissory note payable in two installments,
in January 1998 and January 1999 of $6.0 million and $5.0 million, 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 to be amortized over the term of the
note. The total purchase price of $21.4 million has been capitalized. The
Company determined the useful life of this asset to be three years based on
information regarding products currently in the Company's development pipeline,
competitive products, the off-patent position of Ridaura and expected future
revenues from Ridaura, and has recorded amortization expense of $7.1 million and
$0.6 million for the years ended December 31, 1997 and 1996, respectively.
Accumulated amortization at December 31, 1997 and 1996 were $7.7 million and
$0.6 million, respectively.

        On November 13, 1997, the Company amended the repayment terms of its
non-interest bearing $11.0 million promissory note with SmithKline. The
amendment allows the Company to defer the first $6.0 million installment
payment, originally due in January 1998, to April 1998, October 1998 and January
1999 with payments of $1.0 million, $1.5 million and $3.5 million, respectively.
The Company is required to pay interest on the principal amount outstanding of
the $6.0 million from January 1, 1998 through January 4, 1999 at prime rate plus
2% (10.5% at December 31, 1997). The second installment payment of $5.0 million
under the note remains due in January 1999.

        On December 18, 1997, the Company amended the equity and asset purchase
agreements with SmithKline. Pursuant to the omnibus amendment, the guaranteed
value of the common stock was revised form $9.0 million based on the fair market
value of the Company's common stock on December 31, 1997 to $8.0 million on
April 1, 1998, with a maximum of 1,675,512 shares to be issued in total. In the
event that the sum of such shares exceeds 1,675,512 shares, the dollar value of
the excess portion of the second issuance shall be added to the Company's
maximum sales-based royalty payments of $6.0 million to be paid to SmithKline at
a royalty rate equal to 8% of net sales of Ridaura commencing from the time of
closing. The Company also paid SmithKline $1.0 million on December 31, 1997 in
consideration of the amendment. This amendment also adjusts the November 13,
1997 amended note repayments from $1.5 million and $3.5 million to $1.0 million
and $4.0 million in October 1998 and January 1999, respectively. All other
payment terms pertaining to the November 13, 1997 amendment remain unchanged. As
of December 31, 1997, the Company has classified principal and accrued interest
on this note of $2.0 million in current portion of notes payable and other
liabilities and $8.5 million in other long-term liabilities.

        Under a related Transitional Services Agreement, customer orders and
distribution for the product were managed by SmithKline through 1997 with no
additional consideration for performing such services. The parties also entered
into a Supply Agreement, under which SmithKline will manufacture and supply
Riduara, in final package form, to the Company for an initial term through
December 2001.


<PAGE>   58
        On December 18, 1997, the Company also entered into a Canadian Asset
Purchase Agreement ("Canadian Rights") and a supply agreement with
Pharmascience, Inc., a Canadian corporation, whereby the Company sold its
Canadian rights to Ridaura for a net consideration of $1.3 million. Under the
Supply Agreement with Pharmascience, Inc. the Company, through its relationship
with SmithKline or other future vendors, will supply Ridaura exclusively in
Canada to Pharmascience, Inc. At December 31, 1997, the book value of the
Canadian rights to Ridaura was approximately $775,000. As a result, the Company
recognized $525,000 in gain on the sale of the Canadian rights to Pharmascience,
Inc. in 1997.

        License agreements

        In September 1993, the Company entered into a Letter Agreement and a
License Agreement with a corporation (the "Licensor"), which was subsequently
amended in July 1994, for an exclusive right to make, use and sell certain
products arising from licensed technology in a defined field and territory in
exchange for Series A preferred stock which 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, is due
in September 1998 and has been included in current portion of notes payable and
other liabilities. The Company will also pay to the Licensor royalties on sales
of products arising from the licensed technology, if any. In April 1996, the
Company acquired worldwide rights to such technology from the Licensor.

        In June 1996, the Company entered into an exclusive License Agreement
with Soltec Research Pty Ltd. (the "Licensor"), to develop and market
betamethasone mousse (a quick-break 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 and $22,500 was paid
in January 1998, in licensing fees to the Licensor (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 the Licensor's foam
formulation for the delivery of other compounds.

        Technology acquisition agreement

        In June 1994, the Company entered into a Technology Acquisition
Agreement (the "Agreement") with a corporation to purchase all rights to certain
technology and for the exclusive right to make, use and sell certain products
pursuant to a sublicense agreement in exchange for the issuance of a $1,350,000
subordinated promissory note. The note, including interest, was paid in full in
February 1996 after the closing of the Company's initial public offering of
common stock. In addition to this note, the Company has accrued additional
consideration of $500,000, 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.
This amount has been included in other long-term liabilities.

        The Agreement also provided for certain contingent payments based on
future financings. As a result of the Series B financing which was completed in
1995, the Company issued an additional note in the amount of $855,000 under this
Agreement. The note, including interest, was paid in full in February 1996 after
the closing of the Company's initial public offering of common stock. An
additional $1,000,000 will be payable by the Company upon FDA approval of a
product involving the licensed technology.

        Under the terms of the Agreement, the Company is also committed to pay
royalties on applicable sales.


<PAGE>   59
        Technology license agreement

        In December 1995, the Company entered into a Technology License
Agreement (the "License") to acquire exclusive rights to develop and market
products arising from certain licensed technology, other than for its currently
marketed indications, for dermatological diseases in the United States as part
of a collaborative marketing and profit sharing agreement. Such agreement is
contingent upon the Company using its best efforts to achieve commencement of a
Phase III clinical trial within 30 months of the agreement effective date. In
September 1996, the Company achieved this milestone with the initiation of a
Phase III clinical trial. In August 1997, the Company announced the results from
its Phase III clinical trial, and analysis of the trial did not show an
acceptable therapeutic response to the primary clinical endpoint. As a result,
the Company has suspended plans to submit a Biological License Application (BLA)
for this licensed technology.

6.  FINANCING ARRANGEMENTS

        Long-Term Debt

        On December 21, 1995, the Company entered into a term Loan and Security
Agreement (the "Term Loan") with a bank consortium (the "Lenders") under which
the Company borrowed $5,000,000. The Term Loan bears interest at 13%, with
interest only payments for the first six months, and interest and principal
payments for the following 30 months. In connection with the Term Loan, the
Company issued a warrant to purchase 73,071 shares of Common Stock at an
exercise price of $5.78 per share. The warrant is exercisable at any time
through December 2002. In conjunction with the Term Loan, the Company granted
the lender a first security interest in its corporate assets. Under the terms of
the loan, the Company is required to maintain a minimum cash balance of the
greater of $6,000,000 or six times the Company's average monthly cash usage. If
the Company violates the covenants during the loan period, the Company would be
required to pledge restricted cash of 65% of the outstanding loan, or $1,427,000
as of December 31, 1997, to cure the violation. At December 31, 1997, the
Company was in compliance with these covenants.

        Future minimum principal payment under the Term Loan for year ending
December 31, 1998 is $2,196,000, at which point the loan will be paid in full.

        Structured Equity Line Flexible Financing

        On December 2, 1996, the Company entered into a Structured Equity Line
Flexible Financing Agreement (the "Agreement") with Kepler Capital LLC
("Kepler") that allows the Company to access up to $25 million through sales of
its Common Stock. The equity line will be available for a three-year period
beginning on or before December 1, 1997. The Agreement provides that the Company
can obtain from $500,000 to $2,000,000 at any one time through a sale of its
Common Stock to Kepler, subject to the satisfaction of certain conditions,
including registration of the shares for resale, minimum volume requirements,
and a minimum trading price of $7.00 per share over a specified period. In
addition, the Company must sell $500,000 of its Common Stock from time to time
if the price per share exceeds $10.00 and certain volume conditions are met.
Such sales will occur no more frequently than every 60 trading days. Any shares
sold under the equity line will be priced at 93% of the lesser of (i) the
average of the daily low trading price of the Common Stock for the 5 days
preceding the sale and (ii) the weighted average of daily low trading price of
the Common Stock during a valuation period. The purchase price will be subject
to further adjustment, up to a maximum discount of 15% depending on the length
of the valuation period - the period following the purchase date and ending on
the day, not to exceed 80 trading 


<PAGE>   60
days, on which the aggregate value of open market trading during the period
equals or exceeds the aggregate value of open market trading during the 20 days
preceding the purchase date. 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). The Company's trading price has been below
the $7.00 minimum price requirement since September 1997 and, as a result, is
currently unable to draw under the equity line.

7.  CAPITAL LEASE OBLIGATIONS AND CAPITAL LOANS

        The Company has capital lease and capital loan credit lines available
totaling $3,222,000 at December 31, 1997, of which $598,000 was unused and
available at December 31, 1997. Under the terms of the master lease agreement,
ownership of the leased equipment reverts to the Company at the end of the lease
term.

        As of December 31, 1997, future minimum lease payments under capital
leases and principal payments on capital loans are as follows:


<TABLE>
<CAPTION>
                                                               CAPITAL LEASES   CAPITAL LOANS
                                                               --------------   -------------
                                                                       (IN THOUSANDS)
<S>                                                            <C>              <C>     
Year ending December 31:                                                        
  1998 .................................................          $    302         $    293
  1999 .................................................                79              225
  2000 .................................................                54              168
  2001 .................................................                39             --
  Thereafter ...........................................              --               --
                                                                  --------         --------
Total minimum lease and principal payments, respectively               474         $    686
                                                                  --------         ========
Less amount representing interest ......................                61      
                                                                  --------      
Present value of future payments .......................               413      
Less current portion of capital lease obligations ......               263      
                                                                  --------      
Non-current portion of capital lease obligations .......          $    150      
                                                                  ========      
</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.

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 future
minimum rental payments under the leases are as follows (in thousands):

<TABLE>
             Years ending December 31:
<S>                                                            <C>   
             1998..........................................    $  692
             1999..........................................       379
                                                               ------
                                                               $1,071  
                                                               ======
</TABLE>


        The Company recognizes rent expenses on a straight-line basis over the
term of each lease. Rent expense under operating leases was approximately
$639,000, $425,000 and $416,000 for the years ended December 31, 1997, 1996 and
1995, respectively.


<PAGE>   61
9.  NOTES RECEIVABLE FROM STOCKHOLDERS

        At December 31, 1997 and 1996, the Company held $75,000 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.

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 $.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. Dividends and
principal on the Series A Redeemable Preferred Stock are convertible into common
stock at a conversion price equal to 85% of the average daily low price for the
ten trading days immediately preceding the conversion date. Each holder is
entitled to convert all or a portion of its Series A Redeemable Preferred Stock
into common stock at any time. Any Series A Redeemable Preferred Stock that upon
conversion would result in the cumulative issuance of common stock in excess of
20% of the outstanding common stock, will be automatically redeemed by the
Company for cash at a redemption price equal to 120% of the $10,000 original
purchase price plus accrued dividends at the rate of 7%. As of December 31,
1997, 140 shares of Series A Redeemable Preferred Stock plus accrued dividends
of $121,000 had been converted to 442,409 shares of common stock with a value of
$1,521,000.

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
$.001 per share. Prior to the Company's initial public offering, two series of
Preferred Stock, Series A and B were issued. 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 Articles 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 warrant for the purchase of
preferred stock was converted into a warrant for the purchase of one share of
common stock and such warrants are exercisable any time through the later of
seven years from grant date or five years from the Company's initial public
offering of common stock in February 1996.

        In connection with a Master Bridge Loan Agreement with certain
stockholders of the company in December 1995, the Company issued warrants which
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.


<PAGE>   62
        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 $7.425 per share, with an expiration date of
December 4, 2001.

        In conjunction with the Structured Equity Line Flexible Financing
Agreement in December 1996 (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 the Investor 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.

        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 terms determined by the
Board of Directors.

        At December 31, 1997 and 1996, outstanding shares of 36,202 and 154,786,
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 banks' prior written consent.

        Common shares reserved for future issuance

        The Company has reserved shares of common stock as follows:

<TABLE>
<CAPTION>
                                                    DECEMBER 31,
                                            ----------------------------
                                               1997               1996
                                            ---------          ---------
<S>                                         <C>                <C>      
1994 Stock Plan ..................          1,706,467          1,353,347
1995 Employee Stock Purchase Plan              46,147             88,126
1995 Directors Stock Option Plan .            150,000            150,000
Non-plan stock options outstanding             38,863               --
Common stock warrants ............          1,289,193            384,193
                                            ---------          ---------
                                            3,230,670          1,975,666
                                            =========          =========
</TABLE>

        In addition, the Company is required to reserve shares of common stock
for issuance upon the conversion of the Series A Redeemable Convertible
Preferred Stock based on the conversion formula. This amount was approximately
221,280 shares at December 31, 1997.


<PAGE>   63
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, nonstatutory
stock options, and stock purchase rights for up to 2,000,000 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, nonstatutory 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 Company's Board of Directors, 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.

        1995 Director Stock Option Plan

        The 1995 Director Stock Option Plan (the "Directors' Plan") was adopted
by the Board of Directors in December 1995. A total of 150,000 shares of Common
Stock has been reserved for issuance under the Directors' Plan. The Directors'
Plan provides for the grant of nonstatutory stock options to nonemployee
directors of the Company.

        The Directors' Plan provides that each person who first becomes a
nonemployee director of the Company after the date of the Company's initial
public offering shall be granted a nonstatutory stock option to purchase 30,000
shares of Common Stock (the "First Option") on the date on which the optionee
first becomes a nonemployee director of the Company. The First Option was not
granted to any nonemployee director who was a director as of the date of the
offering. Thereafter, on the date of each annual meeting of the Company's
stockholders, each nonemployee director (including directors who were not
eligible for a First Option) shall be granted an additional option to purchase
7,500 shares of Common Stock (a "Subsequent Option") if, on such date, he or she
shall have served on the Company's Board of Directors 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, 1997, 105,000
shares had been granted and outstanding at a weighted average price of $6.9643,
with 45,000 available for future grants.


<PAGE>   64
        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, 1997, a total of
39,612 Non Plan Stock Options were granted. At December 31, 1997, 38,863 shares
were outstanding at a weighted average price of $4.7439 per share.

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

<TABLE>
<CAPTION>
                                                                                  OUTSTANDING OPTIONS
                                                                             ----------------------------
                                                          SHARES                                WEIGHTED
                                                      AVAILABLE FOR          NUMBER OF         AVG. PRICE
                                                          GRANT               SHARES            PER SHARE
                                                      -------------          ---------         ---------- 
<S>                                                   <C>                   <C>                <C>     

Balance, December 31, 1994 ..................             223,803               57,772           $   0.45
  Additional shares authorized ..............           1,011,758                 --                 --
  Stock purchase rights granted .............             (37,320)                --             $   0.45
  Options granted ...........................            (910,178)             910,178           $   0.71
  Options exercised .........................                --                 (3,193)          $   0.45
  Options and stock purchase rights canceled.               9,778               (8,655)          $   0.45
                                                        ---------            ---------                    
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
                                                        =========            =========                    
</TABLE>


        The following table summarizes information concerning outstanding and
exercisable options at December 31, 1997:

<TABLE>
<CAPTION>
                                           OPTIONS OUTSTANDING                        OPTIONS EXERCISABLE
                            --------------------------------------------------  --------------------------------
                                              WEIGHTED-AVG.
                                                REMAINING       WEIGHTED-AVG.                      WEIGHTED-AVG.
RANGE OF                        NUMBER OF      CONTRACTUAL        EXERCISE          NUMBER OF        EXERCISE
EXERCISE PRICE                   SHARES      LIFE (IN YEARS)       PRICE             SHARES           PRICE
--------------                 ----------    ---------------    -------------       ---------      -------------
<S>                            <C>           <C>                <C>                 <C>            <C>  

$0.4448 - $ 0.4500                565,628          7.71            $0.44              282,725         $0.45
$2.2239 - $ 6.7500                524,775          9.22            $4.27               83,352         $2.81
$7.1250 - $11.0000                641,440          8.90            $7.80              122,793         $8.68
                               ----------          ----            -----              -------         -----
$0.4448 - $11.0000              1,731,843          8.61            $4.33              488,870         $2.92
</TABLE>

        For the years ended December 31, 1997 and 1996, the Company recorded
deferred compensation expense for the difference between the exercise price and
the deemed fair value of the Company's common 


<PAGE>   65
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.

        1995 Employee Stock Purchase Plan

        The Company's 1995 Employee Stock Purchase Plan (the "Purchase Plan")
was adopted by the Board of Directors in December 1995. A total of 100,000
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 of
Directors. Employees (including officers and employee directors) of the Company,
or of any majority owned subsidiary designated by the Board of Directors, 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 1997 and 1996,
53,853 and 11,874 shares, respectively, had been issued under the plan and as of
December 31, 1997, 46,147 shares were reserved for future issuance.

        Pro Forma Information

        The Company adopted Statement of Financial Accounting Standards ("SFAS")
No. 123, "Accounting for Stock-Based Compensation," in 1996. In accordance with
the provisions of SFAS No. 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 1995 Employee Stock Purchase
Plan as prescribed by SFAS No. 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)          1997                1996
                                             ----------           ---------- 
<S>                                          <C>                  <C>        
Net loss - as reported ............          $  (27,935)          $  (18,514)
Net loss - pro forma ..............          $  (29,287)          $  (19,339)
Net loss per share - as reported...          $    (2.69)          $    (2.71)
Net loss per share - pro forma ....          $    (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 Plan              Stock Purchase Plan
                                            ---------------------           ---------------------
                                             1997            1996            1997            1996
                                            -----           -----           -----           -----
<S>                                         <C>             <C>             <C>             <C>  
Expected stock price volatility             60.0%           60.0%           60.0%           60.0%
Risk-free interest rate .......              5.77%           5.91%           5.63%           5.48%
Expected life (in years) ......              4.1             3.6             0.5             0.5
Expected dividend yield .......              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. 


<PAGE>   66
Because the Company's options have characteristics significantly different from
those of traded options, and because changes in the subjective input assumptions
can materially affect the fair value estimate, in 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
1997 and 1996 was $3.1174 and $4.846 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.
Because SFAS 123 is applicable only to options granted subsequent to December
31, 1994, its pro forma effect will not be fully reflected until 1998.

        1997 Stockholder Rights Plan

        In May 1997, the Company adopted a stockholder rights plan (the "Rights
Plan") which 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 which are not in the best interest of
stockholders. At December 31, 1997, 90,000 shares were designated and no shares
were issued and outstanding.

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)                           1997               1996               1995
                                                                     --------           --------           --------
<S>                                                                  <C>                <C>                <C>      
Numerator:
   Net loss ...................................................      $(27,935)          $(18,514)          $(10,372)
   Preferred stock dividends ..................................          (124)              --                 --
                                                                     --------           --------           --------
   Numerator for basic and diluted earnings per share --
     loss to common stockholders ..............................       (28,059)           (18,514)           (10,372)

Denominator:
   Denominator for basic and diluted earnings per share --
     weighted-average shares ..................................        10,412              6,825                877
   Adjusted to reflect the effect of the assumed conversion
     of preferred stock from date of issuance .................                                               3,557
                                                                                                            -------
   Denominator for pro forma basic and diluted net loss
       per share ..............................................                                               4,434


Basic and diluted net loss per share ..........................      $  (2.69)          $  (2.71)
                                                                     ========           ========

Pro forma basic and diluted net loss per share ................                                            $  (2.34)
                                                                                                           ========
</TABLE>


Options to purchase 1,731,843 shares of common stock at exercise prices ranging
from $0.4448 to $11.00, warrants to purchase 1,289,193 shares of common stock at
exercise prices ranging from $4.89 to $11.00, 


<PAGE>   67
and 600 shares of redeemable convertible preferred stock, Series A were
outstanding during 1997 but were not included in the computation of diluted
earnings per share as their effect would be antidilutive.

13. INCOME TAXES

        As of December 31, 1997, the Company had federal and state net operating
loss carryforwards of approximately $59,700,000 and $12,600,000, respectively.
The Company also had federal and California research and development tax credit
carryforwards of approximately $1,300,000 and $1,000,000, respectively. The
federal net operating loss and credit carryforwards will expire at various dates
beginning in the year 2008 through 2012, if not utilized. The state of
California net operating losses will expire at various dates beginning in 1998
through 2002, 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. Significant components of the Company's
deferred tax assets for federal and state income taxes are as follows:

<TABLE>
<CAPTION>
                                                         DECEMBER 31,
                                                 ---------------------------
                                                   1997               1996
                                                 --------           --------
<S>                                              <C>                <C>     
                                                        (IN THOUSANDS)
Deferred tax assets
   Net operating loss carryforward ....          $ 21,000           $ 11,300
   Capitalized research and development             2,400              1,200
   Research credit ....................             1,900                800
   Other - Net ........................               600              1,200
                                                 --------           --------
   Total Deferred Tax Assets ..........            25,900             14,500
   Valuation allowance ................           (25,900)           (14,500)
                                                 --------           --------
Net deferred tax assets ...............          $   --             $   --
                                                 ========           ========
</TABLE>


        Due to the Company's lack of earnings history, the net deferred tax
assets has been fully offset by a valuation allowance. The net valuation
allowance increased by $11,400,000 and $7,200,000 for the fiscal years ended
December 31, 1997 and 1996, respectively.


<PAGE>   68
                                 Exhibit Index


Exhibits   
 Number                            Description
--------                           -----------

3.1(1)      Form of Amended and Restated Certificate of Incorporation.
3.2(1)      Form of Bylaws.
3.3(5)      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.
3.4(11)     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.
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(1)      Form of Common Stock Certificate.
4.2(12)     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.


<PAGE>   69
10.1(1)     Form of Indemnification Agreement with the Company's directors and
            officers.
10.2(7)*    1994 Stock Plan, as amended, and form of Option Agreement.
10.3(7)*    1995 Employee Stock Purchase Plan, as amended, and form of
            Subscription Agreement.
10.4(1)*    1995 Directors' Stock Option Plan and form of Option Agreement.
10.5(1)     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.
10.6(1)(2)  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.
10.8(1)     Assignment and Assumption Agreement, dated June 3, 1994, by and
            between the Company and XOMA Corporation.
10.9(1)(2)  Technical Collaboration and Manufacturing Agreement, dated May 24,
            1994, by and between the Company and Scios Nova Inc.
10.10(1)(2) 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.
10.11(1)(2) Agreement on Interferon Gamma-1B dated December 8, 1995 by and
            between the Company and Genentech, Inc.
10.12(1)    Equipment Lease Line, dated May 31, 1994 with Lease Management
            Services, Inc.
10.13(1)    Business Loan Agreement, dated July 18, 1995, between the Company,
            Silicon Valley Bank and MMC/GATX Partnership No. 1.
10.14(1)(2) Research Collaboration and Assignment Agreement, dated July 1, 1994,
            between the Company and Dr. Arthur A. Vandenbark.
10.17(1)    Consulting Agreement dated November 17, 1993 between the Company and
            Brian Seed.
10.18(1)    Consulting Agreement dated November 17, 1993 between the Company and
            Eugene Bauer.
10.19(1)    Employment Agreement dated June 9, 1994 between the Company and
            Thomas Wiggans.
10.20(1)    Loan Agreements between the Company and Thomas Wiggans dated July
            15, 1994 and August 1, 1994.
10.21(1)    Letter Agreement with G. Kirk Raab dated October 1, 1995.
10.23(1)    Facility Master Lease between the Company and Renault & Handley
            dated February 9, 1994.
10.26(1)    Loan and Security Agreement dated December 21, 1995 by and among the
            Company, Silicon Valley Bank and MMC/GATX Partnership No. 1.
10.27(3)(2) Agreement on Relaxin Rights in Asia dated April 1, 1996 between the
            Company and Mitsubishi Chemical Corporation (Exhibits A and B to
            Exhibit 10.27 have been previously filed as Exhibit 10.6 above.
            Confidential treatment has been granted as to certain portions of
            Exhibit 10.6 by the SEC).
10.28(3)(2) Soltec License Agreement dated June 14, 1996.
10.29(4)    Laboratory Services Agreement dated October 24, 1996.
10.30(4)    Agreement with Dr. Edward Amento dated October 24, 1996.
10.31(4)    Form of Directors and Officers Change in Control Agreement
10.32(5)    Common Stock Purchase Agreement, dated December 4, 1996 by and among
            the Company and certain investors.
10.33(5)    Registration Rights Agreement, dated December 4, 1996 by and among
            the Company and certain investors.
10.34(5)    Securities Purchase Agreement, dated December 4, 1996 by and among
            the Company and a certain purchaser.
10.35(5)    Warrant, dated December 4, 1996 between the Company and a certain
            purchaser.
10.36(6)(2) 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.
10.37(6)    Stock Issuance Agreement dated December 31, 1996 between the Company
            and SmithKline Beecham Properties, Inc.
10.38(6)    Secured Promissory Note dated December 31, 1996 issued to SmithKline
            Beecham Corporation.


<PAGE>   70
10.39(6)    Security Agreement dated December 31, 1996 between the Company and
            SmithKline Beecham Corporation.
10.40(6)(2) Supply Agreement dated December 31, 1996 between the Company and
            SmithKline Beecham Corporation.
10.42(8)    Structured Equity Line Flexible Financing Agreement dated January 2,
            1997 between the Company and Kepler Capital LLC.
10.43(8)    Registration Rights Agreement dated January 2, 1997 between the
            Company and Kepler Capital LLC.
10.44(9)    Common Stock and Warrant Purchase Agreement dated May 15, 1997 by
            and among the Company, Genentech, Inc. and certain investors.
10.45(9)    Registration Rights agreement dated May 15, 1997 by and among the
            Company and certain investors.
10.46(9)    Form of Common Stock Purchase Warrant issued to certain investors on
            May 15, 1997.
10.47(7)*   Form of Notice of Stock Option Grant to G. Kirk Raab for stock
            option issued in January 1997.
10.48(10)   Secured Loan Agreement dated October 30, 1997 between the Company
            and W. Scott Harkonen.
10.49(10)*  Letter Agreement with Cynthia M. Butitta dated September 22, 1997.
10.50(10)   Amendment dated November 13, 1997 to Secured Promissory Note dated
            December 31, 1996 issued to SmithKline Beecham Corporation.
10.51(10)   Letter Agreement dated November 26, 1997 between the Company and
            Gerard Klauer Mattison & Co., Inc.
10.52(10)*  Letter Agreement with John L. Higgins dated August 25, 1997.
10.53(10)   Omnibus Agreement with SmithKline Beecham Corporation and related
            entities dated December 18, 1997.
10.54(10)   Canadian Asset Purchase Agreement with Pharmascience, Inc. dated
            December 19, 1997.
10.55(10)   Supply Agreement with Pharmascience, Inc. dated December 19, 1997.
10.56**     Agreement on Relaxin dated January 19, 1998 by and between the
            Company and Howard Florey Institute of Experimental Physiology and
            Medicine. 
10.57**     License Agreement dated January 1, 1998 between the Company and
            Soltec Research Pty Limited.
23.1        Consent of Ernst & Young LLP, Independent Auditors.
24.1        Power of Attorney (see page 46).
27.1        Financial Data Schedule (EDGAR filed version only).

----------

*       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.
**      The Company has omited certain portions of this Exhibit and has
        requested confidential treatment of such portions from the SEC.
1.      Incorporated by reference from an exhibit filed with the Company's
        Registration Statement on Form S-1 (File No. 33-80261) declared
        effective by the Securities and Exchange Commission (the "SEC") on
        January 31, 1996.
2.      Certain portions of this Exhibit were granted confidential treatment
        pursuant to an order from the SEC.
3.      Incorporated by reference from an exhibit to the Company's Quarterly
        Report on Form 10-Q (File No. 0-27406) filed with the SEC for the fiscal
        quarter ended June 30, 1996.
4.      Incorporated by reference from an exhibit to the Company's Quarterly
        Report on Form 10-Q (File No. 0-27406) filed with the SEC for the fiscal
        quarter ended September 30, 1996.
5.      Incorporated by reference from an exhibit to the Company's Report on
        Form 8-K (File No. 0-27406) dated December 4, 1996.
6.      Incorporated by reference from an exhibit to the Company's Report on
        Form 8-K (File No. 0-27406) dated January 15, 1997.
7.      Incorporated by reference from an exhibit filed with Post-Effective
        Amendment No. 1 to the Company's Registration Statement on Form S-8
        (File No. 333-04985) filed with the SEC on June 30, 1997.
8.      Incorporated by reference from an exhibit filed with the Company's
        Annual Report on Form 10-K (File No. 0-27406) for the fiscal year ended
        December 31, 1996.


<PAGE>   71
9.      Incorporated by reference from an exhibit filed with the Company's
        Registration Statement on Form S-3 (File No. 333-21941) filed with the
        SEC on July 3, 1997.
10.     Incorporated by reference from an exhibit filed with the Company's
        Registration Statement on Form S-1 (File No. 333-41195) declared
        effective by the SEC on December 15, 1997.
11.     Incorporated by reference from an exhibit filed with the Company's
        Current Report on Form 8-K (File No. 0-27406) filed on May 23, 1997.
12.     Incorporated by reference from an exhibit filed with the Company's
        Registration Statement on Form 8-A (File No. 0-27406) filed on May 23,
        1997.