SECURITIES AND EXCHANGE COMMISSION
                              Washington, DC 20549
                                  -----------
                                   FORM 10-K

                       FOR ANNUAL AND TRANSITION REPORTS
                    PURSUANT TO SECTIONS 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
(Mark One)
|X|  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934

For the fiscal year ended December 31, 1998
                          -----------------
                                       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 0-28308

                       COLLAGENEX PHARMACEUTICALS, INC.
                       --------------------------------
             (Exact Name of Registrant as Specified in Its Charter)

               Delaware                               52-1758016
    -------------------------------       ------------------------------------
    (State or Other Jurisdiction of       (I.R.S. Employer Identification No.)
     Incorporation or Organization)

301 South State Street, Newtown, Pennsylvania                         18940
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(Address of Principal Executive Offices)                            (Zip Code)

Registrant's telephone number, including area code (215) 579-7388
                                                   -----------------------------

Securities registered pursuant to Section 12(b) of the Act:

    Title of each class                Name of Each Exchange on Which Registered
    -------------------                -----------------------------------------

None
----------------------------           -----------------------------------------

Securities registered pursuant to Section 12(g) of the Act:

                         Common Stock, $0.01 par value
--------------------------------------------------------------------------------
                                (Title of Class)

--------------------------------------------------------------------------------
                                (Title of Class)

<PAGE>


     Indicate by check mark  whether the  registrant:  (1) has filed all reports
required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
1934  during  the  preceding  12 months  (or for such  shorter  period  that the
registrant was required to file such reports),  and (2) has been subject to such
filing requirements for the past 90 days.


               Yes:     X                  No:
                     --------                   --------


     Indicate by check mark if disclosure of delinquent  filers pursuant to Item
405 of Regulation S-K 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|


     State the aggregate market value of the voting common stock held by
non-affiliates of the registrant:  $96,634,170 at February 15, 1999 based on the
last sales price on that date.


     Indicate  the  number of  shares  outstanding  of each of the  registrant's
classes of common stock, as of February 15, 1999:


                 Class                              Number of Shares
                 -----                              ----------------

      Common Stock, $.01 par value                      8,589,704


     The  following  documents  are  incorporated  by reference  into the Annual
Report on Form 10-K: Portions of the registrant's definitive Proxy Statement for
its 1999 Annual Meeting of Stockholders  are incorporated by reference into Part
III of this Report.

<PAGE>
                                     TABLE OF CONTENTS
                                     -----------------



              Item                                                      Page
              ----                                                      ----

PART I           1. Business...................................          1
                 2. Properties.................................          19
                 3. Legal Proceedings..........................          19
                 4. Submission of Matters to a Vote of                   
                    Security Holders...........................          19
PART II          5. Market for the Company's Common Equity
                       and Related Stockholder Matters.........          20
                 6. Selected Consolidated Financial Data.......          21
                 7. Management's Discussion and Analysis of
                       Financial Condition and Results of                
                       Operations..............................          23
                7A. Quantitative and Qualitative Disclosures
                       About Market Risk.......................          29
                 8. Financial Statements and Supplementary Data          29
                 9. Changes in and Disagreements with
                       Accountants on                                    
                       Accounting and Financial Disclosure.....          29
PART III        10. Directors and Executive Officers of the              
                    Company....................................          30
                11. Executive Compensation.....................          30
                12. Security Ownership of Certain Beneficial
                       Owners and Management...................          30
                13. Certain Relationships and Related                    
                    Transactions...............................          30
PART IV         14. Exhibits, Financial Statement Schedules,
                       and Reports on Form 8-K.................          31

SIGNATURES......................................................         32

EXHIBIT INDEX...................................................         34

FINANCIAL DATA AND SCHEDULES....................................        F-1


                                      -i-
<PAGE>

                                     PART I


Item 1.   Business.

General

     CollaGenex  Pharmaceuticals,  Inc.  (the  "Company")  is  a  pharmaceutical
company focused on providing  innovative  medical therapies for the treatment of
periodontitis and other pathologies characterized by the progressive degradation
of the  body's  connective  tissues.  The  Company's  core  technology  involves
inhibiting the activity of certain enzymes that degrade such connective tissues.
The Company's  first product,  Periostat(R),  is a  prescription  pharmaceutical
capsule that was approved by the United States Food and Drug Administration (the
"FDA") in September 1998 as an adjunct to scaling and root planning ("SRP"), the
most  prevalent  non-surgical  therapy  for  adult  periodontitis,   to  promote
attachment  level  gain and to  reduce  pocket  depth  in  patients  with  adult
periodontitis.  Adult  periodontitis,  a chronic  disease  characterized  by the
progressive  loss of  attachment  between  the  tooth  root and the  surrounding
periodontal structures due to chronic progressive connective tissue degradation,
may result in tooth loss if untreated. See " -- Periostat."

     Existing  therapies and those treatments known to be under  development for
periodontitis are designed primarily to treat the bacterial infection associated
with  periodontitis on a short-term,  periodic basis.  These treatments  include
mechanical   and  surgical   techniques,   prophylactic   approaches,   such  as
mouthwashes,   and  locally-delivered   pharmaceutical  therapies.  The  Company
believes,  however,  that periodic treatments designed solely to fight bacterial
infection are inadequate and that such  treatments  would be  considerably  more
effective if augmented by a long-term pharmaceutical therapy, such as Periostat,
which inhibits connective tissue destruction.

     In November  1998,  Periostat  first became  available by  prescription  in
pharmacies  across the country.  In January  1999,  the Company  trained a sales
force of  approximately  125 sales  representatives  and  managers  and began to
promote Periostat to the dental community.

     The Company's  core  technology is licensed on an exclusive  basis from the
Research Foundation of the State University of New York at Stony Brook ("SUNY").
This technology involves modulating the body's pathological  response to certain
acute and chronic illnesses. In particular,  CollaGenex has developed inhibitors
of  certain  chronic  degenerative  processes  that lead to the  destruction  of
connective tissue during inflammation.  Connective tissues are components of the
body that form the structural basis for skin, bone, cartilage and ligaments.

     These  inhibitors  have shown the  potential to treat a variety of diseases
including adult periodontitis and inflammatory  diseases of the musculoskeletal,
respiratory and gastrointestinal  systems.  CollaGenex and its collaborators are
also researching and developing other potential applications for its technology,
particularly for cancer metastasis and diabetic complications.  Phase I clinical
trials for  Metastat(R),  the  Company's  lead  compound  for the  treatment  of
metastatic  cancer,  were initiated in January 1998 under the sponsorship of the
National  Cancer  Institute  (the  "NCI").  The Company  also has a  preclinical
compound, Nephrostat(R), for the

                                      -1-
<PAGE>

treatment of the  complications  of diabetes.  SUNY has  conducted  animal model
studies on the Company's behalf in connection with Nephrostat.

     The Company  was  incorporated  in Delaware in January  1992 under the name
CollaGenex,  Inc. The Company's name was changed to CollaGenex  Pharmaceuticals,
Inc. in April 1996.  The  Company's  executive  offices are located at 301 South
State Street,  Newtown,  Pennsylvania  18940,  and its telephone number is (215)
579-7388.

     "Periostat(R),"   "Metastat(R)"  and   "Nephrostat(R)"  are  United  States
trademarks  of the Company.  All other trade names,  trademarks or service marks
appearing  in  this  Annual  Report  on Form  10-K  are the  property  of  their
respective owners and are not property of the Company.


Technology

     The Company's core technology involves the pharmaceutical modulation of the
activity  of a  broad  class  of  enzymes  known  as  matrix  metalloproteinases
("MMPs").  MMPs are  responsible  for the normal  turnover of collagen and other
proteins that are integral components of a variety of connective tissues such as
skin, bone, cartilage and ligaments.

     Under normal physiological conditions, the natural breakdown of collagen is
regulated by the interaction  between the  degradative  properties of MMPs and a
group  of  naturally   occurring   biomolecules   called  tissue  inhibitors  of
metalloproteinases  ("TIMPs"), which modulate the level of MMP activity. In many
pathological  conditions,  however,  the balance between collagen production and
degradation  is  disrupted  resulting in excessive  loss of tissue  collagen,  a
process called collagenolysis.  One such example is the progressive  destruction
of the periodontal  ligament and alveolar bone in adult  periodontitis.  Similar
degradative  activity is associated  with other disorders and conditions such as
cancer metastasis,  wounds, osteoarthritis,  osteoporosis,  rheumatoid arthritis
and diabetic nephropathy.

     The Company's core  technology is licensed on an exclusive  basis from SUNY
and results from the research of Drs.  Lorne M. Golub and Thomas F. McNamara and
their colleagues at SUNY. These researchers  demonstrated that tetracyclines can
significantly   reduce  the  pathologically   excessive   collagen   degradation
associated  with  periodontitis.  They also were able to  demonstrate  that this
result was unrelated to the antibiotic properties of tetracyclines. Furthermore,
they demonstrated that the  administration of doses of antibiotic  tetracyclines
well below the dosage  levels  necessary  to  destroy  microbes  (sub-antibiotic
doses) was still effective in preventing the loss of connective tissue in models
of  periodontitis.   Studies  published  in  scientific   journals  support  the
hypothesis  that the  mechanism  of action for this  activity is the result,  in
part,  of the direct  binding of  tetracyclines  to certain  metal binding sites
associated with the MMP structure.

     Although  commercially  available  antibiotic  tetracyclines show effective
anti-collagenolytic  potential,  long-term  administration of these compounds at
normal  antibiotic  doses can result in  well-known  complications  of long-term
antibiotic therapy,  such as gastrointestinal  disturbance,  overgrowth of yeast
and fungi,  and the emergence of  antibiotic-resistant  bacteria.

                                      -2-
<PAGE>

The Company's Phase III clinical trials using  Periostat  demonstrated  that the
administration of sub-antimicrobial  doses of doxycycline over a 12-month period
exerted  no  anti-microbial  effects.  Thus,  the  use of this  dosage  strength
provides the anti-collagenolytic  effects without the complications of long-term
antibiotic therapies.

     The  Company's  license  from SUNY also covers a broad class of  chemically
modified tetracyclines ("CMTs") that have been chemically modified to retain and
enhance their  anti-collagenolytic  properties but which have had the structural
elements  responsible for their antibiotic  activity  removed.  These compounds,
which  lack any  antibiotic  activity,  have  shown  potential  in a  number  of
pre-clinical  models of excessive  connective  tissue  breakdown.  The Company's
current research and development programs are focused on the use of CMTs in drug
therapies for potential  applications  where more potent doses of  tetracyclines
may enhance the efficacy of the treatment. See "--Other Potential Applications."

Overview of Periodontitis

     Periodontitis is a chronic disease characterized by the progressive loss of
attachment  between the periodontal  ligament and the surrounding  alveolar bone
due to chronic progressive  connective tissue degradation,  ultimately resulting
in tooth loss.  According  to industry  data,  in the United  States  alone,  an
estimated  one-third of all adults,  or approximately 67 million people,  suffer
from some form of  periodontal  disease.  Approximately  13 million  people seek
professional  treatment annually for periodontal  disease,  resulting in over 17
million  periodontal  procedures and annual  expenditures  of  approximately  $6
billion, primarily for procedures and surgeries performed by a periodontist or a
dental  professional.  In more  severe  periodontitis,  the gums  are  partially
removed through resective surgery to reduce pocket depth around the tooth and to
improve the effectiveness of home oral hygiene techniques.  These treatments are
designed  primarily to treat bacterial  infection  associated with periodontitis
and are performed by both periodontists and general dentists.

     As a result of the  chronic  nature  of  periodontitis  and the  short-term
nature of existing therapies, patients require frequent treatments. In addition,
patients  are  commonly   referred  to  a   specialist   for  such   treatments.
Periodontitis  is,  therefore,  among the more expensive  dental  pathologies to
treat,  and the Company  believes  that the treatment of  periodontitis  will be
increasingly important to dental health managed care organizations ("DHMOs") and
dental  practitioners  operating under capitated or fixed fee arrangements.  The
Company also believes that Periostat is well positioned to meet the economic and
therapeutic  requirements  of DHMOs and  dental  practitioners  by  providing  a
cost-effective therapy for periodontitis management.

     Increased  competition  within  the dental  profession  has  created  rapid
adoption of new  technologies.  The Company believes that a new safe,  painless,
efficacious   and   cost-effective   treatment   will   facilitate   efforts  by
periodontists and dentists to attract and retain patients with periodontitis.


                                      -3-
<PAGE>


Periostat

     The Company's primary focus to date has been on the development of
Periostat,  which  the  Company  believes  is  the  first  orally  administered,
systemically delivered  pharmaceutical indicated as an adjunct to SRP to promote
attachment  level  gain and to  reduce  pocket  depth  in  patients  with  adult
periodontitis.   Periostat,   a  20  mg  dose  of   doxycycline,   is  a  unique
sub-anti-microbial  dosage  strength that suppresses the chronic and progressive
tissue  degradation   characteristic  of  periodontitis   without  exerting  any
anti-microbial  effect.  Doxycycline  is an active  ingredient  of  several  FDA
approved drugs and has been in use for  approximately 30 years for the treatment
of  microbial  infections  and,  along  with  other  tetracyclines,  has a  well
established  safety  record.  Periostat's  mechanism of action is believed to be
through  the  direct  inhibition  of  collagenase,  an MMP which is  excessively
produced as a result of inflammation  resulting from bacterial  infection in the
gums.  Periostat  is intended to be taken orally by the patient  between  dental
visits.  In September 1998, the FDA granted the Company  marketing  approval for
Periostat  as an  adjunct  to SRP to  promote  attachment  level gain and reduce
pocket depth in patients with adult periodontitis.

     Prior  to  achieving  such  FDA  approval  and in  support  of its New Drug
Application ("NDA") submission,  the Company completed Phase III clinical trials
consisting  of three  parallel,  separate,  multi-centered,  placebo-controlled,
double-blinded clinical trials in patients with adult periodontitis.

     The  primary  clinical  endpoint of the Phase III  clinical  trials was the
measurement  of  changes in  clinical  attachment  level  ("ALv"),  a  parameter
defining the  integrity of the  connective  tissue that anchors the tooth to the
alveolar  bone.  This  endpoint is the one most often  recognized  by the FDA to
determine  the  validity  of a claim for therapy of  periodontitis.  Each of the
Phase III clinical trials demonstrated statistically significant improvements in
ALv or probing pocket depth.

     Another  significant  primary  clinical  endpoint,  the  percentage  of all
probing sites that deteriorated by a clinically significant threshold of change,
was  studied  using  only a manual  probe.  Periostat  was found to  reduce  the
percentage  of  probing  sites that  deteriorated  by a  clinically  significant
amount.

     Several other secondary clinical endpoints were measured and analyzed using
the  manual  probing  technique  during the  course of the  Company's  Phase III
clinical  trials.  These  included  probing  pocket depth (the distance from the
gumline  to the base of the  periodontal  pocket),  the extent to which the gums
bled when the periodontal pocket was probed (a common screen for the severity of
periodontitis)  and the loss of alveolar  bone  (measured  using a complex x-ray
technique  known as digital  subtraction  radiography).  All of these  secondary
clinical endpoints generally exhibited statistically significant improvements in
each of the three clinical trials and in the combined data.

     The Company's  three Phase III clinical  trials were  completed in December
1994.  The  Company  compiled  the  data,  performed  statistical  analysis  and
conducted  certain   additional  

                                      -4-
<PAGE>

testing  necessary to complete  its NDA for  Periostat,  which it completed  and
submitted to the FDA in August 1996.  The NDA was accepted for filing by the FDA
in October 1996.

     During 1996,  the Company  initiated a fourth  Phase III clinical  trial to
evaluate the  efficacy of  Periostat  as an adjunct to SRP,  the most  prevalent
therapy for moderate to severe  periodontitis.  This trial was completed and the
data  analyzed in late 1997.  While the earlier  Phase III clinical  trials were
intended to evaluate the efficacy of  Periostat  in  conjunction  with a routine
dental scaling and  prophylaxis,  this trial was the first to  demonstrate  that
Periostat can significantly enhance the efficacy of SRP.

     In this study, 190 adult patients with  periodontitis were administered SRP
at the outset of a nine-month,  double-blind,  placebo-controlled clinical trial
at five  university  centers in the United  States.  Patients were then randomly
assigned to take either  Periostat or placebo.  Measurements  of probing  pocket
depth and clinical  attachment level were made every three months using a manual
probe.  Results were compared with  measurements  taken immediately prior to the
course of SRP.

     In the group receiving Periostat, statistically significant improvements in
probing pocket depth and clinical  attachment level (compared with placebo) were
seen in all  diseased  sites as early as three months  following  SRP and at all
time points  thereafter.  As in the previous pivotal studies,  the more severely
diseased sites improved the most, with  improvements in probing pocket depth and
clinical attachment level of as much as 67% and 52%, respectively, over SRP with
placebo.

     In  September  1998,  the FDA granted the Company  marketing  approval  for
Periostat  as an  adjunct  to SRP to  promote  attachment  level gain and reduce
pocket depth in patients with adult periodontitis.

Cancer Metastasis

     Cancer  metastasis  is the spread of cancer cells from a diseased  organ to
the lymphatic or circulatory  system,  where such cells then migrate  throughout
the body causing  cancer to develop in other  organs.  Tumor cell  invasion is a
complex  process that  involves the  destruction  of the basement  membrane,  or
structural  support  tissue,  of the lymphatic or  circulatory  system,  and the
migration of tumor cells to secondary sites,  followed by proliferation of these
cells.  Data from  pre-clinical  studies  sponsored  by the Company at two major
universities  suggest that several of the  Company's  CMT drug  candidates  have
potent activity in models of cancer invasion,  including prostate, breast, lung,
colon and melanoma.

     These studies also demonstrated that the inhibition of certain MMP activity
by conventional  tetracyclines  and CMTs results in a decreased ability of tumor
cells to invade the lung in models of  metastasis.  In addition,  CMTs have been
shown to  modulate  the  specific  type of MMP  isolated  from human lung cancer
cells,  the activity of which has been correlated with the metastatic  potential
of tumors.  In animal  models  involving  a variety of human  cancer cell types,
including  prostate,  breast,  lung,  colon and melanoma,  CMTs developed by the
Company exhibited an ability to inhibit metastasis.

                                      -5-
<PAGE>

     In October  1996,  the Company  and the NCI  executed a letter of intent to
formalize a collaborative  research and development  agreement pursuant to which
the NCI agreed to perform  pharmacology,  toxicology and Phase I clinical trials
using the  Company's  lead  compound for the  prevention  of cancer  metastasis,
Metastat.

     In June 1997,  the Company  announced  that it had  formally  extended  its
Collaboration  Agreement  with  the  NCI  with  respect  to the  development  of
Metastat.  On December 5, 1997, the Company  announced that the NCI had filed an
investigational new drug application ("IND") for Metastat.  In January 1998, the
Company initiated Phase I clinical trials with respect to Metastat. Such studies
are being sponsored by the NCI pursuant to the Company's Collaboration Agreement
with the NCI. In February 1999, the Company released initial findings related to
such studies.  Following oral administration,  desired plasma  concentrations of
the  compound  were  achieved  and no  dose-limiting  side  effects  other  than
manageable  phototoxicity  were encountered.  In February 1999, the Company also
announced the allowance of a U.S.  patent which provides  intellectual  property
protection for the use of Metastat for the inhibition of cancer metastasis.

Diabetic Nephropathy

     Diabetes is the fourth  leading  cause of death from disease and the number
one leading cause of blindness in the United States. Despite currently available
therapies  for the  treatment of diabetes,  including  diet  restrictions,  oral
medications and insulin injections,  the long-term complications of this disease
continue to reduce the quality and longevity of life for diabetic patients.

     Nephropathy  is one of the most serious  complications  of  diabetes.  This
condition results in the progressive loss of kidney function, requiring dialysis
or a kidney transplant to maintain  survival,  and frequently leads to end-stage
renal disease.  The destruction  observed in diabetic  nephropathy is associated
with elevated levels of MMPs which degrade the basement  membrane of the kidney,
causing  it to lose  its  ability  to  effectively  act as a  filter.  An  early
indicator of kidney disease is proteinuria, which is the excretion of protein in
the urine.  Animal model studies conducted on behalf of the Company by SUNY have
shown that the  administration  of CMTs  significantly  reduces the  severity of
proteinuria as well as ocular manifestations of the disease. In addition,  these
animal studies showed improvements in other complications of diabetes, including
tooth loss and eye disorders.  Administration  of Nephrostat  also increased the
longevity  of the  severely  hyperglycemic  diabetic  animals used in the study.
Based on these promising early results, the Company initiated toxicology testing
of Nephrostat during 1998.  Following the completion of such toxicology studies,
the Company will review and evaluate the data with the intent to initiate  human
clinical trials.

     Research and Development

     In  April  1998,  the  Company  entered  into a  Research  and  Development
Agreement with Quintiles Scotland Ltd. ("Quintiles") pursuant to which Quintiles
will  perform  certain  research

                                      -6-
<PAGE>

and  development  activities  with  respect  to  Nephrostat.  Such  studies  are
currently in progress and should be completed during 1999.

Other Potential Applications

     The Company's research and discoveries relating to CMTs have yielded other
potential  therapeutic programs which the Company may develop and commercialize,
possibly through the  establishment of corporate  partnering  arrangements.  The
Company  believes that its core technology may be utilized to develop  therapies
for other diseases and conditions which, like  periodontitis,  are characterized
by the progressive destruction of connective tissues of the body, such as cancer
metastasis  (see  above),  wounds,  osteoarthritis,   osteoporosis,   rheumatoid
arthritis and diabetic  nephropathy  (see above).  In November 1997, the Company
announced  that it had  signed an  agreement  with Heska  Corporation  ("Heska")
pursuant to which Heska is evaluating  certain of the Company's  CMTs for use in
companion animal health applications,  including  osteoarthritis,  periodontitis
and cancer.

     Wound Repair

     The repair of the  connective  tissue in response to acute injury  involves
the remodeling of collagen and related proteins.  The Company has generated data
in pre-clinical studies conducted at SUNY which suggest the potential utility of
certain of its compounds in facilitating  this process.  To further explore this
application,  the Company has entered into an evaluation  agreement with Smith &
Nephew,  pursuant to which Smith & Nephew is seeking to validate the preliminary
efficacy data  developed at SUNY in the field of wound  repair.  The Company has
granted to Smith & Nephew a right of first  negotiation  with respect to certain
compounds in the field of wound repair.

     Osteoarthritis

     Osteoarthritis is a progressive,  degenerative  joint disease involving the
breakdown of the synovial  cartilage  in the joint.  Trauma,  resulting in joint
instability,  most  often is the cause of this  disease,  which  results  in the
gradual  destruction  of bone and especially of collagen.  Several  pre-clinical
studies  carried  out by the  Company  in  collaboration  with a major  teaching
hospital and other  institutions have demonstrated that the use of the Company's
compounds inhibit the loss of synovial  cartilage in the joint. In May 1996, the
Company  entered into a research  agreement  with Istituto  Gentili,  an Italian
pharmaceutical  company (now called Abiogen), to evaluate the application of the
Company's  technology  in the  field of  osteoarthritis.  Istituto  Gentili  was
acquired and the research agreement has lapsed.

     Osteoporosis

     Osteoporosis is characterized by reductions in both the amount and strength
of  bone  tissue  due to the  loss  of  calcium  from  the  bone,  resulting  in
susceptibility to fracture.  A pre-clinical  study carried out by the Company in
collaboration  with a major university  demonstrated  that many of the Company's
CMTs  inhibit  bone  resorption,   or  the  loss  of  bone  tissue,  in  various

                                      -7-
<PAGE>


experimental  models.  A clinical study using  doxycycline has been initiated in
post-menopausal women at SUNY to study surrogate markers of bone decay.

     Rheumatoid Arthritis

     Rheumatoid  arthritis  is a chronic  inflammatory  joint  disease with many
pathophysiological   similarities   to   periodontitis.   Substantial   evidence
implicates collagenase, an MMP, as a cause of bone, joint and tissue destruction
in this disease.  Several animal studies  carried out by the Company and SUNY in
collaboration  with a major teaching  hospital have demonstrated that the use of
the Company's CMTs significantly  reduced radiographic evidence of cartilage and
bone  destruction in the joint that  correlated  with the  normalization  of MMP
activity.

Sales and Marketing

     The Company  markets and sells its products in the United States  through a
direct sales force and, internationally in collaboration with marketing partners
upon receipt of the requisite  foreign  regulatory  approvals.  This strategy is
intended to enable the Company to gain rapid market  acceptance  and establish a
commercial presence in the dental market with Periostat.

     United States

     In June of 1997, the Company hired a Vice President of Marketing and a Vice
President of Sales. In January 1999, under their direction,  the Company trained
a sales force of approximately 125 sales  representatives and managers and began
to promote Periostat to the dental community.

     In order to provide an  integrated  dental  product  line and  leverage the
Company's sales and marketing  organization,  the Company is actively seeking to
in-license or acquire  high-quality  diagnostic and therapeutic  dental products
complementary  to  Periostat.  In May 1997,  the Company  announced  that it had
signed  an  exclusive   marketing   agreement  with  the  Parke-Davis   Division
("Parke-Davis")  of the  Warner  Lambert  Company  to  promote  the  Parke-Davis
product, Ponstel(R) (Mefenamic Acid), to the professional community.  Ponstel is
a nonsteroidal anti-inflammatory drug indicated for the relief of moderate pain.
Following  FDA  marketing   approval  of  Periostat,   the  Company  decided  to
discontinue  promotional  efforts  with  respect to Ponstel.  In June 1997,  the
Company  announced  that it had  signed  a  marketing  agreement  with  Advanced
Clinical Technologies, Inc. pursuant to which the Company promotes Periocheck(R)
to the professional  dental  community.  Periocheck is an FDA-approved  test for
monitoring  periodontal  disease  progression in the dentist's  office.  Because
Periocheck  measures  the level of  tissue-destructive  enzymes  in a  patient's
gingival  fluid, it is a natural  complement to Periostat,  which inhibits those
enzymes.

     The Company  executed a  Co-Promotion  Agreement with  SmithKline  Beechman
Consumer Healthcare,  L.P.  ("SmithKline") in October 1998 pursuant to which the
Company  will  promote   SmithKline's   Denavir(R)   product,   an  FDA-approved
prescription pharmaceutical for the 

                                      -8-
<PAGE>

treatment of recurrent cold sores in healthy adults, to the United States dental
community.  The  agreement  provides for certain  payments by  SmithKline to the
Company upon future sales of Denavir.

     Consistent  with the  Company's  strategy to  outsource  certain  specialty
functions,  in September 1998, the Company entered into a Professional  Services
Agreement with Science  Oriented  Solutions  ("SOS")  pursuant to which SOS will
establish and operate a medical  professional  inquiry  support  center to field
product inquiries regarding Periostat from the professional community.

     International

     The Company is establishing  relationships  with key partners to market and
sell Periostat internationally, upon receipt of the requisite foreign regulatory
approvals.  In 1996,  the  Company  executed a  manufacturing  and  distribution
agreement with Roche S.P.A.  (formerly  Boehringer  Mannheim Italia) pursuant to
which Roche S.P.A.  has the exclusive  right to market  Periostat in Italy,  San
Marino and The Vatican City.  In 1997,  the Company  announced  that a Marketing
Authorization  for  Approval was filed for  Periostat  by Roche S.P.A.  with the
Italian  Ministry  of  Health.  The  Marketing  Authorization  for  Approval  is
currently under review.

     In July 1998, the Company executed a licensing  agreement with Laboratoires
Pharmascience S.A. ("Laboratories Pharmascience") pursuant to which Laboratoires
Pharmascience  will market and  distribute  Periostat on an  exclusive  basis in
France, Morocco, Algeria, Tunisia and other countries of French speaking Africa.

     In October  1998,  the Company  announced  that a  Marketing  Authorization
Application had been filed with the United Kingdom  Medicine Control Agency with
respect to  Periostat.  Such  application  was filed under the  European  Mutual
Recognition  System in order to expedite the approval  process for  Periostat in
other  European  countries.  There can be no  assurance  that the  Company  will
achieve such approvals,  or will successfully  market  Periostat,  in the United
Kingdom or other European countries.

Manufacturing, Distribution and Suppliers

     The Company has entered into a supply agreement with Hovione  International
Limited  ("Hovione")  pursuant  to which the  active  ingredient  in  Periostat,
doxycycline,  is  supplied  by Hovione  from its  offshore  facilities.  Hovione
supplies a substantial portion of the doxycycline used in the United States from
two independent, FDA-registered and approved facilities, providing for a back-up
supply in the event  that one  facility  is unable to  manufacture.  The  supply
agreement is in effect until January 25, 2000 and will  automatically  renew for
successive  two-year periods unless, 90 days prior to the expiration of any such
periods,  either party gives the other party written notice of  termination.  In
addition,  in the event of a default,  uncured for 90 days,  the  non-defaulting
party can  terminate  the  agreement  effective  immediately  at the end of such
90-day  period.   The  Company  relies  on  Hovione  as  its  sole  supplier  of
doxycycline.


                                      -9-
<PAGE>

     The  Company  relies  on  third-party  contract  manufacturers  to  produce
doxycycline,  the active drug  ingredient in Periostat,  and for the  commercial
manufacturing  of  Periostat.   In  June,   1998,  the  Company   finalized  its
manufacturing arrangements with Applied Analytical Industries,  Inc. ("AAI"), in
Wilmington,  North  Carolina for the  manufacture  of Periostat.  AAI supplied a
portion of the products used in the  Company's  Phase III clinical  trials.  The
Company's agreement with AAI terminates three years from the date of the initial
product launch and automatically extends for consecutive one-year periods unless
12-month  prior  written  notice  is  provided  before  the  expiration  of  the
applicable  term.  AAI is required to comply with good  manufacturing  practices
("GMP")  requirements.  The Company is currently  identifying ways to reduce its
cost of product sales by exploring a tablet formulation of Periostat.

     In November 1998, the Company  executed a Distribution  Services  Agreement
with Cord  Logistics,  Inc.  ("Cord"),  pursuant  to which  Cord will act as the
Company's  exclusive  distribution  agent for Periostat in the United States and
Puerto Rico. Cord is a subsidiary of Cardinal Health,  Inc., a leading wholesale
distributor  of  pharmaceutical  and  related  healthcare  products.  Under this
agreement,  Cord will warehouse and ship Periostat from its central distribution
facility  to  wholesalers  and large  national  retail  chains  who in turn will
distribute   Periostat  to  pharmacies   throughout  the  United   States,   for
prescription sale to patients.  Cord will also provide various financial support
services to the Company,  including  billing and  collections,  contract pricing
maintenance,  cash  application,  chargeback  processing  and related  reporting
services.  Under this  agreement,  Cord will provide  certain  customer  service
functions  and supply data for certain of the  Company's  required  governmental
filings. The Distribution  Services Agreement has an initial term of three years
and will renew  automatically  for successive  one-year periods unless notice of
termination is provided by either party 90 days prior to expiration.

     There  can be no  assurance  that the  Company  will be able to enter  into
additional,   or  maintain  existing   manufacturing,   distribution  or  supply
agreements  on  acceptable  terms,  if at all.  In the event that the Company is
unable  to  obtain   sufficient   quantities  of  doxycycline  or  Periostat  on
commercially  reasonable  terms,  or in a  timely  manner,  or if the  Company's
suppliers fail to comply with GMP, or if the Company's  distributors  are unable
to ship or support the Company's  products,  the Company's  business,  financial
condition and results of operations would be materially adversely affected.  See
"--Government Regulation."


Research and Development

     The Company's  research and  development  activities are conducted by third
parties,  primarily  contract  research  organizations,  academic and government
institutions and corporate  partners.  The main focus of these activities is the
identification  and  development  of  novel  tetracycline-based   compounds  for
application in a variety of inflammatory and tissue-destructive disorders.

     Other than Periostat,  the most advanced  program  involves  Metastat,  the
Company's  lead  compound  for  treating   metastatic  cancer.   Three  Phase  I
dose-escalation  studies of  patients  with  refractory  metastatic  disease are
underway  in  collaboration  with NCI,  and NCI plans to  initiate  at least one
additional  clinical  study of this  compound in  additional  tumor types during
1999. The 


                                      -10-
<PAGE>

second most significant  development  program currently  underway is preclinical
toxicology  studies  for  Nephrostat,  a  compound  aimed  at  ameliorating  the
complications of diabetes,  in particular diabetic nephropathy (kidney failure).
The Company expects to continue  pre-clinical  trials on Nephrostat to determine
whether to file an IND with the FDA seeking  permission to begin human  clinical
trials.

     Metastat and Nephrostat,  may also have  application in other  inflammatory
disorders  involving  connective  tissue  destruction  such  as  osteoarthritis,
rheumatoid arthritis and periodontitis, as well as diseases involving connective
tissue destruction in the lung such as cystic fibrosis.

     Furthermore,  the Company has established a three-year  research  agreement
with SUNY to screen  novel  tetracyclines,  developed  in  collaboration  with a
research team funded by the Company at the University of Rochester, in a variety
of in vitro and in vivo assay  systems  in order to  identify  new,  proprietary
compounds with particular properties relevant to their clinical application in a
variety of acute and chronic inflammatory disorders.

     The  Company   receives  certain   proprietary   rights  to  inventions  or
discoveries  that  arise as a result of this  research.  The  Company's  current
research and development  objective is to develop additional  products utilizing
its CMT technology. See "--Technology" and "-- Other Potential Applications."

     The Company's research and development expenditures were approximately $4.4
million, $4.2 million and $4.7 million in 1996, 1997 and 1998, respectively.


Patents, Trade Secrets and Licenses

     The  Company's  success  will  depend  in part on patent  and trade  secret
protection for its technologies,  products and processes,  and on its ability to
operate without  infringement of proprietary rights of other parties both in the
United States and in foreign  countries.  Because of the  substantial  length of
time and expense  associated with bringing new products  through  development to
the marketplace,  the pharmaceutical  industry places considerable importance on
obtaining  and   maintaining   patent  and  trade  secret   protection  for  new
technologies, products and processes.

     The Company  depends on the license  from the  Research  Foundation  of the
State of New York at Stony  Brook  for all of its  core  technology  (the  "SUNY
License"). The SUNY License grants the Company an exclusive worldwide license to
make and sell products employing  tetracyclines that are designed or utilized to
alter a biological process. Nineteen United States patents and ten United States
patent  applications  held by SUNY are  licensed to the  Company  under the SUNY
License.  One of  the  ten  patent  applications  has  been  co-assigned  to the
University  of  Miami,   Florida,   and  another  patent  application  has  been
co-assigned  to Washington  University.  The primary United States patent claims
methods of use of conventional tetracyclines to inhibit pathologically excessive
collagenolytic  activity (the "Primary  Patent"),  while a related United States
patent claims methods of use of tetracyclines which have no


                                      -11-
<PAGE>

antibiotic activity (the "Secondary Patent").  The seventeen other United States
patents  relate to the  compositions  of certain  CMTs with  anti-collagenolytic
properties,  methods of use of  tetracyclines to reduce bone loss and methods of
use of tetracyclines  to enhance bone growth and inhibit protein  glycosylation.
SUNY did not apply in foreign countries for patents corresponding to the Primary
Patent but has  obtained  patents that  correspond  to the  Secondary  Patent in
Australia,   Canada  and  certain  European  countries.   A  patent  application
corresponding  to the  Secondary  Patent  is  pending  in  Japan.  SUNY also has
obtained patents in certain European countries, Canada and Japan and has pending
patent  applications in certain other foreign  countries which correspond to its
United States patents relating to methods of use of tetracyclines to reduce bone
loss.  All of SUNY's United States and foreign  patents  expire between 2004 and
2017.  The  Company's  rights  under the SUNY  License  are  subject  to certain
statutory rights of the United States government  resulting from federal support
of  research  activities  at SUNY.  The  failure to obtain and  maintain  patent
protection  may mean that the Company  will face  increased  competition  in the
United States and in foreign  countries.  The SUNY License is terminable by SUNY
on 90 days prior notice only upon the Company's failure to make timely payments,
reimbursements or reports,  if the failure is not cured by the Company within 90
days. The termination of the SUNY License, or the failure to obtain and maintain
patent protection for the Company's technologies,  would have a material adverse
effect on the Company's business, financial condition and results of operations.

     One of the  United  States  patents  and a  corresponding  Japanese  patent
application  licensed to the Company under the SUNY License are owned jointly by
SUNY and a Japanese  company.  These patent rights,  which expire in 2012, cover
particular  CMTs (the  "Jointly  Owned  CMTs")  that were  involved  in research
activities between SUNY and the Japanese company.  The Japanese company may have
exclusive rights to these Jointly Owned CMTs in Asia,  Australia and New Zealand
and may have a non-exclusive  right to exploit these Jointly Owned CMTs in other
territories.  These  Jointly  Owned  CMTs  are  not  involved  in the  Company's
Periostat  product but could,  in the future,  prove to be important  for one or
more of the Company's  other potential  applications  of its technology.  If the
Company does incorporate the Jointly Owned CMTs in any future product, it may be
precluded from marketing  these products in Asia,  Australia and New Zealand and
could experience increased competition in other markets from the joint owner.

     In  consideration of the license granted to the Company,  the Company:  (i)
issued to SUNY 78,948  shares of Common  Stock;  and (ii) has agreed to pay SUNY
royalties  on the net sales of products  employing  tetracyclines,  with minimum
annual  royalty  payments  per year.  The term of the  license is: (i) until the
expiration  of the last to expire of the licensed  patents in each  country;  or
(ii)  until  20  years  from  the  first  commercial  sale  of  any  collagenase
inhibition-related  product  by the  Company  for  know-how,  at which  time the
Company has a fully paid, non-exclusive license.

     In addition to the patents and patent applications licensed from SUNY which
represent the core technology,  the Company owns additional technology for which
applications for United States patents have been filed and have been issued.  In
this regard, the Company reports the existence of two issued patents as follows:
for (i) a  toothpaste/mouthwash  formulation  for  the  


                                      -12-
<PAGE>

amelioration  of dentin  hypersensitivity;  and (ii) a method  for  treating  H.
Pylori.  Furthermore,  the Company  reports a pending  application  covering new
tetracycline derivatives having increased lipophilicity.

     The  Company  intends to  enforce  its patent  rights  against  third-party
infringers.  Due to the general availability of generic tetracyclines for use as
antibiotics,  the Company could become involved in infringement  actions,  which
could  entail  substantial  costs to the  Company.  Regardless  of the  outcome,
defense and  prosecution of patent claims is expensive and time  consuming,  and
results  in  the  diversion  of  substantial  financial,  management  and  other
resources from the Company's other activities.

     The patent positions of pharmaceutical  firms,  including the Company,  are
generally   uncertain  and  involve   complex   legal  and  factual   questions.
Consequently,  as to the patent  applications  licensed  to it,  even though the
Company currently is prosecuting such patent applications with United States and
foreign  patent  offices,  the  Company  does  not  know  whether  any  of  such
applications  will result in the issuance of any  additional  patents or, if any
additional patents are issued, whether they will provide significant proprietary
protection or will be circumvented or invalidated.  Since patent applications in
the United  States are  maintained in secrecy  until  patents  issue,  and since
publication of discoveries in the scientific and patent  literature tends to lag
behind actual  discoveries by several months, the Company cannot be certain that
it was the first creator of inventions covered by pending patent applications or
that it was the first to file patent applications for such inventions.

     There can be no  assurance  that patent  applications  to which the Company
holds rights will result in the issuance of patents,  that any patents issued or
licensed to the Company will not be challenged  and held to be invalid,  or that
any  such  patents  will  provide  commercially  significant  protection  to the
Company's  technology,  products and  processes.  In  addition,  there can be no
assurance that others will not independently  develop  substantially  equivalent
proprietary  information not covered by patents to which the Company owns rights
or obtain  access to the Company's  know-how,  or that others will not be issued
patents which may prevent the sale of one or more of the Company's products,  or
require  licensing  and the  payment of  significant  fees or  royalties  by the
Company to third parties in order to enable the Company to conduct its business.
In the event that any relevant claims of third-party patents are upheld as valid
and  enforceable,  the Company  could be prevented  from selling its products or
could be required to obtain licenses from the owners of such patents.  There can
be no assurance that such licenses would be available or, if available, would be
on terms  acceptable  to the  Company.  The  Company's  failure to obtain  these
licenses  would  have a  material  adverse  effect  on the  Company's  business,
financial condition and results of operations.

     The Company's success also is dependent upon know-how,  unpatentable  trade
secrets,  and  the  skills,  knowledge  and  experience  of its  scientific  and
technical   personnel.   The  Company  requires  all  employees  to  enter  into
confidentiality   agreements   that  prohibit  the  disclosure  of  confidential
information to anyone outside the Company and require  disclosure and assignment
to the Company of their ideas,  developments,  discoveries  and  inventions.  In
addition,  the Company  seeks to obtain such  agreements  from its  consultants,
advisors and research  


                                      -13-
<PAGE>

collaborators.  There  can be no  assurance  that  adequate  protection  will be
provided  for  the  Company's  trade  secrets,  know-how  or  other  proprietary
information  in the event of any  unauthorized  use or  disclosure.  The Company
occasionally   provides   information   and   chemical   compounds  to  research
collaborators  in academic  institutions,  and requests  that the  collaborators
conduct tests in order to investigate certain properties of the compounds. There
can be no assurance that the academic  institutions will not assert intellectual
property  rights  in  the  results  of  the  tests  conducted  by  the  research
collaborators,  or that the academic institutions will grant licenses under such
intellectual  property  rights  to  the  Company  on  acceptable  terms.  If the
assertion of  intellectual  property  rights by an academic  institution  can be
substantiated,  failure  of  the  academic  institution  to  grant  intellectual
property  rights to the  Company  could  have a material  adverse  effect on the
Company's business, financial condition and results of operations.


Government Regulation

     The Company's  activities  and product  candidates are subject to extensive
and  rigorous  regulation  by a number of  governmental  entities  in the United
States,  primarily the FDA, and by comparable  regulatory  authorities  in other
countries.  These governmental entities regulate,  among other things,  research
and development  activities  including animal and human testing,  manufacturing,
safety, effectiveness, labeling, storage, record keeping, approval, advertising,
promotion,  distribution and sale of prescription drug products. Different types
of FDA regulation  apply to various drug  products,  depending upon whether they
are  marketed  only  upon  the  order of a  physician  (prescription  drugs)  or
over-the-counter,  are biological or antibiotic  drugs or are controlled  drugs,
such as  narcotics.  Product  development  and approval  within this  regulatory
framework  takes a number of years,  involves  the  expenditure  of  substantial
resources  and  approval is  uncertain.  Many  products  that  initially  appear
promising  ultimately  do not reach the market  because they are not found to be
safe and effective, as demonstrated by testing required by government regulation
during the development process. In addition, there can be no assurance that this
regulatory  framework  will not change or that  additional  regulation  will not
arise  at any  stage  of the  Company's  product  development  that  may  affect
approval, delay an application or require additional expenditure by the Company.
Moreover, even if approval is obtained, failure to comply with present or future
regulatory  requirements,  or new information adversely reflecting on the safety
or effectiveness of the approved drug, can lead to FDA withdrawal of approval to
market the product.  Failure to comply with applicable FDA and other  regulatory
requirements  can  result in  sanctions  being  imposed  on the  Company  or the
manufacturers of its products,  including  warning  letters,  product recalls or
seizures,  injunctions,  refusals  to permit  products  to be  imported  into or
exported  out of the  United  States,  refusals  of the FDA to grant  pre-market
approval  of drugs or to allow  the  Company  to enter  into  government  supply
contracts,   withdrawals  of  previously  approved  marketing  applications  and
criminal prosecutions.

     The  activities  required  before a new drug product may be marketed in the
United States begin  primarily with  pre-clinical  testing.  Pre-clinical  tests
include laboratory evaluation of product chemistry and other characteristics and
animal  studies to assess the  potential  safety and  efficacy of the product as
formulated.  Many  pre-clinical  (toxicology)  studies are  regulated by the 


                                      -14-
<PAGE>

FDA under Good  Laboratory  Practice  ("GLP")  regulations.  Violations of these
regulations can, in some cases,  lead to invalidation of the studies,  requiring
such studies to be repeated.

     The entire body of  pre-clinical  development  work necessary to administer
investigational  drugs to human  volunteers  or  patients  is provided in an IND
filed with the FDA. FDA regulations provide that human clinical trials may begin
30 days  following  receipt  of an IND,  unless  the FDA  advises  otherwise  or
requests additional information,  clarification or additional time to review the
IND  submission.  There  is no  assurance  that  the  submission  of an IND will
eventually  allow a company  to  commence  clinical  trials.  Once  trials  have
commenced,  the FDA may stop the  trials,  or  particular  types of  trials,  by
placing a "clinical hold" on such trials because of concerns about, for example,
the safety of the product being tested or the adequacy of the trial design. Such
holds can cause substantial delay and, in some cases, may require abandonment of
a product.  Clinical testing involves the  administration of the drug to healthy
human  volunteers or to patients under the supervision of a qualified  principal
investigator,  usually a physician,  pursuant to a FDA reviewed  protocol.  Each
clinical  study is  conducted  under the auspices of  independent  Institutional
Review Boards ("IRBs") at the institutions at which the study will be conducted.
An IRB will consider,  among other things,  ethical factors, the safety of human
subjects and the possible  liability of the  institution.  Human clinical trials
typically are conducted in three sequential  phases, but the phases may overlap.
Phase I trials  consist of testing the product in a small  number of patients or
normal volunteers,  primarily for safety and tolerance,  in one or more dosages,
as well as characterization of a drug's  pharmacokinetic  and/or pharmacodynamic
profile.  In Phase II, in  addition  to safety,  the  efficacy of the product is
evaluated in a patient population. Phase III trials typically involve additional
testing  for  safety  and  clinical  efficacy  with an  expanded  population  at
geographically  dispersed sites. A clinical plan, or "protocol,"  accompanied by
the approval of an IRB,  must be submitted to the FDA prior to  commencement  of
each clinical  trial.  All patients  involved in the clinical trial must provide
informed consent prior to their participation.

     A company  seeking FDA  approval to market a new drug must file an NDA with
the FDA  pursuant to the Federal  Food,  Drug and  Cosmetic  Act. In addition to
reports of the pre-clinical and clinical trials conducted under the FDA-approved
IND, the NDA includes  information  pertaining  to the  preparation  of the drug
substance,  analytical  methods,  drug  product  formulation,   details  on  the
manufacture  of  finished  products as well as proposed  product  packaging  and
labeling.  Submission of an NDA does not assure FDA approval for marketing.  The
application  review  process  generally  takes one to three  years to  complete,
although  reviews of  treatments  for cancer and other rare or  life-threatening
diseases  may be  accelerated  or  expedited.  However,  the  process  may  take
substantially  longer if, among other things,  the FDA has questions or concerns
about the safety or efficacy of a product. In general, the FDA requires at least
two  properly   conducted,   adequate  and   well-controlled   clinical  studies
demonstrating   safety  and  efficacy  with  sufficient  levels  of  statistical
assurance. However, additional information may be required. For example, the FDA
also may request long-term toxicity studies or other studies relating to product
safety  or  efficacy.  Notwithstanding  the  submission  of such  data,  the FDA
ultimately  may decide that the  application  does not  satisfy  its  regulatory
criteria for approval.  Finally,  the FDA may require additional  clinical tests
following  NDA  approval  to further  delineate  safety and  efficacy  (Phase IV
clinical trials).


                                      -15-
<PAGE>

     The FDA has requested  that a  post-approval,  post-marketing  animal study
related to  long-term  dosing and  carcinogenicity  of Periostat be conducted to
satisfy the regulatory  requirement  for a chronically  administered  drug. Such
studies are currently underway.

     The FDA may, in some  circumstances,  impose  restrictions  on the use of a
drug,  compliance with which may be difficult and expensive.  Product  approvals
may be withdrawn if compliance with regulatory requirements is not maintained or
if  problems  occur after the  product  reaches  the market.  After a product is
approved for a given indication in an NDA, subsequent new indications or dosages
for the same product are reviewed by the FDA by the filing of an NDA supplement.
The NDA  supplement is much more focused than the NDA and deals  primarily  with
safety and effectiveness  data related to the indication or dosage, and labeling
information  for the new  indication.  Finally,  the FDA  requires  reporting of
certain information that becomes known to a manufacturer of an approved drug.

     The FDA does not permit a manufacturer  or distributor to market or promote
an approved  drug  product for an  unapproved  "off label" use or dosage  level.
Therefore,  any  company  that  markets or promotes  doxycycline  for use in the
treatment of adult  periodontitis in an unapproved dosage level (for example,  a
50 mg scored  tablet)  without  first  obtaining  FDA  approval for such use and
dosage would be subject to  regulatory  action.  Generally,  the FDA,  under its
"practice of medicine" policy,  does not prohibit a physician,  dentist or other
licensed   practitioner  from  prescribing  an  approved  drug  product  for  an
unapproved  use or dosage.  Nor does the FDA generally  regulate the practice of
pharmacy  where  the  pharmacist  fills  a  prescription  issued  by a  licensed
practitioner for an individual  patient.  There can be no assurance that the FDA
or a state agency regulating the practice of medicine would initiate  regulatory
action  against a  licensed  practitioner  for  prescribing  doxycycline  in the
currently available dosage for use in the treatment of adult periodontitis.

     The Drug Price Competition and Patent Term Restoration Act of 1984 provides
for abbreviated approval requirements for generic drugs,  exclusivity protection
for  innovative  products  that prevents FDA approval of generic  versions,  and
patent  extension  for a certain  period  of time  that it takes to  obtain  FDA
approval.  Periostat is being treated by the FDA as an "antibiotic."  Therefore,
the Company will have to rely solely on its patent  protection as Periostat will
not be entitled to a three-year period of marketing  exclusivity  before generic
versions  can be approved by the FDA for  commercial  sale,  and no  patent-term
extension will be available. In addition, the Company will be subject to certain
user fees that the FDA is authorized to collect under the Prescription User Fees
Act of 1992 for reviewing NDAs and other marketing applications.

     Among the  requirements  for product  approval is the requirement  that the
prospective  manufacturer conform to GMP regulations.  In complying with the GMP
regulations,  manufacturers  must  continue to expend time,  money and effort in
product,  record-keeping  and quality  control to assure that the product  meets
applicable specifications and other requirements.  The FDA periodically inspects
manufacturing facilities in the United States in order to assure compliance with
applicable GMP requirements. Foreign manufacturers also are inspected by the FDA
if their  drugs are  marketed  in the United  States.  Failure of the  Company's
foreign  supplier


                                      -16-
<PAGE>

of the active  ingredient used in the  manufacture of the Company's  products or
failure of the Company's  manufacturer  of its finished  dosage form products to
comply with the GMP regulations or other FDA regulatory  requirements would have
a material  adverse  effect on the Company's  business,  financial  condition or
results of operations.

     In  September  1998,  the FDA granted the Company  marketing  approval  for
Periostat  as an  adjunct  to SRP to  promote  attachment  level gain and reduce
pocket  depth in patients  with adult  periodontitis.  The Company is subject to
numerous  continuing  requirements  with regard to such  approval.  For example,
quality  control and  manufacturing  must  conform to complex and  detailed  GMP
requirements.  In addition,  the FDA may require post-marketing testing and will
require  surveillance  to  monitor  the  record  of the  product  and  continued
compliance with regulatory requirements.  Upon approval, a prescription drug may
only be marketed for the approved  indications in the approved  dosage forms and
at the  approved  dosage.  Also,  an NDA holder is  required  to report  certain
adverse reactions to the FDA, and to comply with certain requirements concerning
advertising and promotion labeling for their products. There can be no assurance
that  approval  from the FDA to market  Periostat  will not be withdrawn or that
Periostat  will never be recalled.  Withdrawal  of FDA  marketing  approval or a
recall of  Periostat  would  have a  material  adverse  effect on the  Company's
business, financial condition and results of operations.

     In addition to the applicable FDA  requirements,  the Company is subject to
foreign regulatory authorities governing clinical trials and drug sales. Whether
or not FDA approval has been obtained,  approval of a pharmaceutical  product by
the  comparable  regulatory  authorities  of foreign  countries must be obtained
prior to the  commencement of marketing of the product in those  countries.  The
approval  process  varies from  country to country and the time  required may be
longer or shorter than that required for FDA approval.


Competition

     The  pharmaceutical  industry is subject to intense  competition as well as
rapid  and  significant  technological  change.  The  Company  believes  that  a
significant  competitive factor is the relative speed with which the Company can
supply  commercial  quantities of the product to the market on an ongoing basis.
In addition,  the Company expects that  competition in the periodontal area will
be   based   on   other   factors,    including   product   efficacy,    safety,
cost-effectiveness,  ease of use, patient  discomfort,  availability,  price and
patent position.



                                      -17-
<PAGE>

      The Company believes that Periostat is  distinguished  from other existing
and known  periodontitis  treatments in that it is the only  treatment  which is
directed to suppression of the enzymes that degrade periodontal support tissues.
The Company believes that all other therapies focus on temporarily  removing the
bacteria   associated   with   periodontitis.   Periostat   is  a   prescription
pharmaceutical  capsule  indicated  as an adjunct  to SRP to promote  attachment
level gain and to reduce pocket depth in patients with adult  periodontitis that
is taken by the patient  between  dental visits.  The Company  believes that the
following chart summarizes the available forms of periodontitis treatment, other
than SRP, resective surgery and systemic antibiotics:


  Product          Product          Dental    Delivery    Patient     Treatment
    Name     Manufacturer/Marketer Procedure   Route    Administered    Focus
    ----     --------------------- ---------  --------  ------------  ---------

Periostat(R) CollaGenex               No      Systemic       Yes      Tissue
             Pharmaceuticals, Inc.                                   degradation

Atridox(TM)  Atrix Laboratories/      Yes      Local         No       Bacteria
             Block Drug

Actisite(R)  Alza/Proctor & Gamble    Yes      Local         No       Bacteria

Periochip(TM)PerioProducts, Ltd./     Yes      Local         No       Bacteria
             Astra U.S.

     Many  of  the  companies   participating   in  the  periodontal  area  have
substantially greater financial,  technical and human resources than the Company
and may be better equipped to develop,  manufacture and market  products.  These
companies may develop and introduce  products and processes  competitive with or
superior to those of the Company.


Employees

     The Company historically has outsourced its manufacturing, clinical trials,
NDA  preparation  and other  activities.  The  Company  intends to  continue  to
outsource many of the activities  which it historically  has  outsourced.  As of
December 31, 1998,  the Company  employed  134 persons.  Each of its  management
personnel has had extensive prior experience with pharmaceutical,  biotechnology
or medical products companies. The Company has increased its sales and marketing
staff  to  include   approximately  123  sales   representatives   and  managers
nationwide, of which 19 are part-time. In addition, the Company plans to recruit
additional sales  representatives  in 1999;  however,  there can be no assurance
that the Company will be able to recruit and retain  qualified  inside sales and
marketing  personnel,   additional  foreign  sub-licensees  or  distributors  or
marketing  partners or that the  Company's  marketing  and sales efforts will be
successful. Currently, none of the Company's employees are covered by collective
bargaining  agreements.  In  general,  the  Company's  employees  are covered by
confidentiality  agreements.  The Company considers relations with its employees
to be excellent.


                                      -18-
<PAGE>

Item 2.   Properties.

     The Company owns no real property.  The Company leases 3,500 square feet of
office space in Newtown,  Pennsylvania  under two leases. The Company's facility
contains all of its executive and administrative  offices.  One of the Company's
leases  expired in September of 1998 and the second lease expires in December of
2000.  The Company  has agreed to extend the lease at its current  facility on a
month-to-month basis. In May 1999, the Company expects to move its executive and
administrative  offices  to  a  new  facility  in  Newtown,   Pennsylvania  with
approximately  14,000  square  feet of office  space.  The  Company  expects  to
negotiate a ten-year lease for such facility.


Item 3.   Legal Proceedings.

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


Item 4.   Submission of Matters to a Vote of Security Holders.

     Not applicable.


                                      -19-
<PAGE>


                                     PART II


Item 5.  Market for the Company's Common Equity and Related Stockholder Matters.

     Prior to June  1996,  there was no  established  market  for the  Company's
Common  Stock.  Since June 20,  1996,  the Common Stock has traded on the Nasdaq
National Market ("NNM") under the symbol "CGPI."

     The  following  table sets forth the high and low bid  information  for the
Common  Stock for each of the quarters in the period  beginning  January 1, 1997
through  December  31,  1998  as  reported  on  NNM.  Such  quotations   reflect
inter-dealer prices, without retail mark-up, mark-down or commission and may not
represent actual transactions.

      Quarter Ended            High           Low
--------------------------------------------------------

March 31, 1997..........      $ 17.50       $ 8.00
June 30, 1997...........      $ 14.50       $10.50
September 30, 1997......      $ 12.875      $ 9.75
December 31, 1997.......      $ 16.625      $ 9.875
March 31, 1998..........      $ 13.125      $ 5.50
June 30, 1998...........      $ 10.75       $ 7.25
September 30, 1998......      $ 14.50       $ 7.75
December 31, 1998.......      $ 14.375      $ 8.25

     As of February 15, 1999, the approximate number of holders of record of the
Common Stock was 118 and the  approximate  number of  beneficial  holders of the
Common Stock was 3000.

     The Company has never  declared or paid any cash  dividends  on its capital
stock.  Except as set forth below, the Company intends to retain any earnings to
fund future growth and the operation of its business. In connection with a Stock
Purchase  Agreement  entered into in March 1999,  the Company  plans to seek the
approval of its  stockholders  at the 1999 Annual Meeting of Stockholders of the
Company for a private  placement  of Series D Cumulative  Convertible  Preferred
Stock.  If stockholder  approval is obtained,  the Company would have cumulative
cash and common stock  dividend  obligations in the future to the holders of the
Series D Cumulative Convertible Preferred Stock. Such financing arrangement also
limits  the  Company's  ability to  generally  declare  dividends  to its common
stockholders.  See "Management's  Discussion and Analysis of Financial Condition
and Results of Operations--Liquidity and Capital Resources."


                                      -20-
<PAGE>

Item 6.   Selected Consolidated Financial Data.

     The selected  consolidated  financial  data set forth below with respect to
the  Company's  statement  of  operations  data  for  each of the  years  in the
three-year  period ended December 31, 1998, and with respect to the consolidated
balance  sheet  data at  December  31,  1997 and 1998 are  derived  from and are
qualified by reference to the audited consolidated  financial statements and the
related  notes  thereto of the Company  found at "Item 14.  Exhibits,  Financial
Statement  Schedules,  and Reports on Form 8-K." The  consolidated  statement of
operations  data for the years ended December 31, 1994 and 1995 and with respect
to the  consolidated  balance sheet data as of December 31, 1994,  1995 and 1996
are derived from consolidated  audited financial statements not included in this
Annual Report on Form 10-K. The selected  consolidated  financial data set forth
below  should be read in  conjunction  with and is qualified in its entirety by,
the  Company's  audited  consolidated  financial  statements  and related  notes
thereto found at "Item 14. Exhibits,  Financial Statement Schedules, and Reports
on Form 8-K" and "Item 7.  Management's  Discussion  and  Analysis of  Financial
Condition and Results of Operations" which are included elsewhere in this Annual
Report on Form 10-K.


                                      -21-
<PAGE>





                                    Years Ended December 31,
                              ------------------------------------
                              1994    1995    1996    1997    1998
                              ----    ----    ----    ----    ----
Consolidated Statement of    (in thousands except for per share data)
  Operations Data:            ------------------------------------
  Revenues:
   Product sales.........     $  --  $  --   $  --   $ --   $3,053
   License revenues......        --     --     400    325      400
   Contract revenues.....        --     --      --      9        8
                              -----  -----   -----   ----     ----
  Total revenues.........        --     --     400    334     3461
                              -----  -----   -----   ----     ----
  Operating expenses:
   Cost of product sales.        --     --      --      --     745
   Research and development   1,928  3,635   4,436   4,200   4,670
   Selling, general and
   administrative........       793  1,548   2,527   6,096  10,600
  Operating loss.........    (2,721)(5,183) (6,563) (9,962)(12,554)
  Net loss...............    (2,653)(5,269) (5,918) (8,624)(11,566)
  Net loss allocable to
   common stockholders...    (3,229)(6,028) (6,638) (8,624)(11,566)

  Net loss per share(1):
   Basic.................          $(19.91) $(1.74) $(1.04) $(1.35)
   Diluted...............           (14.60)  (1.72)  (1.04)  (1.35)
  Shares used in computing 
   net loss per share(1):
   Basic.................              303   3,809   8,291   8,579
   Diluted...............              413   3,864   8,291   8,579

                                             As of December 31,
                               ------------------------------------------------
                               1994      1995       1996       1997       1998
                               ----      ----       ----       ----       ----
Balance Sheet Data:                           (in  thousands)

Cash, cash equivalents and
  short-term investments...  $   617     $5,806   $18,215    $22,771    $10,250
Total assets...............      628      5,840    18,437     23,165     14,740
Mandatorily redeemable
  convertible preferred        
  stock....................    7,510     18,908        --         --         --
Accumulated deficit........   (6,552)   (11,820)  (17,739)   (26,362)   (37,928)
Total stockholders'           
equity(deficit)............   (7,581)   (13,581)   17,592     20,708      9,281
      

(1) See Note 2 of Notes to  Consolidated  Financial  Statements for  information
    concerning computation of net loss per share.

                                      -22-
<PAGE>

Item 7. Management's  Discussion and Analysis of Financial Condition and Results
        of Operations.


Overview

     CollaGenex  Pharmaceuticals,  Inc. began  operations in January 1992 and is
focused  on  providing   innovative  medical  therapies  for  the  treatment  of
periodontitis and other pathologies characterized by the progressive degradation
of the  body's  connective  tissues.  The  Company's  core  technology  involves
inhibiting the activity of certain enzymes that degrade such connective tissues.
The Company's first product, Periostat, is a prescription pharmaceutical capsule
that was  approved by the FDA in  September  1998 as an adjunct to SRP, the most
prevalent  therapy for  periodontitis,  to promote  attachment level gain and to
reduce  pocket depth in patients  with adult  periodontitis.  Periostat has been
shipped to  wholesalers  and is presently  available to patients  throughout the
United States.

     Since  inception,  the  Company  has  operated  with a  minimal  number  of
employees.  Substantially all pharmaceutical  development activities,  including
clinical trials, have been contracted to independent contract research and other
organizations.  The Company has recently  increased,  and expects to continue to
increase,  the number of its employees over the next several years, primarily in
the selling, general and administrative areas.

     The  Company  has  incurred  losses  each year since  inception  and had an
accumulated  deficit of $37.9 million at December 31, 1998. The Company  expects
to continue to incur losses in the foreseeable  future from expenditures on drug
development, marketing, manufacturing and administrative activities.

     Statements  contained or incorporated by reference in this Annual Report on
Form 10-K that are not based on historical fact are "forward-looking statements"
within the meaning of Section 21E of the  Securities  Exchange  Act of 1934,  as
amended.   Forward-looking   statements   may  be   identified  by  the  use  of
forward-looking   terminology  such  as  "may,"  "will,"  "expect,"  "estimate,"
"anticipate,"  "continue,"  or similar  terms,  variations  of such terms or the
negative of those terms. This Form 10-K contains forward-looking statements that
involve risks and uncertainties.  The Company's  business of selling,  marketing
and  developing  pharmaceutical  products is subject to a number of  significant
risks, including risks relating to the implementation of the Company's sales and
marketing  plans for  Periostat,  risks  inherent  in research  and  development
activities,  risks  associated  with conducting  business in a highly  regulated
environment,  risks relating to the Company's Year 2000  compliance and the Year
2000   compliance   of  the   Company's   vendors,   suppliers,   manufacturers,
distributors, marketing partners and certain other parties, uncertainty relating
to clinical trials of products under  development  and  uncertainty  relating to
stockholder  approval of the Company's  proposed  Preferred  Stock financing and
whether such Preferred  Stock financing will be consummated in a timely fashion,
if at all. The success of the Company  depends to a large degree upon the market
acceptance of Periostat by  periodontists,  dental  practitioners,  other health
care providers,  patients and insurance companies.  Other than Periostat,  which
has been FDA  approved  for  marketing  in the  United  States,  there can be no
assurance that any of the Company's other product candidates will be 


                                      -23-
<PAGE>

approved by any regulatory  authority for marketing in any  jurisdiction  or, if
approved,  that any such products  will be  successfully  commercialized  by the
Company.  The Company's  actual results may differ  materially  from the results
discussed in the forward-looking statements contained herein.


Results of Operations

     From its  founding  through the quarter  ending  September  30,  1998,  the
Company  had no  revenues  from  sales of its own  products.  During  the fourth
quarter  of 1998,  the  Company  achieved  net  product  sales  of $3.1  million
following  the  commercial  launch of  Periostat in November  1998.  The Company
realized  a net loss  during  the fourth  quarter  of 1998,  however,  resulting
primarily from pre-launch and post-launch  marketing  activities incurred during
1998. Total operating  expenses  consist of the cost of product sales,  research
and development expenses and selling,  general and administrative expenses. Cost
of  product  sales  consists  primarily  of direct  manufacturing  expenses  and
royalties.  Research and development expenses consist primarily of funds paid to
contract research  organizations for the provision of services and materials for
drug  development  and  clinical  trials.  Selling,  general and  administrative
expenses consist primarily of personnel salaries and benefits,  direct marketing
costs,  professional and consulting fees, insurance and general office expenses.
The Company anticipates that selling,  general and administrative  expenses will
increase  during the next several  years due to the  continued  expansion of its
commercial infrastructure, primarily in sales and marketing.

     Years Ended December 31, 1998 and December 31, 1997

     The Company  realized $3.5 million in net revenues  during 1998 compared to
$334,000  during 1997.  Revenues in 1998  included  $3.1 million in net sales of
Periostat and $408,000 in licensing and contract  revenues.  The 1998  licensing
revenues  of  $400,000  were   attributable   to  a  licensing   agreement  with
Laboratories  Pharmascience  pursuant to which Laboratories  Pharmascience will,
following all requisite  regulatory  approvals,  market  Periostat in France and
certain other related  territories.  Revenues in 1997 included a  non-refundable
$300,000 licensing fee from Boehringer Mannheim Italia (now called Roche S.P.A.)
related to the achievement of the first  milestone  under a licensing  agreement
pursuant  to  which  Roche  S.P.A.  will,  following  all  requisite  regulatory
approvals, distribute and manufacture Periostat in Italy.

     Cost of product  sales were  $745,000 in 1998,  while there were no cost of
product sales in 1997. Such increase  resulted from the Company's  initial sales
of Periostat in 1998.

     Research and  development  expenses  increased from $4.2 million in 1997 to
$4.7 million in 1998. This increase resulted primarily from expenses relating to
additional  costs  associated  with  the  Company's  amendment  to its  NDA  for
Periostat submitted to the FDA in March 1998, a Phase 3b clinical trial intended
to support future marketing activities for Periostat,  the initiation of certain
pre-clinical studies for Nephrostat, the Company's compound for the treatment of
diabetic complications,  and consulting and product registration fees associated
with the Marketing Authorization Application that the Company has filed with the
United Kingdom Medicine Control Agency with respect to potential Periostat sales
in the United Kingdom.



                                      -24-
<PAGE>

     Selling, general and administrative expenses increased from $6.1 million in
1997 to $10.6 million in 1998.  This increase was due primarily to the Company's
pre-launch marketing  activities related to Periostat,  the hiring of additional
sales personnel and sales and marketing  efforts related to certain  contractual
marketing arrangements entered into during 1997.

     Interest  income  decreased  from $1.3 million in 1997 to $988,000 in 1998.
This decrease was due to lower balances in cash and short-term  investments as a
result of normal  operating  activities  since the  Company's  follow-on  public
offering of Common Stock in April 1997.

     Years Ended December 31, 1997 and December 31, 1996

     The Company  earned  $325,000 in licensing fee revenue during 1997 compared
to $400,000 during 1996. During 1996, the Company executed a licensing agreement
with  Boehringer  Mannheim  Italia (now called Roche S.P.A.),  pursuant to which
Roche S.P.A. will, following all requisite regulatory approvals,  distribute and
manufacture Periostat in Italy. The agreement provided for Roche S.P.A. to pay a
$400,000  license  fee  upon  signing,  additional  fees  to be  paid  upon  the
achievement  of future  milestones  and royalty  payments  upon future  sales of
Periostat in Italy,  San Marino and the Vatican City.  During the second quarter
of 1997, the Company received a non-refundable $300,000 licensing fee from Roche
S.P.A. related to the achievement of the first milestone under the agreement.

     Research and  development  expenses  decreased from $4.4 million in 1996 to
$4.2  million  in 1997.  This  decrease  resulted  primarily  from  lower  costs
associated with the NDA for Periostat, which was submitted in 1996. Research and
development  expenses  in  1997  related  primarily  to  costs  associated  with
completing  a Phase III scaling and root  planing  trial,  validating  Periostat
manufacturing processes and continuing certain toxicology studies.

     Selling, general and administrative expenses increased from $2.5 million in
1996 to $6.1  million  in  1997.  This  increase  was due  primarily  to  higher
marketing,  general and administrative expenses associated with the expansion of
the Company's commercial infrastructure.

     Interest  income  increased  from $645,000 in 1996 to $1.3 million in 1997.
This increase was due to higher balances in cash and short-term investments as a
result of the Company's follow-on public offering of Common Stock in 1997.


Liquidity and Capital Resources

     Since its origin in January 1992,  the Company has financed its  operations
through  private  placements  of preferred  stock and common  stock,  an initial
public  offering  of  2,000,000  shares of common  stock,  which  generated  net
proceeds to the Company of approximately  $18.0 million after  underwriting fees
and related  expenses,  and a subsequent  public offering of 1,000,000 shares of
common stock, which generated net proceeds to the Company of approximately $11.6
million after  underwriting  fees and related  expenses.  On March 19, 1999, the
Company  announced that it had entered into an agreement with investors who have
committed to purchase $20.0 million of Series D Cumulative Convertible Preferred
Stock (the  "Preferred  Stock") of the  


                                      -25-
<PAGE>

Company  at a purchase  price of $100 per  share.  In  accordance  with  certain
stockholder  approval  requirements  of  the  Nasdaq  Stock  Market,  Inc.,  the
Preferred  Stock  financing is expected to be presented to the Company's  common
stockholders for approval at the Company's Annual Meeting of Stockholders in May
1999 and,  assuming  such  approval,  the  Company  expects  to  consummate  the
Preferred Stock  financing as soon as practicable  following such Annual Meeting
of Stockholders.  Simultaneous with the signing of the Preferred Stock financing
agreement,  the Company executed a Senior Secured  Convertible Note (the "Note")
pursuant to which the Company  received  $10.0 million from one of the investors
in the financing  transaction to be used for working capital purposes.  The Note
has a term of one year,  bears  interest  at a rate of 12.0% per annum,  must be
repaid  upon the  closing of the  Preferred  Stock  financing  and is secured by
certain  intellectual  property of the Company. In the event the Preferred Stock
financing is not  consummated by June 30, 1999,  the  noteholder  shall have the
option to convert  the  principal  due under the Note into  1,538,462  shares of
Common  Stock.  Any interest due under the Note would also be  convertible  into
shares of Common Stock at a conversion price of $6.50 per share. At December 31,
1998,  the Company had cash,  cash  equivalents  and  short-term  investments of
approximately  $10.3 million, a decrease of $12.5 million from the $22.8 million
balance at December 31, 1997. In accordance with investment  guidelines approved
by the Company's  Board of Directors,  cash balances in excess of those required
to fund  operations  have been  invested in short-term  United  States  Treasury
securities  and commercial  paper with a credit rating no lower than A1/P1.  The
Company's  working capital at December 31, 1998 was $9.0 million,  a decrease of
$11.6 million from December 31, 1997.  This decrease was primarily  attributable
to the payment of normal operating expenses incurred during 1998.

     The Company had no debt or capital leases  outstanding (other than accounts
payable and accrued  expenses)  at December  31,  1998.  On June 26,  1997,  the
Company  entered into a credit  arrangement  consisting of a $5,000,000  line of
credit (the "LOC") to support the future  working  capital needs of the Company.
The LOC will be unsecured as long as the Company's cash and investment  balances
maintained  with the lender or an  affiliate of the lender equal or exceed $10.0
million. At the Company's option, the LOC will bear interest at either the prime
rate  charged by the lender or LIBOR plus 2.15%.  The LOC is  terminable  by the
lender at any time.  No balance was  outstanding  under the LOC at December  31,
1998.

     The Company  anticipates that its existing  working capital,  including the
$10.0 million  proceeds from the Note,  will be sufficient to fund the Company's
operations  through  at least  year  end  1999.  The  Company's  future  capital
requirements  and the  adequacy  of its  available  funds  will  depend  on many
factors,  including,  the size and scope of the Company's  marketing  effort and
sales of  Periostat,  the  terms  of  agreements  entered  into  with  corporate
partners,  if any, and the results of research and development and  pre-clinical
and clinical  studies for other  applications of the Company's core  technology.
Over the long-term, the Company's liquidity is dependent on market acceptance of
its products and technology.

     As of December 31, 1998, the Company had available  $35.3 million and $29.6
million in net operating loss  carryforwards  to offset future Federal and state
taxable  income.  The Federal and state net operating  loss  carryforwards  will
begin  expiring in the year 2007 and 2005,  respectively,  if not  utilized.  In
addition,  the  utilization  of the state net operating  loss  


                                      -26-
<PAGE>

carryforwards  is subject to a $1.0 million annual  limitation.  The Company had
research and experimentation tax credits of approximately $500,000,  which begin
expiring in 2007 and are available to reduce Federal  income taxes.  As a result
of past financings, including the Company's initial public offering in June 1996
and  the  Company's  follow-on  public  offering  in  April  1997,  the  Company
experienced  ownership  changes as defined by rules  enacted with the Tax Reform
Act of 1986 (the "Reform Act").  Accordingly,  the Company's  ability to use its
net operating  loss and research and  experimentation  credit  carryforwards  is
subject to certain limitations as defined by the Reform Act and may be limited.

Year 2000 Issues

     Assessment

     The Company  believes its exposure to Year 2000 problems lies  primarily in
two areas: (i) its own internal operating systems; and (ii) Year 2000 compliance
by third parties with whom the Company has a material relationship.  The Company
has  completed an assessment of its principal  internal  systems.  However,  the
Company is  continuing  to assess its Year 2000  exposure  with respect to third
parties.  While the costs of these  assessment  efforts  are not  expected to be
material  to  the  Company's  financial  condition  or  any  year's  results  of
operations, there can be no assurance that this will be the case.

     Internal Operating Systems

     The Company  believes  that its  principal  internal  systems are Year 2000
compliant.  The Company  recently  installed  upgraded  versions of its internal
accounting, management and financial reporting applications which the vendor has
represented  are  Year  2000  compliant.  Some  of  the  Company's  non-critical
applications, however, may not be Year 2000 compliant. The Company is conducting
a program to identify and resolve any such exposure.  Although the costs related
to these  efforts are not  expected to be  material to the  Company's  business,
financial condition or results of operations, no assurance can be made that this
will be the case.

     Third-Party Relationships

      The  Company is  conducting  a program to identify  and resolve  Year 2000
exposure from third parties.  The Company is presently  conducting  inquiries of
     its outside vendors, suppliers, manufacturers, distributors and marketing
partners to assess their Year 2000 readiness.  Any failure of third parties with
whom the Company has a material  relationship to resolve Year 2000 problems in a
timely  manner  could  materially   adversely  affect  the  Company's  business,
financial condition or results of operations.

     Risks of the Company's Year 2000 Issues

     The Company  expects to identify  and resolve all Year 2000  problems  that
could materially adversely affect the Company's business, financial condition or
results of operations.  However, the Company believes that it is not possible to
determine with complete  certainty that all Year 2000 problems affecting it have
been  identified or will be corrected.  Further,  the 


                                      -27-
<PAGE>

Company  cannot  accurately  predict how many failures  related to the Year 2000
problem will occur or the severity,  duration or financial  consequences of such
failures.  As a result,  the Company  expects that it could possibly  suffer the
following consequences:

     o    A significant number of operational  inconveniences and inefficiencies
          for the  Company  and the  Company's  customers  that may  divert  the
          Company's  time and attention and financial and human  resources  from
          the Company's ordinary business activities; and

     o    A lesser  number of serious  system  failures  (whether the  Company's
          systems   or  those   of  its   vendors,   suppliers,   manufacturers,
          distributors  and  marketing  partners)  that may require  significant
          efforts by the Company,  its  customers or third parties to prevent or
          alleviate material business disruptions.

     Costs

     Other than time spent by the Company's own  personnel,  to date the Company
has not incurred any significant  costs in identifying and remediating Year 2000
problems.

     The Company's Contingency Plans

     The Company  believes  its plans for  addressing  the Year 2000 problem are
adequate. The Company does not believe it will incur a material financial impact
from system failures, or from the costs associated with assessing and addressing
the risks of failure,  arising  from the Year 2000  problem.  Consequently,  the
Company does not intend to create a detailed contingency plan. In the event that
the Company does not adequately  identify and resolve its Year 2000 issues,  the
absence of a  detailed  contingency  plan may  materially  adversely  affect its
business, financial condition and results of operations.

European Monetary Union

     On January 1, 1999,  eleven of the fifteen member countries of the European
Union set fixed  conversion  rates between their existing legacy  currencies and
the euro. At such time, these participating  countries adopted the euro as their
common  legal  currency.  The  eleven  participating  countries  will now  issue
sovereign debt exclusively in euro and will redenominate  outstanding  sovereign
debt.  The legacy  currencies  will continue to be used as legal tender  through
January 1, 2002, at which point the legacy  currencies will be canceled and euro
bills  and  coins  will be  used  for  cash  transactions  in the  participating
countries.

     The Company does not denominate its international  licensing  agreements in
foreign  currencies.  The  Company  currently  does  not  believe  that the euro
conversion will have a material impact on the Company's results of operations or
financial condition.



                                      -28-
<PAGE>



Item 7A.  Quantitative and Qualitative Disclosures About Market Risk.

     The Company is not subject to a material  impact to its financial  position
or results of operations.


Item 8.   Financial Statements and Supplementary Data.

     The financial  statements  required to be filed pursuant to this Item 8 are
appended to this Annual Report on Form 10-K. A list of the financial  statements
filed herewith is found at "Item 14. Exhibits,  Financial  Statement  Schedules,
and Reports on Form 8-K."


Item  9.  Changes  in and  Disagreements  with  Accountants  on  Accounting  and
          Financial Disclosure.

     Not applicable.



                                      -29-
<PAGE>



                                    PART III


Item 10.  Directors and Executive Officers of the Company.

     The information relating to the Company's directors,  nominees for election
as directors and executive  officers under the headings  "Election of Directors"
and "Executive  Officers" in the Company's  definitive  proxy  statement for the
1999 Annual Meeting of Stockholders is incorporated  herein by reference to such
proxy statement.


Item 11.  Executive Compensation.

     The discussion under the heading "Executive  Compensation" in the Company's
definitive  proxy  statement  for the 1999  Annual  Meeting of  Stockholders  is
incorporated herein by reference to such proxy statement.

Item 12.  Security Ownership of Certain Beneficial Owners and Management.

     The discussion under the heading "Security  Ownership of Certain Beneficial
Owners and Management" in the Company's  definitive proxy statement for the 1999
Annual Meeting of Stockholders is incorporated herein by reference to such proxy
statement.


Item 13.  Certain Relationships and Related Transactions.

     The  discussion  under  the  heading  "Certain  Relationships  and  Related
Transactions"  in the Company's  definitive  proxy statement for the 1999 Annual
Meeting  of  Stockholders  is  incorporated  herein by  reference  to such proxy
statement.


                                      -30-
<PAGE>


                                     PART IV


Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

(a)  (1) Financial Statements.

          Reference is made to the Index to  Consolidated  Financial  Statements
          and Schedule on Page F-1. 

     (2)  Financial  Statement  Schedule.  Reference  is  made to the  Index  to
          Consolidated  Financial  Statements  and  Schedule  on Page  F-1.  

     (3)  Exhibits.  Reference  is made to the Index to Exhibits on Page 34. 

(b)       Reports on Form 8-K. No Reports on Form 8-K have been filed during the
          quarter ended December 31, 1998. The Company filed a Current Report on
          Form 8-K on March 25, 1999 relating to its issuance of a $10.0 million
          Senior  Secured  Convertible  Note and its proposed  issuance of $20.0
          million of Series D Cumulative  Convertible Preferred Stock to certain
          investors.

                                      -31-
<PAGE>



                                   SIGNATURES

          Pursuant to the  requirements of Section 13 or 15(d) of the Securities
     Exchange  Act of 1934,  the  Registrant  has duly  caused this report to be
     signed on its behalf by the  undersigned,  thereunto duly  authorized  this
     29th day of March, 1999.

                                         COLLAGENEX PHARMACEUTICALS, INC.

                                         By:/s/Brian M. Gallagher 
                                            ------------------------------------
                                            Brian M. Gallagher, Ph.D., President
                                            and Chief Executive Officer

                                      -32-
<PAGE>


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

            Signature                        Title                  Date
---------------------------------  --------------------------  -----------------

/s/ Brian M. Gallagher, Ph.D.      President, Chief            March 29, 1999
---------------------------------  Executive Officer and
    Brian M. Gallagher, Ph.D.      Director (Principal
                                   Executive Officer)
                                   
/s/ Nancy C. Broadbent             Chief Financial Officer,    March 29, 1999
---------------------------------  Treasurer and Secretary
    Nancy C. Broadbent             (Principal Financial and
                                   Accounting Officer)
                                   
/s/ Helmer P.K. Agersborg, Ph.D.   Chairman of the Board and   March 29, 1999
---------------------------------  Director
    Helmer P.K. Agersborg, Ph.D.   

/s/ James E. Daverman              Director                    March 29, 1999
---------------------------------
    James E. Daverman

                                   Director                    
---------------------------------
    Robert J. Easton

                                   Director                    
---------------------------------
    Stephen W. Ritterbush, Ph.D.

/s/ Pieter J. Schiller             Director                    March 29, 1999
---------------------------------
    Pieter J. Schiller

/s/ Terence E. Winters, Ph.D.      Director                    March 29, 1999
---------------------------------
    Terence E. Winters, Ph.D.

/s/ Peter R. Barnett               Director                    March 29, 1999
---------------------------------
    Peter R. Barnett


                                      -33-
<PAGE>



                                  EXHIBIT INDEX

 Exhibit No.                        Description of Exhibit
 -----------                        ----------------------

    3.1(a)    Amended and Restated Certificate of Incorporation.
    3.2(a)    Amended and Restated Bylaws.
    4.1(a)    Registration  Rights  Agreement  dated  September  29, 1995 by and
              among the Company and certain investors, as supplemented.
    4.2(a)(b) Letter dated  December 16, 1993 re:  certain rights of the Company
              with respect to certain  securities  of the Company owned by Brian
              M. Gallagher, Ph.D.
    4.3(a)    Fourth Investment  Agreement as of September 29, 1995 by and among
              the Company and certain Investors.
    4.4(d)    Shareholder Protection Rights Agreement, dated as of September 15,
              1997,  between  the Company and  American  Stock  Transfer & Trust
              Company which includes (i) the Form of Rights Certificate and (ii)
              the Certificate of Designation of Series A Participating Preferred
              Stock of the Company.
    4.5(j)    Amendment No. 1 to Shareholder Protection Rights Agreement,  dated
              as of March 16,  1999,  between  the Company  and  American  Stock
              Transfer & Trust Company.
  +10.1(a)    Assignment of, Amendment to and Restatement of Agreement, with all
              exhibits, as amended, and schedules, dated January 13, 1992 by and
              among the Company,  Johnson & Johnson Consumer Products,  Inc. and
              Research Foundation of State University of New York.
  +10.2(a)    Supply  Agreement  dated  January 23, 1995 between the Company and
              Hovione International Limited.
  +10.3(a)    Manufacturing  Agreement  as of April 12,  1996 by and between the
              Company and Applied Analytical Industries, Inc.
   10.4(a)    Form of  Non-Disclosure  Agreement  executed by all  Employees  as
              employed from time to time.
   10.5(a)(b) Form of  Non-Competition  Agreement  executed  by each of Brian M.
              Gallagher, Ph.D., Nancy C. Broadbent and Robert A. Ashley.
   10.6(a)    Form  of  Mutual  Non-Disclosure  Agreement  executed  by  certain
              consultants  and research  collaborators  as retained from time to
              time.
   10.7(a)(b) Form  of  Indemnification   Agreement  executed  by  each  of  the
              Company's directors and officers.
   10.8(a)    Forms of Consulting  Agreement  executed by each of Lorne M. Golub
              and Thomas F. McNamara.
   10.9(a)    Form of  Material  Transfer  Agreement  between  the  Company  and
              Researchers.


                                      -34-
<PAGE>

 Exhibit No.                        Description of Exhibit
 -----------                        ----------------------

   10.10(g)   Lease  Agreement  dated  September 5, 1995 between the Company and
              Stocking  Works  Associates  (incorporated  by  reference  to  the
              Company's   Registration   Statement  on  Form  S-1  (File  Number
              333-3582)  which became  effective on June 20,  1996),  as amended
              effective  January  1, 1997 (such  amendment  is  incorporated  by
              reference  to the  Company's  Registration  Statement  on Form S-1
              (File Number  333-24151) which became effective on April 2, 1997),
              as amended  effective  January 1, 1998  (such  Amendment  is filed
              herewith).
   10.11(a)   Master  Consulting  Agreement dated September 19, 1994 between the
              Company and Quintiles, Inc.
   10.12(a)(b)1992 Stock Option Plan of the Company, as amended to date.
   10.13(a)(b)1996 Stock Plan of the Company.
   10.14(a)(b)1996 Non-Employee Director Stock Option Plan of the Company.
  +10.15(c)   License  Agreement  dated July 18, 1996 by and between the Company
              and Boehringer Mannheim Italia.
   10.16(e)   Letter  Agreement  dated June 24, 1997 relating to CoreStates Bank
              N.A. line of credit,  together with Master  Commercial  Promissory
              Note.
   10.17(e)   Consulting and Contract  Service  Agreement dated February 1, 1997
              by and between the Company and Innovative Customer Solutions, Ltd.
   10.18(g)   Lease  Agreement  dated  August 22,  1997  between the Company and
              Stocking Works  Associates  which became effective on September 1,
              1997.
   10.19(h)   Contract between  Quintiles  Scotland Ltd. and the Company,  dated
              April 28, 1998.
  +10.20(i)   License  Agreement  dated as of June 30,  1998 by and  between the
              Company and Laboratories Pharmascience S.A.
  +10.21(i)   Exhibit A to the  Manufacturing  Agreement as of April 12, 1996 by
              and between the Company and Applied Analytical  Industries,  Inc.,
              filed with the Company's  Registration Statement on Form S-1 (File
              Number 333-3582) which became effective on June 20, 1996.
  +10.22(i)   Co-Promotion  Agreement dated October 13, 1998 between  SmithKline
              Beecham Consumer Healthcare, L.P. and the Company.
  +10.23(i)   Distribution  Services  Agreement  dated  August 15, 1998  between
              Cord Logistics, Inc. and the Company.
   10.24(j)   Convertible  Loan and  Security  Agreement  dated as of March  19,
              1999,  between OCM  Principal  Opportunities  Fund,  L.P.  and the
              Company.
   10.25(j)   Convertible  Note dated  March 19,  1999,  made by the  Company in
              favor of OCM Principal Opportunities Fund, L.P.
   10.26(j)   Stock  Purchase  Agreement  dated  March  19,  1999,  between  the
              Company,   OCM  Principal   Opportunities  Fund,  L.P.  and  other
              Purchasers set forth therein.
   21(f)      List of subsidiaries of the Registrant.
   23.1       Consent of KPMG LLP.


                                      -35-
<PAGE>

 Exhibit No.                        Description of Exhibit
 -----------                        ----------------------

   27         Financial Data Schedule.

--------------
+    Confidential treatment has been requested and granted for a portion of this
     Exhibit.  
(a)  Incorporated by reference to the Company's  Registration  Statement on Form
     S-1 (File Number 333-3582) which became effective on June 20, 1996.
(b)  A management  contract or compensatory  plan or arrangement  required to be
     filed as an exhibit pursuant to Item 14(c) of Form 10-K.
(c)  Incorporated  by reference to the Company's  Quarterly  Report on Form 10-Q
     for the  quarter  ended  September  30,  1996  which  was  filed  with  the
     Securities and Exchange Commission on October 29, 1996.
(d)  Incorporated  by reference  to the  Company's  Current  Report on Form 8-K,
     dated September 16, 1997,  which was filed with the Securities and Exchange
     Commission on September 17, 1997.
(e)  Incorporated  by reference to the Company's  Quarterly  Report on Form 10-Q
     for the quarter  ended June 30, 1997,  which was filed with the  Securities
     and Exchange Commission on August 1, 1997.
(f)  Incorporated  by reference to the Company's  Annual Report on Form 10-K for
     the year ended  December 31, 1996,  which was filed with the Securities and
     Exchange Commission on March 28, 1997. 
(g)  Incorporated  by reference to the Company's  Annual Report on Form 10-K for
     the year ended  December 31, 1997,  which was filed with the Securities and
     Exchange Commission on March 30, 1998. 
(h)  Incorporated by reference to the
     Company's  Quarterly  Report on Form 10-Q for the  quarter  ended  June 30,
     1998, which was filed with the Securities and Exchange Commission on August
     14, 1998. 
(i)  Incorporated  by reference to the Company's  Quarterly  Report on Form 10-Q
     for the  quarter  ended  September  30,  1998,  which  was  filed  with the
     Securities and Exchange Commission on November 16, 1998.
(j)  Incorporated  by reference  to the  Company's  Current  Report on Form 8-K,
     dated  March 19,  1999 which was filed  with the  Securities  and  Exchange
     Commission on March 25, 1999.


                                      -36-
<PAGE>

                                        
                        COLLAGENEX PHARMACEUTICALS, INC.

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

                        AND FINANCIAL STATEMENT SCHEDULE

                                                                      Page
                                                                      ----

Report of Independent Accountants................................     F-2

Consolidated balance sheets as of December 31, 1997 and 1998.....     F-3

Consolidated   statements  of  operations  for  the  years  ended
  December 31, 1996, 1997, and 1998..............................     F-4

Consolidated  statements of  stockholders'  equity  (deficit) for
  the years ended December 31, 1996, 1997 and 1998...............     F-5

Consolidated  statements  of  cash  flows  for  the  years  ended
  December 31, 1996, 1997 and 1998...............................     F-6

Notes to consolidated financial statements.......................     F-7

Financial Statement Schedule
  Schedule of Valuation and Qualifying Accounts..................     F-21



                                      F-1
<PAGE>


                          Independent Auditors' Report



The Board of Directors and Stockholders
CollaGenex Pharmaceuticals, Inc.:


We  have  audited  the   consolidated   financial   statements   of   CollaGenex
Pharmaceuticals,  Inc. and subsidiary as listed in the  accompanying  index.  In
connection with our audits of the  consolidated  financial  statements,  we also
have  audited the  financial  statement  schedule as listed in the  accompanying
index. These consolidated  financial statements and financial statement schedule
are the  responsibility of the Company's  management.  Our  responsibility is to
express an opinion on these  consolidated  financial  statements  and  financial
statement schedule based on our audits.

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

In our opinion, the consolidated  financial statements referred to above present
fairly,  in  all  material  respects,   the  financial  position  of  CollaGenex
Pharmaceuticals,  Inc. and  subsidiary as of December 31, 1997 and 1998, and the
results  of their  operations  and their cash flows for each of the years in the
three-year period ended December 31, 1998, in conformity with generally accepted
accounting  principles.  Also in our opinion,  the related  financial  statement
schedule,  when  considered  in  relation  to the basic  consolidated  financial
statements  taken as a whole,  present  fairly,  in all material  respects,  the
information set forth therein.



/s/   KPMG LLP


Princeton, New Jersey
January 29, 1999, except as to note 13, which
   is as of March 19, 1999


                                      F-2
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                           Consolidated Balance Sheets

                           December 31, 1997 and 1998

                  (dollars in thousands, except per share data)

                      Assets                           1997       1998
                                                     ---------  ---------

Current assets:
    Cash and cash equivalents...................   $   16,379  $    3,286
    Short term investments......................        6,392       6,964
    Accounts receivable, net of allowance
      of $293 in 1998...........................           --       3,045
    Inventories (note 3)........................           --         342
    Prepaid expenses and other current assets...          278         823
                                                     --------   ---------

             Total current assets...............       23,049      14,460

Equipment, net (note 3).........................          103         267
Other assets....................................           13          13
                                                     --------   ---------
           Total assets.........................   $   23,165  $   14,740
                                                     ========   =========

       Liabilities and Stockholders' Equity

Current liabilities:
    Accounts payable.............................  $      551  $   2,914
    Accrued expenses (note 3)....................       1,906      2,545
                                                     --------   --------

           Total current liabilities.............       2,457      5,459
                                                     --------   --------

Stockholders' equity (notes 6 and 7):
    Preferred stock, $0.01 par value, 5,000,000
      shares authorized, no shares outstanding in         
      1997 and 1998..............................          --         --
    Common stock, $0.01 par value; 25,000,000
      shares authorized, 8,567,579 and 8,587,204
      shares issued and outstanding in 1997   
      and 1998, respectively.....................          86         86
    Additional paid in capital...................      47,297     47,317
    Deferred compensation (note 7)...............        (313)      (194)
    Accumulated deficit..........................     (26,362)   (37,928)
                                                      -------    -------

           Stockholders' equity.................       20,708      9,281

Commitments (notes 5, 9, 10, 12 and 13)
                                                      -------    -------
           Total   liabilities  and  stockholders' $   23,165  $  14,740
           equity...............................
                                                     ========   ========

          See accompanying notes to consolidated financial statements.

                                      F-3
<PAGE>



                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                      Consolidated Statements of Operations

              For the years ended December 31, 1996, 1997 and 1998

                  (dollars in thousands, except per share data)

                                            1996       1997         1998
                                          ---------  ----------  ------------

Revenues:
    Product sales...................... $       -- $        -- $       3,053
    License revenues...................        400         325           400
    Contract revenues..................         --           9             8
                                          ---------  ----------  ------------
         Total revenues................        400         334         3,461
                                          ---------  ----------  ------------

Operating expenses:
    Cost of product sales..............         --          --           745
    Research and development
      (notes 9 and 12).................      4,436       4,200         4,670
    Selling, general and administrative      2,527       6,096        10,600
                                          ---------  ----------  ------------
         Total operating expenses......      6,963      10,296        16,015
                                          ---------  ----------  ------------
         Operating loss................     (6,563)     (9,962)      (12,554)

Interest Income.. .....................        645       1,338           988
                                          ---------  ----------  ------------
         Net loss...................... $   (5,918) $   (8,624) $    (11,566)
                                          =========  ==========  ============

Accretion of undeclared
    dividends attributable to
    mandatorily redeemable
    convertible preferred stock........ $      720 $         -- $          --
                                          =========  ==========  ============

Net loss allocable to common
    stockholders....................... $   (6,638) $   (8,624) $    (11,566)
                                          =========  ==========  ============

Net loss per share (note 2):
    Basic.............................. $    (1.74) $    (1.04) $      (1.35)
    Diluted............................      (1.72)      (1.04)        (1.35)
                                          =========  ==========    ==========

Shares used in computing net loss 
  per share (note 2):
    Basic............................    3,808,734   8,291,167     8,579,054
    Diluted..........................    3,863,734   8,291,167     8,579,054
                                         =========   =========     =========

          See accompanying notes to consolidated financial statements.

                                      F-4
<PAGE>

<TABLE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

            Consolidated Statements of Stockholders' Equity (Deficit)

              For the years ended December 31, 1996, 1997 and 1998

                             (dollars in thousands)

<CAPTION>
                                                                            Additional                                 Total
                                                         Common stock         paid-in                                stockholders'
                                                     --------------------
                                                     Number of     Par        capital      Deferred     Accumulated    equity
                                                       shares     value      (deficit)    compensation    deficit     (deficit)
                                                     ---------  ---------    ------------ ------------  -----------  -------------

<S>                                                  <C>        <C>          <C>          <C>           <C>          <C>
Balance, December 31, 1995 ........................    312,659   $       3   $  (1,744)   $     (20)    $(11,820)    $(13,581)

     Exercise of common stock options (note 7) ....     23,750          --           6           --           --            6
     Issuance of common stock at $10 per share in 
        conjunction with the Initial Public 
        Offering, net of issuance costs ............ 2,000,000          20      18,007           --           --       18,027
     Accretion of undeclared dividends on 
        mandatorily redeemable convertible 
        preferred stock (note 4) ...................        --          --        (720)          --           --         (720)
     Conversion of mandatorily redeemable 
        convertible preferred stock into common
        stock in conjunction with the Initial 
        Public Offering ............................ 5,199,124          52      19,576           --           --       19,628
     Deferred compensation resulting from grant 
        of options (note 7) ........................        --          --         426         (426)          --           --
     Amortization of deferred compensation .........        --          --          --          150           --          150
     Net loss ......................................        --          --          --           --       (5,918)      (5,918)
                                                     ---------   ---------    ---------    ---------    ---------    ---------

Balance, December 31, 1996 ......................... 7,535,533          75      35,551         (296)     (17,738)      17,592

     Exercise of common stock options (note 7) .....    32,046           1          52           --           --           53
     Issuance of common stock at $12.50 per share 
        in conjunction with follow-on Offering,
        net of issuance costs (note 6) ............. 1,000,000          10      11,552           --           --       11,562
     Deferred compensation resulting from
        grant of options (note 7) ..................        --          --         142         (142)          --           --
     Amortization of deferred compensation .........        --          --          --          125           --          125
     Net loss ......................................        --          --          --           --       (8,624)      (8,624)
                                                     ---------   ---------    ---------    ---------    ---------    ---------

Balance, December 31, 1997 ......................... 8,567,579          86      47,297         (313)     (26,362)      20,708

     Exercise of common stock options (note 7) .....    19,625          --          20           --           --           20
     Amortization of deferred compensation .........        --          --          --          119           --          119
     Net loss ......................................        --          --          --           --      (11,566)     (11,566)
                                                     ---------   ---------    ---------    ---------    ---------    ---------
Balance, December 31, 1998 ......................... 8,587,204   $      86   $  47,317    $    (194)   $ (37,928)   $   9,281
                                                     =========   =========    =========    =========    =========    =========

</TABLE>

                                
          See accompanying notes to consolidated financial statements.




                                      F-5
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                      Consolidated Statements of Cash Flows

              For the years ended December 31, 1996, 1997 and 1998

                             (dollars in thousands)

                                                      1996      1997      1998
                                                     --------  --------  -------
Cash flows from operating activities:
    Net loss..................................... $  (5,918) $ (8,624) $(11,566)
    Adjustments to reconcile net loss to net
     cash used in operating activities:
       Noncash compensation expense..............       150       125       119
       Depreciation and amortization expense.....        17        31        66
       Change in assets and liabilities:
           Increase in accounts receivable.......        --        --    (3,045)
           Increase in inventories...............        --        --      (342)
           Increase in prepaid expenses and            
           other assets..........................       (148)     (125)    (545)
           Increase in accounts payable..........         28       505    2,363
           Increase  in  accrued   expenses   and       
           other liabilities.....................        304     1,107      639
                                                     -------   -------   -------
             Net cash used in operating    
               activities........................     (5,567)   (6,981) (12,311)
                                                     --------   ------- --------

Cash flows from investing activities:
    Capital expenditures.........................        (57)      (78)    (230)
    Proceeds from the sale of short term
      investments................................      3,923    25,402    6,880
    Purchase of short term investments...........    (12,290)  (23,427)  (7,452)
                                                     --------  --------  -------

             Net cash (used in) provided by
               investing activities..............     (8,424)    1,897     (802)
                                                     --------  --------  -------

Cash flows from financing activities:
    Proceeds from issuance of common stock.......     18,033    11,615       20
                                                     --------  --------  -------
              Net cash provided by financing          
                activities.......................     18,033    11,615       20
                                                     --------  --------  -------

Net increase (decrease) in cash and cash      
 equivalents....................................       4,042     6,531  (13,093)

Cash and cash equivalents at beginning of period       5,806     9,848   16,379
                                                     --------  --------  -------
Cash and cash equivalents at end of period......   $   9,848 $  16,379 $  3,286
                                                     ========  ========  =======

Supplemental schedule of noncash financing 
  activities:
    Deferred compensation........................  $     426 $     142 $      --
    Accretion of undeclared dividends
     attributable to mandatorily redeemable 
     convertible preferred stock.................        720         --       --
    Conversion of mandatorily redeemable
     convertible preferred stock to common stock.     19,628         --       --
                                                     ========  ========  =======

          See accompanying notes to consolidated financial statements.



                                      F-6
<PAGE>

                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                        December 31, 1996, 1997 and 1998

                  (dollars in thousands, except per share data)

(1)  Business

     CollaGenex  Pharmaceuticals,  Inc.  ("CollaGenex  Pharmaceuticals"  or  the
     "Company") was incorporated in Delaware on January 10, 1992. The Company is
     a    pharmaceutical    enterprise    engaged   in   the   development   and
     commercialization  of  innovative,  proprietary  medical  therapies for the
     treatment  of  periodontal  disease  and other  pathologies.  The  Company,
     through  its  own  sales  and  marketing  force,  is  currently   marketing
     Periostat(R)  (doxycycline  hyclate),  the  Company's  lead  drug  for  the
     treatment of adult  periodontal  disease which  received  approval from the
     U.S. Food & Drug  Administration (the "FDA") in September 1998. The Company
     has other compounds in the research and development stage.

     The accompanying  consolidated  financial statements include the results of
     operations  of the  Company  and its  wholly-owned  subsidiary  (CollaGenex
     International,  Ltd.). All intercompany accounts and transactions have been
     eliminated  in  consolidation.  As a result  of the  product  approval  and
     revenues  earned on product sales during 1998,  the Company is no longer in
     the development stage as it was in prior years.

(2)  Summary of Significant Accounting Policies

     Cash and Cash Equivalents

     The  Company  considers  all highly  liquid  investments  with an  original
     maturity of three months or less when purchased to be cash equivalents. All
     cash  and  cash  equivalents  are  invested  in  obligations  of  the  U.S.
     Government  and in commercial  paper which bears minimal risk. The carrying
     amount of cash and cash equivalents  approximates its fair value due to its
     short-term nature. To date, the Company has not experienced any significant
     losses on its cash equivalents.

     Short-Term Investments

     Short-term investments consist of U.S. Government obligations and corporate
     debt  securities  with original  maturities  greater than three months.  In
     accordance  with  Statement  of  Financial  Accounting  Standards  No. 115,
     "Accounting  for Certain  Investments in Debt and Equity  Securities,"  the
     company  classifies  its  short-term  investments  as  available  for sale.
     Available  for sale  securities  are  recorded at their fair  value,  which
     approximates  cost,  of the  investments  based on quoted  market prices at
     December 31, 1997 and 1998.  The Company  considers  all of its  short-term
     investments to be available for sale.


                                      F-7
<PAGE>
                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)

     Inventories

     Inventories  are  stated at the lower cost or  market.  Cost is  determined
     using the first-in, first-out method.

     Equipment

     Equipment,   consisting  of  computer  and  office  equipment  and  exhibit
     equipment,  is  recorded  at  cost.  Depreciation  is  provided  using  the
     straight-line  method  over  the  estimated  useful  lives  of the  assets,
     generally three to five years. Expenditures for repairs and maintenance are
     expensed as incurred.

     Product Sales

     In September  1998, the Company  received  clearance from the FDA to market
     Periostat.  The Company has the exclusive right to market  Periostat in the
     United  States.  In  November,  the Company  began  shipping  Periostat  to
     wholesalers  throughout the United  States.  The Company  recognizes  sales
     revenue upon shipment.  Sales are reported net of allowances for discounts,
     rebates, chargebacks and product returns.

     License Revenues

     Revenue from license arrangements is recognized when the related milestones
     are  met  by  the  Company  and  when  all  of  the  Company's  significant
     performance  obligations  under  the  terms of the  arrangement  have  been
     satisfactorily completed.

     Contract Revenues

     Contract revenues are earned and recognized  according to the provisions of
     each collaborative agreement. Contract milestone payments are recognized as
     revenues upon the completion of the milestone event or requirement and when
     the Company's significant  performance obligations have been satisfactorily
     completed.

     Research and Development

     Research and product development costs are expensed as incurred.

     Accounting for Income Taxes

     Deferred tax assets and  liabilities  are  determined  based on differences
     between the financial reporting and tax bases of assets and liabilities and
     are  measured  using the  enacted tax rates and laws that will be in effect
     when such differences are expected to 


                                      F-8
<PAGE>
                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)


     reverse.  The measurement of deferred tax assets is reduced,  if necessary,
     by a valuation  allowance for any tax benefits which are not expected to be
     realized.  The effect on deferred tax assets and liabilities of a change in
     tax  rates is  recognized  in the  period  that such tax rate  changes  are
     enacted.

     Management Estimates

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

     Stock-Based Compensation

     As described in note 7, Statement of Financial Accounting Standards No. 123
     ("SFAS 123"),  "Accounting  for Stock-Based  Compensation,"  encourages but
     does not require  companies  to record  compensation  cost for  stock-based
     employee  compensation  plans at fair  value.  The  Company  has  chosen to
     continue to account for stock-based  compensation using the intrinsic value
     method   prescribed  in  Accounting   Principles   Board  Opinion  No.  25,
     "Accounting  for Stock Issued to Employees,"  and related  Interpretations.
     Accordingly,  compensation  cost for stock  options  issued to employees is
     measured as the excess,  if any, of the market price of the Company's stock
     at the date  both the  number  of  shares  and  price  per  share are known
     (measurement date) over the exercise price. Such amounts are amortized over
     the respective vesting periods of the option grants.

     Concentration of Credit and Other Risks

     The company  invests its excess cash in deposits with major U.S.  financial
     institutions, money market funds, U.S. Government obligations and corporate
     debt  securities.  The  Company  has  established  guidelines  relative  to
     diversification and maturities that maintain safety and liquidity. To date,
     the Company has not experienced any significant losses.

     The  Company  currently  contracts  with a single  source for the  domestic
     manufacturing  of  Periostat  which is sold  throughout  the United  States
     exclusively to wholesale and retail distributors. During 1998, two of these
     customers accounted for 28% and 27%, of net product sales, respectively.

     The Company's business of selling,  marketing and developing pharmaceutical
     products  is  subject to a number of  significant  risks,  including  risks
     relating to the  implementation of 


                                      F-9
<PAGE>

                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)

     the Company's  sales and marketing  plans,  risks  inherent in research and
     development  activities,  risks  associated with  conducting  business in a
     highly regulated  environment and uncertainties  related to clinical trials
     of products under development.

     Equity Security Transactions

     Prior to the Company's  initial  public  offering  consummated in June 1996
     (the  "IPO"),  the Board of  Directors  had  established  the fair value of
     equity securities based upon facts and circumstances  existing at the dates
     such equity  transactions  occurred,  including  the price at which  equity
     instruments were sold to independent third parties.  Subsequent to the IPO,
     fair market  value is  determined  based on the quoted  market price of the
     Company's stock.

     Net Loss Per Share

     Statement of Financial  Accounting  Standards No. 128, "Earnings Per Share"
     (SFAS 128),  was adopted by the Company on December 31, 1997. In accordance
     with the  pronouncement,  all prior year  earnings per share data have been
     restated upon adoption to conform to the new standards. SFAS 128 simplifies
     the  calculation of earnings per share data by replacing  primary and fully
     diluted  earnings  per share with  basic and  diluted  earnings  per share,
     respectively.  Basic  earnings  per  share  excludes  potentially  dilutive
     securities,  including stock options,  and is calculated by dividing income
     (loss)  available to common  shareholders  by the weighted  average  common
     shares outstanding for the period. Diluted earnings per share, reflects the
     dilution to  earnings  that would occur if  convertible  securities,  stock
     options and  potentially  dilutive  securities  were  converted into common
     stock resulting in the issuance of common stock.

     Pursuant  to  Securities  Exchange  Commission  Staff  Accounting  Bulletin
     ("SAB") No. 98, issued in February 1998, for periods prior to the Company's
     IPO,  all  common  stock  issued  during the  periods  prior to the IPO for
     nominal  consideration  are to be included in the  calculation of basic net
     loss per  share as if they  were  outstanding  for all  periods  presented.
     Similarly,  common  stock and  potential  common  stock  issued  during the
     periods  prior to the IPO for nominal  consideration  have been included in
     the calculation of diluted net loss per share,  even though  anti-dilutive,
     as if outstanding for all periods  presented (55,000 shares for 1996). 1996
     per share data reflects this guidance.  In the  calculation of net loss per
     share  for  1996,  accretion  of  undeclared   dividends   attributable  to
     mandatorily  redeemable  convertible  preferred  stock  is  included  as an
     increase to the net loss.

     Options to purchase 1,016,829 shares of common stock at prices ranging from
     $0.20 to $13.50 per share were  outstanding  at December  31, 1998 but were
     not included in the  

                                      F-10
<PAGE>

                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)


     computation  of net loss per  share  because  the  effect  would  have been
     anti-dilutive  for the periods  presented.  As a result,  basic and diluted
     loss per share are the same for 1997 and 1998. These options expire through
     2008.

     Reclassification

     Certain  amounts in the 1997  consolidated  financial  statements have been
     reclassified to conform to the current year presentation.

(3)  Composition of Certain Financial Statement Captions

     Inventories

     Inventories at December 31, 1997 and 1998 consists of the following:

                                                   1997              1998
                                                -----------        ----------

     Raw materials.......................      $        --        $      124
     Finished goods......................               --               218
                                                -----------        ----------
                                               $        --        $      342
                                                ===========        ==========

     Equipment

     Equipment at December 31, 1997 and 1998 consists of the following:

                                                   1997              1998
                                                -----------        ----------
      Computer and office equipment.......      $      125        $      198
      Exhibit equipment...................              28               185
                                                -----------        ----------
                                                       153               383
      Less accumulated depreciation.......             (50)             (116)
                                                -----------        ----------
                                                 $     103        $      267
                                                ===========        ==========

                                      F-11
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)


      Accrued Expenses

      Accrued expenses at December 31, 1997 and 1998 consists of the following:

                                                   1997              1998
                                                -----------       -----------

      Contracted development and
         manufacturing costs..............      $     1,086        $      984
      Sales and marketing costs...........              299               637
      Payroll and related costs...........              244               421
      Professional and consulting fees....              212               268
      Royalties...........................               12               163
      Miscellaneous taxes.................               17                29
      Other...............................               36                43
                                                -----------        ----------
                                                $     1,906        $    2,545
                                                ===========        ==========

(4)  Mandatorily Redeemable Convertible Preferred Stock

     The  Company  completed  the sale of its  Series A,  Series B and  Series C
     mandatorily redeemable convertible preferred stock ("Series A, Series B and
     Series  C",  respectively)  in 1992,  1993 and 1995 at per share  prices of
     $1.00,  $1.675 and $2.00,  respectively.  Aggregate  net cash proceeds from
     such equity  transactions  totaled  $13,508  ($16,533  after  conversion of
     promissory notes and accrued interest to preferred stock).

     During  1995,  the  Company  issued  convertible  promissory  notes  in the
     principal  amount of  $3,029 to  various  Series A and  Series B  preferred
     stockholders.  The  convertible  promissory  notes bore interest at 10% per
     annum with maturity dates of February and July 1996. Principal plus accrued
     interest on the convertible promissory notes totaling $3,025 were converted
     into  1,512,344  shares  of  Series C  mandatorily  redeemable  convertible
     preferred  stock in  September  1995 in  accordance  with the  terms of the
     financing agreement upon the closing of the Series C mandatorily redeemable
     convertible   preferred  stock  sale.  One   convertible   promissory  note
     aggregating  $132 (principal plus accrued  interest) was repaid to the note
     holder in September 1995.

     The holders of Series A, Series B and Series C were originally  entitled to
     cumulative dividends at an annual rate of 9% of the original purchase price
     per share on the date of issuance, if and when declared.  Such amounts have
     been accreted in the accompanying consolidated financial statements for the
     respective historical periods in which they accumulated. In June 1996, upon
     the  closing  of  the  IPO,  all  issues  of  the  mandatorily   redeemable
     convertible  preferred  stock were converted into 5,199,124  common shares,


                                      F-12
<PAGE>



                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)



     and all undeclared dividends previously accreted were forfeited. All rights
     with respect to the above noted securities ceased.

(5)  Line of Credit

     On June 26, 1997, the Company entered into a credit arrangement  consisting
     of a $5,000  line of credit  (the  "LOC") to  support  the  future  working
     capital  needs of the  Company.  The LOC will be  unsecured  as long as the
     Company's cash and  investment  balances  maintained  with the lender or an
     affiliate  of the  lender  equals  or  exceeds  $10,000,  which  was met at
     December 31, 1998. At the Company's  option,  the LOC will bear interest at
     either the prime rate charged by the lender or LIBOR plus 2.15%. The LOC is
     terminable by the lender at any time. No balance was outstanding  under the
     LOC at December 31, 1997 and 1998.

(6)  Stockholders' Equity

     The  Company's  Board  of  Directors  may  without  further  action  by the
     Company's stockholders, from time to time, direct the issuance of shares of
     preferred  stock in series and may, at the time of issuance,  determine the
     rights,  preferences  and  limitations  of  each  series.  The  holders  of
     preferred stock would normally be entitled to receive a preference  payment
     in the event of any  liquidation,  dissolution or winding-up of the Company
     before any payment is made to the holders of the common stock.

     On June 20,  1996,  the Company  completed  an initial  public  offering of
     2,000,000  shares of its common stock at $10 per share. Net proceeds to the
     Company after underwriting fees and all related expenses were $18,027.

     On April 8, 1997, the Company  completed a follow-on  offering of 1,000,000
     shares of its common stock at a price of $12.50 per share. The net proceeds
     for the  offering  after  underwriting  fees and all related  expenses  was
     $11,562.

     The Company maintains a Shareholder Rights Plan (the "Rights Plan").  Under
     the Rights  Plan,  each common  shareholder  receives  one "Right" for each
     share of common  stock held.  Each Right,  once  exercisable,  entitles the
     holder to purchase  from the Company  one  one-hundredth  of a share of the
     Company's  Series A  Participating  Preferred Stock at an exercise price of
     $65. All Rights expire on September 26, 2007 unless  earlier  redeemed.  At
     December  31,  1998,  the  Rights  were  neither   exercisable  nor  traded
     separately from the Company's common stock, and become  exercisable only if
     a person or a group of affiliated or  associated  persons has acquired,  or
     obtained the right to acquire,  beneficial  ownership of 20% or more of the
     voting power of all outstanding shares of the Company's common stock and in
     certain other limited circumstances. Upon 


                                      F-13
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)



     separation from the common stock, each Right will entitle the holder, other
     than  the  acquiring  person  that  has  triggered  such   separation,   to
     effectively  purchase certain shares of the Company's common stock equal in
     market value to two times the then applicable  exercise price of the Right.
     If the  Company  is  acquired  in a merger  or other  business  combination
     transaction,  or 50% or more of the  Company's  assets or earning power are
     sold in one or more related transactions,  the Rights will entitle holders,
     upon  exercise  of the  Rights,  to receive  shares of common  stock of the
     acquiring  or  surviving  company  with a market  value  equal to twice the
     exercise price of each Right. In March 1999, the Company amended its Rights
     Plan to specifically  exclude an initial issuance of the Company's Series D
     Cumulative  Convertible Preferred Stock, to be effected upon the attainment
     of requisite stockholder approval.

(7)  Stock Option Plans

     The Company has three stock-based  compensation plans (the "Plans") and has
     adopted the  disclosure-only  provisions of SFAS 123. The Company continues
     to apply APB Opinion No. 25 in  accounting  for its stock option plans and,
     accordingly,   no   compensation   expense  has  been   recognized  in  the
     consolidated  financial statements for stock options issued to employees at
     exercise prices equal to the market value on the measurement date.

     Deferred  compensation  of $426  and $142 was  recorded  in 1996 and  1997,
     respectively,  for options  granted where the market value of the Company's
     stock on the measurement  date exceeded the exercise price of such options.
     Deferred  compensation is being  amortized to  compensation  expense in the
     accompanying  consolidated  statement  of  operations  over the  respective
     vesting periods of such grants ($150, $125 and $119 in 1996, 1997 and 1998,
     respectively).

     The 1992 Stock Option Plan, as amended,  (the "1992 Plan") provided for the
     granting of incentive and nonstatutory options to directors,  employees and
     consultants  to  purchase  up to 121,228  shares,  which was  increased  to
     300,000 and 425,000 in 1993 and 1995, respectively,  and reduced to 291,000
     in 1996,  of the  Company's  common  stock at a  price,  for the  incentive
     options,  not less than the fair market value on the measurement date. Such
     options are  exercisable for a period of 10 years and generally vest over a
     four year period.  All such 291,000  options  available under the 1992 Plan
     were granted by March 31, 1996.

     The 1996 Stock Option Plan (the "1996  Plan")  provides for the granting of
     incentive and nonstatutory options to employees and consultants to purchase
     up to 750,000  options of the  Company's  common stock at a price,  for the
     incentive  options,  not less than the fair market value on the measurement
     date. Incentive and nonstatutory options granted to 


                                      F-14
<PAGE>



                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)


     individuals  owning  more than 10% of the  voting  power of all  classes of
     stock at the time of grant must have an exercise price no less than 110% of
     the fair market value on the date of grant.  Such  options are  exercisable
     for a period of 10 years and generally vest over a two to five year period,
     and may be accelerated for certain grants in certain circumstances.

     In March 1996, the Board of Directors  approved a nonqualified plan for the
     issuance of stock options to non-employee  directors under the Non-Employee
     Director Stock Option Plan (the "Non-Employee  Director Plan").  Under this
     plan,  300,000  shares on May 8, 1997,  of common  stock are  reserved  for
     issuance at an exercise price equal to the fair market value on the date of
     grant.  Such options vest 20% per annum  commencing one year from the grant
     date.

     In May and June of 1996,  11,000  options  were  granted to employees at an
     exercise  price of $2.00 per share.  These grants were not issued under the
     terms  of any  of  the  above  Plans.  All  options  granted  to  employees
     subsequent to the IPO were granted under the 1996 Plan.

     At December 31, 1998,  there were 111,250 shares  available for grant under
     the 1996 Plan and 150,000 under the Non-Employee Director Plan.

     The following table summarizes stock option activity for 1996 through 1998:

                                                                Exercise price
                                                  Shares          per share
                                                -----------     --------------

      Balance, December 31, 1995..........          233,500     $  0.20 - 1.20
        Granted...........................          200,500        2.00 - 10.00
        Exercised.........................          (23,750)       0.20 - 0.355
                                                -----------

      Balance, December 31, 1996..........          410,250        0.20 - 10.00
        Granted...........................          348,750        9.00 - 13.50
        Exercised.........................          (32,046)       0.20 - 2.00
        Cancelled.........................           (1,000)      0.355 - 1.20
                                                -----------

      Balance, December 31, 1997..........          725,954        0.20 - 13.50
        Granted...........................          313,500        6.25 - 13.25
        Exercised.........................          (19,625)      0.355 - 2.00
        Cancelled.........................           (3,000)          6.75
                                                -----------

      Balance, December 31, 1998..........        1,016,829      $ 0.20 - 13.50
                                                ===========      ==============


                                      F-15
<PAGE>



                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)



     As of December 31, 1998,  the Plans had the following  options  outstanding
     and exercisable by price range as follows:

                                 Outstanding                   Exercisable
                      ----------------------------------- ----------------------
                                   Weighted    Weighted              Weighted
                                   average      average              average
         Range of                 remaining    exercise              exercise
         exercise     Number of  contractual   price per  Number of  price per
          prices       shares        life        share     shares      share
      --------------- ---------  -----------   ---------  --------   ---------
       $0.20 - 2.00    228,079     6.7 years    $   1.01   174,204    $   0.81
       6.25 - 10.00    517,000     8.6 years        8.32    92,075        9.49
       10.25 - 13.50   271,750     8.9 years       11.35    84,512       11.21
                     ---------                  --------   -------    --------
                     1,016,829                  $   7.49   350,791    $   5.59
                     =========                  ========   =======    ========

     Had the Company  determined  compensation  cost for options  granted during
     1995,  1996,  1997 and 1998  under  SFAS 123 based on the fair value at the
     measurement  date,  the Company's net loss would have been increased to the
     pro forma amounts shown below:

                                       1996           1997            1998
                                    ------------  -------------   -------------

      Net loss allocable to common 
       stockholders:
         As reported..............   $   6,638     $     8,624      $  11,566
         Pro forma................       6,730           9,267         12,487

      Net loss per basic share:
         As reported.............   $     1.74     $      1.04     $     1.35
         Pro forma...............         1.77            1.12           1.46
 
      Net loss per diluted share:
         As reported.............   $     1.72     $      1.04     $     1.35
         Pro forma................        1.74            1.12           1.46

     Pro forma net loss reflects only options  granted in 1995,  1996,  1997 and
     1998.  Consequently,  the full impact of calculating  compensation cost for
     stock  options  under SFAS 123 is not  reflected  in the pro forma net loss
     amounts  presented above because  compensation  cost is incurred under SFAS
     123 over the respective vesting period of such options, and options granted
     by the Company  prior to January 1, 1995 are not reflected in the pro forma
     net loss figures above.


                                      F-16
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)

     The weighted average fair values of stock options granted during 1996, 1997
     and 1998 were $7.00, $5.93 and $4.64 per share,  respectively,  on the date
     of grant. Such fair values were determined using the  Black-Scholes  option
     pricing model and are based on the following assumptions:

                                       1996           1997           1998
                                   ------------   ------------   -------------

      Expected life in years..          7              5               5
      Risk-free interest rate.         7.5%          6.25%           6.25%
      Volatility..............         60%            60%             60%
      Dividend yield..........          0%             0%             0%


(8)  Income Taxes

     As of December 31, 1998, the Company has  approximately  $35,300 of Federal
     and $29,571 of state net operating loss  carryforwards  available to offset
     future   taxable   income.   The  Federal  and  state  net  operating  loss
     carryforwards will begin expiring in the year 2007 and 2005,  respectively,
     if not utilized.  In addition,  the  utilization of the state net operating
     loss  carryforwards  is  subject  to a $1 million  annual  limitation.  The
     Company also has  research  and  development  tax credit  carryforwards  of
     approximately  $500,  which begin  expiring in 2007,  and are  available to
     reduce Federal income taxes.

     The Tax Reform Act of 1986 (the "Act")  provides  for a  limitation  on the
     annual use of NOL and research  and  development  tax credit  carryforwards
     (following  certain  ownership  changes,  as defined by the Act) that could
     significantly  limit the Company's ability to utilize these  carryforwards.
     The Company has experienced  various ownership  changes,  as defined by the
     Act, as a result of past financings and the IPO. Accordingly, the Company's
     ability  to  utilize  the  aforementioned  carryforwards  may  be  limited.
     Additionally,  because  U.S.  tax laws limit the time  during  which  these
     carryforwards  may be applied against future taxes,  the Company may not be
     able to take full  advantage  of these  attributes  for Federal  income tax
     purposes.

     The tax  effects of  temporary  differences  that give rise to  significant
     portions of the deferred tax assets and deferred tax  liability at December
     31, 1997 and 1998 are presented below:


                                      F-17
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)


                                                   1997              1998
                                                -----------      -----------

      Deferred tax assets:
        Capitalized start up costs........      $       931      $       677
        Net operating loss carryforwards..            8,078           14,145
        Tax credit carryforward...........              206              500
        Accrued expenses..................              170              134
                                                -----------      -----------

          Total gross deferred tax assets.            9,385           15,456

        Less valuation allowance..........           (9,383)         (15,450)
                                                -----------      -----------
 
          Total deferred tax assets.......                2                6
       Deferred tax liability:
        Depreciation......................               (2)              (6)
                                                -----------      -----------

          Total gross deferred tax liability             (2)              (6)
                                                -----------      -----------
          Net deferred taxes..............      $        --      $        --
                                                ===========      ===========


     The net change in the valuation  allowance for the years ended December 31,
     1997  and  1998  were   increases  of   approximately   $1,878  and  $6,067
     respectively, related primarily to additional net operating losses incurred
     by the Company.

(9)  Technology License

     At the time of its formation in 1992, the Company entered into an agreement
     with SUNY  whereby  the  Company  received  an option to  acquire a certain
     technology  license.  The  Company's  option to  acquire  the  license  was
     exercised in 1995 and remains in effect for a period not to exceed 20 years
     from the date of the first sale of  product  incorporating  the  technology
     under  license  or the  last to  expire  of the  licensed  patents  in each
     country. The Company is liable to SUNY for annual royalty fees based on net
     sales,  if any, as defined in the  agreement.  A minimum  annual royalty is
     required for the duration of the technology  license.  The Company incurred
     royalties of $50 in 1996 and 1997, respectively, and $200 in 1998.

     In addition,  the Company is required to reimburse  SUNY for certain patent
     related costs, as well as to support certain additional research efforts.


                                      F-18
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)


(10) Commitments and Contingencies

     The Company maintains various operating leases, primarily for office space.
     As of December 31, 1998, future minimum rent payments under  noncancellable
     leases are as follows:

                         1999.........      $  82
                         2000.........         82
                                            -----
                           Total......      $ 164
                                            =====


     Rent expense for the years ended  December 31, 1996,  1997 and 1998 totaled
     $63, $70 and $86, respectively.

(11) 401(k) Salary Reduction Plan

     In January 1995,  the Company  adopted a 401(k) Salary  Reduction Plan (the
     "401(k)  Plan")  available to all  employees  meeting  certain  eligibility
     requirements.  The 401(k) Plan permits participants to contribute up to 15%
     of their annual salary not to exceed the limits established by the Internal
     Revenue Code. All  contributions  made by participants  vest immediately in
     the  participant's   account.  The  Company  did  not  make  any  "matching
     contributions"  in 1996,  1997 or 1998 in accordance  with the terms of the
     401(k) Plan.

(12) Contract Research Agreement

     In May 1998,  the  Company  entered  into a three year  evaluation  testing
     agreement with SUNY pursuant to which SUNY will evaluate certain  compounds
     supplied by the Company under which the Company will pay SUNY up to $1,570.
     Either party may terminate the agreement at any time. Costs incurred during
     1998 were $333.

     The Company has entered  into  several  contract  research  agreement  with
     another  research  company to provide  certain  clinical  monitoring,  data
     management,  statistical  analysis and regulatory services on behalf of the
     Company.  The Company is billed as research  services are performed.  Costs
     incurred under this agreement aggregated  approximately  $1,766, $1,064 and
     $1,837 for 1996, 1997 and 1998, respectively.

(13) Subsequent Event

     On March 19, 1999,  the Company  received $10 million in proceeds  from the
     issuance of a Senior Secured Convertible Note (the "Note") to OCM Principal
     Opportunities Fund, L.P. ("OCM").  The Note bears interest at a rate of 12%
     per  annum,  is due one year from 

                                      F-19
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                   Notes to Consolidated Financial Statements

                   December 31, 1996, 1997 and 1998, Continued

                  (dollars in thousands, except per share data)


     the date of issuance and is secured by certain intellectual property of the
     Company.  The Note must be repaid with the  proceeds  from the  issuance of
     Series D Cumulative  Convertible  Preferred Stock (the  "Preferred  Stock")
     prior to June 30,  1999 (see  below).  If the Note has not been repaid with
     the proceeds of the Preferred Stock financing by June 30, 1999, the Note is
     convertible, at the holder's option, into 1,538,462 shares of the Company's
     common  stock.  In  addition,  any  interest  due on the Note would also be
     convertible  into shares of common stock at a conversion price of $6.50 per
     share.

     Simultaneous  with the execution of the Note,  the Company  entered into an
     agreement  to issue $20 million in Preferred  Stock at a purchase  price of
     $100 per share to OCM and other  investors  contingent  upon and as soon as
     practicable following stockholder approval at the Annual Meeting on May 11,
     1999. During the first three years following issuance,  the Preferred Stock
     would  pay  dividends  in  common  stock  at a  rate  of  8.4%  per  annum.
     Thereafter,  the  Preferred  Stock would pay dividends in cash at a rate of
     8.0% per annum. The Preferred Stock would be convertible by the holder into
     common shares of the Company at an initial  conversion  price of $11.00 per
     share, subject to adjustment, at any time.


                                      F-20
<PAGE>


                                                                     SCHEDULE II



                 CollaGenex Pharmaceuticals, Inc. and Subsidiary
                          Financial Statement Schedule
                        Valuation and Qualifying Accounts
                          Year Ended December 31, 1998
                                 (in thousands)

------------------------------------------------------------------------------
     Col A         Col B            Col C           Col D         Col E
------------------------------------------------------------------------------
  Description   Balance 1/1/98   Additions       Deductions  Balance 12/31/98
                  
------------------------------------------------------------------------------
------------------------------------------------------------------------------
                               Charged to    Other
                                Costs and
                               Expenses or
   Accounts                     Revenues
  Receivable              
  Allowance                --        $293      --         --              $293
------------------------------------------------------------------------------


                                      F-21