SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 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, 1997
                          -----------------

                                      OR

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

For the transition period from             to
                               ----------      ----------

                         Commission File Number 0-28308


                        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
--------------------------------------------------------------------------------
(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. |_|


      State the  aggregate  market  value of the  voting  common  stock  held by
non-affiliates of the registrant:  $53,547,369 at February 15, 1998 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, 1998:


                 Class                             Number of Shares
                 -----                             ----------------
     Common Stock, $.01 par value                      8,567,579


      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 1998 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............................................     18

           3. Legal Proceedings.....................................     18

           4. Submission of Matters to a Vote of Security Holders...     18

PART II    5. Market for the Company's Common Equity
              and Related Stockholder Matters.......................     19

           6. Selected Consolidated Financial Data..................     20

           7. Management's Discussion and Analysis of
              Financial Condition and Results of Operations.........     22

           8. Financial Statements and Supplementary Data...........     25

           9. Changes in and Disagreements with Accountants
              on Accounting and Financial Disclosure................     25

PART III  10. Directors and Executive Officers of the Company.......     26

          11. Executive Compensation................................     26

          12. Security Ownership of Certain Beneficial
              Owners and Management.................................     26

          13. Certain Relationships and Related Transactions........     26

PART IV   14. Exhibits, Financial Statement Schedules,
                and Reports on Form 8-K.............................     27

SIGNATURES..........................................................     28

EXHIBIT INDEX.......................................................     30

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


                                      i


<PAGE>


                                     PART I


ITEM 1.   BUSINESS.


General
-------

      CollaGenex  Pharmaceuticals,  Inc.  ("CollaGenex  Pharmaceuticals"  or the
"Company") is engaged in the  development and  commercialization  of innovative,
proprietary medical therapies for the treatment of periodontal disease and other
pathologies.  The Company believes that its initial drug, Periostat(R),  will be
the first orally administered,  systemically  delivered  pharmaceutical to treat
periodontitis.   Unlike  existing  treatments,  which  focus  on  the  bacterial
infection   associated  with  periodontitis,   Periostat  inhibits  the  chronic
progressive  tissue degradation  characteristic of the disease.  The Company has
completed four Phase III clinical  trials on Periostat.  Based on these clinical
trials,   the  Company   believes  that   Periostat  is  a  safe,   efficacious,
cost-effective therapy for the long-term treatment of periodontitis. The Company
submitted a new drug  application  ("NDA") for Periostat in August 1996. The NDA
was accepted for filing by the United States Food and Drug  Administration  (the
"FDA") in October 1996 and is presently under review by the FDA. There can be no
assurance  that the Company's NDA with respect to Periostat  will be approved by
the FDA on a timely  basis,  or at all.  Failure to obtain FDA approval of a NDA
for Periostat  would have a material  adverse effect on the Company's  business,
financial condition and results of operations. 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.

      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 inhibiting the activity of certain enzymes that destroy
the  connective  tissues of the body.  Connective  tissues are components of the
body that form the structural basis for skin, bone, cartilage and ligaments.  In
addition to periodontal disease, this core technology may be applicable to other
diseases  and  conditions   characterized  by  the  progressive  destruction  of
connective   tissues   of  the  body,   such  as  cancer   metastasis,   wounds,
osteoarthritis, osteoporosis, rheumatoid arthritis and diabetic nephropathy.

      In  late  1997,   the  National   Cancer   Institute   ("NCI")   filed  an
investigational   new  drug   application   ("IND")   with  the  FDA   regarding
Metastat(TM),  the Company's lead compound for the inhibition of cancer invasion
and  metastasis.  In animal  studies  involving  a variety of human  cancer cell
types,  including  prostate,  breast,  lung,  colon and  melanoma,  Metastat and
related  compounds  developed  by the  Company  exhibited  an ability to inhibit
metastasis. Following


                                       1
<PAGE>


FDA  acceptance  of the IND,  several  Phase I clinical  trials on Metastat were
initiated in January 1998.

      During  1997,  the  Company  conducted  preclinical  studies  on its  lead
diabetes compound,  Nephrostat(TM).  These studies  demonstrated that Nephrostat
was effective in treating certain complications of diabetes,  including diabetic
nephropathy, tooth loss and delayed wound healing.  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 intends to
continue  this  preclinical  work in 1998  with  the  goal of  initiating  human
clinical trials in 1999.

      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),"  "CollaGenex(TM)," "Metastat(TM)" and "Nephrostat(TM)" 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 the excessive loss of tissue collagen,  a
process called collagenolysis.  One such example is the progressive  destruction
of the periodontal  ligament and alveolar bone in periodontal  disease.  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  periodontal  disease.  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  periodontal  disease.


                                       2
<PAGE>


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.  The Company's
Phase III clinical trials using Periostat  demonstrated that the  administration
of  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 Periodontal Disease
-------------------------------

      Periodontitis  is a chronic disease  characterized by the progressive loss
of attachment  between the  periodontal  ligament and the  surrounding  alveolar
bone,  ultimately  resulting in tooth loss.  According to industry  data, in the
United States alone, an estimated one-third of all adults, or 67 million people,
suffer from some form of periodontitis.  The cost of treating  periodontitis can
be  considerable  due to the  frequent  treatments  required.  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.

      The primary treatment for periodontal disease is mechanical  intervention,
known as scaling and root planing ("SRP"),  in which bacterial plaque is removed
from the supra-and  sub-gingival  tooth  surfaces  (above and below the gumline)
using a metal  scraper or  ultrasound  scaling  device.  Alternatively,  in more
severe  periodontal  disease,  the  gums are  partially  removed  by a  surgical
procedure  to  reduce   pocket  depth  around  the  tooth  and  to  improve  the
effectiveness of home oral hygiene techniques.  These treatments are designed to
treat  bacterial  infection  associated  with  periodontitis  on  a  short-term,
periodic basis 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.  Periodontal
disease is, therefore, among the more expensive dental pathologies to treat, and
the Company  believes that the treatment of  periodontitis  will be


                                       3
<PAGE>


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 such DHMOs and dental  practitioners by providing a
cost-effective therapy for periodontal disease 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  periodontal
disease.


Periostat
---------

      The  Company's  primary  focus  to date  has  been on the  development  of
Periostat,  which the Company  believes  will be the first orally  administered,
systemically delivered pharmaceutical to treat adult periodontitis. Periostat, a
20mg  dose of  doxycycline,  is a unique  sub-antibiotic  dosage  strength  that
inhibits  the  chronic   progressive   tissue   degradation   characteristic  of
periodontal  disease without exerting any  anti-microbial  effect.  Periostat is
intended to be taken orally by the patient, on an extended basis, between dental
visits.  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.  The Company has completed  three  pivotal Phase III clinical  trials on
Periostat.  In  addition,  following  the  submission  of its NDA,  the  Company
completed a fourth  Phase III  clinical  trial which  evaluated  the efficacy of
Periostat administered in conjunction with SRP.

      The Company's  Phase III clinical  trials  supporting  its NDA  submission
consisted  of  three  parallel,  separate,  multi-centered,  placebo-controlled,
double-blinded  clinical trials in patients with adult  periodontal  disease.  A
total of 436  patients  were  enrolled  in the three  clinical  trials at eleven
dental schools across the United States.  These clinical  trials were managed by
an independent contract research organization and were conducted over a 12-month
period.  In each trial,  patients were  randomly  assigned into groups that were
administered  Periostat  or placebo  capsules.  At the  outset of these  trials,
baseline measurements were taken of each of the clinical endpoints to be studied
and each  patient  received a  supragingival  sealing  and  dental  prophylaxis.
Subsequent  measurements  were  obtained at regular  intervals and an additional
dental  cleaning  was  carried out after six months.  Data were  analyzed  using
conventional statistical techniques to establish whether significant differences
existed  between  the  Periostat-dosed  groups  and those  receiving  placebo by
comparing  data obtained at 12 months with baseline  measurements.  A confidence
level  of not  less  than  95%  was  used  to  establish  whether  statistically
significant differences existed in clinical endpoints.

      The primary  clinical  endpoint of the 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 periodontal disease. The Company utilized two
independent techniques in the clinical trials to measure ALv, manual probing and


                                       4
<PAGE>


automated probing.  Using the manual probing technique,  ALv was measured at six
separate  probing  sites around each tooth,  regardless  of whether  disease was
present or active.  Therefore,  in a typical mouth with 30 teeth,  approximately
180 probing  sites were  measured.  In  contrast,  using the  automated  probing
technique,  ALv was  measured at only a subset of probing  sites that  exhibited
active moderate-to-severe disease at the outset of the study.

      Each  of  the  Phase  III  clinical  trials   demonstrated   statistically
significant  improvements  in ALv. The data  observed  using the manual  probing
technique revealed that the Periostat group exhibited an average  improvement in
ALv of 40% and 21% in probing  sites with  mild-to-moderate  disease  and severe
disease, respectively, when compared with the placebo group. Similarly, the data
from the subset of probing sites with active moderate-to-severe disease measured
with the automated  probe revealed that the Periostat  group exhibited a greater
than three-fold improvement in ALv when compared with the placebo group.

      Another  significant  primary  clinical  endpoint,  the  percentage of all
probing sites that deteriorated by a clinically significant threshold of change,
was  studied  using only the  manual  probe.  Periostat  was found to reduce the
percentage  of  probing  sites that  deteriorated  by a  clinically  significant
amount.  In addition,  in those probing sites with normal ALv,  mild-to-moderate
periodontal  disease  and severe  periodontal  disease,  Periostat  reduced  the
progression of the disease by 32%, 46% and 55%, respectively.

      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
periodontal  disease) 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 pivotal Phase III clinical  trials were  completed in
December  1994.  Based on these  clinical  trials,  the  Company  believes  that
Periostat  is a safe,  efficacious,  cost-effective  therapy  for the  long-term
treatment of periodontitis. The Company compiled the data, performed statistical
analysis and conducted certain  additional 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 scaling and root  planing,
the most  prevalent  therapy for moderate to severe  periodontal  disease.  This
trial was  completed  and the data  analyzed  in late  1997.  While the  earlier
pivotal  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   periodontal   disease  were
administered SRP at the outset of a nine-month, double-blind, placebo-controlled
clinical trial at five  university  centers in


                                       5
<PAGE>


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  periodontal  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 approximately 50% over SRP with placebo.

      On September 2, 1997, the Company announced that it had received its first
action letter from the FDA regarding the NDA. In such letter and in a subsequent
discussion with the Company, the FDA indicated that additional information would
be needed to obtain marketing clearance, primarily clarification relating to the
statistical  methodology used in the NDA. The Company  subsequently met with the
FDA to discuss  the  issues  raised in the  action  letter  and to  provide  the
requested  information.  On January 28, 1998, the Company  announced that it had
received  its second  action  letter  from the FDA  regarding  the NDA.  In such
letter,  and in  subsequent  discussions  with the  Company,  the FDA raised new
issues  about the NDA.  At a meeting  with the FDA in March  1998,  the  Company
addressed  these issues and provided a review of summary  clinical  results from
its recently  completed SRP trial.  The FDA and the Company then agreed that the
Company  would  seek a  claim  based  on  the  submission  of an  NDA  amendment
containing  the  results  from this trial.  The  Company  expects to submit this
amendment  by April  1998,  and the FDA has  committed  to review the  amendment
within six months of the Company's  submission.  There can be no assurance  that
the  Company's  NDA with respect to  Periostat  will be approved by the FDA on a
timely basis,  or at all.  Failure to obtain FDA approval of a NDA for Periostat
would  have a  material  adverse  effect on the  Company's  business,  financial
condition and results of operations.


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.

      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


                                       6
<PAGE>


types, including prostate,  breast, lung, colon and melanoma,  CMTs developed by
the Company exhibited an ability to inhibit metastasis.

      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
IND for  Metastat.  Clinical  studies in patients  with  metastatic  cancer were
initiated in January 1998.

      In December 1996, the Company signed an agreement with Boehringer Mannheim
Italia  ("BMI")  under which BMI will  conduct  animal  studies to evaluate  the
potential of certain of the Company's  compounds to treat metastatic cancer. The
results  of these  studies  supported  the  earlier  findings  of the  Company's
academic  collaborators.  However,  BMI's recent merger with Hoffman LaRoche has
resulted  in a  cessation  of all  licensing  discussions,  and the  Company  is
evaluating various options for the development of Metastat.


Diabetic Nephropathy
--------------------

      Diabetes is the fourth  leading  cause of death from disease 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  delayed  wound  healing.  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  intends to
continue  this  preclinical  work in 1998  with  the  goal of  initiating  human
clinical trials in 1999.


Other Potential Applications
----------------------------

      The Company's research and discoveries relating to CMTs have yielded other
potential  therapeutic  programs  which  the  Company  intends  to  develop  and
commercialize,  possibly


                                       7
<PAGE>


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 periodontal  disease,  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 will develop  certain of the  Company's  CMTs for use in
companion  animal health  applications,  including  osteoarthritis,  periodontal
disease 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 will seek 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.


      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
experimental models.


      Rheumatoid Arthritis

      Rheumatoid  arthritis is a chronic  inflammatory  joint  disease with many
pathophysiological  similarities to periodontal  disease.  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


                                       8
<PAGE>


radiographic  evidence  of  cartilage  and bone  destruction  in the joint  that
correlated with the normalization of MMP activity.


Marketing
---------

      The  Company  plans to market  Periostat  following  FDA  approval to both
periodontists  and general  dentists in the United States through a direct sales
force of approximately 130 sales representatives.  In February 1997, the Company
retained ICS, a sales and marketing organization focused on the dental industry,
to conduct  certain  prelaunch  sales and marketing  activities on behalf of the
Company.  The  Company  subsequently  terminated  its  relationship  with ICS in
December  1997.  In January 1998 the Company  began  contracting  directly  with
experienced  dental  salespersons to provide the nucleus for future expansion of
its sales  force.  In  addition,  the Company  intends to establish a network of
sub-licensees or distributors to market and sell Periostat outside of the United
States.  For  example,  in July  1996,  the  Company  executed a  marketing  and
manufacturing  agreement with BMI pursuant to which BMI has the exclusive  right
to market  Periostat in Italy,  San Marino and The Vatican  City.  The agreement
provided for BMI to pay the Company a nonrefundable license fee upon signing and
additional  fees upon the  achievement  of future  milestones and royalties upon
future  sales of Periostat in Italy,  San Marino and The Vatican  City.  In July
1997, the Company announced that a Marketing Authorization for Approval had been
filed for Periostat by BMI with the Italian Ministry of Health.

      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  dental  community.
Ponstel is a  nonsteriodal  anti-inflammatory  drug  indicated for the relief of
moderate pain.

      Further,  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  the  periodontal  disease
process  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.

      In June 1997, the Company  announced that it had hired a Vice President of
Marketing and a Vice President of Sales. The Company currently has approximately
20 sales  representatives  employed under  contract and will recruit  additional
sales representatives prior to FDA approval of Periostat. Initially, the Company
expects  a  significant  portion  of  such  additional  representatives  will be
retained  through the  services of an  independent  established  contract  sales
organization.  There can be no assurance, however, that the Company will be able
to recruit  and  retain  qualified  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.


                                       9
<PAGE>


Research and Development
------------------------

      The Company  conducts a broad-based  research and drug  discovery  program
through its collaborations with corporate partners,  researchers,  universities,
medical   institutions  and  leading  scientists.   Pharmaceutical   development
activities are carried out primarily by contract  research  organizations at the
direction of the Company.  Historically,  the Company's  research has focused on
the  inhibition  of   collagenolytic   activity  with  particular   emphasis  on
periodontal disease. The Company maintains an ongoing research relationship with
SUNY and is currently funding a basic research effort relating to tetracyclines,
including  CMTs, and their effect on connective  tissue  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 has entered an agreement with a contract research organization
pursuant to which such  entity  performs a majority  of the  Company's  clinical
development, data management and regulatory affairs activities. Either party may
terminate such agreement on 90 days prior written notice. The Company's research
and development  expenditures were approximately $3.6 million,  $4.4 million and
$4.3 million, in 1995, 1996 and 1997, respectively. Of such amounts, $1,679,000,
$1,766,000 and $1,030,000 were incurred under this agreement for such periods.


Manufacturing and Suppliers
---------------------------

      The  Company  relies on  third-party  contract  manufacturers  to  produce
doxycycline,  the active drug  ingredient in Periostat,  and for the  commercial
manufacturing  of  Periostat.  The  Company  has  entered  into a  manufacturing
agreement 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. This agreement,  which
requires the Company to purchase minimum amounts of Periostat,  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 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.


                                       10
<PAGE>


      There can be no  assurance  that the Company will be able to enter into or
maintain supply or manufacturing  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, the Company's
business,  financial  condition  and results of  operations  would be materially
adversely affected. See "--Government Regulation."


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.   Thirteen  U.S.  patents  and  ten  U.S.  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  U.S.  patent  claims  methods  of  use of
conventional  tetracyclines to inhibit pathologically  excessive  collagenolytic
activity (the "Primary  Patent"),  while a related U.S. patent claims methods of
use of tetracyclines which have no antibiotic activity (the "Secondary Patent").
The eleven other U.S.  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 U.S.  patents  relating to methods of use of  tetracyclines to
reduce bone loss. All of SUNY's U.S. and foreign patents expire between 2004 and
2016.  The  Company's  rights  under the SUNY  License  are  subject  to certain
statutory  rights of the U.S.  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.


                                       11
<PAGE>


      One of the U.S.  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 which  represent  the core  technology of the
Company,  the Company also owns additional  technology for which  applications
for U.S.  patents  have been  filed and have  been  allowed  (but have not yet
issued).  In this  regard,  the Company  reports the  existence  of three U.S.
applications.   These  pending  applications  will  soon  be  issued  as  U.S.
patents.  The allowed U.S. patents generally cover technology as follows:  (i)
composition  for  treating  periodontis;   (ii)  composition  and  method  for
treating  H.  Pylori;  and  (iii)  toothpaste/mouthwash  formulation  for  the
amelioration of dentin hypersensitivity.

      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 U.S. 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


                                       12
<PAGE>


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  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


                                       13
<PAGE>


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 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 Company's  pre-clinical studies were conducted
in accordance with GLP regulations.

      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


                                       14
<PAGE>


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 a 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 a 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).

      In late 1995, the FDA requested that the Company conduct additional animal
studies regarding certain effects  associated with the reproductive  effects and
long-term  dosing of doxycycline  and that the data be included in the Company's
NDA submission. Such animal studies have been conducted and the results included
in the Company's NDA for Periostat. The FDA also requested that a post-approval,
post-marketing  animal study related to long-term dosing and  carcinogenicity 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 a NDA,  subsequent new indications or dosages
for the same product are reviewed by the FDA by the filing of a 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.


                                       15
<PAGE>


      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
50mg 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"
and is being  reviewed  pursuant to Section 507 of the  Federal  Food,  Drug and
Cosmetic  Act.  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  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.

      The product  testing and approval  process is likely to take a substantial
number of years and involves expenditure of substantial resources.  On September
2, 1997, the Company announced that it had received its first action letter from
the FDA  regarding the NDA. In such letter and in a subsequent  discussion  with
the Company,  the FDA indicated that additional  information  would be needed to
obtain marketing clearance,  primarily clarification relating to the statistical
methodology  used in the  NDA.  The  Company  subsequently  met  with the FDA to
discuss  the issues  raised in the action  letter and to provide  the  requested
information. On January 28, 1998, the Company announced that it had received its
second  action  letter from the FDA


                                       16
<PAGE>


regarding  the NDA.  In such  letter,  and in  subsequent  discussions  with the
Company,  the FDA raised new issues  about the NDA. At a meeting with the FDA in
March 1998, the Company  addressed these issues and provided a review of summary
clinical results from its recently  completed SRP trial. The FDA and the Company
then agreed that the Company  would seek a claim based on the  submission  of an
NDA amendment  containing  the results from this trial.  The Company  expects to
submit this  amendment  by April 1998,  and the FDA has  committed to review the
amendment  within  six  months  of the  Company's  submission.  There  can be no
assurance  that the Company's NDA with respect to Periostat  will be approved by
the FDA on a timely  basis,  or at all.  Failure to obtain FDA approval of a NDA
for Periostat  would have a material  adverse effect on the Company's  business,
financial  condition  and  results  of  operations.  The FDA  also  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.  Adverse  experiences
with the product must be reported to the FDA.

      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.  While the Company  believes that
there are no other  products for the  treatment  of  periodontal  disease  which
operate through systemic delivery of therapeutics  designed to reduce connective
tissue destruction, the Company is aware of companies that have developed or are
developing  products that may compete in the same market.  The Company  believes
that a  significant  competitive  factor is the  relative  speed  with which the
Company can complete the approval process and, if Periostat is approved,  supply
commercial  quantities  of the product to the market.  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.

      Many of the Company's  potential  competitors 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 relied upon  consultants to perform many of
its operating activities and has outsourced its manufacturing,  clinical trials,
NDA  preparation  and other


                                       17
<PAGE>


activities. As of December 31, 1997, the Company employed fourteen persons. Each
of  its  management   personnel  has  had  extensive   prior   experience   with
pharmaceutical, biotechnology or medical products companies. The Company intends
to increase  its sales and  marketing  staff as  appropriate  and to continue to
outsource many of the  activities  which it  historically  has  outsourced.  The
Company  currently has  approximately  twenty  part-time  sales  representatives
employed under contract and plans to recruit  additional  sales  representatives
prior to FDA approval of Periostat. There can be no assurance, however, 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.
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.


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.  The leases expire in
September of 1998 and December of 2000.


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.


                                       18
<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  since the quarter  ended June 30, 1996 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
-----------------------------------------------------------

June 30, 1996................       $ 10.25        $  8.25
September 30, 1996...........       $ 11.25        $  6.125
December 31, 1996............       $ 11.75        $  7.50
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

      As of February 15, 1998,  the  approximate  number of holders of record of
the Common Stock was 86 and the approximate  number of beneficial holders of the
Common Stock was 1,700.

      The Company has never  declared or paid any cash  dividends on its capital
stock.  The Company intends to retain any earnings to fund future growth and the
operation of its business and,  therefore,  does not anticipate  paying any cash
dividends in the foreseeable future.


                                       19
<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, 1997 and for the period  January 10, 1992
(inception) to December 31, 1997, and with respect to the  consolidated  balance
sheet data at December 31, 1996 and 1997 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,  1993 and  December  31,  1994 and with
respect to the consolidated balance sheet data as of December 31, 1993, 1994 and
1995 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.


<TABLE>
<CAPTION>

                                                                                                   For the
                                                                                                    Period
                                                                                                   January 10,
                                                                                                     1992
                                                         Years Ended December 31,                 (inception) to
                                        --------------------------------------------------------  December 31,
                                          1993        1994        1995        1996        1997        1997
                                        --------    --------    --------    --------    --------    --------
Consolidated Statement of                          (in thousands except for per share data)
  Operations Data:                      --------------------------------------------------------
   Revenues:
<S>                                     <C>         <C>         <C>         <C>         <C>         <C>
      Licensing revenues ............   $   --      $   --      $   --      $    400    $    325    $    725
      Contract revenue ..............       --          --          --          --             9           9
                                        --------    --------    --------    --------    --------    --------
      Total revenues ................       --          --          --           400         334         734
   Operating expenses:
      Research and development ......      1,913       1,928       3,635       4,436       4,319      17,362
      General and administrative ....        613         793       1,548       2,527       5,977      11,791
                                        --------    --------    --------    --------    --------    --------
   Operating loss ...................     (2,526)     (2,721)     (5,183)     (6,563)     (9,962)    (28,419)
   Net loss .........................     (2,483)     (2,653)     (5,269)     (5,918)     (8,624)    (26,362)
   Net loss allocable to common
     stockholders ...................     (2,834)     (3,229)     (6,028)     (6,638)     (8,624)    (28,959)
Pro-forma(1):
   Net loss per share:
      Basic .........................                           $  (1.57)   $  (0.90)   $  (1.04)
      Diluted .......................                              (1.52)      (0.89)      (1.04)
   Shares used in computing pro
     forma net loss per share:
      Basic .........................                              3,354       6,572       8,291
      Diluted .......................                              3,464       6,627       8,291
</TABLE>


                                       20
<PAGE>


<TABLE>
<CAPTION>

                                                               As of December 31,
                                           --------------------------------------------------------
                                              1993       1994        1995        1996        1997
                                           --------    --------    --------    --------    --------
Balance Sheet Data:                                               (in thousands)
<S>                                        <C>         <C>         <C>         <C>         <C>
Cash, cash equivalents and
   short-term investments ..............   $  3,369    $    617    $  5,806    $ 18,215    $ 22,771
Total assets ...........................      3,374         628       5,840      18,437      23,165
Mandatorily redeemable convertible
  preferred stock ......................         51       7,510      18,908        --          --
Deficit accumulated during the
  development stage ....................     (3,732)     (6,552)    (11,820)    (17,739)    (26,362)
Total stockholder's equity(deficit) ....      2,653      (7,581)    (13,581)     17,592      20,708



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

</TABLE>


                                       21
<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
engaged in the  development  and  commercialization  of innovative,  proprietary
medical   therapies  for  the  treatment  of   periodontal   disease  and  other
pathologies. Since its origin, the Company has had no revenues from sales of its
own products and has funded its operations primarily from the proceeds of public
and private issuances of equity  securities.  Substantially all of the Company's
expenditures  to date have been for  pharmaceutical  development  activities and
general and administrative expenses.

      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 anticipates that it will significantly  increase the
number of its employees over the next several  years,  primarily in the selling,
general and administrative areas, following regulatory approval of Periostat.

      The  Company has  incurred  losses  each year since  inception  and had an
accumulated  deficit of $26.4 million at December 31, 1997. 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,"  "anticipate"  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 developing  pharmaceutical products is
subject to a number of significant  risks,  including risks inherent in research
and  development  activities  and in conducting  business in a highly  regulated
environment. The success of the Company depends to a large degree upon obtaining
FDA  and  foreign  regulatory   approval  to  market  products  currently  under
development.  There  can be no  assurance  that  any of  the  Company's  product
candidates  will be 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 in the forward-looking statements contained herein.


Results of Operations
---------------------

      From its founding  through  December 31, 1997, the Company had no revenues
from sales of its own  products.  Operating  expenses  consist of  research  and
development  expenses  and


                                       22
<PAGE>


general and administrative  expenses.  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.  General and
administrative  expenses consist  primarily of personnel  salaries and benefits,
professional  and  consulting  fees,  insurance,  facilities  and general office
expenses.  The Company  anticipates  that  selling,  general and  administrative
expenses will increase during the next several years due to the expansion of its
commercial infrastructure, primarily in sales and marketing.

      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 BMI pursuant to which BMI will, following  regulatory approval,  distribute
and  manufacture  Periostat in Italy.  The  agreement  provided for BMI to pay a
$400,000  license fee upon signing and additional  fees upon the  achievement of
future  milestones  and royalties  upon future sales of Periostat in Italy,  San
Marino and the  Vatican  City.  During the second  quarter of 1997,  the Company
received  a  nonrefundable  $300,000  licensing  fee  from  BMI  related  to the
achievement of the first milestone under the agreement.


      Years Ended December 31, 1997 and December 31, 1996

      Research and development  expenses  decreased from $4.4 million in 1996 to
$4.3  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.

      General and administrative expenses increased from $2.5 million in 1996 to
$6.0  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 $0.6 million 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.


      Years Ended December 31, 1996 and December 31, 1995

      Research and development  expenses  increased from $3.6 million in 1995 to
$4.4  million  in 1996.  This  increase  resulted  from  higher  contract  costs
associated  with preparing and submitting a new drug  application for Periostat,
including data  compilation,  statistical  analysis and validation of production
processes.

      General and administrative expenses increased from $1.5 million in 1995 to
$2.5  million  in 1996.  This  increase  was due  primarily  to higher  employee
compensation  expense  due to the  hiring of  additional  staff in  finance  and
commercial   development,   including   a   non-cash   compensation   charge  of
approximately  $0.1 million  resulting from the grant of certain  employee stock
options,  and higher insurance and professional  fees associated with becoming a
public company.


                                       23
<PAGE>


      Interest  income  increased  from $0.1  million in 1995 to $0.6 million in
1996.  This  increase  was  due  to  higher  balances  in  cash  and  short-term
investments as a result of the Company's initial public offering of Common Stock
in 1996.


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.  At December 31, 1997 the
Company's  cash,  cash  equivalents  and short term  investments  totaled  $22.8
million.  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 U.S.  Treasury  securities and commercial paper
with a credit  rating no lower than  A1/P1.  The  Company's  working  capital at
December 31, 1997 was $20.6  million,  an increase of $3.1 million from December
31, 1996. This increase was primarily attributable to the proceeds received from
the  Company's  follow-on  public  offering of common  stock in 1997,  which was
reduced by normal operating expenses incurred during 1997.

      The Company had no debt or capital leases outstanding (other than accounts
payable and accrued  expenses)  at December  31,  1997.  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,
1997.

      The  Company  anticipates  that  its  existing  working  capital  will  be
sufficient to fund the Company's operations through at least 1998. The Company's
future capital  requirements and the adequacy of its available funds will depend
on many factors,  including the timing of FDA approval, if any, of the Company's
NDA for Periostat, such NDA having been submitted to the FDA in August 1996, the
size and  scope of the  Company's  sales  and  marketing  effort,  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, 1997, the Company had available  $23.2 million and $3.0
million  in net  operating  carryforwards  to offset  future  Federal  and state
taxable  income,  if any,  through  the year  2012 and  2000,  respectively.  In
addition,   the  Company  had  research  and   experimentation  tax  credits  of
approximately $200,000,  which expire at various times through the year 2012. As
a result of past financings,  including the Company's initial public offering in
June 1996 and the


                                       24
<PAGE>


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.


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.

      On January 19, 1996, the Company selected KPMG Peat Marwick LLP, to act as
independent  accountants  for the Company and informed the prior  auditors,  the
Company's  independent  accountants  since January  1994,  of its decision.  The
former  auditors'  report on the Company's  financial  statements for the period
from  January  10,  1992  (inception)  to  December  31, 1993 does not cover the
financial statements of the Company included in this Annual Report on Form 10-K.
In connection with its audit for the period from January 10, 1992 (inception) to
December 31, 1993,  there were no  disagreements  with the prior auditors on any
matters of accounting  principles or practices,  financial statement disclosure,
or auditing scope or  procedures.  The prior  auditors'  report on the Company's
financial  statements  for the period  from  January  10,  1992  (inception)  to
December 31, 1993 contained no adverse  opinion or disclaimer of opinion and was
not  modified  or  qualified  as to  uncertainty,  audit  scope,  or  accounting
principles.  The decision to change accountants was approved by the Board of the
Directors of the Company.  The prior  auditors have furnished the Company with a
letter  addressed  to the  Securities  and  Exchange  Commission  stating  their
agreement with the above  statements.  Such letter appears in Exhibit 16 to this
Annual Report on Form 10-K.


                                       25
<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
1998 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 1998  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 1998
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 1998 Annual
Meeting  of  Stockholders  is  incorporated  herein by  reference  to such proxy
statement.


                                       26
<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 Financial  Statements  and Schedules
          on Page F-1.

     (2)  Financial Statement Schedules.

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

     (3)  Exhibits.

          Reference is made to the Index to Exhibits on Page 30.

(b)       Reports on Form 8-K.

          No  Reports  on Form 8-K have been  filed  during  the  quarter  ended
          December 31, 1997.


                                       27
<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 30th day of March,
1998.

                                    COLLAGENEX PHARMACEUTICALS, INC.

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


                                       28
<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 Executive    March 30, 1998
-------------------------------   Officer and Director
   Brian M. Gallagher, Ph.D.      (Principal Executive
                                  Officer)

/s/Nancy C. Broadbent             Chief Financial Officer,      March 30, 1998
-------------------------------   Treasurer and Secretary
   Nancy C. Broadbent             (Principal Financial and
                                  Accounting Officer)

/s/Helmer P.K. Agersborg, Ph.D.   Chairman of the Board and     March 30, 1998
-------------------------------   Director
   Helmer P.K. Agersborg, Ph.D.

/s/James E. Daverman              Director                      March 30, 1998
-------------------------------
   James E. Daverman

/s/Robert J. Easton               Director                      March 30, 1998
-------------------------------
   Robert J. Easton

/s/Stephen W. Ritterbush, Ph.D.   Director                      March 30, 1998
-------------------------------
   Stephen W. Ritterbush, Ph.D.

/s/Pieter J. Schiller             Director                      March 30, 1998
-------------------------------
   Pieter J. Schiller

/s/Terence E. Winters, Ph.D.      Director                      March 30, 1998
-------------------------------
   Terence E. Winters, Ph.D.

/s/Peter R. Barnett               Director                      March 30, 1998
-------------------------------
   Peter R. Barnett


                                       29
<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.
+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.


                                       30
<PAGE>


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

 10.10       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       Lease Agreement dated August 22, 1997 between the Company and
             Stocking Works Associates which became effective on September 1,
             1997.
 16(a)       Letter re:  Change in Certifying Accountants.
 21(f)       List of subsidiaries of the Registrant.
 23          Consent of KPMG Peat Marwick LLP.
 27          Financial Data Schedules for the years ended December 31, 1997,
             1996 and 1995.

----------

+     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.


                                       31
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

                                                                          Page
                                                                          ----

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

Consolidated balance sheets as of December 31, 1996 and 1997............  F-3

Consolidated  statements of operations  for the years ended December
  31, 1995,  1996, and 1997 and for the period from January 10, 1992
  (inception) to December 31, 1997......................................  F-4

Consolidated  statements of  stockholders'  equity (deficit)for
  the period from January 10, 1992 (inception) to December 31, 1997.....  F-5

Consolidated  statements of cash flows for the years ended  December
  31, 1995,  1996, and 1997 and for the period from January 10, 1992
  (inception) to December 31, 1997......................................  F-8

Notes to consolidated financial statements..............................  F-10


                                      F-1
<PAGE>


                          Independent Auditors' Report



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



We have  audited the  accompanying  consolidated  balance  sheets of  CollaGenex
Pharmaceuticals,  Inc. and  subsidiary (A  Development  Stage  Enterprise) as of
December  31,  1996  and  1997,  and  the  related  consolidated  statements  of
operations,  stockholders' equity (deficit) and cash flows for each of the years
in the three-year period ended December 31, 1997 and for the period from January
10,  1992  (inception)  to  December  31,  1997.  These  consolidated  financial
statements   are  the   responsibility   of  the   Company's   management.   Our
responsibility  is  to  express  an  opinion  on  these  consolidated  financial
statements based on our audits.

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

In our opinion, the consolidated  financial statements referred to above present
fairly,  in  all  material  respects,   the  financial  position  of  CollaGenex
Pharmaceuticals,  Inc. and  subsidiary (A  Development  Stage  Enterprise) as of
December 31, 1996 and 1997,  and the results of their  operations and their cash
flows for each of the years in the three-year period ended December 31, 1997 and
for the period from  January 10, 1992  (inception)  to  December  31,  1997,  in
conformity with generally accepted accounting principles.





                                                KPMG Peat Marwick LLP




Princeton, New Jersey
January 30, 1998


                                      F-2
<PAGE>
<TABLE>
<CAPTION>

                                  COLLAGENEX PHARMACEUTICALS, INC.
                                           AND SUBSIDIARY
                                  (A Development Stage Enterprise)

                                    Consolidated Balance Sheets

                                     December 31, 1996 and 1997


                                                                          1996            1997
                       ASSETS                                         ------------    ------------
<S>                                                                   <C>             <C>
Current assets:
      Cash and cash equivalents ....................................  $  9,848,177    $ 16,379,324
      Short-term investments .......................................     8,366,736       6,391,680
      Interest receivable ..........................................        65,534          87,573
      Prepaid expenses .............................................        88,443         189,905
                                                                      ------------    ------------
                    Total current assets ...........................    18,368,890      23,048,482
Equipment, net (note 3) ............................................        56,496         103,307
Other assets .......................................................        11,158          12,733
                                                                      ------------    ------------
                     Total assets ..................................  $ 18,436,544    $ 23,164,522
                                                                      ============    ============

                       LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
      Accounts payable .............................................  $     45,434    $    550,752
      Accrued expenses (note 4) ....................................       798,925       1,905,980
                                                                      ------------    ------------
                     Total current liabilities .....................       844,359       2,456,732
                                                                      ------------    ------------

Stockholders' equity (notes 7, 8 and 10):
      Preferred stock, $0.01 par value, 5,000,000 shares
         authorized, no shares outstanding in 1996 and 1997 ........          --              --
      Common stock, $0.01 par value; 25,000,000 shares
         authorized, 7,535,533 and 8,567,579 shares issued
           and outstanding in 1996 and 1997, respectively ..........        75,356          85,676
      Additional paid-in capital ...................................    35,551,459      47,297,662
      Deferred compensation (note 8) ...............................      (295,825)       (313,065)
      Deficit accumulated during the development stage .............   (17,738,805)    (26,362,483)
                                                                      ------------    ------------

                    Stockholders' equity ...........................    17,592,185      20,707,790
                                                                      ------------    ------------

Commitments and contingencies (notes 6, 10, 11 and 13)
                    Total liabilities and stockholders' equity .....  $ 18,436,544    $ 23,164,522
                                                                      ============    ============


                   See accompanying notes to consolidated financial statements.
</TABLE>


                                                F-3
<PAGE>
<TABLE>
<CAPTION>

                                       COLLAGENEX PHARMACEUTICALS, INC.
                                                AND SUBSIDIARY
                                       (A Development Stage Enterprise)

                                     Consolidated Statements of Operations

                             For the years ended December 31, 1995, 1996 and 1997
                                   and for the period from January 10, 1992
                                       (inception) to December 31, 1997


                                                                                               For the period
                                                                                                from January
                                                         Year ended December 31,                  10, 1992
                                               --------------------------------------------    (inception) to
Revenues:                                           1995           1996            1997        December 31, 1997
                                               ------------    ------------    ------------    -----------------
<S>                                            <C>             <C>             <C>               <C>
    License revenues .......................   $       --      $    400,000    $    325,000      $    725,000
    Contract revenue .......................           --              --             8,913             8,913
                                               ------------    ------------    ------------      ------------
               Total revenues ..............           --           400,000         333,913           733,913
                                               ------------    ------------    ------------      ------------

    Operating expenses incurred in
      the development stage:
           Research and development
             (notes 10 and 13) .............      3,635,374       4,436,296       4,318,551        17,362,542
           General and administrative ......      1,547,997       2,527,179       5,976,862        11,790,714
                                               ------------    ------------    ------------      ------------
               Total operating expenses ....      5,183,371       6,963,475      10,295,413        29,153,256
                                               ------------    ------------    ------------      ------------
               Loss from operations ........     (5,183,371)     (6,563,475)     (9,961,500)      (28,419,343)
Other income (expense):
Interest income ............................         58,917         645,157       1,337,822         2,200,968
Interest expense ...........................       (144,108)           --              --            (144,108)
                                               ------------    ------------    ------------      ------------
                                                    (85,191)        645,157       1,337,822         2,056,860
                                               ------------    ------------    ------------      ------------
               Net loss ....................   $ (5,268,562)   $ (5,918,318)   $ (8,623,678)     $(26,362,483)
                                               ============    ============    ============      ============
Accretion of undeclared dividends
  attributable to mandatorily
  redeemable convertible
  preferred stock ..........................        759,801         719,562            --           2,596,708
                                               ============    ============    ============      ============
Net loss allocable to common
  stockholders .............................     (6,028,363)     (6,637,880)     (8,623,678)      (28,959,191)
                                               ============    ============    ============      ============
Pro-forma net loss per share
  (notes 2 and 7):
           Basic ...........................          (1.57)          (0.90)          (1.04)
           Diluted .........................          (1.52)          (0.89)          (1.04)
                                               ============    ============    ============
Shares used in computing pro-forma
  net loss per share (notes 2 and 7):
           Basic ...........................      3,354,371       6,572,104       8,291,167
           Diluted .........................      3,464,371       6,627,104       8,291,167
                                               ============    ============    ============


                         See accompanying notes to consolidated financial statements.
</TABLE>


                                                     F-4
<PAGE>
<TABLE>
<CAPTION>

                                                  COLLAGENEX PHARMACEUTICALS, INC.
                                                           AND SUBSIDIARY
                                                  (A Development Stage Enterprise)

                                     Consolidated Statements of Stockholders' Equity (Deficit)

                                                For the period from January 10, 1992
                                                  (inception) to December 31, 1997

                                                                                                        Deficit
                                                                                                       accumulated
                                                           Common stock      Additional                  during          Total
                                                        ------------------    paid-in      Deferred        the         stockholders
                                                         Number of   Par      capital      compensa-    development      equity
                                                          shares    value    (deficit)       tion         stage         (deficit)
                                                        ---------  -------  ------------   ---------   ------------   ------------
<S>                                                        <C>     <C>      <C>            <C>         <C>            <C>
Issuance of common stock in exchange for technology
  license in January 1992 at inception ...............     54,552  $   546  $     10,364   $    --     $       --     $     10,910
Issuance of common stock in exchange for consulting
  services ...........................................      7,500       75        14,925        --             --           15,000
Issuance of common stock in exchange for technology
  license in November 1992 ...........................     24,396      244         4,635        --             --            4,879
Accretion of undeclared dividends on mandatorily
  redeemable convertible preferred stock (note 5) ....       --       --        (190,903)       --             --         (190,903)
Net loss .............................................       --       --            --          --       (1,415,703)    (1,415,703)
                                                        ---------  -------  ------------   ---------   ------------   ------------
Balance, December 31, 1992 ...........................     86,448      865      (160,979)       --       (1,415,703)    (1,575,817)

Accretion of undeclared dividends on mandatorily
  redeemable convertible preferred stock (note 5) ....       --       --        (351,072)       --             --         (351,072)
Net loss .............................................       --       --            --          --       (2,482,757)    (2,482,757)
                                                        ---------  -------  ------------   ---------   ------------   ------------


                                   See accompanying notes to consolidated financial statements.


                                                               F-5
</TABLE>
<PAGE>
<TABLE>
<CAPTION>

                                                  COLLAGENEX PHARMACEUTICALS, INC.
                                                           AND SUBSIDIARY
                                                  (A Development Stage Enterprise)

                                     Consolidated Statements of Stockholders' Equity (Deficit)

                                                For the period from January 10, 1992
                                                  (inception) to December 31, 1997

                                                                                                        Deficit
                                                                                                       accumulated
                                                           Common stock      Additional                  during          Total
                                                        ------------------    paid-in      Deferred        the         stockholders
                                                         Number of   Par      capital      compensa-    development      equity
                                                          shares    value    (deficit)       tion         stage         (deficit)
                                                        ---------  -------  ------------   ---------   ------------   ------------

Continued from previous page

<S>                                                        <C>     <C>      <C>            <C>         <C>            <C>
Balance, December 31, 1993 ...........................     86,448      865      (512,051)       --       (3,898,460)    (4,409,646)

Exercise of common stock options ($0.20 per share)
  (note 8) ...........................................     75,969      760        14,771        --             --           15,531
Issuance of common shares to an executive officer
  at $0.335 per share in November 1994 ...............    125,000    1,250        40,625        --             --           41,875
Accretion of undeclared dividends on mandatorily
  redeemable convertible preferred stock (note 5) ....       --       --        (575,370)       --             --         (575,370)
Net loss .............................................       --       --            --          --       (2,653,465)    (2,653,465)
                                                        ---------  -------  ------------   ---------   ------------   ------------

Balance, December 31, 1994 ...........................    287,417    2,875    (1,032,025)       --       (6,551,925)    (7,581,075)

Exercise of common stock options ($0.20 per share)
  (note 8) ...........................................     25,242      252         5,471        --             --            5,723
Deferred compensation resulting from grant of
  options (note 8) ...................................       --       --          43,250     (43,250)          --             --
Amortization of deferred compensation (note 8) .......       --       --            --        23,067           --           23,067
Accretion of undeclared dividends on mandatorily
  redeemable convertible preferred stock (note 5) ....       --       --        (759,801)       --             --         (759,801)
Net loss .............................................       --       --            --          --       (5,268,562)    (5,268,562)
                                                        ---------  -------  ------------   ---------   ------------   ------------

Balance, December 31, 1995 ...........................    312,659    3,127    (1,743,105)    (20,183)   (11,820,487)   (13,580,648)

Exercise of common stock options ($0.20-
  $0.335 per share) (note 8) .........................     23,750      238         5,544        --             --            5,782
Issuance of common stock at $10 per share in
  conjunction with the Initial Public Offering, net
  of issuance costs ..................................  2,000,000   20,000    18,006,905        --             --       18,026,905
Accretion of undeclared dividends on mandatorily
  redeemable convertible preferred stock (note 5) ....       --       --        (719,562)       --             --         (719,562)
Conversion of mandatorily redeemable convertible
  preferred stock into common stock in conjunction
  with the Initial Public Offering ...................  5,199,124   51,991    19,575,677        --             --       19,627,668


                                   See accompanying notes to consolidated financial statements.

                                                               F-6
</TABLE>
<PAGE>
<TABLE>
<CAPTION>

                                                  COLLAGENEX PHARMACEUTICALS, INC.
                                                           AND SUBSIDIARY
                                                  (A Development Stage Enterprise)

                                     Consolidated Statements of Stockholders' Equity (Deficit)

                                                For the period from January 10, 1992
                                                  (inception) to December 31, 1997

                                                                                                        Deficit
                                                                                                       accumulated
                                                           Common stock      Additional                  during          Total
                                                        ------------------    paid-in      Deferred        the         stockholders
                                                         Number of   Par      capital      compensa-    development      equity
                                                          shares    value    (deficit)       tion         stage         (deficit)
                                                        ---------  -------  ------------   ---------   ------------   ------------

Continued from previous page

<S>                                                        <C>     <C>      <C>            <C>         <C>            <C>
Deferred compensation resulting from grant of
   options (note 8) ..................................       --       --         426,000    (426,000)          --             --
Amortization of deferred compensation (note 8) .......       --       --            --       150,358           --          150,358
Net loss .............................................       --       --            --          --       (5,918,318)    (5,918,318)
                                                        ---------  -------  ------------   ---------   ------------   ------------

Balance, December 31, 1996 ...........................  7,535,533   75,356    35,551,459    (295,825)   (17,738,805)    17,592,185

Exercise of common stock options ($0.20-$2.00 per
  share) (note 8) ....................................     32,046      320        52,042        --             --           52,362
Issuance of common stock at $12.50 per share in
  conjunction with follow-on Offering, net of
  issuance costs (note 7) ............................  1,000,000   10,000    11,552,411        --             --       11,562,411
Deferred compensation resulting from grant of
  options (note 8) ...................................       --       --         141,750    (141,750)          --             --
Amortization of deferred compensation (note 8) .......       --       --            --       124,510           --          124,510
Net loss .............................................       --       --            --          --       (8,623,678)    (8,623,678)
                                                        ---------  -------  ------------   ---------   ------------   ------------
Balance, December 31, 1997 ...........................  8,567,579  $85,676  $ 47,297,662   $(313,065)  $(26,362,483)  $ 20,707,790
                                                        =========  =======  ============   =========   ============   ============


                                   See accompanying notes to consolidated financial statements.

                                                               F-7
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
                                                 COLLAGENEX PHARMACEUTICALS, INC.

                                                          AND SUBSIDIARY
                                                 (A Development Stage Enterprise)

                                              Consolidated Statements of Cash Flows
                                       For the years ended December 31, 1995, 1996 and 1997
                                             and for the period from January 10, 1992
                                                 (inception) to December 31, 1997


                                                                                                                      For the
                                                                                                                     period from
                                                                                                                   January 10, 1992
                                                                                Years ended December 31,            (inception) to
                                                                   ---------------------------------------------     December 31,
                                                                       1995            1996            1997            1997
                                                                   ------------    ------------    ------------    ----------------
<S>                                                                <C>             <C>             <C>             <C>
Cash flows from operating activities:
      Net loss .................................................   $ (5,268,562)   $ (5,918,318)   $ (8,623,678)   $(26,362,483)
      Adjustments to reconcile net loss to net cash
           used in operating activities:
               Noncash research and development expense ........           --              --              --           513,789
               Noncash compensation expense ....................         23,067         150,358         124,510         297,935
               Noncash consulting expense ......................           --              --              --            15,000
               Depreciation and amortization expense ...........          3,617          17,051          31,376          55,140
               Change in assets and liabilities:
                    Increase in interest receivable ............           --           (65,534)        (22,039)        (87,573)
                    Increase in prepaid expenses ...............         (7,282)        (81,161)       (101,462)       (189,905)
                    Increase in other assets ...................         (7,328)           (770)         (1,575)        (12,734)
                    Increase (decrease) in accounts payable.....       (514,602)         27,762         505,318         550,752
                    Increase in accrued expenses ...............        328,216         304,070       1,107,055       1,905,980
                                                                   ------------    ------------    ------------    ------------
               Net cash used in operating activities ...........     (5,442,874)     (5,566,542)     (6,980,495)    (23,314,099)
Cash flows from investing activities:
      Organizational costs .....................................           --              --              --            (5,000)
      Capital expenditures .....................................        (11,758)        (57,667)        (78,187)       (153,446)
      Proceeds from the sale of short-term investments .........           --         3,923,142      25,402,301      29,325,443
      Purchase of short-term investments .......................           --       (12,289,878)    (23,427,245)    (35,717,123)
                                                                   ------------    ------------    ------------    ------------
               Net cash used in investing activities ...........        (11,758)     (8,424,403)      1,896,869      (6,550,126)
Cash flows from financing activities:
      Proceeds from issuance of common stock ...................          5,723      18,032,687      11,614,773      29,710,589
      Proceeds from issuance of preferred stock ................      7,613,273            --              --        13,508,273
      Proceeds from issuance of promissory notes ...............      3,149,687            --              --         3,149,687
      Repayment of promissory note .............................       (125,000)           --              --          (125,000)
                                                                   ------------    ------------    ------------    ------------
               Net cash provided by financing activities .......     10,643,683      18,032,687      11,614,773      46,241,549
                                                                   ------------    ------------    ------------    ------------
Net increase in cash and cash equivalents ......................      5,189,051       4,041,742       6,531,147      16,379,324


                         See accompanying notes to consolidated financial statements.


                                                     F-8
<PAGE>


                                                COLLAGENEX PHARMACEUTICALS, INC.

                                                          AND SUBSIDIARY
                                                 (A Development Stage Enterprise)

                                              Consolidated Statements of Cash Flows
                                       For the years ended December 31, 1995, 1996 and 1997
                                             and for the period from January 10, 1992
                                                 (inception) to December 31, 1997


                                                                                                                      For the
                                                                                                                     period from
                                                                                                                   January 10, 1992
                                                                                Years ended December 31,            (inception) to
                                                                   ---------------------------------------------     December 31,
                                                                       1995            1996            1997            1997
                                                                   ------------    ------------    ------------    ----------------
Continued from previous page

<S>                                                                <C>             <C>             <C>             <C>
Cash and cash equivalents at beginning of period ...............        617,384       5,806,435       9,848,177            --
                                                                   ------------    ------------    ------------    ------------
Cash and cash equivalents at end of period .....................   $  5,806,435    $  9,848,177    $ 16,379,324    $ 16,379,324
                                                                   ============    ============    ============    ============
Supplemental disclosure of cash flows information -
      Cash paid for interest ...................................   $     22,921    $       --      $       --      $     22,921
                                                                   ============    ============    ============    ============
Supplemental schedule of noncash financing activities:
      Conversion of promissory notes to preferred stock.........   $  2,903,500    $       --      $       --      $  2,903,500
      Deferred compensation ....................................         43,250         426,000         141,750         611,000
      Accretion of undeclared dividends
           attributable to mandatorily redeemable
           convertible preferred stock .........................        759,801         719,562            --         2,596,708
      Conversion of mandatorily redeemable
           convertible preferred stock to common
           stock ...............................................           --        19,627,668            --        19,627,668
      Preferred stock issued in connection
           with technology license agreements ..................           --              --              --           498,000
                                                                   ============    ============    ============    ============


                         See accompanying notes to consolidated financial statements.
</TABLE>


                                                              F-9
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

                   Notes to Consolidated Financial Statements

                           December 31, 1996 and 1997


(1)   BUSINESS

      CollaGenex  Pharmaceuticals,  Inc.  ("CollaGenex  Pharmaceuticals"  or the
      "Company") was  incorporated  in Delaware on January 10, 1992. The Company
      is  a  development  stage   pharmaceutical   enterprise   engaged  in  the
      development  and  commercialization  of  innovative,  proprietary  medical
      therapies for the treatment of periodontal  disease and other pathologies.
      The  Company  has funded its  operations  primarily  from the  proceeds of
      public and private placements of its equity securities.

      The accompanying  consolidated financial statements include the results of
      operations  of the Company  and its  wholly-owned  subsidiary  (CollaGenex
      International,  Ltd.) for the period from January 10, 1992  (inception) to
      December 31, 1997. All intercompany  accounts and  transactions  have been
      eliminated in consolidation.

      The Company's business of developing pharmaceutical products is subject to
      a number of significant  risks,  including  risks inherent in research and
      development  activities and in conducting  business in a highly  regulated
      environment.  The  success of the Company  depends to a large  degree upon
      obtaining FDA and foreign regulatory approval to market products currently
      under  development.  There can be no assurance  that any of the  Company's
      product  candidates  will be  approved  by any  regulatory  authority  for
      marketing in any  jurisdiction.  The Company has not generated any product
      revenues and has not experienced  positive cash flow from operations.  The
      Company's  further   development  will  require   significant   additional
      financing.  The Company's deficit accumulated during the development stage
      aggregated $26,362,483 through December 31, 1997.


(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.


                                      F-10
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(2)   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONT.

      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 ("SFAS 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 the
      approximate fair value of the investments based on quoted market prices at
      December 31, 1997. The Company considers all of its current investments to
      be available for sale.

      Equipment
      ---------

      Equipment,  consisting  of computer and office  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.

      Revenue Recognition
      -------------------

      Revenue from license  agreements 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  license  have  been
      satisfactorily  completed.  Contract  revenues are recorded in  accordance
      with the contract provisions as the earnings process is completed.

      Patent Costs
      ------------

      Patent application and maintenance costs are expensed as incurred.

      Licensed Technology
      -------------------

      Costs  incurred in  obtaining  the  license  rights to  technology  in the
      research and development stage are expensed as incurred.

      Research and Development
      ------------------------

      Research and product development costs are expensed as incurred.


                                      F-11
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(2)   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONT.

      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 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.

      Use of 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 8,  Statement of Financial  Accounting  Standards No.
      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 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 amount an
      individual must pay to acquire the stock.  Such amounts are amortized over
      the respective vesting periods of the option grant.

      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
      common  shares,  Series  A,  B and C  mandatorily  redeemable  convertible
      preferred  stock,  and common stock options and warrants  based upon facts
      and circumstances existing at the dates such equity transactions


                                      F-12
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(2)   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONT.

      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.

      Concentration of Credit 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.

      Pro-Forma Net Loss Per Share
      ----------------------------

      For periods  subsequent to the Company's IPO, pro-forma net loss per share
      is calculated by dividing the net loss by the weighted  average  number of
      common shares outstanding for the respective periods.

      Pursuant to Securities and 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
      pro-forma  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 pro-forma diluted net loss per share,
      even though anti-dilutive, as if outstanding for all periods presented. In
      accordance  with the SAB, all prior year per share data has been  restated
      to reflect this new guidance.  The calculation of shares used in computing
      pro-forma basic and diluted net loss per share also included all series of
      mandatorily  redeemable  convertible  preferred stock, assuming conversion
      into shares of common  stock  (using the  if-converted  method) from their
      respective original dates of issuance.


                                      F-13
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(2)   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONT.

      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 has been
      restated upon adoption to conform to the new standard. 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,  which is
      generally  consistent  with the fully  diluted  calculation  under present
      accounting  rules,  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.

      The  following  table sets forth the  calculation  of the total  number of
      shares used in the computation of pro-forma net loss per share,  basic and
      diluted for the years ended December 31, 1995, 1996 and 1997:

                                                 1995         1996       1997
                                              ----------  ----------   ---------
      Pro-forma weighted average common
        shares outstanding - shares used in
        computing pro-forma basic net loss
        per share ...........................  3,354,371   6,572,104   8,291,167
       Shares assumed to be outstanding
        related to stock options granted
        for nominal consideration ...........    110,000      55,000        --
                                              ----------  ----------   ---------
      Shares used in computing pro-forma
        diluted net loss per share ..........  3,464,371   6,627,104   8,291,167
                                              ----------  ----------   ---------
      Pro-forma net loss per share:
           Basic ............................ $    (1.57) $    (0.90)  $  (1.04)
                                              ==========  ==========   =========
           Diluted .......................... $    (1.52) $    (0.89)  $  (1.04)
                                              ==========  ==========   =========

      Options to purchase  725,954 shares of common stock at prices ranging from
      $0.20 to $13.50 per share were  outstanding  at December 31, 1997 but were
      not included in the


                                      F-14
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(2)   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONT.

      computation  of pro-forma net loss per share because the effect would have
      been antidilutive for the periods presented.  These options expire through
      2007.

      New Accounting Pronouncement
      ----------------------------

      Statement  of  Financial  Accounting  Standards  No.  130,  "Comprehensive
      Income" (SFAS 130),  was issued in June 1997.  SFAS 130 becomes  effective
      for the  Company's  fiscal  year  1998 and  requires  reclassification  of
      earlier financial statements for comparative  purposes.  SFAS 130 requires
      that all items defined as comprehensive  income,  including changes in the
      amounts of certain items,  foreign  currency  translation  adjustments and
      gains and losses on certain securities, be shown in a financial statement.
      SFAS 130 does not require a specific  format for the financial  statements
      in which comprehensive income is reported, but does require that an amount
      representing total comprehensive income be reported in that statement. The
      Company  believes the adoption of SFAS 130 will not have a material effect
      on the consolidated financial statements.

(3)   EQUIPMENT

      Equipment consists of the following at December 31, 1996 and 1997:

                                               1996      1997
                                            --------   ---------
      Computer and office equipment .....   $ 75,259   $ 153,446
      Less accumulated depreciation .....     18,763      50,139
                                            --------   ---------
                                            $ 56,496   $ 103,307
                                            ========   =========



                                      F-15
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(4)   ACCRUED EXPENSES

      Accrued expenses consist of the following at December 31, 1996 and 1997:

                                                 1996          1997
                                              ----------   -----------
      Contracted development costs ........   $  376,151   $ 1,085,640
      Professional and consulting fees ....      228,452       510,800
      Payroll and related costs ...........       83,750       244,167
      Miscellaneous taxes .................       46,000        17,102
      Royalties ...........................       12,500        12,500
      Other ...............................       52,072        35,771
                                              ----------   -----------
                                              $  798,925   $ 1,905,980
                                              ==========   ===========

(5)   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  (see note 10  regarding  certain
      Series A shares  issued in  connection  with the  acquisition  of  certain
      technology).  Aggregate net cash  proceeds  from such equity  transactions
      totaled $13,508,273  ($16,532,960 after conversion of promissory notes and
      accrued interest to preferred stock).

      During  1995,  the  Company  issued  convertible  promissory  notes in the
      principal  amount of $3,028,500 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  $3,024,687
      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  $131,952 (principal plus accrued interest) was repaid to
      the note holder in September 1995.


                                      F-16
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(5)   MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK, CONT.

      The holders of Series A, Series B and Series C were originally entitled to
      cumulative  dividends at a 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,
      and all  undeclared  dividends  previously  accreted were  forfeited.  All
      rights with respect to the above noted securities ceased.

(6)   LINE OF CREDIT

      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  equals or exceeds  $10,000,000,  which was met at
      December 31, 1997. 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.

(7)   STOCKHOLDERS' EQUITY

      On April 10, 1996, the Company effected a one-for-two  reverse stock split
      of all outstanding  shares of common stock including shares issuable under
      any stock option plan.  All common share,  per share and pro-forma amounts
      in  the   accompanying   consolidated   financial   statements  have  been
      retroactively restated to reflect this reverse stock split.

      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 $18,026,905.

      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 $11,562,411.


                                      F-17
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(8)   STOCK OPTION PLANS

      The Company has three stock-based compensation plans (the "Plans") and has
      adopted  the   disclosure-only   provisions   of  Statement  of  Financial
      Accounting  Standards  No. 123 (SFAS  123),  "Accounting  for  Stock-Based
      Compensation".  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 at exercise  prices equal to the fair market value on
      the measurement date.

      Deferred  compensation  of $43,250 and  $426,000  was recorded in 1995 and
      1996,  respectively,  for options  granted prior to the Company's  initial
      public  offering  where the  estimated  fair market value of the Company's
      stock on the measurement date exceeded the exercise price of such options.
      Such deferred compensation ($23,067 in 1995 and $150,358 in 1996) is being
      amortized  to  compensation  expense  in  the  accompanying   consolidated
      statements  of  operations  over the  respective  vesting  periods of such
      grants.

      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
      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 four year
      period,   which  may  be   accelerated   for  certain  grants  in  certain
      circumstances.


                                      F-18
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(8)   STOCK OPTION PLANS, CONT.

      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,  109,000  shares,  which was increased to 300,000 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.  During  1996,  total  options
      granted  exceeded the shares available for grant. The fair market value of
      the  Company's  stock on the date of  shareholder  approval  exceeded  the
      exercise  price of such  options  on the date of grant  and,  accordingly,
      deferred  compensation  of $141,750  was recorded in 1997.  Such  deferred
      compensation   is  being   amortized  to   compensation   expense  in  the
      accompanying  consolidated  statements of operations  over the  respective
      vesting period of the grants.

      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, 1997,  there were 421,750 shares available for grant under
      the 1996 Plan and 150,000 under the Non-Employee Director Plan.

      Had the Company  determined  compensation  cost for options granted during
      1995,  1996  and 1997  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:

                                          1995          1996           1997
                                      -----------   -----------   -----------
      Net loss:
           As reported ............   $ 5,268,562   $ 5,918,318   $ 8,623,678
           Pro-forma ..............     5,279,737     6,009,817     9,267,320
      Net loss per basic share:
           As reported ............   $      1.57   $      0.90   $      1.04
           Pro-forma ..............          1.57          0.91          1.12
      Net loss per diluted share:
           As reported ............   $      1.52   $      0.89   $      1.04
           Pro-forma ..............          1.52          0.91          1.12


                                      F-19
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(8)   STOCK OPTION PLANS, CONT.

      Pro-forma net loss reflects only options  granted in 1995,  1996 and 1997.
      Consequently,  the full impact of calculating  compensation cost for stock
      options  under  SFAS No.  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.

      The following is a summary of the activity in the  Company's  stock option
plans:

                                                             Exercise price
                                                Shares         per share
                                               --------      --------------
      January 10, 1992 (inception) .......         --        $    --
         Granted .........................       63,125          0.20
                                               --------
      Balance, December 31, 1992 .........       63,125          0.20
         Granted .........................       36,836          0.20
                                               --------
      Balance, December 31, 1993 .........       99,961          0.20
         Granted .........................       56,750        0.20-0.335
         Exercised .......................      (75,969)         0.20
                                               --------
      Balance, December 31, 1994 .........       80,742        0.20-0.335
         Granted .........................      178,000        0.335-1.20
         Exercised .......................      (25,242)         0.20
                                               --------
      Balance, December 31, 1995 .........      233,500        0.20-1.20
         Granted .........................      200,500        2.00-10.00
         Exercised .......................      (23,750)       0.20-0.335
                                               --------
      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)       0.335-1.20
                                               --------
      Balance, December 31, 1997 .........      725,954      $ 0.20-13.50
                                               ========


                                      F-20
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(8)   STOCK OPTION PLANS, CONT.

      As of December 31, 1997, 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   247,704   7.66 years    $  1.01    128,299      $ 0.68
        9.00 -13.50   478,250   9.19 years      10.17     62,875       10.06

      The weighted  average fair values of stock  options  granted  during 1995,
      1996 and 1997 were $0.79, $7.00 and $5.93 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:

                                      1995      1996      1997
                                      ----      ----      ----
      Expected life in years .......    7         7         5
      Risk-free interest rate ......   6.5%      7.5%      6.25%
      Volatility ...................   60%       60%       60%
      Dividend yield ...............    0%        0%        0%

(9)   INCOME TAXES

      At December 31, 1997, the Company had available net operating loss ("NOL")
      carryforwards of approximately  $23,200,000 and $3,000,000 for Federal and
      state income tax reporting purposes,  respectively, which are available to
      offset future Federal and state taxable income,  if any,  through 2012 and
      2000,  respectively.  The Company also has research  and  development  tax
      credit  carryforwards  of  approximately  $206,000 for Federal  income tax
      reporting  purposes which are available to reduce Federal income taxes, if
      any, through 2012.


                                      F-21
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(9)   INCOME TAXES, CONT.

      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, 1996 and 1997 are presented below:

                                                          1996           1997
                                                      -----------    -----------
      Deferred tax assets:
          Capitalized start-up costs ..............  $ 1,557,864    $   931,440
          Net operating loss carryforwards ........    5,669,500      8,077,526
          Tax credit carryforward .................      130,771        206,309
          Accrued expenses ........................      151,743        170,149
                                                     -----------    -----------
               Total gross deferred tax assets ....    7,509,878    $ 9,385,424
          Less valuation allowance ................   (7,505,124)    (9,383,480)
                                                     -----------    -----------
                   Total deferred tax assets ......  $     4,754          1,944
      Deferred tax liability:
          Depreciation ............................       (4,754)        (1,944)
                                                     -----------    -----------
               Total gross deferred tax liability..       (4,754)        (1,944)
                                                     -----------    -----------
               Net deferred taxes .................  $      --      $      --
                                                     ===========    ===========

      The net  change  in the total  valuation  allowance  for the  years  ended
      December 31, 1996 and 1997 were increases of approximately  $2,963,000 and
      $1,878,000  respectively,  related  primarily to additional  net operating
      losses incurred by the Company.


                                      F-22
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(10)  TECHNOLOGY LICENSE

      At the  time  of its  formation  in  1992,  the  Company  entered  into an
      agreement with the Research Foundation of the State University of New York
      - Stony Brook ("SUNY") whereby the Company received an option to acquire a
      certain technology  license. In return for this option, the Company issued
      to another party (which had previously  licensed the technology from SUNY)
      498,000 shares of Series A mandatorily  redeemable  convertible  preferred
      stock at an  issuance  price of $1.00  per share and  issued  SUNY  54,552
      shares of common stock. In November 1992, the Company issued an additional
      24,396 shares of common stock to SUNY in accordance  with the terms of the
      technology  license in order to  maintain  SUNY's  ownership  at 5% (which
      requirement   ceased  upon  the  Company   having  raised   $3,000,000  of
      financing).  The  Company  recorded  a  $513,789  charge to  research  and
      development  expense in the 1992  consolidated  statement of operations in
      connection with these common and preferred stock issuances.

      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 paid annual royalties of
      $50,000 in 1995, 1996 and 1997.

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

(11)  COMMITMENTS AND CONTINGENCIES

      In January 1995, the Company  entered into an exclusive  supply  agreement
      with a vendor to purchase a principal raw material  component required for
      its product that is currently  under  development.  This supply  agreement
      expires in January 2000 with automatic two-year renewal periods. There are
      no minimum purchase commitments applicable to such agreement.

      In April 1995, the Company entered into a manufacturing  agreement for the
      manufacture  of  Periostat(R).  Under  the  terms of this  agreement,  the
      Company is  obligated to annual  minimum  purchase  commitments  with such
      vendor for three years following the date of initial  product  launch,  as
      defined.


                                      F-23
<PAGE>


                        COLLAGENEX PHARMACEUTICALS, INC.
                                 AND SUBSIDIARY

                        (A Development Stage Enterprise)

              Notes to Consolidated Financial Statements, Continued


(11)  COMMITMENTS AND CONTINGENCIES, CONT.

      The Company  maintains  various  operating  leases,  primarily  for office
      space.  As of December  31,  1997,  future  minimum  rent  payments  under
      noncancellable leases are as follows:

                            1998......   $  57,672
                            1999......      48,672
                            2000......      48,672
                                         ---------
                            Total.....   $ 155,016
                                         =========

      Rent expense for the years ended December 31, 1995,  1996 and 1997 totaled
      $58,259, $63,368 and $69,828, respectively.

      The Company is involved in various claims and legal actions arising in the
      ordinary  course of business.  In the opinion of management,  the ultimate
      disposition  of these matters will not have a material  adverse  effect on
      the Company's  consolidated  financial position,  results of operations or
      liquidity.

(12)  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 1995,  1996 or 1997 in  accordance  with the
      terms of the 401(k) Plan.

(13)  CONTRACT RESEARCH AGREEMENT

      In September 1994, the Company entered into a 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 by the  research  company  as  research
      services are performed.  Costs  incurred  under this agreement  aggregated
      approximately  $1,679,000,  $1,766,000,  $1,030,000 and $5,104,000 for the
      years ended December 31, 1995,  1996, 1997 and the period from January 10,
      1992 (inception) to December 31, 1997, respectively.


                                      F-24