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UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington D.C. 20549




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FORM 10-K



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|                                                         |  |                                                                                           
|-------------------------------------------------------- |  | ------------------------------------------------------------------------------------------
|(Mark One)                                               |  |                                                                                           
|þ                                                        |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
	15(d)
	OF THE SECURITIES EXCHANGE ACT OF 1934    
|                                                        
|For the fiscal year ended December 31,
	2001            
|                                                        
|OR                                                      
|                                                        
|o                                                        |  | 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: 0-28402



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ARADIGM CORPORATION

(Exact Name of Registrant as Specified in Its
Charter)


|                                                                |  |                                      
|--------------------------------------------------------------- |  | -------------------------------------
|California                                                      |  | 94-3133088                           
|(State or Other Jurisdiction of
	Incorporation or Organization) |  | (I.R.S. Employer
	Identification No.)

3929 Point Eden Way, Hayward, CA
94545

(Address of Principal Executive
Offices)


Registrants telephone number, including
area code:

(510) 265-9000


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

None


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

Common Stock, no par value




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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 þ          No o

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. o

As of February 28, 2002, there were
29,543,883 shares of common stock outstanding. The
aggregate market value of common stock held by non-affiliates of
the Registrant was approximately $65,317,000 based upon the
closing price of the common stock on February 28, 2002 on
The Nasdaq Stock Market. Shares of common stock held by each
officer, director and holder of five percent or more of the
outstanding common stock have been excluded in that such persons
may be deemed to be affiliates. This determination of affiliate
status is not necessarily a conclusive determination for other
purposes.

Items 10, 11, 12 and 13 of Part III
incorporate information by reference from the Registrants
definitive proxy statement for the Annual Meeting of
Shareholders to be held on May 17, 2002.



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TABLE OF CONTENTS



|               |                                                                                               |  |  |  |  |  |  | 
|-------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I        
|               | Item 1. Business                                                                             
|               | Item 2. Properties                                                                           
|               | Item 3. Legal Proceedings                                                                    
|               | Item 4. Submission Of Matters To A Vote Of Security Holders                                  
|PART II       
|               | Item 5. Market for the Registrants Common Stock and Related Stockholder Matters             
|               | Item 6. Selected Financial Data                                                              
|               | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|               | Item 7A. Quantitative and Qualitative Disclosure About Market Risk                           
|               | Item 8. Financial Statements and Supplementary Data                                          
|               | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 
|PART III      
|               | Item 10. Directors and Executive Officers Of The Registrant                                  
|               | Item 11. Executive Compensation                                                              
|               | Item 12. Security Ownership Of Certain Beneficial Owners and Management                      
|               | Item 13. Certain Relationships and Related Transactions                                      
|PART IV       
|               | Item 14. Exhibits, Financial Statements Schedules, And Reports On Form 8-K                   
|EXHIBIT 3.3   
|EXHIBIT 3.5   
|EXHIBIT 3.6   
|EXHBIIT 10.15A
|EXHIBIT 10.15B
|EXHIBIT 10.22 
|EXHIBIT 10.23 
|EXHIBIT 23.1  



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PART I




Item 1.     Business

This Report on Form 10-K contains
forward-looking statements, including, without limitation,
statements regarding timing and results of clinical trials, the
timing of regulatory approvals, the establishment of corporate
partnering arrangements, the anticipated commercial introduction
of our products and the timing of our cash requirements. These
forward-looking statements involve certain risks and
uncertainties that could cause actual results to differ
materially from those in such forward-looking statements.
Potential risks and uncertainties include, without limitation,
those mentioned in this Report and, in particular, the factors
described below in Part II under the heading Risk
Factors.

Overview

Aradigm Corporation is a leading developer of
advanced pulmonary drug delivery systems for the treatment of
systemic conditions as well as lung diseases. Our hand-held AERx
platform is being designed for the rapid and reproducible
delivery of a wide range of pharmaceutical drugs and biotech
compounds via pulmonary delivery or through the lung. We believe
that our non-invasive AERx systems, which have been shown in
clinical studies to achieve performance comparable to injection,
will be a welcome alternative to injection-based drug delivery.
In addition, our systems may improve therapeutic efficacy in
cases where other existing drug delivery methods, such as pills,
transdermal patches or inhalers, are too slow or imprecise.

According to IMS Health Incorporated, the total
United States market for injectable drugs was approximately
$20 billion in 2000. Of this market, we believe that drugs
with aggregate sales in excess of $7 billion could
potentially be delivered using the AERx platform. In addition,
most biotech compounds currently under development rely on
injection as their primary means of delivery.

We have tested 11 compounds in human
clinical trials, including Phase 2b clinical trials that
were successfully completed during the fourth quarter of 2001.
We have attracted the attention of some of the worlds
leading pharmaceutical and biotechnology companies, who have
contributed cumulatively over $88 million in contract
revenue for the advancement of our AERx technology. Our most
advanced programs are based on development partnerships with:



| |   |                                                                                                                    
| | - | -------------------------------------------------------------------------------------------------------------------
| |  | Novo Nordisk A/S, the world leader in
	insulin products, for the needle-free delivery of insulin for
	diabetes; and
|
| |  | SmithKline Beecham, now GlaxoSmithKline plc, for
	the rapid, needle-free delivery of morphine to treat severe pain.

We believe that our technology platform will
provide the basis for the next generation in pulmonary drug
delivery systems. Our AERx platform is based on a set of
proprietary technologies, protected to date by 77 issued
United States patents, that control the physical factors
critical for rapid, reproducible pulmonary drug delivery. These
proprietary technologies allow us to:



| |   |                                                                                                 
| | - | ------------------------------------------------------------------------------------------------
| |  | utilize existing liquid formulation technology
	instead of more expensive dry powder processing;
|
| |  | consistently create the high-quality aerosol
	required to reach the deep lung;                  
|
| |  | guide patients to inhale in the most effective
	manner for deep lung delivery; and              
|
| |  | automatically monitor and control patient drug
	usage, allowing for better disease management.  

Background  Pulmonary Drug
Delivery

Today an increasing number of drugs, including
nearly all biotech drugs, are delivered by injection. While
injections are quick and efficient, they have inherent
limitations, including inconvenience, discomfort and risk of
infection. These limitations have prompted drug manufacturers to
explore alternatives such as improved oral delivery
formulations, transdermal, or through the skin, patch
technologies and pulmonary delivery

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systems. Due to the natural ability of the lung
to transfer molecules into the bloodstream, pulmonary drug
delivery systems are now being pursued as a primary alternative
to injection.


Pulmonary delivery systems were originally
developed to treat lung diseases by depositing aerosolized, or
fine particles or mists of, medication in the large airways of
the lung. These aerosols were created in medical devices,
i.e. nebulizers, metered-dose inhalers and dry powder
inhalers, for inhalation by the patient. While these systems
have been useful in the treatment of diseases such as asthma,
they generate a wide range of particle sizes, only a portion of
which can reach the targeted lung tissues, and rely heavily on
proper patient breathing technique to effect actual delivery.

Considerable recent research has been devoted to
developing a means to create well defined small particle
aerosols suitable for efficient pulmonary delivery of drugs,
either to treat lung diseases or for absorption into the
bloodstream for systemic effect. To deliver pharmaceuticals to
or through the lungs, drugs must be transformed into an aerosol
that can be inhaled by the patient. In order for aerosols to be
delivered to the deep lung, the individual particles must be
small, three microns or less in diameter, and the velocity of
these particles must be low as they pass through the upper
airways and into the deep lung. The particle velocity is largely
determined by how fast the patient is inhaling. Larger or fast
moving particles typically get deposited in the mouth or upper
airways where they cannot be absorbed and may not be effective.

Recent advances in dry powder formulation
technology have made possible the creation of smaller particle
aerosols suitable for more efficient deep lung delivery, and
several companies are developing systems based on this approach.
However, most drugs being considered for pulmonary delivery are
currently marketed in stable liquid formulations. We believe the
extra steps involved in making dry powder formulations of these
drugs will make them more difficult and costly to produce than
liquid-based formulations. In addition, todays dry powder
delivery systems under development continue to rely on
individual patient breathing technique to effect the actual drug
delivery. It is well documented that the typical patient
frequently strays from proper inhalation technique and may not
be able to maintain a consistent approach over even moderate
periods of time after training. Given the need with many
medications to achieve precise and reproducible dosing,
variability in technique among patients or from dose to dose may
compromise safety or therapeutic efficacy.

The Aradigm Solution

Our AERx technology platform is being developed
to enable pulmonary delivery of a wide range of pharmaceuticals
in liquid formulations for local or systemic effect. Our
proprietary AERx technologies focus principally on small
particle aerosol generation from liquid formulation at the point
of delivery and control over patient inhalation technique in
order to efficiently and reproducibly deliver the aerosol drug
to the deep lung. We have developed these proprietary
technologies through an integrated approach that combines
expertise in physics, electrical engineering, mechanical
engineering, laser engineering and pharmaceutical sciences. The
key features of the AERx platform include:

Ease of Drug
Formulation

The AERx platform takes advantage of existing
liquid drug formulations, reducing the time, cost and risk of
formulation development compared to dry powder-based
technologies. The liquid formulation technology of the AERx
platform allows us to use standard, sterile pharmaceutical
manufacturing techniques. We believe that this approach will
result in lower cost production methods than those used in dry
powder systems because we are able to bypass entirely the
complex formulation processes required for those systems.
Moreover, the liquid drug formulations used in AERx systems are
expected to have the same stability profile as the currently
marketed versions of the same drugs.

Efficient,
Precise Aerosol Generation

Our proprietary technology produces the
low-velocity, small-particle aerosols necessary for efficient
deposition of a drug in the deep lung. Liquid drug formulations
are aerosolized from pre-packaged, single-use, disposable
packets using the hand-held AERx device. Each disposable packet
is comprised of a small blister package of drug adjacent to an
aerosolization nozzle. The AERx device compresses the packet to
push the

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drug through the nozzle and thereby creates the
aerosol. No propellants are required since mechanical pressure
is used to generate the aerosol. Each packet is used only once
to avoid plugging or wear that would degenerate aerosol quality
if reused. Through this technology, we believe we can achieve
highly efficient and reproducible aerosols.


Automated
Breath-Controlled Delivery

Studies have shown that even well trained
patients tend to develop improper inhalation technique over
time, resulting in less effective therapy. The AERx platform
employs a patented technology to electronically measure the
patients inhalation flow rate through the mouthpiece of the
hand-held device. Indicator lights on the device guide the
patient to inhale slowly and evenly for optimal drug delivery.
When the desired flow rate is established early in the breath,
drug delivery is automatically initiated. As a result, a
consistent dose of medication is delivered each time the product
is used.

Individual AERx systems can also be designed to
incorporate features desirable for the particular therapeutic
application through customization of the patient interface. For
example, the electronic inhaler can record information, such as
the date, the time and the name of the drug on each dose
delivered. An AERx system can also be configured to impose timed
programmable lockouts and to limit access to the inhaler to
authorized users. We can even design the system to allow the
patient to adjust the dosage administered from an individual
packet if that degree of precision is required for effective
therapy.

Strategy

Our goal is to become the leader in the
development and commercialization of pulmonary drug delivery
products. Our strategy incorporates the following principal
elements:

Establish
Broad Applicability of the AERx Platform

We believe that the AERx platform will be broadly
applicable to drugs that are intended for systemic delivery and
for local delivery to the lung. Many patients suffering from
pain, diabetes, obesity, cancer, AIDS, Parkinsons disease,
multiple sclerosis, hepatitis, growth hormone deficiency and
other debilitating chronic diseases currently can only get
effective treatment by injection. In addition to two major
collaborations, we are conducting clinical and preclinical
studies on a number of compounds to demonstrate the
applicability of the AERx platform to a broad range of molecule
sizes and types, including small and large proteins and other
substances to distribute genetic materials in the body. We
believe this strategy will maximize the number of commercial
product opportunities for us and will increase the interest of
potential partners in developing drugs for the AERx platform,
thereby reducing our dependence on any single product.

In addition, our work on proteins and gene vector
delivery anticipates the role that genomics and proteomics are
expected to play in future drug discovery. Many new drugs
developed as a result of information garnered from efforts to
sequence and study the human genome will be composed of protein
or DNA. Pulmonary drug delivery may be the only viable
non-invasive way to deliver many of these new therapies. We
believe that the capabilities of the AERx platform will make it
particularly attractive for these potential future applications.

Focus on
Quicker-to-Market Opportunities

Our principal commercial development efforts have
been focused on product opportunities that have the potential to
reach the market quickly. As part of this effort, we seek to
minimize development risk by focusing on marketed drugs that are
well characterized and have demonstrated safety profiles. This
approach is evidenced by the drugs (insulin and morphine) that
underlie our two leading development programs.

Expand
Existing and Develop New Collaborative
Relationships

In order to enhance our commercial opportunities
and effectively leverage our core scientific resources, we
intend to continue entering into multiple collaborative
relationships with pharmaceutical and biotech

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companies for the development and
commercialization of new products utilizing our technologies.
Through product development collaborations, we seek access to
proprietary pharmaceutical compounds as well as to the resources
and expertise necessary to conduct late stage clinical trials
and obtain regulatory approvals. In addition, we will continue
pursuing relationships with companies with established sales
forces and distribution channels in our target markets. Where
consistent with other objectives, we plan to give preference to
development partners whose pipelines contain multiple products
whose value could be enhanced by our AERx pulmonary drug
delivery technology. For example, we believe that our existing
two development partners have the potential to develop
additional products using our AERx technology. By establishing
such collaborative relationships, we intend to introduce
multiple new products while avoiding the need to establish drug
discovery research and sales and marketing capabilities for each
target market.


Create a
Large and Loyal Customer Base

Our goal is to create a large and loyal customer
base that will repeatedly purchase disposable AERx packets. The
disposable packets are expected to generate most of our revenues
and substantially all of our profits over time. The AERx device
is being designed to be a convenient hand-held unit that has
features that meet the specific needs of patients in each
therapeutic category. We believe that physicians and patients
will find our unique product features attractive relative to
anticipated competitive products. We intend to capitalize on
what we believe will be a customer preference for the
value-added features of our AERx device by pricing the device
competitively to help ensure ongoing repeat usage of the
high-margin disposable AERx packets. We believe that patients
will tend to remain loyal to a superior product for the life of
the device. Accordingly, we are designing the AERx device to
last for several years.

Enhance Our
Strong Proprietary Position

We believe that establishing a strong proprietary
position in pulmonary drug delivery could provide an important
competitive advantage in our target markets. We have
aggressively pursued comprehensive patent protection of our
technology and, as of February 28, 2002, had 77 issued
United States patents with a number of additional United States
patent applications pending. While there can be no assurance
that any of our patents will provide a significant commercial
advantage, these patents are intended to provide protection for
important aspects of our technology, including aerosol
generation, breath control, compliance monitoring and unit-dose
formulation. In addition, we are maintaining as trade secrets
key elements of our manufacturing technologies, particularly
those associated with production of disposable unit-dose packets
for the AERx systems.

Maintain
Technological Leadership

We are making a substantial research and
development investment to establish and maintain technological
leadership in pulmonary drug delivery. This includes a research
and development program to design the future generations of the
AERx technology platform. The goal of this program is to access
a wider range of markets, broaden our technology base, achieve
manufacturing efficiencies and reduce the size and weight of our
hand-held devices.

Aradigm Product Applications

We are developing the hand-held AERx platform
based on a comprehensive approach to pulmonary drug delivery
that includes drug formulation, aerosol generation, patient
breath control and compliance monitoring technologies. We are
currently developing AERx products for pain and diabetes
management. In addition, we are planning to develop AERx systems
for the non-invasive delivery of certain other drugs, including
proteins, peptides, gene vectors and small molecules.

AERx insulin
Diabetes Management System

We are developing the AERx insulin Diabetes
Management System to permit patients with diabetes to
non-invasively self-administer insulin. We believe that
patients, when provided with a non-invasive delivery

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alternative to injection, will be more likely to
self-administer insulin as often as needed to keep tight control
of their blood glucose levels. We are developing and planning to
commercialize this product in collaboration with Novo Nordisk.
We successfully completed a Phase 2b clinical trial in
November 2001. We are now focused on preparing for Phase 3
clinical trials, which Novo Nordisk currently intends to
commence during the summer of 2002. There can be no assurance
that this development program will be successful.


The
Market

Unregulated glucose levels in people with
diabetes are associated with short and long-term effects,
including blindness, kidney disease, heart disease, amputation
resulting from chronic or extended periods of reduced blood
circulation to body tissue and other circulatory disorders.
Patients with Type 1 diabetes do not have the ability to
produce their own insulin and must self-inject insulin regularly
to control their disease. Patients with Type 2 diabetes are
unable to efficiently use the insulin that their bodies produce.
While they may have some impairment in their ability to produce
insulin as well, it is the defect in their ability to use
insulin efficiently that leads to the addition of insulin to
their treatment program. By increasing the circulating insulin
concentration in their bodies, patients with Type 2
diabetes can partially overcome the inefficiency. The Diabetes
Control and Complications Trial study of patients with
Type 1 diabetes sponsored by National Institutes of Health
indicated that insulin doses should be adjusted throughout the
day in response to frequently measured blood glucose levels. The
Diabetes Control and Complications Trial study showed that
keeping blood glucose levels as close to normal as possible
slows complications caused by diabetes. In fact, the Diabetes
Control and Complications Trial study demonstrated that any
sustained lowering of blood glucose levels is beneficial, even
if the person has a history of poor blood glucose control.
Separately, the United Kingdom Prospective Diabetes Study has
also demonstrated that tighter blood glucose control can provide
essentially the same benefits for patients with Type 2
diabetes.

We believe that approximately 800,000 Americans
suffer from Type 1 diabetes. Virtually all of them are on
daily insulin injection therapy, and most are currently
monitoring their own blood glucose level. According to the
Center for Disease Control, as of 2000, approximately ten
million Americans had been diagnosed with Type 2 diabetes.
These Type 2 diabetes patients consume the majority of
insulin used in the United States due to their larger numbers.
However, given their less severe impairment, many of these
patients are reluctant to use injection-based therapy. We
believe that this failure to comply with recommended therapies
contributes to approximately $45 billion in annual direct
costs associated with the treatment of diabetes. Through our
convenient, non-invasive AERx insulin Diabetes Management
System, we believe we can address this patient reluctance,
reduce overall treatment costs and grow the total worldwide
insulin market beyond 1999 levels of $3.6 billion. The
leading supplier of insulin is Novo Nordisk, followed by Eli
Lilly, and these two companies together account for more than
90% of the worldwide insulin market.

The
Product

Patients with diabetes often avoid or limit the
amount of insulin therapy because of the pain and inconvenience
of administering the drug by injection. The AERx insulin
Diabetes Management System is being designed as a painless and
convenient alternative to drug injection to enable patients with
diabetes to comply more effectively with their insulin therapy,
thereby lessening the risk of long-term complications. We also
believe that the features of the AERx insulin Diabetes
Management System will allow people with diabetes to achieve
more consistent and precise control over their blood glucose
levels. A clinical study conducted by us in healthy fasting
volunteers has shown that the way an individual breathes during
drug delivery has a significant effect on the pharmacokinetic
(measurement of drug level in the blood) profile of the
delivered insulin. We believe that the proprietary breath
control technology incorporated in the AERx insulin Diabetes
Management System may eliminate this potential variability as a
factor in the pulmonary delivery of insulin.

Standard insulin therapies presently require that
doses of insulin given by injection be adjusted in increments of
one international unit, which is a standard unit of measure for
insulin. We are not aware of any competitive products under
development that are being designed to provide the same one unit
dosing adjustability as the AERx insulin Diabetes Management
System. We believe that our AERx insulin Diabetes

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Management System can provide a non-invasive
method for delivery of insulin that would be very efficient and
easily reproduced. Clinical studies conducted by us to date have
demonstrated that insulin delivered via a prototype of the AERx
insulin Diabetes Management System achieved maximum blood
glucose reductions in healthy fasting volunteers in half the
time required for subcutaneous, or under the skin, insulin
injections. We believe this more rapid onset of action could
allow people with diabetes to dose themselves closer to
mealtimes, better matching insulin levels to caloric intake. The
reductions in blood glucose levels were also at least as
reproducible in both magnitude and time to maximum reduction as
subcutaneous injections.


Clinical
Development

In 2000, we presented data that showed that as
the dose of insulin inhaled from our AERx system is increased,
both the blood level of insulin and its ability to reduce
glucose in the blood are increased proportionally. A publication
by Brunner et al at the American Diabetes Association
(ADA) meeting in San Antonio, Texas, showed proportionately
increasing blood levels of insulin with increasing AERx insulin
doses in 18 female and male, non-smoking, Type 1 diabetic
subjects. The euglycaemic clamp method, which is a method by
which the effect of insulin is measured by the incremental
amount of glucose required to keep the blood glucose level
constant in the body, used in this study demonstrated a linear
or proportional response to the insulin delivery as measured by
the glucose infusion rate. The efficiency of the amount of
insulin packaged in an AERx dosage form relative to insulin
injected from a syringe was approximately 13%. We presented
similar results from a study of AERx insulin given immediately
before a standard meal, compared to insulin given by
subcutaneous injection 30 minutes prior to the meal. A
study by Kipnes et al in 20 Type 1 diabetics was
presented at the European Association for the Study of Diabetes
(EASD) meeting in Jerusalem, Israel. The AERx system
efficiency compared to subcutaneous insulin injections was 16%
when comparing blood insulin levels and 17% when comparing blood
glucose levels. These data mean that insulin, when inhaled, may
require six to eight times more drug than when it is injected to
have the same effect. We also completed a number of concurrent
clinical studies in both healthy subjects and in diabetic
subjects in 2000 in preparation for the upcoming pivotal trials.

In November 2001, we successfully completed
Phase 2b clinical trials for our AERx insulin Diabetes
Management System, which showed that the product may be
successfully used to treat Type 2 diabetes patients with
insulin delivered via the pulmonary route. The Phase 2
trial was designed to investigate the safety and efficacy of
pulmonary insulin via the AERx insulin Diabetes Management
System compared to intensified treatment with insulin injections
in patients with Type 2 diabetes. Approximately
100 patients were included for a twelve-week period in the
study. The results of the study showed the AERx insulin Diabetes
Management System to be at least as effective as intensified
subcutaneous injections of insulin.

The
Collaboration

In June 1998, we entered into a product
development and commercialization agreement with Novo Nordisk,
the world leader in insulin therapy, covering the use of the
AERx insulin Diabetes Management System for the delivery of
blood glucose regulating medicines. Novo Nordisk has been
granted worldwide sales and marketing rights to any products
developed under the terms of the agreement, and we retain all
manufacturing rights. For any system developed under the
collaboration, which receives regulatory approval, we expect to
receive a share of gross profit on the sales of such products by
Novo Nordisk.

Pursuant to the Novo Nordisk agreement, we could
receive approximately $38 million in milestone payments in
addition to reimbursement for product development expenses and
$10 million in equity investments by the time the first
product from the collaboration is commercialized. Through
December 31, 2001, we received from Novo Nordisk
approximately $61.3 million in product development
payments, approximately $7 million in milestone payments
and $10 million from the purchase of our common stock by
Novo Nordisk, $5 million of which was sold at a
25% premium to market price. Through December 31,
2001, of the payments received approximately $51.9 million
of product development and $3.5 million of milestone
payments have been recognized as contract revenue. Additional
milestone payments and product development payments will be paid
by Novo Nordisk if Novo Nordisk and we decide to jointly develop
additional AERx products under the terms of the agreement.

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In October 2001, we entered into a common stock
purchase agreement with Novo Nordisk Pharmaceuticals, Inc., an
affiliate of Novo Nordisk A/ S, pursuant to which Novo Nordisk
Pharmaceuticals purchased $20 million of our common stock
at the fair market price. We also have the option under the
agreement to sell an aggregate of up to $25 million
additional shares to Novo Nordisk Pharmaceuticals for the
purchase price provided in the agreement by delivering written
notice, or a share sales notice, to Novo Nordisk Pharmaceuticals
of our election to sell additional shares. Subject to certain
restrictions, we may deliver a sale shares notice specifying an
amount between $5 million and $10 million for Novo
Nordisk Pharmaceuticals to purchase once every three months
until we have sold an aggregate of $25 million additional
shares of common stock to Novo Nordisk Pharmaceuticals. The sale
of additional shares is subject to certain conditions,
including, among other things, Novo Nordisk not owning more than
45% of our outstanding common stock and the accuracy of certain
representations. Novo Nordisk and its affiliates currently own
approximately 23% of our outstanding common stock. In a separate
agreement, we and Novo Nordisk agreed to share manufacturing
responsibilities where Novo Nordisk has accepted all
responsibility for high volume production beyond the capacity of
our first factory. This has potentially shifted a significant
future investment in additional manufacturing capacity to Novo
Nordisk and was accomplished without changing the basic economic
arrangements of the original agreement.

AERx Pain
Management System

We are developing the hand-held AERx Pain
Management System as a non-invasive, patient-controlled
pulmonary drug delivery product for treatment of severe pain. We
are developing and plan to commercialize this product in
collaboration with GlaxoSmithKline. In October 2001, we
successfully completed Phase 2b clinical trials of the AERx
Pain Management System. We will be working with GlaxoSmithKline
to determine the next steps for the AERx morphine program.
Future progress for this program is contingent on either
GlaxoSmithKline recommitting to this program or a new partner
entering into another development agreement with us. We will
continue to prepare this program towards commencement of
Phase 3 clinical trials, which could occur 6 to
12 months after entering into a development agreement with
a new partner. There can be no assurance that this development
program will be successful.

The
Market

We have targeted cancer pain and other chronic
pain as the first two applications for the AERx Pain Management
System. More than four million cancer patients worldwide
suffer from pain, a majority of which experience multiple
breakthrough pain events each day. Breakthrough pain relates to
extreme levels of pain the patient experiences that is above and
beyond the pain level being managed by routine use of
medication. The market for potent narcotic analgesics (pain
killers) to treat such pain events in the United States in 2000
was approximately $3.8 billion.

Most pain medication taken by patients at home is
delivered orally or by transdermal patch. These methods are
typically slow to act and difficult to adjust to match the level
of pain. Intravenous patient-controlled analgesia products,
which are used primarily in hospitals, allow patients to
self-administer pain medication on demand from a
microprocessor-controlled infusion pump. Although effective for
treating severe pain, widespread adoption of patient-controlled
analgesia outside the hospital has been limited by the regular
and expensive maintenance required by its use. Home use of
patient-controlled analgesia can cost as much as $4,000 per
month, due partially to the home nursing required to maintain
the needle site. However, there are currently no non-invasive
pain management products that can match the speed of intravenous
administration of narcotic analgesics for rapid relief of
breakthrough pain events.

The
Product

We believe that a patient-controlled,
non-invasive drug delivery system that enables rapid uptake of
medication could significantly expand the market for pain
management in the outpatient setting and improve the management
of pain in the hospital. The AERx Pain Management System is
expected to have features similar to current intravenous
patient-controlled analgesia systems, but without the need for
intravenous access and the resulting impairment of patient
mobility and risk of infection. The AERx Pain Management

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System is being designed to be programmed to
allow for patient-activated delivery in accordance with a
physician-directed dosing program. Lockout mechanisms being
designed for the product should eliminate the risk of
inappropriate dosing, and a patented electronic patient
identification feature should prevent unauthorized use of the
device. An automatically maintained dosing event diary kept by
the AERx Pain Management System is designed to allow a physician
to closely monitor patient use. We believe that these features
of the AERx Pain Management System, combined with the inherent
speed of onset of pulmonary delivery, should provide a
significant advance in pain management with important
applications in both the home and hospital settings.


Clinical
Development

In 2000, we reported the start of a Phase 2b
study using the AERx Pain Management System to deliver inhaled
morphine to cancer patients and also the results of two
completed clinical studies involving inhaled fentanyl (narcotic
agent) via the AERx Pain Management System.

The two fentanyl studies were conducted at the
Centre for Anaesthesia and Pain Management Research, University
of Sydney at Royal North Shore Hospital, Sydney, Australia. The
first study involved 10 healthy volunteers and was designed to
evaluate the safety and pharmacokinetic profile of inhaled
fentanyl. The subjects received two inhalations of fentanyl via
the AERx Pain Management System followed one week later by an
intravenous drip of fentanyl. Results showed an average inhaled
bioavailability (the fraction of drug dosage in each unit-dose
packet absorbed into the blood) of 67% from the AERx Pain
Management System, with a plasma or blood profile very similar
to that of the intravenous injection. This means that inhaled
fentanyl may require one-third more drug than the injectable
form to have the same effect. These data were presented at the
29th Annual Meeting of the American College of Clinical
Pharmacology held in September 2000, in Chicago, Illinois.

The second trial on fentanyl via the AERx Pain
Management System was an open-label (where the patient knows
which drug they are taking) study of 20 cancer patients who were
experiencing breakthrough pain episodes and who were receiving
opioid-based pain management. Results of this study showed that
all patients were able to achieve satisfactory breakthrough pain
relief using the AERx Pain Management System. The average time
to satisfactory pain relief was 10 minutes (range 6-24
minutes) which is similar to that reported for intravenous
fentanyl. Ninety percent of patients expressed very good to
excellent pain relief on the AERx Pain Management System. The
results of this study were presented at the 19th Annual
Scientific Meeting of the American Pain Society held in November
2000, in Atlanta, Georgia.

In December 2001, we successfully completed
Phase 2b clinical trials for our AERx Pain Management
System. The multicenter, Phase 2b AERx morphine trials were
conducted in the United States and Australia. Over 100 patients
were treated in two separate studies. In a study of 16 patients
with breakthrough pain from advanced cancer, AERx morphine
demonstrated significantly faster onset of pain control and
comparable overall pain relief when compared to immediate
release oral morphine solution. In a separate study of 89
patients with acute postoperative pain, the AERx Pain Management
System was shown to provide pain relief comparable to
intravenous morphine when given in similar doses. These data
were presented at the American Pain Society 21st Annual
Scientific Meeting held in March 2002, in Baltimore, Maryland.

The
Collaboration

In September 1997, we entered into a product
development and worldwide commercialization agreement with
SmithKline Beecham (now GlaxoSmithKline) covering the use of the
AERx Pain Management System for the delivery of narcotic
analgesics. In December 2000, the agreement was amended to
transfer control of further development and provide certain
other new rights to us. We also assumed responsibility for
financing the remainder of all development activities under the
agreement, as amended. Under the terms of the amended agreement,
unless GlaxoSmithKline or we have terminated the agreement,
GlaxoSmithKline can restore its rights and obligations to
participate in and fund development and commercialization of the
AERx Management System upon payment of a restoration fee. We
anticipate that GlaxoSmithKline will review its restoration
election after the delivery of Phase 2b trial results,
which will be made available to them in the first

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half of 2002, but there can be no assurance that
GlaxoSmithKline will elect to restore its rights. If we elect to
terminate the agreement and continue or intend to continue any
development activities, either alone or in collaboration with a
third party, then we will be required to pay an exit fee to
GlaxoSmithKline. The payment of the exit fee would not have a
material impact on our financial position or operating results.
We have the right to explore partnering options with other
companies while this agreement is in effect. We are currently in
discussions with several alternate partners that may participate
in this product if GlaxoSmithKline does not continue in its
capacity. If GlaxoSmithKline elects to restore its rights under
the agreement and if this system receives regulatory approval,
we would expect to sell AERx hand-held devices and drug packets
to, and to receive royalties on sales by, GlaxoSmithKline.
Through December 31, 2001, we had received from
GlaxoSmithKline and recognized as contract revenue approximately
$23.7 million in product development and milestone payments
and $10 million from the purchase of our common stock by
GlaxoSmithKline, $5 million of which was sold to
GlaxoSmithKline at a 25% premium to market price. No additional
product development or milestone payments were received during
2001.


Additional
Potential AERx Applications

We believe that the AERx system has applicability
for a range of compounds developed by pharmaceutical and
biotechnology companies, including many compounds that cannot be
delivered orally. Due to their large size and poor oral
bioavailability, large molecules developed by the biotechnology
industry are typically developed in liquid formulations and
delivered by injection. We believe that the AERx platform can
provide for improved delivery and increased utilization of these
therapies.

We believe that we have greater experience in
human clinical trials than any other company in the advanced
pulmonary drug delivery market. In addition, we believe that the
breadth of our human testing, which has encompassed both small
molecules and large molecules for both local lung delivery and
systemic delivery, is the most comprehensive ever conducted in
pulmonary drug delivery.

We currently have six programs that are
developing or evaluating the use of the AERx delivery technology
across a range of drug therapies. In addition to our
collaboration with Novo Nordisk, these programs include a
Stage II grant from the National Institutes of Health to
evaluate the use of the AERx platform for delivery of gene
therapies.

In addition to the above active programs, we have
conducted feasibility testing across a broad range of molecules,
including three additional compounds where we have conducted
early phase clinical trials that we believe could be pursued in
the future. Some of these molecules are listed below:

|                                                                                                                             |  |                                                                                                   
|---------------------------------------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------------------------------
|Chronic bronchitis and emphysema drugs
	Antibodies
	Gene therapies
	Asthma drugs
	Hematopoetic factors
	Human growth factors |  | Anti-obesity drugs
	Migraine drugs
	Anti-Parkinsons drugs
	Interleukins
	Interferons
	Antibiotics

Sales and Marketing

We plan to establish additional collaborative
relationships, similar to our agreement with Novo Nordisk, to
develop and commercialize our AERx products. Through these
collaborations, we intend to access resources and expertise to
conduct late-stage clinical development and to market and sell
AERx products. Ideal development partners will generally have
both a commercial and a development presence in the target
market, and will also have a commitment to grow that market via
our drug delivery technology. Where consistent with other
objectives, we plan to give preference to development partners
whose pipelines contain multiple products whose value could be
enhanced by our AERx pulmonary drug delivery technology.

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Manufacturing

Our clinical packet manufacturing facility was
completed and validated in July 1998. We believe that it is
capable of producing the AERx unit-dose packets in volumes
adequate to support all of our current and anticipated clinical
trials for our products under development and limited commercial
requirements. Current capacity of this facility exceeds
50 million disposable packets per year.

While significant capital expenditures will be
required to provide for the high-volume drug packet capacity
needed to support commercialization of multiple AERx products,
that capacity will be based on existing standard pharmaceutical
manufacturing processes and no significant additional process
development will be necessary. As a result, we believe that we
can move too much higher levels of scale in a reasonably
predictable manner and with minimal risk to our product
development programs.

We completed the construction of a new facility
for commercial scale production in 2001. We plan to internally
produce the disposable nozzles, assemble the disposable
unit-dose packets and fill the drug into the unit-dose packets.
We will look to contract manufacturers to produce the main
components and subassemblies for the AERx devices, but we plan
to perform final assembly, calibration, testing and packaging of
these devices ourselves. All of our manufacturing capabilities
are being established at our facilities in California.

There can be no assurance that we will not
encounter unanticipated delays or expenses in establishing
high-volume production capacity for AERx devices and disposable
drug packets. Any such delays or expenses could harm our
business.

Intellectual Property and Other Proprietary
Rights

Our business and competitive position is
dependent upon our ability to protect our proprietary technology
and avoid infringing the proprietary rights of others. We have
conducted original research on a number of aspects relating to
pulmonary drug delivery. This research has led to novel ideas,
which in turn have resulted in our being issued 77 United States
patents to date, with 34 United States patent applications
pending. In addition, we have purchased three United States
patents covering inventions that are relevant to our
technologies. We have 51 issued foreign patents and 82 foreign
patent applications pending.

We are protecting the AERx technology platform
through patents covering the AERx device, the AERx disposable
drug packet and methods for using the AERx platform for specific
drug delivery applications. Our patents, such as United States
patents 5,469,750; 5,509,404; 5,522,385; 5,694,919; 5,735,263
and 5,855,564, address current or potential features related to
the AERx device. Our United States patents 4,508,749; 5,497,763;
5,544,646; 5,718,222; 5,823,178 and 5,829,435, address current
or potential features related to the AERx disposable drug packet
and pertinent manufacturing methods.

We have conducted clinical studies demonstrating
requirements for delivering insulin and insulin analogs by
inhalation. These studies have allowed us to define various
specific breathing maneuvers required for efficient,
reproducible delivery of insulin and insulin analogs by
inhalation. These discoveries have led to the issuance of key
patents, which cover the delivery of insulin, and insulin
analogs regardless of the device used (e.g., automatic or
manual) or the drug formulation technique employed (e.g., liquid
or powder). Examples of these patents are:



| |   |                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | United States patent 5,672,581, which is directed
	to the inspiratory or inhaled flow rate and volume at which an
	insulin aerosol should be released into the patients
	inhalation.
|
| |  | United States patent 5,884,620, which is directed
	to the role of total inhaled volume for the delivery of
	aerosolized insulin.                                                     
|
| |  | United States patent 5,888,477, which is directed
	to the delivery of monomeric, or fast acting, insulin by
	inhalation.                                                             

Our success will depend to a significant extent
on our ability to obtain and enforce patents, maintain trade
secret protection and operate without infringing on the
proprietary rights of third parties. Because the field of
aerosolized drug delivery is crowded and a substantial number of
patents have been issued and because patent positions can be
highly uncertain and frequently involve complex legal and
factual questions, the breadth of claims obtained in any
application or the enforceability of our patents cannot be
predicted. Commercialization

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of pharmaceutical products can also be subject to
substantial delays as a result of the time required for product
development, testing and regulatory approval.


Our current policy is to file patent applications
on what we deem to be important technological developments that
might relate to our products or methods of using our products.
We also seek to protect some of these inventions through foreign
counterpart applications in selected other countries. Statutory
differences in patentable subject matter may limit the
protection we can obtain on some of our inventions outside of
the United States. For example, methods of treating humans are
not patentable in many countries outside of the United States.
These and other issues may limit the patent protection we will
be able to secure outside of the United States.

The coverage claimed in a patent application can
be significantly reduced before a patent is issued, either in
the United States or abroad. Consequently, we do not know
whether any of our pending or future patent applications will
result in the issuance of patents or, to the extent patents have
been issued or will be issued, whether these patents will be
subjected to further proceedings limiting their scope, will
provide significant proprietary protection or competitive
advantage, or will be circumvented or invalidated. Furthermore,
patents already issued to us or our pending applications may
become subject to dispute, and any disputes could be resolved
against us. For example, Eli Lilly has brought an action against
us seeking to have one or more employees of Eli Lilly named as
co-inventors on one of our patents. In addition, because patent
applications in the United States are currently maintained in
secrecy until patents issue and patent applications in certain
other countries generally are not published until more than
18 months after they are first filed, and because
publication of discoveries in scientific or patent literature
often lags behind actual discoveries, we cannot be certain that
we were the first creator of inventions covered by pending
patent applications or that we were the first to file patent
applications on such inventions.

Our policy is to require our officers, employees,
consultants and advisors to execute proprietary information and
invention and assignment agreements upon commencement of their
relationships with us. These agreements provide that all
confidential information developed or made known to the
individual during the course of the relationship shall be kept
confidential except in specified circumstances. These agreements
also provide that all inventions developed by the individual on
behalf of us shall be assigned to us and that the individual
will cooperate with us in connection with securing patent
protection on the invention if we wish to pursue such
protection. There can be no assurance, however, that these
agreements will provide meaningful protection for our
inventions, trade secrets or other proprietary information in
the event of unauthorized use or disclosure of such information.

We also execute confidentiality agreements with
outside collaborators and consultants. However, disputes may
arise as to the ownership of proprietary rights to the extent
that outside collaborators or consultants apply technological
information developed independently by them or others to our
projects, or apply our technology to other projects, and there
can be no assurance that any such disputes would be resolved in
our favor.

We may incur substantial costs if we are required
to defend ourselves in patent suits brought by third parties.
These legal actions could seek damages and seek to enjoin
testing, manufacturing and marketing of the accused product or
process. In addition to potential liability for significant
damages, we could be required to obtain a license to continue to
manufacture or market the accused product or process and there
would be no assurance that any license required under any such
patent would be made available to us on acceptable terms, if at
all. Litigation may also be necessary to enforce our patents
against others or to protect our know-how or trade secrets. Such
litigation could result in substantial expense, and there can be
no assurance that any litigation would be resolved in our favor.

Competition

We are in competition with pharmaceutical,
biotechnology and drug delivery companies, hospitals, research
organizations, individual scientists and nonprofit organizations
engaged in the development of alternative drug delivery systems
or new drug research and testing, as well as with entities
producing and developing injectable drugs. We are aware of a
number of companies currently seeking to develop new products
and non-invasive alternatives to injectable drug delivery,
including oral delivery systems, intranasal delivery systems,
transdermal systems, bucal, or mouth cavity, and colonic
absorption systems. Several of

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these companies may have developed or are
developing dry powder devices that could be used for pulmonary
delivery. Many of these companies and entities have greater
research and development capabilities, experience,
manufacturing, marketing, financial and managerial resources
than we do. Accordingly, our competitors may succeed in
developing competing technologies, obtaining Food and Drug
Administration, or FDA, approval for products or gaining market
acceptance more rapidly than we can.


We believe our technology and integrated
pulmonary delivery systems approach provides us with important
competitive advantages in the delivery of drugs compared with
currently known alternatives. While we believe that the
capabilities of our AERx platform will provide us with certain
important competitive advantages, new drugs or further
developments in alternative drug delivery methods may provide
greater therapeutic benefits, or comparable benefits at lower
cost, in a given drug application than the AERx system.

Several companies are marketing and developing
dry powder and other devices that could have applications for
pulmonary drug delivery, including Inhale Therapeutic Systems
and Alkermes Pharmaceuticals. These companies also have
collaborative arrangements with corporate partners for the
development of pulmonary delivery systems for insulin. There can
be no assurance that competitors will not introduce products or
processes competitive with or superior to ours.

Government Regulation

All medical devices and drugs, including our
products under development, are subject to extensive and
rigorous regulation by the federal government, principally the
FDA, and by state and local governments. If these products are
marketed abroad, they also are subject to export requirements
and to regulation by foreign governments. The regulatory
clearance process is generally lengthy, expensive and uncertain.
The Federal Food, Drug, and Cosmetic Act, and other federal
statutes and regulations, govern or influence the development,
testing, manufacture, labeling, storage, approval, advertising,
promotion, sale and distribution of such products. Failure to
comply with applicable FDA and other regulatory requirements can
result in sanctions being imposed on us or the manufacturers of
our products, including warning letters, fines, 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 approval of drugs or to allow us 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 include preclinical and
clinical testing. Preclinical 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 preclinical studies are
regulated by the FDA under a series of regulations called the
current Good Laboratory Practice regulations. Violations of
these regulations can, in some cases, lead to invalidation of
the studies, requiring such studies to be replicated.

The preclinical work necessary to administer
investigational drugs to human subjects is summarized in an
Investigational New Drug application to the FDA. FDA regulations
provide that human clinical trials may begin 30 days
following submission of an Investigational New Drug application,
unless the FDA advises otherwise or requests additional
information. There is no assurance that the submission of an
Investigational New Drug application will eventually allow a
company to commence clinical trials. Once trials have commenced,
the FDA may stop the trials by placing them on clinical
hold because of concerns about, for example, the safety of
the product being tested.

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 FDA reviewed protocol. Each clinical
study is conducted under the auspices of an Institutional Review
Board at each of the institutions at which the study will be
conducted. An Institutional Review Board will consider, among
other things, ethical factors, the safety of human subjects,
informed consent requirements and the possible liability of the
institution. Human clinical trials typically are conducted in
three sequential phases, but the phases may overlap.
Phase 1 trials consist of testing the product in a small
number of patients or normal volunteers, primarily for safety,
at one or more dosage levels, as well as characterization of a
drugs pharmacokinetic and/ or pharmacodynamic profile. In
Phase 2 clinical trials, in addition to safety, the
efficacy of the product is

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usually evaluated in a patient population.
Phase 3 trials typically involve additional testing for
safety and clinical efficacy in an expanded population at
geographically dispersed sites.


A company seeking FDA approval to market a new
drug must file a new drug application 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 an
effective Investigational New Drug application, the new drug
application includes information pertaining to the preparation
of the drug substance, analytical methods, drug product
formulation, details on the manufacture of finished products and
proposed product packaging and labeling. Submission of a new
drug application does not assure FDA approval for marketing. The
application review process can take a year or more to complete,
although reviews of treatments for cancer and other
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 efficacy with sufficient levels of
statistical assurance.

Notwithstanding the submission of safety and
efficacy data, the FDA ultimately may decide that the
application does not satisfy all of its regulatory criteria for
approval. The FDA could also determine that there is
insufficient data or experience with chronic administration of
drugs delivered via the lung for systemic effect to demonstrate
that such chronic administration is safe, and could require
further studies. The FDA also may require additional clinical
tests (i.e., Phase 4 clinical trials) following new drug
application approval to confirm safety and efficacy.

In addition, the FDA may in some circumstances
impose restrictions on the use of the drug that may be difficult
and expensive to administer. Product approvals may be withdrawn
if compliance with regulatory requirements is not maintained or
if problems occur after the product reaches the market. The FDA
also requires reporting of certain safety and other information
that becomes known to a manufacturer of an approved drug. The
product testing and approval process is likely to take a
substantial number of years and involves expenditure of
substantial resources. There is no guarantee that any approval
will be granted on a timely basis, or at all. Upon approval, a
prescription drug may only be marketed for the approved symptoms
in the approved dosage forms and at the approved dosage.

Among the other requirements for drug product
approval is the requirement that the prospective manufacturer
conform to the FDAs Good Manufacturing Practices, or GMP,
regulations for drugs. In complying with the GMP regulations,
manufacturers must continue to expend time, money and effort in
production, 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 to assure compliance with
applicable GMP requirements. A companys failure to comply
with the GMP regulations or other FDA regulatory requirements
could have a material adverse effect on that companys
business.

Products marketed outside the United States that
are manufactured in the United States are subject to certain FDA
regulations, as well as regulation by the country in which the
products are to be sold. We also would be subject to foreign
regulatory requirements governing clinical trials and drug
product sales if products are marketed abroad. Whether or not
FDA approval has been obtained, approval of a product by the
comparable regulatory authorities of foreign countries usually
must be obtained prior to the 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.

We are subject to numerous federal, state and
local laws relating to such matters as:



| |   |                                                            
| | - | -----------------------------------------------------------
| |  | controlled drug substances;                                
|
| |  | safe working conditions;                                   
|
| |  | manufacturing practices                                    
|
| |  | environmental protection;                                  
|
| |  | fire hazard control; and                                   
|
| |  | disposal of hazardous or potentially hazardous
	substances.

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We are subject to numerous federal, state and
local laws relating to such matters as controlled drug
substances, safe working conditions, manufacturing practices,
environmental protection, fire hazard control and disposal of
hazardous or potentially hazardous substances. For example, the
United States Drug Enforcement Agency, or DEA, regulates
controlled drug substances, such as morphine and other
narcotics. Establishments handling controlled drug substances
such as morphine must be registered and inspected by the DEA and
may be subject to export, import, security and production quota
requirements. In addition, advertising and promotional materials
are, in certain instances, subject to regulation by the Federal
Trade Commission. There can be no assurance that we will not be
required to incur significant costs to comply with such laws and
regulations in the future or that such laws or regulations will
not have a material adverse effect upon our business.

Product development and approval within this
regulatory framework takes a number of years, involves the
expenditure of substantial resources and is uncertain. Many drug
products ultimately do not reach the market because they are not
found to be safe or effective or cannot meet the FDAs
other regulatory requirements. In addition, there can be no
assurance that the current regulatory framework will not change
or that additional regulation will not arise at any stage of our
product development that may affect approval, delay the
submission or review of an application or require additional
expenditures by us. There can be no assurance that we will be
able to obtain necessary regulatory clearances or approvals on a
timely basis, if at all, for any of our products under
development, and delays in receipt or failure to receive such
clearances or approvals, the loss of previously received
clearances or approvals, or failure to comply with existing or
future regulatory requirements could have a material adverse
effect on our business.

International Scientific Advisory
Board

We have assembled an International Scientific
Advisory Board comprised of scientific and development advisors
that provide expertise, on a consulting basis, in the areas of
pain management, allergy and immunology, pharmaceutical
development and drug delivery, but are employed elsewhere on a
full time basis. As a result, they can only spend a limited
amount of time on our affairs. The International Scientific
Advisory Board assists us on issues related to potential product
applications, product development and clinical testing. Its
members, and their affiliations and areas of expertise, include:

|                                     |  |                                                                |  |                                   
|------------------------------------ |  | -------------------------------------------------------------- |  | ----------------------------------
|Name                                 |  | Affiliation                                                    |  | Area of Expertise                 
|                                     |  |                                                                |  |                                   
|Peter Byron, Ph.D.                   |  | Medical College of Virginia, Virginia
	Commonwealth University |  | Aerosol Science/ Pharmaceutics    
|Michael Cousins, M.D.                |  | University of Sydney, Australia                                |  | Pain Management                   
|Peter Creticos, M.D.                 |  | The Johns Hopkins University School of Medicine                |  | Allergy/ Immunology/ Asthma       
|Lorne Eltherington, M.D., Ph.D.      |  | Sequoia Hospital                                               |  | Pain Management                   
|Igor Gonda, PhD                      |  | Acrux Limited                                                  |  | Drug Delivery                     
|Henrik Egesborg Hansen               |  | NovoNordisk                                                    |  | Device Technology                 
|Lawrence M. Lichtenstein, M.D., Ph.D |  | The Johns Hopkins University School of Medicine                |  | Allergy/ Immunology               
|Robert Ratner, M.D.                  |  | Medlantic Research Institute                                   |  | Endocrinology                     
|Christopher Saudek, M.D.             |  | The John Hopkins University School of Medicine                 |  | Endocrinology                     
|Leigh Thompson, M.D., Ph.D.          |  | CEO, Profound Quality Resources                                |  | Pharmaceutical Product Development
|Vincent Lee, Ph.D.                   |  | USC School of Pharmacy                                         |  | Drug Delivery                     

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Employees

As of February 28, 2002, we had
307 employees, of whom 262 were in research and development
and product development and 45 were in business development,
finance and administration. We believe that our future success
is dependent on attracting and retaining highly skilled
scientific, sales and marketing and senior management personnel.
Competition for such skills is intense, and there is no
assurance that we will continue to be able to attract and retain
high-quality employees. Our employees are not represented by any
collective bargaining agreement. We consider our relations with
our employees to be good.

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MANAGEMENT

Directors and Executive Officers

The directors and executive officers of the
Company and their ages as of February 28, 2002 are as
follows:

|                          |  |     |    |          |  |                                                
|------------------------- |  | --- | -- | -------- |  | -----------------------------------------------
|Name                      |  | Age |    | Position
|                          |  |     |    |         
|Richard P. Thompson       |  |     | 50 |          |  | President, Chief Executive Officer and Director
|Bikash K. Chatterjee      |  |     | 43 |          |  | Vice President, Operations                     
|Steven J. Farr, Ph.D.     |  |     | 42 |          |  | Vice President, Pharmaceutical Sciences        
|Maximillian D. Fiore      |  |     | 47 |          |  | Vice President, Engineering                    
|Klaus D. Kohl, Ph.D.      |  |     | 51 |          |  | Vice President, Quality                        
|V. Bryan Lawlis, Ph.D.    |  |     | 50 |          |  | Chief Operating Officer                        
|Dan P. Maher              |  |     | 46 |          |  | Vice President, Project Management             
|Norma L. Milligin         |  |     | 63 |          |  | Vice President, Human Resources                
|Babatunde A. Otulana, M.D |  |     | 44 |          |  | Vice President, Clinical & Regulatory Affairs  
|Frank H. Barker(1)        |  |     | 71 |          |  | Director                                       
|Stan M. Benson(2)         |  |     | 51 |          |  | Director                                       
|Igor Gonda(2)             |  |     | 54 |          |  | Director                                       
|John Nehra(1)             |  |     | 53 |          |  | Director                                       
|Wayne I. Roe(1)           |  |     | 51 |          |  | Director                                       
|Virgil D. Thompson(2)     |  |     | 62 |          |  | Director                                       



---



|    |                                      
|--- | -------------------------------------
|(1) | Member of the Audit Committee.       
|   
|(2) | Member of the Compensation Committee.

Richard P. Thompsonhas been a director and has served
as our President and Chief Executive Officer since 1994 and was
named Chairman of the Board in 2000. From 1991 to 1994, he was
President of LifeScan, Inc., a Johnson & Johnson
Company, a diversified health care company. In 1981,
Mr. Thompson co-founded LifeScan, which was sold to
Johnson & Johnson in 1986. Mr. Thompson holds a
B.S. in biological sciences from the University of California at
Irvine and an MBA from California Lutheran College.

Bikash K. Chatterjeehas served as our Vice President,
Pharmaceutical Operations since March 1998. From September 1997
until March 1998, Mr. Chatterjee was our Director of
Pharmaceutical Operations. From January 1992 to August 1997,
Mr. Chatterjee was the plant manager for manufacturing
Boehringer-Mannheims disposable coagulation testing
system. From 1988 to 1992, he held a number of senior
manufacturing positions at various pharmaceutical companies,
including Syntex Corporation. Mr. Chatterjee holds a B.A.
in biochemistry and a B.S. in chemical engineering from the
University of California at San Diego.

Stephen J.
Farr, Ph.D., has served as our
Vice President, Research and Development since July 2000. From
January 1999 to June 2000, Dr. Farr was Vice President,
Pharmaceutical Sciences and from January 1995 to December 1998,
he was Senior Director of Pharmaceutical Sciences. From
September 1985 to December 1994, Dr. Farr was Lecturer and
later Senior Lecturer in the Welsh School of Pharmacy, Cardiff
University, United Kingdom. He was a founder and director of
Cardiff Scintigraphics Ltd. Dr. Farr holds a B.Sc. in
pharmacy from DeMontfort University, a Ph.D. in pharmaceutics
from the University of Wales and is a Visiting Associate
Professor in the Department of Pharmaceutics, School of
Pharmacy, Virginia Commonwealth University, Richmond, Virginia.

Maximillian D. Fiorehas served as our Vice President,
Engineering since September 1994. From January 1991 to September
1994, Mr. Fiore served as Director of Engineering at
LifeScan, Inc. From November 1989 to December 1990,
Mr. Fiore held various senior engineering and management
positions with Abbott Laboratories, a pharmaceutical and medical
device company. Mr. Fiore holds a B.S.E.E. and a B.S. in

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engineering from Northwestern University and an
M.S.E.E. in bio-medical/microprocessor-based instrument design
from the University of Wisconsin.


Klaus D.
Kohl, Ph.D., has served as our
Vice President, Quality, since October 2000. From 1998 to 2000,
Dr. Kohl was Quality Manager of GE Bayer Silicones, a joint
venture of General Electric and Bayer Corporation. From 1996 to
1998, he was Vice President of Quality Assurance, Pharmaceutical
Division, Bayer Corporation North America. Dr. Kohl joined
Bayer in 1985 and held various positions in quality
assurance/drug product development in the United States and in
Europe. Previously, Dr. Kohl spent more than 7 years
in basic research at the Research Center Juelich, Germany and
the Max Planck Institute, Dortmund Germany. Dr. Kohl
received his undergraduate degree in mathematics and physics
from the University of Marburg, Germany and his Ph.D. from the
University of Aachen, Germany.

V.     Bryan
Lawlis, Ph.D., joined in 2001 as
our Chief Operating Officer. Previously, he was acting Chairman,
President and Chief Executive Officer of Diosynth RTP, Inc.
Dr. Lawlis founded Covance Biotechnology Services, a
contract biopharmaceutical manufacturing operation, and served
as its President and Chief Executive Officer from 1996 to 2000,
and as Chairman in 2001, when it was sold to Diosynth, a
division of Akzo Nobel. From 1981 to 1996 he was employed at
Genencor, Inc. and Genentech, Inc. His last position at
Genentech was Vice President of Process Sciences.
Dr. Lawlis holds a B.A. in microbiology from the University
of Texas at Austin, and a Ph.D. in biochemistry from Washington
State University.

Daniel P. Maherhas served as our Vice President,
Project Management and Program Director, AERx iDMS, since April
2001. From November 1998 to April 2001, Mr. Maher was Sr.
Director of Project Management, and Program Director, AERx iDMS.
From 1996 to 1998, he was the Director of Clinical Operations at
Chiron Corporation. Previously, Mr. Maher was Vice
President of Operations at Spectra Biomedical Inc. Earlier, he
was the Director of Therapeutics Project Management at Chiron
Corporation and held various positions at Genentech in
operations and product development, ultimately heading the
Product Development Group. Mr. Maher holds a B.A. in
biology from San Francisco State University and an MBA in health
services management from Golden Gate University.

Norma L. Milliginhas served as our Vice President,
Human Resources since September 1998. From January 1995 to
August 1998, Ms. Milligin worked as a consultant in the
human resources area for a number of firms. From 1985 to January
1994, she held positions as Vice President of Human Resources at
LifeScan, Inc., a Johnson & Johnson Company, and
Chemtrak, Inc., a medical device company. From 1978 to
1985, she also held a number of senior human resource positions
at Syntex Corporation. Ms. Milligin has taught
organizational behavior at Pepperdine University, and holds a
B.S. in business from the University of Colorado and an MBA from
Pepperdine University.

Babatunde A. Otulana,
M.D., has served as our Vice
President, Clinical Affairs since October 1997. From 1991 to
September 1997, Dr. Otulana was a Medical Reviewer in the
Division of Pulmonary Drug Products at the Center for Drug
Evaluation and Research, Food and Drug Administration. From 1991
to 1997, Dr. Otulana also served as an Assistant Professor
of Medicine in the Division of Pulmonary and Critical Care
Medicine, Howard University Hospital. Dr. Otulana obtained
his M.D. from the University of Ibadan, Nigeria and completed a
Pulmonary Fellowship at Papworth Hospital, University of
Cambridge, United Kingdom.

Frank H. Barkerhas been a director since May
1999. He has been the Chairman of U.S. Dermatologics, Inc.,
an over-the-counter pharmaceutical company, since February 1999,
and was its President and Chief Executive Officer from October
1997 to February 1999. From January 1989 to January 1996,
Mr. Barker served as a company group chairman of
Johnson & Johnson. Mr. Barker holds a B.A. in
business administration from Rollins College, Winter Park,
Florida. Mr. Barker is a director of Catalina Marketing
Corporation, a direct-to-consumer marketing company.

Stan M. Bensonhas been a director since April
2001. Mr. Benson served as Senior Vice President, Sales and
Marketing of Amgen, Inc., a biotechnology company from 1995 to
2001. Prior to joining Amgen, Mr. Benson worked at Pfizer
Inc, a pharmaceutical company, for 19 years in various
senior management

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positions. Mr. Benson received a B.A. and an
M.S. from New York University. He is also a director of Aderis
Pharmaceuticals, Inc. Mr. Benson is now retired.


Igor Gonda,
Ph.D., has been a director since
September 2001. He is the Chief Executive Officer and Managing
Director of Acrux Limited, a drug delivery company in Melbourne,
Australia. Dr. Gonda was our Chief Scientific Officer until
December 2001 and previously held the position of Vice
President, Research and Development, from October 1995 until
July 2001. From February 1992 to September 1995, Dr. Gonda
was a Senior Scientist and Group Leader at Genentech, Inc. Prior
to that, Dr. Gonda held academic positions at the
University of Aston in Birmingham, UK, and the University of
Sydney, Australia. Dr. Gonda has a B.Sc. in chemistry and a
Ph.D. in physical chemistry from Leeds University, UK. He is the
Chairman of Scientific Boards at Aradigm Corporation and Exhale
Therapeutics, Inc.

John M. Nehrawas elected director by our Board
of Directors in December 2001. Mr. Nehra is a Special
Partner of NEA 10, a venture capital partnership, and a General
Partner of NEA VI, NEA VII, NEA VIII and
NEA IX. Mr. Nehra is also the managing General Partner
of Catalyst Ventures, a venture capital partnership. Prior to
joining NEA and its affiliated venture funds in 1989,
Mr. Nehra was Managing Director of Alex. Brown & Sons,
an investment banking firm. Upon joining Alex. Brown in 1975,
Mr. Nehra was responsible for building the firms
healthcare research and healthcare banking practice, and forming
its capital markets group. Mr. Nehra is a director of
Iridex Corporation and Celeris Corporation and also serves on
the boards of several privately held healthcare companies.
Mr. Nehra holds a B.A. from the University of Michigan.

Wayne I. Roehas been a director since May
1999. Mr. Roe was Senior Vice President of United
Therapeutics Corporation, a pharmaceutical manufacturer, from
1999 to 2000. He was Chairman of Covance Health Economics and
Outcomes Services, Inc., a strategic marketing firm from 1996 to
1998. From June 1988 to March 1996, Mr. Roe was the
President of Health Technology Associates, a pharmaceutical
industry consulting firm. Mr. Roe received a B.A. from
Union College, an M.A. from the State University of New York at
Albany and an M.A. from the University of Maryland. He is also a
director of Ista Pharmaceuticals Inc., Aderis Pharmaceuticals
Inc., Novosonics Inc., and Favrille Inc. Mr. Roe currently
is an independent consultant in the life sciences industry.

Virgil D. Thompsonhas been a director since June
1995. Since September 2000, he has been President, Chief
Executive Officer and Director of Chimeric Therapies, Inc., a
biotechnology company. From May 1999 until September 2000, he
was the President, Chief Operating Officer and a Director of
Bio-Technology General Corp., a pharmaceutical company. From
January 1996 to April 1999, he was the President and Chief
Executive Officer and a Director of Cytel Corporation, a
biopharmaceutical company. From 1994 to 1996, he was President
and Chief Executive Officer of Cibus Pharmaceuticals, Inc., a
drug delivery device company. From 1991 to 1993 he was President
of Syntex Laboratories, Inc., a pharmaceutical company.
Mr. Thompson holds a B.S. in pharmacy from Kansas
University and a J.D. from The George Washington University Law
School. He is also a director of Questcor Pharmaceutical
Corporation and Bio-Technology General Corporation.




Item 2.     Properties

At December 31, 2001, we leased a total of
approximately 253,898 square feet of office space in two office
parks. We leased approximately 163,658 square feet in three
buildings in an office park at 3929 Point Eden Way,
Hayward, California and leased 90,240 square feet in one
building in an office park located at 2704 West Winton
Avenue, Hayward, California. The leases for the various office
spaces expire at various times through the year 2016. Minimum
annual payments under these leases will be approximately
$4.9 million and $ 5.1 million in 2002 and 2003,
respectively. We use this space for general administrative,
product development, clinical, manufacturing and research and
development purposes. We believe that our existing facilities
are adequate to meet our requirements for the near term and that
additional space will be available on commercially reasonable
terms if needed.

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Item 3.     Legal
Proceedings

In June 1998, Eli Lilly and Company filed a
complaint against us in the United States District Court for the
Southern District of Indiana. The complaint made various
allegations against us, arising from our decision to enter into
an exclusive collaboration with Novo Nordisk with respect to the
development and commercialization of a pulmonary delivery system
for insulin and insulin analogs. We sponsored various studies of
the pulmonary delivery of insulin and insulin analogs using
materials supplied by Lilly under a series of agreements dating
from January 1996. We and Lilly had also conducted negotiations
concerning a long-term supply agreement under which Lilly would
supply bulk insulin to us for commercialization in our AERx
insulin Diabetes Management System, and a separate agreement
under which we would license certain intellectual property to
Lilly. These negotiations were terminated after we proceeded
with our agreement with Novo Nordisk. The complaint sought a
declaration that Lilly scientists were co-inventors of a patent
application filed by us relating to pulmonary delivery of an
insulin analog or, in the alternative, enforcement of an alleged
agreement to grant Lilly a nonexclusive license under such
patent application. The complaint also contained allegations of
misappropriation of trade secrets, breach of fiduciary duty,
conversion and unjust enrichment and seeks unspecified damages
and injunctive relief. We filed an answer denying all material
allegations of the complaint and a motion for summary judgment
directed against all claims in Lillys complaint. The Court
has issued two written rulings on our motion substantially
limiting the claims against us. Specifically, the Court granted
our motion as to Lillys claim to enforce an alleged
license agreement, for misappropriation of trade secrets, breach
of fiduciary duty, conversion, estoppel and breach of contract
(in part) and dismissed those claims from the case. The Court
denied our motion as to Lillys claims for declaratory
relief, unjust enrichment and breach of contract (in part),
based on factual disputes between the parties, and those issues
remain to be resolved. We recently filed a motion asking the
Court to reconsider summary judgment on the inventorship and
unjust enrichment claims, based on evidence recently produced by
Lilly; the Court denied our motion but we may raise those issues
again. Lilly filed a motion seeking to add several new patents
to the case, but withdrew that motion after our opposition
papers were filed and after discussion with the Court. Trial was
set for November 2001, but has been continued to April 22,
2002 due to a conflict on the Courts calendar. The risks
to us should Lilly prevail in this case are that Lilly would be
given rights of an owner, along with us, on one of our patents
relating to pulmonary delivery of monomeric, or fast acting,
insulin lispro and/or that Lilly would be awarded damages on its
remaining claims for breach of contract and unjust enrichment.
Lilly also contends that factual findings made in any trial of
this case would have some effect on other patents relating to
pulmonary delivery of monomeric insulin lispro. Management
believes that we have meritorious defenses against each of Eli
Lillys remaining claims and that this litigation will not
have a material adverse effect on our business. However, there
can be no assurance that we will prevail in this case.




Item 4.     Submission
Of Matters To A Vote Of Security Holders

No matters were submitted to a vote of our
security holders during the quarter ended December 31, 2001.

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PART II




Item 5.     Market
for the Registrants Common Stock and Related Stockholder
Matters

Market Information

Our common stock is traded on The Nasdaq Stock
Market under the symbol ARDM. The following table
sets forth the intra-day high and low sale prices for our common
stock as reported on The Nasdaq Stock Market for the periods
indicated below.

|     |                                           |      |   |       |  |  |   |       | 
|---- | ----------------------------------------- | ---- | - | ----- |  |  | - | ----- | 
|     |                                           | High |   | Low  
|     |                                           |      |   |      
|2000 |                                           |      |   |       |  |  |   |      
|     | First Quarter                             |      | $ | 44.25 |  |  | $ | 10.50 | 
|     | Second Quarter                            |      |   | 19.25 |  |  |   | 13.25 | 
|     | Third Quarter                             |      |   | 25.00 |  |  |   | 11.19 | 
|     | Fourth Quarter                            |      |   | 26.88 |  |  |   | 13.19 | 
|    
|2001 |                                           |      |   |       |  |  |   |      
|     | First Quarter                             |      | $ | 15.25 |  |  | $ | 4.28  | 
|     | Second Quarter                            |      |   | 8.56  |  |  |   | 4.88  | 
|     | Third Quarter                             |      |   | 6.92  |  |  |   | 3.02  | 
|     | Fourth Quarter                            |      |   | 7.10  |  |  |   | 3.15  | 
|    
|2002 |                                           |      |   |       |  |  |   |      
|     | First Quarter (through February 28, 2002) |      | $ | 7.29  |  |  | $ | 4.01  | 

On February 28, 2002, there were
138 holders of record of our common stock. On
March 14, 2002, the last sale price reported on the Nasdaq
National Market for the common stock was $4.05 per share.

Dividend Policy

We have never declared or paid any cash
dividends. We currently intend to retain any future earnings to
finance the growth and development of our business and therefore
do not anticipate paying any cash dividends in the foreseeable
future.

Recent Sales of Unregistered
Securities

On December 14, 2001, we issued
2,001,236 shares of our Series A Convertible Preferred
Stock to certain institutional investors for an aggregate
purchase price of $48.4 million in a private placement.
Each share of Series A preferred stock is convertible at
any time into four shares of our common stock, for an aggregate
of 8,004,944 shares of common stock. In connection with the
sale, we issued warrants to purchase an aggregate of
5,203,212 shares of our common stock at an exercise price
of $6.97 per share. The warrants are exercisable at the election
of the warrant holders for a five-year term. The sale and
issuance of the preferred stock and warrants was deemed to be
exempt from registration under the Securities Act of 1933, as
amended, by virtue of Regulation D promulgated under such
Act. Each purchaser represented that it was an accredited
investor within the meaning of Rule 501(a) of the Act and
that it was acquiring the securities for investment only and not
with the view to the distribution thereof.

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Item 6.     Selected
Financial Data

The following selected financial data should be
read in conjunction with the Managements Discussion
and Analysis of Financial Condition and Results of
Operations and the financial statements and notes thereto
included in this Report on Form 10-K.

|                                                                                                |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |        | 
|----------------------------------------------------------------------------------------------- | -------------------------- | ---------------------------------------- | -------- | ------ |  | ---- | -------- | ------ |  | ---- | ------- | ------ |  | - | ------- | ------ |  | - | ------- | ------ | 
|                                                                                                |                            |                                         
|                                                                                                |                            | Years Ended December 31,                
|                                                                                                |                            |                                         
|                                                                                                |                            | 2001                                     |          | 2000   |  | 1999 |          | 1998   |  | 1997
|                                                                                                |                            |                                          |          |        |  |      |          |        |  |     
|                                                                                                |                            |                                         
|                                                                                                |                            | (In thousands, except per share amounts)
|Statements of Operations Data:                                                                  |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Contract and license revenues                                                                   |                            | $                                        | 28,916   |        |  | $    | 20,303   |        |  | $    | 16,812  |        |  | $ | 17,515  |        |  | $ | 3,685   |       
|Operating expenses:                                                                             |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|                                                                                                | Research and development   |                                          |          | 58,836 |  |      |          | 48,176 |  |      |         | 33,625 |  |   |         | 25,549 |  |   |         | 13,452 | 
|                                                                                                | General and administrative |                                          |          | 9,355  |  |      |          | 9,271  |  |      |         | 7,849  |  |   |         | 8,661  |  |   |         | 6,012  | 
|                                                                                                |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|                                                                                                | Total expenses             |                                          |          | 68,191 |  |      |          | 57,447 |  |      |         | 41,474 |  |   |         | 34,210 |  |   |         | 19,464 | 
|                                                                                                |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Loss from operations                                                                            |                            |                                          | (39,275  | )      |  |      | (37,144  | )      |  |      | (24,662 | )      |  |   | (16,695 | )      |  |   | (15,779 | )     
|Interest income                                                                                 |                            |                                          | 1,324    |        |  |      | 3,110    |        |  |      | 1,947   |        |  |   | 1,754   |        |  |   | 1,329   |       
|Interest expense and other                                                                      |                            |                                          | (1,081   | )      |  |      | (1,528   | )      |  |      | (888    | )      |  |   | (513    | )      |  |   | (234    | )     
|                                                                                                |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Net loss before extraordinary gain                                                              |                            |                                          | (39,032  | )      |  |      | (35,562  | )      |  |      | (23,603 | )      |  |   | (15,454 | )      |  |   | (14,684 | )     
|Extraordinary gain                                                                              |                            |                                          | 6,675    |        |  |      |         |        |  |      |        |        |  |   |        |        |  |   |        |       
|                                                                                                |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Net loss                                                                                        |                            | $                                        | (32,357  | )      |  | $    | (35,562  | )      |  | $    | (23,603 | )      |  | $ | (15,454 | )      |  | $ | (14,684 | )     
|Deemed dividend                                                                                 |                            |                                          | (10,722  | )      |  |      |         |        |  |      |        |        |  |   |        |        |  |   |        |       
|                                                                                                |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Net loss applicable to common shareholders                                                      |                            | $                                        | (43,079  | )      |  | $    | (35,562  | )      |  | $    | (23,603 | )      |  | $ | (15,454 | )      |  | $ | (14,684 | )     
|                                                                                                |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Basic and diluted loss per share applicable to
	common shareholders(1):                         |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Loss before extraordinary gain                                                                  |                            | $                                        | (2.28    | )      |  | $    | (2.07    | )      |  | $    | (1.66   | )      |  | $ | (1.32   | )      |  | $ | (1.43   | )     
|Extraordinary gain                                                                              |                            |                                          | 0.30     |        |  |      |         |        |  |      |        |        |  |   |        |        |  |   |        |       
|                                                                                                |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Net loss applicable to common shareholders                                                      |                            | $                                        | (1.98    | )      |  | $    | (2.07    | )      |  | $    | (1.66   | )      |  | $ | (1.32   | )      |  | $ | (1.43   | )     
|                                                                                                |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Shares used in computing basic and diluted loss
	per share applicable to common shareholders(1) |                            |                                          | 21,792   |        |  |      | 17,196   |        |  |      | 14,216  |        |  |   | 11,682  |        |  |   | 10,280  |       
|                                                                                                |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Balance Sheet Data:                                                                             |                            |                                          |          |        |  |      |          |        |  |      |         |        |  |   |         |        |  |   |         |       
|Cash, cash equivalents and investments                                                          |                            | $                                        | 71,164   |        |  | $    | 44,381   |        |  | $    | 31,259  |        |  | $ | 31,036  |        |  | $ | 24,305  |       
|Working capital                                                                                 |                            |                                          | 48,308   |        |  |      | 19,862   |        |  |      | 22,797  |        |  |   | 16,483  |        |  |   | 15,999  |       
|Total assets                                                                                    |                            |                                          | 132,100  |        |  |      | 71,371   |        |  |      | 50,790  |        |  |   | 44,949  |        |  |   | 30,294  |       
|Noncurrent portion of notes payable and capital
	lease obligations                              |                            |                                          | 2,727    |        |  |      | 6,230    |        |  |      | 9,609   |        |  |   | 4,570   |        |  |   | 2,139   |       
|Redeemable convertible preferred stock                                                          |                            |                                          | 30,735   |        |  |      |         |        |  |      |        |        |  |   |        |        |  |   |        |       
|Accumulated deficit                                                                             |                            |                                          | (153,535 | )      |  |      | (110,441 | )      |  |      | (74,904 | )      |  |   | (51,279 | )      |  |   | (35,827 | )     
|Total shareholders equity                                                                      |                            |                                          | 71,149   |        |  |      | 37,785   |        |  |      | 24,157  |        |  |   | 21,660  |        |  |   | 18,659  |       



---



|    |                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------
|(1) | See Note 1 of Notes to Financial Statement
	for an explanation of shares used in computing basic and diluted
	net loss per share.

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

The discussion below contains forward-looking
statements that are based on the beliefs of management, as well
as assumptions made by, and information currently available to
management. Our future results, performance or achievements
could differ materially from those expressed in, or implied by,
any such forward-looking statements as a result of certain
factors, including, but not limited to, those discussed in this
section as well as in the section entitled Risk
Factors. This discussion should be read in conjunction
with the financial statements and notes to financial
statements.

Overview

Since our inception in 1991, we have been engaged
in the development of pulmonary drug delivery systems. As of
December 31, 2001, we had an accumulated deficit of
$153.6 million. We have not been profitable since inception
and expect to incur additional operating losses over the next
several years as research and development efforts, preclinical
and clinical testing activities and manufacturing scale-up
efforts expand and as we plan and build our late-stage clinical
and early commercial production capabilities. To date, we have
not had any material product sales and do not anticipate
receiving any revenue from the sale of products during 2002. The
sources of working capital have been equity financings,
equipment lease financings, contract revenues and interest
earned on investments.

We have performed initial feasibility work on a
number of compounds and have been compensated for expenses
incurred while performing this work in several cases pursuant to
feasibility study agreements with third parties. Once
feasibility is demonstrated with respect to a potential product,
we seek to enter into development contracts with pharmaceutical
corporate partners. We currently have such agreements pursuant
to which we are developing pulmonary delivery systems with Novo
Nordisk A/ S, to manage diabetes using insulin and other blood
glucose regulating compounds, and with GlaxoSmithKline plc, to
manage acute and breakthrough pain using opioid analgesics.

The collaborative agreement with Novo Nordisk
provides for reimbursement of research and development expenses
as well as additional payments to us as we achieve certain
significant milestones. We also expect to receive royalties from
this development partner based on revenues from sales of product
and to receive revenue from the manufacturing of unit dose
packets and hand-held devices. We recognize revenues under the
terms of our collaborative agreement as the research and
development expenses are incurred, to the extent they are
reimbursable. During 2001, this partner-funded program has
contributed approximately 90% of our total contract revenues.

During December 2000, GlaxoSmithKline and we
amended the product development and commercialization agreement
whereby we assumed full control and responsibility for
conducting and financing the remainder of all development
activities. Under the amendment, unless we have terminated the
agreement, GlaxoSmithKline can restore its rights to participate
in development and commercialization of the product under the
amended agreement upon payment of a restoration fee to us. We
anticipate that GlaxoSmithKline will review its restoration
election upon the delivery of Phase 2b trial results, which
will be made available to them in the first half of 2002, but
there can be no assurance that GlaxoSmithKline will elect to
restore its rights. If we elect to terminate the agreement and
continue or intend to continue any development activities,
either alone or in collaboration with a third party, we will be
obligated to pay an exit fee to GlaxoSmithKline. If we elect to
pay the exit fee it will not have a material impact on our
financial position or operating results. This development
program is currently being funded through existing working
capital.

In February 2001, we announced that Genentech had
discontinued the development of dornase alfa using our
proprietary AERx Respiratory Management System. We also entered
into a new agreement allowing Genentech to evaluate the
feasibility of using the AERx Pulmonary Drug Delivery System for
pulmonary delivery of other Genentech compounds. Under the terms
of the agreement, Genentech did not require us to repay the loan
of funds required to conduct product development under the
discontinued program. Forgiveness of the loan and accrued
interest resulted in an extraordinary gain during the first
quarter of 2001 of approximately $6.7 million. During 2001,
we reimbursed Genentech $773,000 for unspent project prepayments.

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In addition to the diabetes and pain management
programs, we have three additional partner-funded programs and a
gene therapy effort, which is funded through the National
Institutes of Health. It is our policy not to disclose the
partner or the drug until we have entered into long-term
development agreements with a partner.

Critical Accounting Policies

We consider certain accounting policies related
to revenue recognition, impairment of long-lived assets and the
use of estimates to be critical accounting policies that require
the use of significant judgements and estimates relating to
matters that are inherently uncertain and may result in
materially different results under different assumptions and
conditions.

Revenue
Recognition

Contract revenues consist of revenue from
collaboration agreements and feasibility studies. We recognize
revenue under the agreements as costs are incurred. Deferred
revenue represents the portion of all refundable and
nonrefundable research payments received that have not been
earned. In accordance with contract terms, milestone payments
from collaborative research agreements are considered
reimbursements for costs incurred under the agreements and,
accordingly, are generally recognized as revenue either upon the
completion of the milestone effort when payments are contingent
upon completion of the effort or are based on actual efforts
expended over the remaining term of the agreements when payments
precede the required efforts. Costs of contract revenues
approximate such revenue and are included in research and
development expenses. Refundable development and license fee
payments are deferred until the specified performance criteria
are achieved. Refundable development and license fee payments
are generally not refundable once the specific performance
criteria are achieved.

Impairment of
Long-Lived Assets

We review for impairment whenever events or
changes in circumstances indicates that the carrying amount of
property and equipment may not be recoverable under the
provisions of Statement of Financial Accounting Standards
No. 121, Accounting for the Impairment of Long-Lived Assets
and for Long Lived Assets to be Disposed Of. If it is determined
that an impairment loss has occurred based on expected future
cash flows, the loss is recognized on the Statements of
Operations.

Use of
Estimates

The preparation of financial statements in
conformity with generally accepted accounting principles
requires us to make estimates and assumptions that affect the
amounts reported in the financial statements and accompanying
notes to the financial statements. These estimates include
useful lives for property and equipment and related depreciation
calculations, estimated amortization period for payments
received from product development and license agreements as they
relate to the revenue recognition of deferred revenue and
assumptions for valuing options and warrants. Actual results
could differ from these estimates.

Results of Operations

Years Ended
December 31, 2001, 2000 and 1999

Contract Revenues.We reported revenues from
collaborative contracts of $28.9 million in 2001, compared
to $20.3 million in 2000 and $16.8 million in 1999.
The revenue increase in 2001 and 2000 results primarily from an
increase in partner-funded project development revenue from Novo
Nordisk, which was $26 million in 2001 compared to
$15.4 million in 2000 and $8.7 million in 1999. The
revenue increase in 2001 and 2000 was partially offset by a
reduction in partner-funded project development revenue
principally from GlaxoSmithKline, which was $1.5 million in
2001 compared to $3.4 million in 2000 and $5.2 million
in 1999. Costs associated with contract research revenue are
included in research and development expenses.

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Research and Development Expenses.Research and development expenses have
increased each year since our inception. These expenses were
$58.8 million in 2001 compared to $48.2 million in
2000 and $33.6 million in 1999. Research and development
expenses as a percentage of total operating expenses were 86% in
2001, 84% in 2000 and 81% in 1999. Research and development
expenses in 2001 increased by $10.7 million or 22% over
2000, which was primarily due to the expansion of development
efforts to support the ongoing program with Novo Nordisk and, to
a lessor extent, increases in development efforts for other
funded and unfunded development areas including manufacturing
scale-up efforts. Research and development expenses in 2000
increased by $14.6 million or 43% over 1999, which was due
to the expansion of research and development efforts to support
the ongoing programs with Novo Nordisk and Genentech including
an expansion of manufacturing scale-up efforts. Research and
development expenses associated with collaborative agreements
approximate contract revenue as these expenses are incurred
under the program agreements.

These expenses represent proprietary research
expenses as well as the costs related to contract research
revenue and include salaries and benefits of scientific and
development personnel, laboratory supplies, consulting services
and the expenses associated with the development of
manufacturing processes. We expect research and development
spending will increase over the next few years if we continue to
expand our development activities to support current and
potential future collaborations and initiate commercial
manufacturing of the AERx systems. The increase in research and
development expenditures cannot be predicted accurately as it
depends in part upon continued future success and funding levels
supported by our existing development collaborations, as well as
obtaining new collaborative agreements.

Currently, our lead development program is
developing pulmonary delivery systems to manage diabetes using
insulin and other blood glucose regulating compounds with our
partner Novo Nordisk. During November 2001, Novo Nordisk and we
successfully completed a Phase 2b clinical trial using the AERx
insulin Diabetes Management System. We are now focused on
preparing for Phase 3 clinical trials, which Novo Nordisk
intends to commence during the summer of 2002.

Our next major program is with our partner
GlaxoSmithKline pursuant to our development agreement, as
amended, which covers the use of the AERx Pain Management System
for the delivery of narcotic analgesics. During December 2001,
we successfully completed Phase 2b clinical trials for the AERx
morphine Pain Management System. We will be working with
GlaxoSmithKline to determine the next steps for the AERx
morphine program. Future progress for this program is contingent
on either GlaxoSmithKline recommitting to this program or our
entering into another development agreement with a new partner.
We continue to move forward with this program for a Phase 3
start, which could occur in early 2003.

We have three other partner-funded programs and a
gene therapy effort, which is funded through the National
Institutes of Health, that are all in early Phase 1 clinical
trials. Though Phase 1 clinical trials are expected to be
completed in 2002, future research and development efforts for
these partner-funded programs are difficult to predict at this
time due to their early stage of development.

General and Administrative Expenses.General and administrative expenses
were $9.4 million in 2001 compared to $9.3 million in
2000 and $7.8 million in 1999. General and administrative
expenses remained relatively unchanged in 2001 compared to 2000.
General and administrative expenses increased by approximately
$1.4 million or 18% in 2000 compared to 1999, as a result
of additional personnel and leased facilities to support our
expansion of research, development and manufacturing activities
and increased efforts to develop collaborative relationships
with new corporate partnerships.

Interest Income.Interest income was $1.3 million
in 2001 compared to $3.1 million in 2000 and
$1.9 million in 1999. The decrease in 2001 was primarily
due a combination of interest income being earned on lower
average cash and investment balances and a decrease in interest
rates earned on invested cash balances. The contribution to
interest income due to the funds received from the preferred
stock financing in December 2001 was not material. The increase
in 2000 was primarily due to us maintaining larger average cash
and investment balances, which resulted from the receipt of
research development funding and milestone payments from
collaborative partners and the completion of a follow-on public
offering in April 2000 and the initial sale of common stock
under an existing common stock equity line in December 2000.

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Interest Expense and Other.Interest expense was $1.1 million
in 2001 compared to $1.5 million in 2000 and
$0.9 million in 1999. The decrease in 2001 is primarily due
to the cancellation of the loan made by Genentech in connection
with product development that had been funded by them. The
increase in 2000 is due to higher outstanding capital lease and
equipment loan balances under various equipment and lease lines
of credit and interest expense accrued on increasing loan
balances made by Genentech in connection with the product
development agreement that had been funded by them.

Extraordinary Gain.During 2001, we reported an
extraordinary gain of approximately $6.7 million. The
extraordinary gain resulted from the cancellation of outstanding
loans and accrued interest required to conduct product
development with the program that had been funded by Genentech.

Net Loss.We
reported a net loss of $32.4 million in 2001, compared to
$35.6 million in 2000 and $23.6 million in 1999. The
decrease in net loss for 2001 is primarily due to the
$6.7 million extraordinary gain resulting from the
cancellation of outstanding loans and accrued interest required
to conduct product development under the program that had been
funded by Genentech offset by an increase in net loss from
operations, which was $39.3 million in 2001 and
$37.1 million in 2000 and a decrease in interest income,
which was $1.3 million in 2001 and $3.1 million in
2000. The increase in net loss for 2000 was primarily due to
increased research and development activities relating primarily
to the Genentech program, unfunded programs and activities for
our commercial scale-up efforts.

Deemed Dividend.We
reported a deemed dividend of $10.7 million in 2001, which
related to the Series A redeemable convertible preferred
stock financing completed in December 2001. The deemed dividend
represents the discounted conversion price of the financing
compared to the fair market value of our common stock on the
issuance date of the preferred stock resulting in a beneficial
conversion to the preferred stockholders. The value of the
beneficial conversion feature is reported as a deemed dividend
and is included in the calculation of net loss applicable to the
common shareholders.

Net Loss Applicable to Common Shareholders.We reported a net loss applicable to
common shareholders of $43.1 million in 2001, which
included a deemed dividend to the Series A redeemable
convertible preferred stock financing completed in December
2001. The net loss applicable to common shareholders is used in
the calculation for basic and diluted loss per share applicable
to common shareholders.

Liquidity and Capital Resources

Since inception, we have financed our operations
primarily through private placements and public offerings of our
capital stock, proceeds from equipment lease financings,
contract research funding and interest earned on investments. As
of December 31, 2001, we had cash, cash equivalents and
short-term investments of approximately $71.2 million.

Net cash used in operating activities in 2001 was
$29.1 million compared to $25.8 million in 2000 and
$27.0 million in 1999. The increase in net cash used in
2001 resulted primarily from an increase in net loss before
extraordinary gain combined with an increase in receivables
offset by an increase in deferred revenue. The decrease in net
loss was primarily due to the forgiveness of outstanding loans
and accrued interest under the cancellation of the development
agreement with Genentech. The increase in receivables was due to
invoiced, but unpaid, amounts due from partners for development
activities. The increase in deferred revenue is due to payments
received from our major partner to fund future program
development. The decrease in net cash used in 2000 resulted
primarily from increases in accounts payable and accrued
liabilities combined with a decrease in receivables, partially
offset by an increase in net loss and a decrease in deferred
revenue. The increase in accounts payable and accrued
liabilities is due to increased activity associated with our
development programs including capital expenditures. The
decrease in receivables is due to us receiving payments from our
partners for all billable activities associated with the
development programs. The decrease in deferred revenue is due
primarily to our partners funding future development activity
soon after year-end. The increase in net loss was primarily due
to accelerated activity with several development programs
including manufacturing commercial scale-up.

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Net cash used in investing activities in 2001 was
$14.7 million compared to $16.1 million in 2000 and
$6.0 million in 1999. The increase in cash used in 2001
resulted primarily from higher capital expenditures offset by a
net increase in proceeds from investments. The increase in cash
used in 2000 resulted primarily from higher capital expenditures.

Net cash provided by financing activities in 2001
was $93.0 million compared to $53.3 million in 2000
and $31.6 million in 1999. The increase in net cash
provided by financing activities in 2001 consisted primarily of
proceeds from the exercise of two put options during the year
from two of our partners, which raised net proceeds of
approximately $10 million, the sale of common stock during
the year using a common stock equity line, which raised net
proceeds of approximately $5.5 million, the sale of common
stock through a private placement in August 2001, which raised
net proceeds of approximately $13.8 million, the sale of
common stock to a major partner in October 2001, which raised
net proceeds of approximately $19.9 million and the sale of
redeemable convertible preferred stock in December 2001, which
raised net proceeds of approximately $45.4 million offset
by payments on equipment loans. The increase in net cash
provided by financing activities in 2000 consisted primarily of
proceeds from the completion of a follow-on public offering in
April 2000, which raised net proceeds of $42.6 million, the
initial sale of common stock under a common stock equity line in
December 2000, which raised proceeds of $2.2 million, the
sale of common stock through our employee benefit plans, which
raised proceeds of $4.0 million, notes payable supporting
loans received under a collaborative development agreement with
Genentech and proceeds from equipment loans.

The development of our technology and proposed
products will require a commitment of substantial funds to
conduct the costly and time-consuming research and preclinical
and clinical testing activities necessary to develop and refine
such technology and proposed products and to bring any such
products to market. Our future capital requirements will depend
on many factors, including continued progress and the results of
the research and development of our technology and drug delivery
systems, our ability to establish and maintain favorable
collaborative arrangements with others, progress with
preclinical studies and clinical trials and the results thereof,
the time and costs involved in obtaining regulatory approvals,
the cost of development and the rate of scale-up of our
production technologies, the cost involved in preparing, filing,
prosecuting, maintaining and enforcing patent claims, and the
need to acquire licenses or other rights to new technology.

We continue to review our planned operations
through the end of 2002, and beyond. We particularly focus on
capital spending requirements to ensure that capital outlays are
not expended sooner than necessary. We expect our total capital
outlays for 2002 will be approximately $25 million and for
2003 will be approximately $20 million. Thereafter, we
would anticipate that annual capital expenditures would decrease
significantly. Currently, we are contractually committed to less
than $5 million of the anticipated 2002 capital outlays. We
believe that our existing cash balances at December 31,
2001, together with the $25 million unused common stock
purchase commitment from Novo Nordisk, funding commitments from
corporate development partners and interest earned on our
investments should be sufficient to meet our needs for at least
the next twelve months. The sale of additional common stock to
Novo Nordisk is subject to certain conditions. In addition,
there can be no assurance that our funding commitments from
corporate development partners will not be amended or
terminated. If we cannot exercise our option to sell additional
shares of common stock to Novo Nordisk or if our current funding
commitments from corporate development partners are amended or
terminated, we will need to obtain additional sources of capital.

If we continue to make good progress in our
development programs, we would expect our cash requirements for
capital spending and operations to increase in future periods.
We will need to raise additional capital to fund our capital
spending and operations before we become profitable. We may seek
additional funding through collaborations, borrowing
arrangements or through public or private equity financings.
There can be no assurance that additional financing can be
obtained on acceptable terms, or at all. Dilution to
shareholders may result if funds are raised by issuing
additional equity securities. If adequate funds are not
available, we may be required to delay, to reduce the scope of,
or to eliminate one or more of our research and development
programs, or to obtain funds through arrangements with
collaborative partners or other sources that may require us to
relinquish rights to certain of our technologies or products
that we would not otherwise relinquish.

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The following summarizes our contractual
obligations at December 31, 2001, and the effect such
obligations are expected to have on our liquidity and cash flows
in future periods (In thousands):

|                                   |  |       |        |                        |  |       |        |         |  |   |        |  |  |   |        | 
|---------------------------------- |  | ----- | ------ | ---------------------- |  | ----- | ------ | ------- |  | - | ------ |  |  | - | ------ | 
|                                   |  |       |        |                       
|                                   |  |       |        | Payments Due by Period
|                                   |  |       |        |                       
|                                   |  |       |        | Less than              |  | 1-3   |        | After 3
|                                   |  | Total |        | 1 year                 |  | years |        | years  
|Contractual Obligations            |  |       |        |                        |  |       |        |        
|Capital Lease Obligations          |  | $     | 6,586  |                        |  | $     | 4,006  |         |  | $ | 2,580  |  |  | $ |       | 
|Unconditional Purchase Obligations |  |       | 5,000  |                        |  |       | 5,000  |         |  |   |       |  |  |   |       | 
|Operating Lease Obligations        |  |       | 66,537 |                        |  |       | 4,925  |         |  |   | 15,725 |  |  |   | 45,887 | 
|                                   |  |       |        |                        |  |       |        |         |  |   |        |  |  |   |        | 
|Total Contractual Commitments      |  | $     | 78,123 |                        |  | $     | 13,931 |         |  | $ | 18,305 |  |  | $ | 45,887 | 
|                                   |  |       |        |                        |  |       |        |         |  |   |        |  |  |   |        | 

Recent Financial Accounting
Pronouncements

In July 2001, the Financial Accounting Standards
Board issued Statements of Financial Standards
(SFAS) No. 141, Business Combinations, and
SFAS No. 142, Goodwill and Other Intangible
Assets. The new rules require business combinations
initiated after June 30, 2001 to be accounted for using the
purchase method of accounting and goodwill acquired after this
date will no longer be amortized, but will be subject to annual
impairment tests. All other intangible assets will continue to
be amortized over their estimated useful lives. Companies are
required to adopt SFAS No. 142 for fiscal years beginning
after December 31, 2001. The Company did not complete any
business combinations through the twelve months ended
December 31, 2001, as a result these standards did not have
a material impact on its financial position or operating results.

In August 2001, the FASB issued FASB Statement
No. 144 (FAS 144), Accounting for the Impairment
or Disposal of Long-lived Assets. FAS 144 supercedes
FASB Statement No. 121, Accounting for the Impairment of
Long-lived Assets and for Long-lived Assets to be Disposed of,
and the accounting and reporting provisions of APB Opinion
No. 30, Reporting the Results of Operations 
Reporting the Effects of Disposal of a Segment of a Business,
and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions, for the disposal of a segment of a business (as
previously defined in that Opinion). This Statement also amends
ARB No. 51, Consolidated Financial Statements, to eliminate
the exception to consolidation of a subsidiary for which control
is likely to be temporary. Companies are required to adopt
FAS 144 for fiscal years beginning after December 15,
2001, and interim periods within those fiscal years, but early
adoption is encouraged. The Company has not yet determined the
impact this standard will have on its financial position and
results of operations, although it does not anticipate that the
adoption of this standard will have a material impact on the
Companys financial position or results of operations.

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RISK FACTORS

Except for historical information contained
herein, the discussion in this Report on Form 10-K contains
forward-looking statements, including, without limitation,
statements regarding timing and results of clinical trials, the
establishment of corporate partnering arrangements, the
anticipated commercial introduction of our products and the
timing of our cash requirements. These forward-looking
statements involve certain risks and uncertainties that could
cause actual results to differ materially from those in such
forward-looking statements. Potential risks and uncertainties
include, without limitation, those mentioned in this report and
in particular the factors described below.

We are an early stage company.

You must evaluate us in light of the
uncertainties and complexities present in an early stage
company. Virtually all of our potential products are in an early
stage of research or development. Our potential drug delivery
products require extensive research, development and
pre-clinical and clinical testing. Our potential products also
may involve lengthy regulatory reviews before they can be sold.
Because none of our products has yet received approval by the
Food and Drug Administration or is yet in Phase 3 clinical trial
development, we cannot assure you that our research and
development efforts will be successful, any of our potential
products will be proven safe and effective or regulatory
clearance or approval to sell any of our potential products will
be obtained. Because we have validated only one manufacturing
facility, we cannot assure you that any of our potential
products can be manufactured in commercial quantities or at an
acceptable cost or marketed successfully. Failure to achieve
commercial feasibility, demonstrate safety, achieve clinical
efficacy, obtain regulatory approval or successfully market
products will negatively impact our business.

We have a history of losses and anticipate
future losses.

We have never been profitable, and through
December 31, 2001, we have incurred a cumulative deficit of
approximately $153.6 million. We have not had any material
product sales and do not anticipate receiving any revenue from
product sales in 2002. We expect to continue to incur
substantial losses over at least the next several years as we:



| |   |                                                         
| | - | --------------------------------------------------------
| |  | expand our research and development efforts;            
|
| |  | expand our preclinical and clinical testing
	activities;
|
| |  | expand our manufacturing efforts; and                   
|
| |  | plan and build our commercial production
	capabilities. 

To achieve and sustain profitability, we must,
alone or with others, develop, obtain regulatory approval for,
manufacture, market and sell products using our drug delivery
platform. We cannot assure investors that we will generate
sufficient product or contract research revenue to become
profitable or to sustain profitability.

We may not be able to develop our products
successfully.

Our AERx systems are at an early stage of
development and we are currently testing them using hand-held
prototypes. Before we can begin to sell the AERx systems
commercially, we will need to invest in substantial additional
development and conduct preclinical and clinical testing. In
order to further develop our AERx systems, we will need to
address engineering and design issues, which include ensuring
that the AERx systems can deliver a reproducible amount of drug
into the bloodstream and can be manufactured successfully as
hand-held systems. We cannot assure you that we will be
successful in addressing these design, engineering and
manufacturing issues. Additionally, we will need to formulate
and package drugs for delivery by our AERx systems. We cannot
assure you that we will be able to do this successfully.

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Even if our pulmonary delivery technology is
commercially feasible, it may not be commercially acceptable
across a range of large and small molecule drugs. For the AERx
systems to be commercially viable, we will need to demonstrate
that drugs delivered by the AERx systems:



| |   |                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------
| |  | are safe and effective;                                                                                       
|
| |  | will not be subject to physical or chemical
	instability over time and under differing storage conditions; and
|
| |  | do not suffer from other problems that would
	affect commercial viability.                                    

While our development efforts are at different
stages for different products, we cannot assure you that we will
successfully develop any products. We may also abandon some or
all of our proposed products. If we cannot develop potential
products in a timely manner, our business will be impaired.

We may not be able to commercialize products
successfully.

Our success in commercializing our products
depends on many factors, including acceptance by health care
professionals and patients. Their acceptance of our products
will largely depend on our ability to demonstrate our
products ability to compete with alternate delivery
systems with respect to:



| |   |                 
| | - | ----------------
| |  | safety;         
|
| |  | efficacy;       
|
| |  | ease of use; and
|
| |  | price.          

There can be no assurance that our products will
be competitive with respect to these factors or that our
partners will be able to successfully market any of them in a
timely manner.

We depend on collaborative partners and need
additional collaborative partners.

Our commercialization strategy depends on our
ability to enter into agreements with collaborative partners. In
particular, our ability to successfully develop and
commercialize the AERx insulin Diabetes Management System
depends on our development partnership with Novo Nordisk.

Novo Nordisk has agreed to:



| |   |                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------
| |  | undertake certain collaborative activities with
	us;                                                                     
|
| |  | design and conduct advanced clinical trials;                                                                             
|
| |  | fund research and development activities with us;                                                                        
|
| |  | pay us fees upon achievement of certain
	milestones; and                                                                 
|
| |  | purchase product at a defined premium, pay
	royalties and/or share gross profits if and when we
	commercialize a product.

The development and commercialization of the AERx
insulin Diabetes Management System will be delayed if Novo
Nordisk fails to conduct these collaborative activities in a
timely manner or at all. In addition, our development partners
could terminate these agreements and we have no assurance that
we will receive any development and milestone payments. If we do
not receive development funds or achieve milestones set forth in
the agreements, or if any of our development partners breach or
terminate their agreement, our business will be impaired.

Although we have development arrangements with
other collaborative partners, our arrangement with Novo Nordisk
is our only active funded development agreement. For the year
ended December 31, 2001, this partner-funded program
contributed approximately 90% of our total contract revenues.
Our agreement with Novo Nordisk can be terminated under certain
conditions, including by either party on limited written notice,

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by Novo Nordisk by limited prior written notice
upon the occurrence of certain events, and by either party upon
30 days written notice in the event that the other
party commits a material breach under the agreement and fails to
remedy such breach within 60 days notice of such
breach.


We will also need to enter into agreements with
other corporate partners to conduct the clinical trials,
manufacturing, marketing and sales necessary to commercialize
other potential products. In addition, our ability to apply the
AERx system to any proprietary drugs will depend on our ability
to establish and maintain corporate partnerships or other
collaborative arrangements with the holders of proprietary
rights to such drugs. We cannot assure you that we will be able
to establish such additional corporate partnerships or
collaborative arrangements on favorable terms or at all, or that
our existing or future corporate partnerships or collaborative
arrangements will be successful. In December 2000, our agreement
with GlaxoSmithKline was amended and we assumed full control and
responsibility for conducting and financing the remainder of all
development activities. In February 2001, we mutually agreed
with Genentech to discontinue our development program for
dornase alfa. Nor can we assure you that our existing or future
corporate partners or collaborators will not pursue alternative
technologies or develop alternative products either on their own
or in collaboration with others, including our competitors. We
could have disputes with our existing or future corporate
partners or collaborators. Any such disagreements could lead to
delays in the research, development or commercialization of any
potential products or could result in time-consuming and
expensive litigation or arbitration, which may not be resolved
in our favor. If any of our corporate partners or collaborators
do not develop or commercialize any product to which it has
obtained rights from us, our business could be impaired.

We have limited manufacturing
experience.

We have only limited manufacturing experience. We
have validated only a single clinical manufacturing facility for
disposable packets for our various AERx systems. We anticipate
spending significant amounts to attempt to provide for the
high-volume manufacturing required for multiple AERx products,
and much of this spending will occur before our products are
approved. There can be no assurance that:



| |   |                                                                                                                      
| | - | ---------------------------------------------------------------------------------------------------------------------
| |  | the design requirements of the AERx system will
	make it feasible for us to develop it beyond the current
	prototype;
|
| |  | manufacturing and quality control problems will
	not arise as we attempt to scale-up; or                             
|
| |  | any scale-up can be achieved in a timely manner
	or at a commercially reasonable cost.                               

Failure to address these issues could delay or
prevent late-stage clinical testing and commercialization of our
products.

We are building our own manufacturing
capabilities for the production of key components of our AERx
drug delivery systems. We plan to internally produce the
disposable nozzles, assemble the disposable unit-dose packets
and fill the drug into the unit-dose packets. We have limited
experience in manufacturing disposable unit-dose packets and
there can be no assurance that we can successfully do so in high
volumes, in a timely manner, at an acceptable cost, or at all.

We intend to use contract manufacturers to
produce key components, assemblies and subassemblies in the
clinical and commercial manufacturing of our AERx devices. There
can be no assurance that we will be able to enter into or
maintain satisfactory contract manufacturing arrangements.
Certain components of our products may be available, at least
initially, only from single sources. There can be no assurance
that we could find alternate suppliers for any of these
components. A delay of or interruption in production resulting
from any supply problem could have a material adverse effect on
our business.

We will need additional capital and our
ability to find additional funding is uncertain.

Our operations to date have consumed substantial
and increasing amounts of cash. We expect the negative cash flow
from operations to continue in the foreseeable future. We will
need to commit substantial funds to develop our technology and
proposed products. We will have to continue to conduct costly
and time-

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consuming research and preclinical and clinical
testing to develop, refine and commercialize our technology and
proposed products. Our future capital requirements will depend
on many factors, including:




| |   |                                                                                         
| | - | ----------------------------------------------------------------------------------------
| |  | progress in researching and developing our
	technology and drug delivery systems;       
|
| |  | our ability to establish and maintain favorable
	collaborative arrangements with others;
|
| |  | progress with preclinical studies and clinical
	trials;                                 
|
| |  | time and costs to obtain regulatory approvals;                                          
|
| |  | costs of development and the rate at which we
	expand our production technologies;      
|
| |  | costs of preparing, filing, prosecuting,
	maintaining and enforcing patent claims; and  
|
| |  | our need to acquire licenses or other rights to
	technology.                            

Since inception, we have financed our operations
primarily through private placements and public offerings of our
capital stock, proceeds from equipment lease financings,
contract research funding and interest earned on investments.

We anticipate that we will be able to maintain
current and planned operations for the next 12 months,
including capital spending requirements that will be
approximately $25 million, with proceeds from the sale of
Series A preferred stock and warrants to purchase common
stock in December 2001, committed funding from our corporate
development partners, primarily Novo Nordisk, and projected
interest; however, there can be no assurances that these sources
of funding will be sufficient or that our cash requirements will
not change.

The sale of additional common stock to Novo
Nordisk is subject to certain conditions. In addition, there can
be no assurance that our funding commitments from corporate
development partners will not be amended or terminated. If we
cannot exercise our option to sell additional shares of common
stock to Novo Nordisk or if our current funding commitments from
corporate development partners are amended or terminated, we
will need to obtain additional sources of capital.

We will need to raise additional capital to fund
our capital spending and operations before we become profitable.
We may seek additional funding through collaborations, borrowing
arrangements or through public or private equity financing. We
cannot assure you that additional financing can be obtained on
acceptable terms, or at all. Dilution to shareholders may result
if funds are raised by issuing additional equity securities. If
adequate funds are not available, we may be required to delay,
to reduce the scope of, or to eliminate one or more of our
research and development programs, or to obtain funds through
arrangements with collaborative partners or other sources that
may require us to relinquish rights to certain of our
technologies or products that we would not otherwise relinquish.

We depend upon proprietary technology and the
status of patents and proprietary technology is
uncertain.

Our business and competitive position is
dependent upon our ability to protect our proprietary technology
and avoid infringing the proprietary rights of others. We have
conducted original research on a number of aspects relating to
pulmonary drug delivery. While we cannot assure you that any of
our patents will provide a significant commercial advantage,
these patents are intended to provide protection for important
aspects of our technology, including methods for aerosol
generation, devices used to generate aerosols, breath control,
compliance monitoring certain pharmaceutical formulations,
design of dosage forms and their manufacturing, and testing
methods. In addition, we are maintaining as trade secrets some
of the key elements of our manufacturing technologies,
particularly those associated with production of disposable
unit-dose packets for the AERx systems.

Our success will depend to a significant extent
on our ability to obtain and enforce patents, maintain trade
secret protection and operate without infringing on the
proprietary rights of third parties. Because the field of
aerosolized drug delivery is crowded and a substantial number of
patents have been issued and because patent positions can be
highly uncertain and frequently involve complex legal and
factual questions, the breadth of

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claims obtained in any application or the
enforceability of our patents cannot be predicted.
Commercialization of pharmaceutical products can also be subject
to substantial delays as a result of the time required for
product development, testing and regulatory approval.


We also seek to protect some of these inventions
through foreign counterpart applications in selected other
countries. Statutory differences in patentable subject matter
may limit the protection we can obtain on some of our inventions
outside of the United States.

For example, methods of treating humans are not
patentable in many countries outside of the United States. These
and other issues may limit the patent protection we will be able
to secure outside of the United States.

The coverage claimed in a patent application can
be significantly reduced before a patent is issued, either in
the United States or abroad. Consequently, we do not know
whether any of our pending or future patent applications will
result in the issuance of patents or, to the extent patents have
been issued or will be issued, whether these patents will be
subjected to further proceedings limiting their scope, will
provide significant proprietary protection or competitive
advantage, or will be circumvented or invalidated. Furthermore,
patents already issued to us or our pending applications may
become subject to dispute, and any disputes could be resolved
against us. For example, Eli Lilly and Company has brought an
action against us seeking to have one or more employees of Eli
Lilly named as co-inventors on one of our patents. In addition,
because patent applications in the United States are currently
maintained in secrecy until patents issue, and patent
applications in certain other countries generally are not
published until more than 18 months after they are first
filed, and because publication of discoveries in scientific or
patent literature often lags behind actual discoveries, we
cannot be certain that we were the first creator of inventions
covered by pending patent applications or that we were the first
to file patent applications on such inventions.

Our policy is to require our officers, employees,
consultants and advisors to execute proprietary information and
invention and assignment agreements upon commencement of their
relationships with us. We cannot assure you, however, that these
agreements will provide meaningful protection for our
inventions, trade secrets or other proprietary information in
the event of unauthorized use or disclosure of such information.

We also execute confidentiality agreements with
outside collaborators and consultants. However, disputes may
arise as to the ownership of proprietary rights to the extent
that outside collaborators or consultants apply technological
information developed independently by them or others to our
projects, or apply our technology to other projects, and we
cannot assure you that any such disputes would be resolved in
our favor.

We may incur substantial costs if we are required
to defend ourselves in patent suits brought by third parties.
These legal actions could seek damages and seek to enjoin
testing, manufacturing and marketing of the accused product or
process. In addition to potential liability for significant
damages, we could be required to obtain a license to continue to
manufacture or market the accused product or process and we
cannot assure you that any license required under any such
patent would be made available to us on acceptable terms, if at
all. Litigation may also be necessary to enforce our patents
against others or to protect our know-how or trade secrets. Such
litigation could result in substantial expense, and we cannot
assure you that any litigation would be resolved in our favor.

We may not prevail in our defense of Eli
Lillys complaint against us.

At this time, we are involved in an outstanding
lawsuit with Eli Lilly and Company whereby Eli Lilly is making
various allegations against us, originally arising from our
decision to enter into an exclusive collaboration with Novo
Nordisk with respect to the development and commercialization of
a pulmonary delivery system for insulin and insulin analogs.
Following our motion for summary judgment directed against all
eight claims in Eli Lillys original complaint, Eli
Lillys claims for declaratory relief, unjust enrichment
and breach of contract (in part) currently remain.

The risks to us should Eli Lilly prevail in this
case are that Eli Lilly would be given the rights of an owner,
along with us, on one patent relating to pulmonary delivery of
monmeric insulin lispro and/or that Eli Lilly

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would be awarded damages on its remaining claims
for breach of contract and unjust enrichment. There can be no
assurance that we will prevail in this case.


We may not obtain regulatory approval for our
products on a timely basis, or at all.

All medical devices and new drugs, including our
products under development, are subject to extensive and
rigorous regulation by the federal government, principally the
Food and Drug Administration, or FDA, and by state and local
government agencies. Such regulations govern the development,
testing, manufacture, labeling, storage, approval, advertising,
promotion, sale and distribution of such products. Medical
devices or drug products that are marketed abroad are also
subject to regulation by foreign governments.

The process for obtaining FDA approvals for drug
products is generally lengthy, expensive and uncertain. Securing
FDA approvals often requires applicants to submit extensive
clinical data and supporting information to the FDA. Even if
granted, the FDA can withdraw product clearances and approvals
for failure to comply with regulatory requirements or upon the
occurrence of unforeseen problems following initial marketing.

The activities required before a new drug product
may be marketed in the United States includes pre-clinical and
clinical testing and submission of a new drug application with
the FDA. Preclinical 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. 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.

Human clinical trials typically are conducted in
three sequential phases, but the phases may overlap. Phase 1
trials consist of testing the product in a small number of
patients or normal volunteers, primarily for safety, at one or
more dosage levels, as well as characterization of a drugs
pharmacokinetic and/or pharmacodynamic profile. In Phase 2
clinical trials, in addition to safety, the efficacy of the
product is usually evaluated in a patient population. Phase 3
trials typically involve additional testing for safety and
clinical efficacy in an expanded population at geographically
disperse sites. All of the phases of clinical studies must be
conducted in conformance with FDAs bioresearch monitoring
regulations.

We cannot assure you that we will be able to
obtain necessary regulatory approvals on a timely basis, if at
all, for any of our potential products. Even if granted,
regulatory approvals may include significant limitations on the
uses for which products may be marketed. Moreover, we cannot
assure you that any required approvals, once obtained, will not
be withdrawn or that we will remain in compliance with other
regulatory requirements. If we, or manufacturers of our
components, fail to comply with applicable FDA and other
regulatory requirements, we, and they, are subject to sanctions,
including:



| |   |                                                                                       
| | - | --------------------------------------------------------------------------------------
| |  | warning letters;                                                                      
|
| |  | fines;                                                                                
|
| |  | product recalls or seizures;                                                          
|
| |  | injunctions;                                                                          
|
| |  | refusals to permit products to be imported into
	or exported out of the United States;
|
| |  | withdrawals of previously approved marketing
	applications; and                       
|
| |  | criminal prosecutions.                                                                

Manufacturers of drugs also are required to
comply with the applicable Good Manufacturing Practices, or GMP,
requirements, which relate to product testing, quality assurance
and maintaining records and documentation. We cannot assure you
that we will be able to comply with the applicable GMP and other
FDA regulatory requirements for manufacturing as we expand our
manufacturing operations, which would impair our business.

In addition, to market our products in foreign
jurisdictions, we and our partners must obtain required
regulatory approvals from foreign regulatory agencies and comply
with extensive regulations regarding safety

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and quality. We cannot assure you that we will
obtain regulatory approvals in such jurisdictions or that we
will not incur significant costs in obtaining or maintaining any
foreign regulatory approvals. If approvals to market our
products are delayed, if we fail to receive these approvals, or
if we lose previously received approvals, our business would be
impaired.


Because certain of our clinical studies involve
narcotics, we are registered with the Drug Enforcement Agency,
or DEA, and our facilities are subject to inspection and DEA
export, import, security and production quota requirements. We
cannot assure you that we will not be required to incur
significant costs to comply with DEA regulations in the future
or that such regulations will not otherwise harm our business.

The results of preclinical and clinical
testing are uncertain.

Before we can file for regulatory approval for
the commercial sale of our potential AERx products, the FDA will
require extensive preclinical and clinical testing to
demonstrate their safety and efficacy. To date, we have tested
prototype patient-operated versions of our AERx systems with
morphine, insulin and dornase alfa on a limited number of
individuals in Phase 1 and Phase 2 clinical trials. If
we do not or cannot complete these trials or progress to more
advanced clinical trials, we may not be able to commercialize
our AERx products.

Completing clinical trials in a timely manner
depends on, among other factors, the enrollment of patients. Our
ability to recruit patients depends on a number of factors,
including the size of the patient population, the proximity of
patients to clinical sites, the eligibility criteria for the
study and the existence of competitive clinical trials. Delays
in planned patient enrollment in our current or future clinical
trials may result in increased costs, program delays or both.

Although we believe the limited data we have
regarding our potential products is encouraging, the results of
initial preclinical and clinical testing do not necessarily
predict the results that we will get from subsequent or more
extensive preclinical and clinical testing. Furthermore, we
cannot assure you that clinical trials of these products will
demonstrate that these products are safe and effective to the
extent necessary to obtain regulatory approvals. Many companies
in the pharmaceutical and biotechnology industries have suffered
significant setbacks in advanced clinical trials, even after
promising results in earlier trials. If we cannot adequately
demonstrate that any therapeutic product we are developing is
safe and effective, regulatory approval of that product would be
delayed or prevented, which would impair our business.

We are also developing applications of our AERx
platform for the delivery of other compounds. These applications
are in early stages of development and we do not yet know the
degree of testing and development that will be needed to obtain
necessary marketing approvals from the FDA and other regulatory
agencies. We cannot assure you that these applications will
prove to be viable or that any necessary regulatory approvals
will be obtained in a timely manner, if at all.

In addition, the FDA may require us to provide
clinical data beyond what is currently planned to demonstrate
that the chronic administration of drugs delivered via the lung
for systemic effect is safe. We cannot assure you that we will
be able to present such data in a timely manner, or at all.

We are in a highly competitive market and our
competitors may develop alternative therapies.

We are in competition with pharmaceutical,
biotechnology and drug delivery companies, hospitals, research
organizations, individual scientists and nonprofit organizations
engaged in the development of alternative drug delivery systems
or new drug research and testing, as well as with entities
producing and developing injectable drugs. We are aware of a
number of companies such as Alkermes Pharmaceuticals and Inhale
Therapeutic Systems, Inc. that are currently seeking to develop
new products and non-invasive alternatives to injectable drug
delivery, including oral delivery systems, intranasal delivery
systems, transdermal systems, bucal and colonic absorption
systems. Several of these companies may have developed or are
developing dry powder devices that could be used for pulmonary
delivery. Many of these companies and entities have greater
research and development capabilities, experience,
manufacturing, marketing, financial and managerial resources
than we do. Accordingly, our competitors may succeed in
developing competing technologies, obtaining FDA approval for
products or gaining market acceptance more rapidly than we can.

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We depend on key personnel and must continue
to attract and retain key employees.

We depend on a small number of key management and
technical personnel. Losing any of these key employees could
harm our business and operations. Our success also depends on
our ability to attract and retain additional highly qualified
marketing, management, manufacturing, engineering and research
and development personnel. We face intense competition in our
recruiting activities and may not be able to attract or retain
qualified personnel.

We may be exposed to product
liability.

Researching, developing and commercializing
medical devices and therapeutic products entail significant
product liability risks. The use of our products in clinical
trials and the commercial sale of such products may expose us to
liability claims. These claims might be made directly by
consumers or by pharmaceutical companies or others selling such
products.

Companies often address the exposure of such risk
by obtaining product liability insurance. Although we currently
have product liability insurance, there can be no assurance that
we can maintain such insurance or obtain additional insurance on
acceptable terms, in amounts sufficient to protect our business,
or at all. A successful claim brought against us in excess of
our insurance coverage would have a material adverse effect on
our business.

Third-party reimbursement for our products is
uncertain.

In both domestic and foreign markets, sales of
our potential products depend in part on the availability of
reimbursement from third-party payors such as government health
administration authorities, private health insurers and other
organizations. Third-party payors often challenge the price and
cost-effectiveness of medical products and services. Significant
uncertainty exists as to the reimbursement status of newly
approved health care products. We cannot assure you that any of
our products will be reimbursable by third-party payors. In
addition, we cannot assure you that our products will be
considered cost-effective or that adequate third-party
reimbursement will be available to enable us to maintain price
levels sufficient to realize a profit. Legislation and
regulations affecting the pricing of pharmaceuticals may change
before our products are approved for marketing and any such
changes could further limit reimbursement.

We use hazardous materials.

Our operations involve use of hazardous and toxic
materials, chemicals and various radioactive compounds that
generate hazardous, toxic and radioactive wastes. Although we
believe that our safety procedures for handling and disposing of
such materials comply with all state and federal regulations and
standards, we cannot completely eliminate the risk of accidental
contamination or injury from these materials. In the event of
such an accident, we could be held liable for any damages that
result and such liability could exceed the resources of our
business.

Our stock price is likely to remain
volatile.

The market prices for securities of many
companies in the drug delivery industry, including ours, have
historically been highly volatile, and the market from time to
time has experienced significant price and volume fluctuations
unrelated to the operating performance of particular companies.
Prices for our common stock may be influenced by many factors,
including:



| |   |                                                                                                 
| | - | ------------------------------------------------------------------------------------------------
| |  | investor perception of us;                                                                      
|
| |  | analyst recommendations;                                                                        
|
| |  | fluctuations in our operating results;                                                          
|
| |  | market conditions relating to the drug delivery
	industry;                                      
|
| |  | announcements of technological innovations or new
	commercial products by us or our competitors;

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| |   |                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------
| |  | publicity regarding actual or potential
	developments relating to products under development by us or our
	competitors;
|
| |  | failure to establish new collaborative
	relationships;                                                                 
|
| |  | developments or disputes concerning patent or
	proprietary rights;                                                     
|
| |  | delays in the development or approval of our
	product candidates;                                                      
|
| |  | regulatory developments in both the United States
	and foreign countries;                                              
|
| |  | public concern as to the safety of drug delivery
	technologies;                                                        
|
| |  | period-to-period fluctuations in financial
	results;                                                                   
|
| |  | future sales of substantial amounts of common
	stock by shareholders; or                                               
|
| |  | economic and other external factors.                                                                                   

In the past, class action securities litigation
has often been instituted against companies following periods of
volatility in the market price of their securities. Any such
litigation instigated against us could result in substantial
costs and a diversion of managements attention and
resources.

We have implemented certain anti-takeover
provisions.

Certain provisions of our articles of
incorporation and the California General Corporation Law could
discourage a third party from acquiring, or make it more
difficult for a third party to acquire, control of us without
approval of our board of directors. These provisions could also
limit the price that certain investors might be willing to pay
in the future for shares of our common stock. Certain provisions
allow the board of directors to authorize the issuance of
preferred stock with rights superior to those of the common
stock. We are also subject to the provisions of
Section 1203 of the California General Corporation Law
which requires a fairness opinion to be provided to our
shareholders in connection with their consideration of any
proposed interested party reorganization transaction.

We have adopted a shareholder rights plan,
commonly known as a poison pill. The provisions
described above, our poison pill and provisions of the
California General Corporation Law may discourage, delay or
prevent a third party from acquiring us.




Item 7A.     Quantitative
and Qualitative Disclosure About Market Risk

Market Risk
Disclosure

In the normal course of business, our financial
position is routinely subject to a variety of risks, including
market risk associated with interest rate movement. We regularly
assess these risks and have established policies and business
practices to protect against these and other exposures. As a
result, we do not anticipate material potential losses in these
areas.

As of December 31, 2001, we had cash, cash
equivalents and short-term investments of $71.2 million
consisting of cash and highly liquid, short-term investments.
Our short-term investments will decline by an immaterial amount
if market interest rates increase, and therefore, our exposure
to interest rate changes has been immaterial. Declines of
interest rates over time will, however, reduce our interest
income from our short-term investments. Our outstanding
equipment lease lines and capital lease obligations are all at
fixed interest rates and, therefore, have minimal exposure to
changes in interest rates.

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Item 8.     Financial
Statements and Supplementary Data

REPORT OF ERNST & YOUNG LLP, INDEPENDENT
AUDITORS

The Board of Directors and Shareholders

Aradigm Corporation


We have audited the accompanying balance sheets
of Aradigm Corporation as of December 31, 2001 and 2000,
and the related statements of operations, redeemable convertible
preferred stock and shareholders equity, and cash flows
for each of the three years in the period ended
December 31, 2001. These financial statements are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these financial
statements based on our audits.

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

In our opinion, the financial statements referred
to above present fairly, in all material respects, the financial
position of Aradigm Corporation at December 31, 2001 and
2000, and the results of its operations and its cash flows for
each of the three years in the period ended December 31,
2001, in conformity with accounting principles generally
accepted in the United States.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

Palo Alto, California

February 15, 2002


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ARADIGM CORPORATION

BALANCE SHEETS

(In thousands, except shares data)


|                                                                                                                                                                                                                            |                                                                                                                                 |                                                                                     |        |          |         |  |        |          |        | 
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------- | ------ | -------- | ------- |  | ------ | -------- | ------ | 
|                                                                                                                                                                                                                            |                                                                                                                                 |                                                                                    
|                                                                                                                                                                                                                            |                                                                                                                                 | December 31,                                                                       
|                                                                                                                                                                                                                            |                                                                                                                                 |                                                                                    
|                                                                                                                                                                                                                            |                                                                                                                                 | 2001                                                                                |        | 2000    
|Assets                                                                                                                                                                                                                      |                                                                                                                                 |                                                                                     |        |         
|Current assets:                                                                                                                                                                                                             |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|                                                                                                                                                                                                                            | Cash and cash equivalents                                                                                                       |                                                                                     | $      | 69,965   |         |  | $      | 20,732   |       
|                                                                                                                                                                                                                            | Short-term investments                                                                                                          |                                                                                     |        | 1,199    |         |  |        | 23,649   |       
|                                                                                                                                                                                                                            | Receivables                                                                                                                     |                                                                                     |        | 1,349    |         |  |        | 70       |       
|                                                                                                                                                                                                                            | Current portion of notes receivable from officers
	and employees                                                                |                                                                                     |        | 145      |         |  |        |         |       
|                                                                                                                                                                                                                            | Other current assets                                                                                                            |                                                                                     |        | 812      |         |  |        | 735      |       
|                                                                                                                                                                                                                            |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|                                                                                                                                                                                                                            |                                                                                                                                 | Total current assets                                                                |        |          | 73,470  |  |        |          | 45,186 | 
|Property and equipment, net                                                                                                                                                                                                 |                                                                                                                                 |                                                                                     | 57,940 |          |         |  | 25,323 |         
|Noncurrent portion of notes receivable from
	officers and employees                                                                                                                                                         |                                                                                                                                 |                                                                                     | 160    |          |         |  | 119    |         
|Other assets                                                                                                                                                                                                                |                                                                                                                                 |                                                                                     | 530    |          |         |  | 743    |         
|                                                                                                                                                                                                                            |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|                                                                                                                                                                                                                            |                                                                                                                                 | Total assets                                                                        |        | $        | 132,100 |  |        | $        | 71,371 | 
|                                                                                                                                                                                                                            |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|Liabilities, Redeemable Convertible Preferred
	Stock and Shareholders Equity                                                                                                                                               |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|Current liabilities:                                                                                                                                                                                                        |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|                                                                                                                                                                                                                            | Accounts payable                                                                                                                |                                                                                     | $      | 5,297    |         |  | $      | 4,894    |       
|                                                                                                                                                                                                                            | Accrued clinical and cost of other studies                                                                                      |                                                                                     |        | 703      |         |  |        | 517      |       
|                                                                                                                                                                                                                            | Accrued compensation                                                                                                            |                                                                                     |        | 1,761    |         |  |        | 1,246    |       
|                                                                                                                                                                                                                            | Deferred revenue                                                                                                                |                                                                                     |        | 11,115   |         |  |        | 6,622    |       
|                                                                                                                                                                                                                            | Other accrued liabilities                                                                                                       |                                                                                     |        | 2,760    |         |  |        | 2,234    |       
|                                                                                                                                                                                                                            | Current portion of notes payable                                                                                                |                                                                                     |        |         |         |  |        | 6,712    |       
|                                                                                                                                                                                                                            | Current portion of capital lease obligations                                                                                    |                                                                                     |        | 3,526    |         |  |        | 3,099    |       
|                                                                                                                                                                                                                            |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|                                                                                                                                                                                                                            |                                                                                                                                 | Total current liabilities                                                           |        |          | 25,162  |  |        |          | 25,324 | 
|Noncurrent portion of deferred revenue                                                                                                                                                                                      |                                                                                                                                 |                                                                                     | 2,327  |          |         |  | 2,032  |         
|Capital lease obligations and other, less current
	portion                                                                                                                                                                  |                                                                                                                                 |                                                                                     | 2,727  |          |         |  | 6,230  |         
|Commitments and contingencies                                                                                                                                                                                               |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|Redeemable convertible preferred stock, no par
	value; 5,000,000 shares authorized; issued and outstanding
	shares; 2001 - 2,001,236; 2000 - zero; liquidation
	preference of $48,430 and $0 in 2001 and 2000, respectively |                                                                                                                                 |                                                                                     | 30,735 |          |         |  |       |         
|Shareholders equity:                                                                                                                                                                                                       |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|                                                                                                                                                                                                                            | Common stock, no par value, 40,000,000 shares
	authorized; issued and outstanding shares: 2001 -
	29,536,383; 2000 - 18,266,955 |                                                                                     |        | 224,738  |         |  |        | 148,573  |       
|                                                                                                                                                                                                                            | Shareholder notes receivable                                                                                                    |                                                                                     |        |         |         |  |        | (131     | )     
|                                                                                                                                                                                                                            | Deferred compensation                                                                                                           |                                                                                     |        | (54      | )       |  |        | (216     | )     
|                                                                                                                                                                                                                            | Accumulated deficit                                                                                                             |                                                                                     |        | (153,535 | )       |  |        | (110,441 | )     
|                                                                                                                                                                                                                            |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|                                                                                                                                                                                                                            |                                                                                                                                 | Total shareholders equity                                                          |        |          | 71,149  |  |        |          | 37,785 | 
|                                                                                                                                                                                                                            |                                                                                                                                 |                                                                                     |        |          |         |  |        |         
|                                                                                                                                                                                                                            |                                                                                                                                 | Total liabilities, redeemable convertible
	preferred stock and shareholders equity |        | $        | 132,100 |  |        | $        | 71,371 | 
|                                                                                                                                                                                                                            |                                                                                                                                 |                                                                                     |        |          |         |  |        |         

See accompanying notes.

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ARADIGM CORPORATION

STATEMENTS OF OPERATIONS

(In thousands, except per share
data)


|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |        |        | 
|-------------------------------------------------------------------------------------------- | -------------------------- | ------------------------ | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                                                             |                            |                         
|                                                                                             |                            | Years Ended December 31,
|                                                                                             |                            |                         
|                                                                                             |                            | 2001                     |         | 2000   |        | 1999
|                                                                                             |                            |                          |         |        |        |     
|Contract and license revenues                                                                |                            | $                        | 28,916  |        |        | $    | 20,303  |        |        | $ | 16,812  |       
|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |       
|Operating expenses:                                                                          |                            |                          |         |        |        |      |         |        |        |   |         |       
|                                                                                             | Research and development   |                          |         | 58,836 |        |      |         | 48,176 |        |   |         | 33,625 |       
|                                                                                             | General and administrative |                          |         | 9,355  |        |      |         | 9,271  |        |   |         | 7,849  |       
|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |       
|                                                                                             |                            | Total expenses           |         |        | 68,191 |      |         |        | 57,447 |   |         |        | 41,474 | 
|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |       
|Loss from operations                                                                         |                            |                          | (39,275 | )      |        |      | (37,144 | )      |        |   | (24,662 | )     
|Interest income                                                                              |                            |                          | 1,324   |        |        |      | 3,110   |        |        |   | 1,947   |       
|Interest expense and other                                                                   |                            |                          | (1,081  | )      |        |      | (1,528  | )      |        |   | (888    | )     
|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |       
|Net loss before extraordinary gain                                                           |                            |                          | (39,032 | )      |        |      | (35,562 | )      |        |   | (23,603 | )     
|Extraordinary gain                                                                           |                            |                          | 6,675   |        |        |      |        |        |        |   |        |       
|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |       
|Net loss                                                                                     |                            |                          | (32,357 | )      |        |      | (35,562 | )      |        |   | (23,603 | )     
|Deemed dividend                                                                              |                            |                          | (10,722 | )      |        |      |        |        |        |   |        |       
|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |       
|Net loss applicable to common shareholders                                                   |                            | $                        | (43,079 | )      |        | $    | (35,562 | )      |        | $ | (23,603 | )     
|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |       
|Basic and diluted loss per share applicable to
	common shareholders:                         |                            |                          |         |        |        |      |         |        |        |   |         |       
|Loss before extraordinary gain                                                               |                            | $                        | (2.28   | )      |        | $    | (2.07   | )      |        | $ | (1.66   | )     
|Extraordinary gain                                                                           |                            |                          | 0.30    |        |        |      |        |        |        |   |        |       
|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |       
|Net loss applicable to common shareholders                                                   |                            | $                        | (1.98   | )      |        | $    | (2.07   | )      |        | $ | (1.66   | )     
|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |       
|Shares used in computing basic and diluted loss
	per share applicable to common shareholders |                            |                          | 21,792  |        |        |      | 17,196  |        |        |   | 14,216  |       
|                                                                                             |                            |                          |         |        |        |      |         |        |        |   |         |       

See accompanying notes.

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##### Table of Contents



ARADIGM CORPORATION

STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED
STOCK AND SHAREHOLDERS EQUITY

(In thousands, except shares data)


|                              |                                                                                                                                                  |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |        |         |     |         |  
|----------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------ | ---------------------------------- | ---------------------------------------------------------------- | ------------------------ | - | ----------- | ------ | -------- | - | ----------- | ---------- | ------------- | - | ------- | ------- | ------ | - | - | ---- | --- | - | - | ---- | --- | - | - | -------- | ------- | ------- | --- | ------- | ------ | ------- | --- | ------- | -
|                              |                                                                                                                                                  |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |        
|                              |                                                                                                                                                  | Redeemable                         |                                                                  |                          |   |             |        |          |   |             |            |               |   |        
|                              |                                                                                                                                                  | Convertible                        |                                                                  |                          |   |             |        |          |   |             |            |              
|                              |                                                                                                                                                  | Preferred Stock                    |                                                                  | Common Stock             |   | Shareholder |        |          |   |             |            | Total        
|                              |                                                                                                                                                  |                                    |                                                                  |                          |   | Notes       |        | Deferred |   | Accumulated |            | Shareholders
|                              |                                                                                                                                                  | Shares                             |                                                                  | Amount                   |   | Shares      |        | Amount   |   | Receivable  |            | Compensation  |   | Deficit |         | Equity
|                              |                                                                                                                                                  |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |       
|Balances at December 31, 1998 |                                                                                                                                                  |                                    |                                                                 |                          |   | $           |       |          |   |             | 12,163,616 |               |   | $       | 73,768  |        |   | $ | (288 | )   |   | $ | (541 | )   |   | $ | (51,279  | )       |         | $   | 21,660  |       
|                              | Issuance of common stock for cash, net                                                                                                           |                                    |                                                                  |                         |   |             |        |         |   |             |            | 2,428,338     |   |         |         | 24,798 |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 24,798 |        
|                              | Issuance of common stock under the employee stock
	purchase plan                                                                                 |                                    |                                                                  |                         |   |             |        |         |   |             |            | 98,860        |   |         |         | 713    |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 713    |        
|                              | Issuance of common stock upon exercise of stock
	options                                                                                         |                                    |                                                                  |                         |   |             |        |         |   |             |            | 58,963        |   |         |         | 324    |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 324    |        
|                              | Repayment of shareholders notes                                                                                                                 |                                    |                                                                  |                         |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      | 125 |   |   |      |    |   |   |          |        |         |     |         | 125    |        
|                              | Amortization of deferred compensation                                                                                                            |                                    |                                                                  |                         |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      |    |   |   |      | 162 |   |   |          |        |         |     |         | 162    |        
|                              | Comprehensive loss:                                                                                                                              |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |        |        
|                              |                                                                                                                                                  | Net loss                           |                                                                  |                          |  |             |        |          |  |             |            |               |  |         |         |        |  |   |      |     |  |   |      |     |  |   |          |         | (23,603 | )   |         |        | (23,603 | )  
|                              |                                                                                                                                                  | Other comprehensive income (loss): |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |        |         |    
|                              |                                                                                                                                                  |                                    | Net change in unrealized loss on
	available-for-sale investments |                          |   |            |        |          |   |            |            |               |   |        |         |        |   |  |      |     |   |  |      |     |   |  |          |         |         | (22 | )       |        |         | (22 | )      
|                              |                                                                                                                                                  |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |       
|                              |                                                                                                                                                  |                                    |                                                                  | Total comprehensive loss |   |             |       |          |   |             |           |               |   |         |        |        |   |   |     |     |   |   |     |     |   |   |         |         |         |     | (23,625 | )      |         |     | (23,625 | )
|                              |                                                                                                                                                  |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |       
|Balances at December 31, 1999 |                                                                                                                                                  |                                    |                                                                 |                          |   |             |       |          |   |             | 14,749,777 |               |   |         | 99,603  |        |   |   | (163 | )   |   |   | (379 | )   |   |   | (74,904  | )       |         |     | 24,157  |       
|                              | Issuance of common stock for cash, net                                                                                                           |                                    |                                                                  |                         |   |             |        |         |   |             |            | 2,989,795     |   |         |         | 44,676 |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 44,676 |        
|                              | Issuance of common stock under the employee stock
	purchase plan                                                                                 |                                    |                                                                  |                         |   |             |        |         |   |             |            | 129,414       |   |         |         | 1,058  |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 1,058  |        
|                              | Issuance of common stock upon exercise of stock
	options                                                                                         |                                    |                                                                  |                         |   |             |        |         |   |             |            | 318,676       |   |         |         | 2,940  |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 2,940  |        
|                              | Issuance of common stock for services                                                                                                            |                                    |                                                                  |                         |   |             |        |         |   |             |            | 728           |   |         |         | 3      |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 3      |        
|                              | Issuance of warrants for services                                                                                                                |                                    |                                                                  |                         |   |             |        |         |   |             |            |              |   |         |         | 293    |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 293    |        
|                              | Issuance of common stock for warrants                                                                                                            |                                    |                                                                  |                         |   |             |        |         |   |             |            | 78,565        |   |         |         |       |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         |       |        
|                              | Repayment of shareholders notes                                                                                                                 |                                    |                                                                  |                         |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      | 32  |   |   |      |    |   |   |          |        |         |     |         | 32     |        
|                              | Amortization of deferred compensation                                                                                                            |                                    |                                                                  |                         |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      |    |   |   |      | 163 |   |   |          |        |         |     |         | 163    |        
|                              | Comprehensive loss:                                                                                                                              |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |        |        
|                              |                                                                                                                                                  | Net loss                           |                                                                  |                          |  |             |        |          |  |             |            |               |  |         |         |        |  |   |      |     |  |   |      |     |  |   |          |         | (35,562 | )   |         |        | (35,562 | )  
|                              |                                                                                                                                                  | Other comprehensive income (loss): |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |        |         |    
|                              |                                                                                                                                                  |                                    | Net change in unrealized gain on
	available-for-sale investments |                          |   |            |        |          |   |            |            |               |   |        |         |        |   |  |      |     |   |  |      |     |   |  |          |         |         | 25  |         |        |         | 25  |        
|                              |                                                                                                                                                  |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |       
|                              |                                                                                                                                                  |                                    |                                                                  | Total comprehensive loss |   |             |       |          |   |             |           |               |   |         |        |        |   |   |     |     |   |   |     |     |   |   |         |         |         |     | (35,537 | )      |         |     | (35,537 | )
|                              |                                                                                                                                                  |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |       
|Balances at December 31, 2000 |                                                                                                                                                  |                                    |                                                                 |                          |   |             |       |          |   |             | 18,266,955 |               |   |         | 148,573 |        |   |   | (131 | )   |   |   | (216 | )   |   |   | (110,441 | )       |         |     | 37,785  |       
|                              | Issuance of common stock for cash, net of
	issuance costs of $956                                                                                |                                    |                                                                  |                         |   |             |        |         |   |             |            | 10,881,733    |   |         |         | 49,189 |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 49,189 |        
|                              | Issuance of common stock under the employee stock
	purchase plan                                                                                 |                                    |                                                                  |                         |   |             |        |         |   |             |            | 357,146       |   |         |         | 1,326  |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 1,326  |        
|                              | Issuance of common stock upon exercise of stock
	options                                                                                         |                                    |                                                                  |                         |   |             |        |         |   |             |            | 30,549        |   |         |         | 204    |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 204    |        
|                              | Issuance of redeemable convertible preferred
	stock for cash, net of issuance costs of $3,000 and proceeds
	from issuance of warrants of $14,724 |                                    |                                                                  | 2,001,236                |   |             |        | 30,735   |   |             |            |              |   |         |         | 14,724 |   |   |      |    |   |   |      |    |   |   |          |        |         |     |         | 14,724 |        
|                              | Deemed non-cash dividend on redeemable
	convertible preferred stock                                                                              |                                    |                                                                  |                         |   |             |        |         |   |             |            |              |   |         |         | 10,722 |   |   |      |    |   |   |      |    |   |   |          | (10,722 | )       |     |         |       |        
|                              | Repayment of shareholders notes                                                                                                                 |                                    |                                                                  |                         |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      | 131 |   |   |      |    |   |   |          |        |         |     |         | 131    |        
|                              | Amortization of deferred compensation                                                                                                            |                                    |                                                                  |                         |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      |    |   |   |      | 162 |   |   |          |        |         |     |         | 162    |        
|                              | Comprehensive loss:                                                                                                                              |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |        |        
|                              |                                                                                                                                                  | Net loss                           |                                                                  |                          |  |             |        |          |  |             |            |               |  |         |         |        |  |   |      |     |  |   |      |     |  |   |          |         | (32,357 | )   |         |        | (32,357 | )  
|                              |                                                                                                                                                  | Other comprehensive income (loss): |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |        |         |    
|                              |                                                                                                                                                  |                                    | Net change in unrealized loss on
	available-for-sale investments |                          |   |            |        |          |   |            |            |               |   |        |         |        |   |  |      |     |   |  |      |     |   |  |          |         |         | (15 | )       |        |         | (15 | )      
|                              |                                                                                                                                                  |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |       
|                              |                                                                                                                                                  |                                    |                                                                  | Total comprehensive loss |   |             |       |          |   |             |           |               |   |         |        |        |   |   |     |     |   |   |     |     |   |   |         |         |         |     | (32,372 | )      |         |     | (32,372 | )
|                              |                                                                                                                                                  |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |       
|Balances at December 31, 2001 |                                                                                                                                                  |                                    | 2,001,236                                                        |                          |   | $           | 30,735 |          |   |             | 29,536,383 |               |   | $       | 224,738 |        |   | $ |     |     |   | $ | (54  | )   |   | $ | (153,535 | )       |         | $   | 71,149  |       
|                              |                                                                                                                                                  |                                    |                                                                  |                          |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |         |         |     |         |       

See accompanying notes.

41



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##### Table of Contents



ARADIGM CORPORATION

STATEMENTS OF CASH FLOWS

(In thousands)


|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |       |        |  
|------------------------------------------------------------------------------------------------ | --------------------------------------------------------------------------- | ------------------------ | ------- | ------ | ------ | ---- | ------- | ----- | ------ | - | ------- | ----- | ------ | -
|                                                                                                 |                                                                             |                         
|                                                                                                 |                                                                             | Years Ended December 31,
|                                                                                                 |                                                                             |                         
|                                                                                                 |                                                                             | 2001                     |         | 2000   |        | 1999
|                                                                                                 |                                                                             |                          |         |        |        |     
|Cash flows from operating activities:                                                            |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Net loss                                                                                         |                                                                             | $                        | (32,357 | )      |        | $    | (35,562 | )     |        | $ | (23,603 | )    
|Adjustments to reconcile net loss to net cash
	used in operating activities:                     |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|                                                                                                 | Depreciation and amortization                                               |                          |         | 4,500  |        |      |         | 3,213 |        |   |         | 2,356 |       
|                                                                                                 | Extraordinary gain related to forgiveness of
	Genentech note                |                          |         | (6,675 | )      |      |         |      |        |   |         |      |       
|                                                                                                 | Loss on sale of equipment                                                   |                          |         |       |        |      |         |      |        |   |         | 15    |       
|                                                                                                 | Issuance of warrants and common stock for services                          |                          |         | 48     |        |      |         | 296   |        |   |         |      |       
|                                                                                                 | Amortization of deferred compensation                                       |                          |         | 162    |        |      |         | 163   |        |   |         | 162   |       
|                                                                                                 | Changes in operating assets and liabilities:                                |                          |         |        |        |      |         |       |        |   |         |       |       
|                                                                                                 |                                                                             | Receivables              |         |        | (1,279 | )    |         |       | 3,816  |   |         |       | (3,112 | )
|                                                                                                 |                                                                             | Other current assets     |         |        | (77    | )    |         |       | 278    |   |         |       | (421   | )
|                                                                                                 |                                                                             | Other assets             |         |        | 213    |      |         |       | (401   | ) |         |       | (126   | )
|                                                                                                 |                                                                             | Accounts payable         |         |        | 403    |      |         |       | 2,654  |   |         |       | 261    |  
|                                                                                                 |                                                                             | Accrued compensation     |         |        | 515    |      |         |       | (29    | ) |         |       | 14     |  
|                                                                                                 |                                                                             | Accrued liabilities      |         |        | 675    |      |         |       | 2,129  |   |         |       | (902   | )
|                                                                                                 |                                                                             | Deferred revenue         |         |        | 4,788  |      |         |       | (2,370 | ) |         |       | (1,649 | )
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Net cash used in operating activities                                                            |                                                                             |                          | (29,084 | )      |        |      | (25,813 | )     |        |   | (27,005 | )    
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Cash flows from investing activities:                                                            |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Capital expenditures                                                                             |                                                                             |                          | (37,117 | )      |        |      | (14,376 | )     |        |   | (4,349  | )    
|Proceeds for sale of equipment                                                                   |                                                                             |                          |        |        |        |      |        |       |        |   | 14      |      
|Purchases of available-for-sale investments                                                      |                                                                             |                          | (5,732  | )      |        |      | (26,764 | )     |        |   | (30,841 | )    
|Proceeds from maturities of available-for-sale
	investments                                      |                                                                             |                          | 28,167  |        |        |      | 25,052  |       |        |   | 29,178  |      
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Net cash used in investing activities                                                            |                                                                             |                          | (14,682 | )      |        |      | (16,088 | )     |        |   | (5,998  | )    
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Cash flows from financing activities:                                                            |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Proceeds from issuance of common stock, net                                                      |                                                                             |                          | 50,671  |        |        |      | 48,674  |       |        |   | 25,835  |      
|Proceeds from issuance of redeemable convertible
	preferred stock and common stock warrants, net |                                                                             |                          | 45,459  |        |        |      |        |       |        |   |        |      
|Notes payable                                                                                    |                                                                             |                          |        |        |        |      | 2,756   |       |        |   | 3,956   |      
|Proceeds from repayments of shareholder notes                                                    |                                                                             |                          | 131     |        |        |      | 32      |       |        |   | 125     |      
|Notes receivable from officers                                                                   |                                                                             |                          | (186    | )      |        |      | 11      |       |        |   | 5       |      
|Proceeds from equipment loans                                                                    |                                                                             |                          |        |        |        |      | 4,051   |       |        |   | 3,294   |      
|Payments on capital lease obligations and
	equipment loans                                       |                                                                             |                          | (3,076  | )      |        |      | (2,238  | )     |        |   | (1,630  | )    
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Net cash provided by financing activities                                                        |                                                                             |                          | 92,999  |        |        |      | 53,286  |       |        |   | 31,585  |      
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Net increase (decrease) in cash and cash
	equivalents                                            |                                                                             |                          | 49,233  |        |        |      | 11,385  |       |        |   | (1,418  | )    
|Cash and cash equivalents at beginning of year                                                   |                                                                             |                          | 20,732  |        |        |      | 9,347   |       |        |   | 10,765  |      
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Cash and cash equivalents at end of year                                                         |                                                                             | $                        | 69,965  |        |        | $    | 20,732  |       |        | $ | 9,347   |      
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Supplemental disclosure of cash flow information:                                                |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|                                                                                                 | Cash paid for interest                                                      |                          | $       | 899    |        |      | $       | 855   |        |   | $       | 820   |       
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|Non-cash investing and financing activities:                                                     |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|                                                                                                 | Issuance of warrants and common stock for services                          |                          | $       | 48     |        |      | $       | 296   |        |   | $       |      |       
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|                                                                                                 | Issuance of warrants in conjunction with private
	placement of common stock |                          | $       | 979    |        |      | $       |      |        |   | $       |      |       
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      
|                                                                                                 | Redeemable convertible preferred stock deemed,
	non-cash dividend           |                          | $       | 10,722 |        |      | $       |      |        |   | $       |      |       
|                                                                                                 |                                                                             |                          |         |        |        |      |         |       |        |   |         |      

See accompanying notes

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ARADIGM CORPORATION

NOTES TO FINANCIAL STATEMENTS

1.     Summary of
Significant Accounting Policies

Organization
and Basis of Presentation

Aradigm Corporation (the Company) is
a California corporation engaged in the development and
commercialization of non-invasive pulmonary drug delivery
systems. The Company does not anticipate receiving significant
revenue from the sale of products in the upcoming year.
Principal activities to date have included obtaining financing,
recruiting management and technical personnel, securing
operating facilities, conducting research and development, and
expanding commercial production capabilities. These factors
indicate that the Companys ability to continue its
research, development and commercialization activities are
dependent upon the ability of management to obtain additional
financing as required.

Use of
Estimates

The preparation of financial statements in
conformity with generally accepted accounting principles
requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and
accompanying notes. These estimates include useful lives for
property and equipment and related depreciation calculations,
estimated amortization period for payments received from product
development and license agreements as they relate to the revenue
recognition of deferred revenue and assumptions for valuing
options, warrants and deemed dividend. Actual results could
differ from these estimates.

Cash
Equivalents and Investments

The Company considers all highly liquid
investments purchased with an original maturity of three months
or less to be cash equivalents. The Company places its cash and
cash equivalents in money market funds, commercial paper and
corporate notes. The Companys short-term investments
consist of commercial paper and corporate notes with maturities
ranging from three to twelve months.

The Company classifies its investments as
available-for-sale. Available-for-sale investments are recorded
at fair value with unrealized gains and losses reported as other
comprehensive income (loss) in a separate component of the
statements of redeemable convertible preferred stock and
shareholders equity until realized. Fair values of
investments are based on quoted market prices, where available.
Realized gains and losses, which have been immaterial to date,
are included in interest and other income and are derived using
the specific identification method for determining the cost of
investments sold. Dividend and interest income is recognized
when earned.

Depreciation
and Amortization

The Company records property and equipment at
cost and calculates depreciation using the straight-line method
over the estimated useful lives of the respective assets.
Leasehold improvements are amortized over the shorter of the
term of the lease or useful life of the improvement. The
estimated useful lives of property and equipment are as follows:

|                                |  |              
|------------------------------- |  | -------------
|Machinery and equipment         |  | 5 to 7 years 
|Furniture and fixtures          |  | 5 to 7 years 
|Lab equipment                   |  | 5 to 7 years 
|Computer equipment and software |  | 3 to 5 years 
|Leasehold improvements          |  | 5 to 17 years

Impairment of
Long-Lived Assets

The Company reviews for impairment whenever
events or changes in circumstances indicates that the carrying
amount of property and equipment may not be recoverable under
the provisions of Statement of

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

Financial Accounting Standards No. 121,
Accounting for the Impairment of Long-Lived Assets and for Long
Lived Assets to be Disposed Of. If it is determined that an
impairment loss has occurred based on expected future cash
flows, the loss is recognized on the Statements of Operations.

Revenue
Recognition

Contract revenues consist of revenue from
collaboration agreements and feasibility studies. The Company
recognizes revenue under the agreements as costs are incurred.
Deferred revenue represents the portion of all refundable and
nonrefundable research payments received that have not been
earned. In accordance with contract terms, milestone payments
from collaborative research agreements are considered
reimbursements for costs incurred under the agreements and,
accordingly, are generally recognized as revenue either upon the
completion of the milestone effort when payments are contingent
upon completion of the effort or are based on actual efforts
expended over the remaining term of the agreements when payments
precede the required efforts. Costs of contract revenues
approximate such revenue and are included in research and
development expenses. Refundable development and license fee
payments are deferred until the specified performance criteria
are achieved. Refundable development and license fee payments
are generally not refundable once the specific performance
criteria are achieved.

Research and
Development

Research and development expenses consist of
costs incurred for company-sponsored, collaborative and
contracted research and development activities. These costs
include direct and research-related overhead expenses. Research
and development expenses under collaborative and government
grants approximate the revenue recognized under such agreements.
The Company expenses research and development costs as such
costs are incurred.

Stock Based
Compensation

The Company has elected to follow Accounting
Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees (APB 25), and related
interpretations in accounting for its employee stock options.
This election was made because the alternative fair value
accounting provided for under Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based
Compensation (SFAS 123), requires the use of option
valuation models that were not developed for use in valuing
employee stock options.

The Company accounts for options and warrants
issued to nonemployees under SFAS 123 and Emerging Issues
Task Force Issue No. 96-18. The value of options and
warrants are periodically remeasured over their vesting terms.

Income
Taxes

The Company uses the liability method to account
for income taxes as required by Statement of Financial
Accounting Standards No. 109, Accounting for Income
Taxes. Under this method, deferred income taxes reflect
the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes.

Net Loss Per
Share

Historical net loss per share has been calculated
under Statement of Financial Accounting Standards No. 128,
Earnings Per Share. Basic net loss per share on a
historical basis is computed using the weighted average number
of shares of common stock outstanding less the weighted average
number of shares subject to repurchase. In the years ended
December 31, 2001, 2000 and 1999, the weighted average
number of shares subject to repurchase were zero, zero and
48,000, respectively. No diluted loss per share information has
been

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

presented in the accompanying statements of
operations since potential common shares from stock options,
warrants and redeemable convertible preferred stocks are
antidilutive. For the years ended December 31, 2001, 2000
and 1999, the total number of shares excluded from diluted loss
per share relating to these securities was 10,038,525, 2,232,633
and 899,319 shares, respectively.

Employee
Benefit Plans

The Company has a 401(k) Plan which stipulates
that all full-time employees with at least three months of
employment can elect to contribute to the 401(k) Plan, subject
to certain limitations, up to 20% of salary on a pretax basis.
The Companys option to provide matching contributions had
not been done to date. During December 2000, the Company
approved a change to the employment qualification period from
three months to one month of employment and approved an employer
match program that became effective during 2001. Subject to a
maximum dollar match contribution, the Company will match 50% of
the first 6% of the employees contribution on a pretax
basis, but not to exceed $5,250 per year. During 2001, the
Company expensed total employer matching contributions of
$273,000.

Significant
Concentrations

Although the Company has had development
arrangements with other collaborative partners, the arrangement
with Novo Nordisk is our only active, funded development
agreement. For the year ended December 31, 2001, this
partner-funded program contributed approximately 90% of total
contract revenues. The agreement with Novo Nordisk can be
terminated under certain conditions, including by either party
on limited written notice, by Novo Nordisk by limited prior
written notice upon the occurrence of certain events, and by
either party upon 30 days written notice in the event
that the other party commits a material breach under the
agreement and fails to remedy such breach within
60 days notice of such breach.

Comprehensive
Income (Loss)

Statement of Financial Accounting Standards
No. 130, Reporting Comprehensive Income
(SFAS 130), requires unrealized gains or losses on the
Companys available-for-sales securities to be recorded in
other comprehensive income (loss). Total comprehensive loss has
been disclosed in the statement of redeemable convertible
preferred stock and shareholders equity.

Recent
Accounting Pronouncements

In July 2001, the Financial Accounting Standards
Board issued Statements of Financial Standards (SFAS)
No. 141, Business Combinations, and SFAS
No. 142, Goodwill and Other Intangible Assets.
The new rules require business combinations initiated after
June 30, 2001 to be accounted for using the purchase method
of accounting and goodwill acquired after this date will no
longer be amortized, but will be subject to annual impairment
tests. All other intangible assets will continue to be amortized
over their estimated useful lives. Companies are required to
adopt SFAS No. 142 for fiscal years beginning after
December 31, 2001. The Company did not complete any
business combinations through the twelve months ended
December 31, 2001, as a result these standards did not have
a material impact on its financial position or operating results.

In August 2001, the FASB issued FASB Statement
No. 144 (FAS 144), Accounting for the Impairment or
Disposal of Long-lived Assets. FAS 144 supercedes
FASB Statement No. 121, Accounting for the Impairment of
Long-lived Assets and for Long-lived Assets to be Disposed of,
and the accounting and reporting provisions of APB Opinion
No. 30, Reporting the Results of Operations 
Reporting the Effects of Disposal of a Segment of a Business,
and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions, for the disposal of a segment of a business (as
previously defined in that Opinion). This Statement also amends
ARB No. 51, Consolidated Financial Statements, to eliminate
the exception to

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

consolidation of a subsidiary for which control
is likely to be temporary. Companies are required to adopt
FAS 144 for fiscal years beginning after December 15,
2001, and interim periods within those fiscal years, but early
adoption is encouraged. The Company has not yet determined the
impact this standard will have on its financial position and
results of operations, although it does not anticipate that the
adoption of this standard will have a material impact on the
Companys financial position or results of operations.

Reclassifications

Certain reclassifications of prior year amounts
have been made to conform with current year presentation.

2.     Financial
Instruments

Cash
Equivalents and Short-term Investments

The following summarizes the Companys fair
value of cash equivalents and investments (amounts in thousands):

|                        |                   |              |        |        |  |   |        |        | 
|----------------------- | ----------------- | ------------ | ------ | ------ |  | - | ------ | ------ | 
|                        |                   |             
|                        |                   | December 31,
|                        |                   |             
|                        |                   | 2001         |        | 2000  
|                        |                   |              |        |       
|Cash equivalents:       |                   |              |        |        |  |   |        |       
|                        | Money market fund |              | $      | 2,845  |  |   | $      | 3,343  | 
|                        | Commercial paper  |              |        | 67,068 |  |   |        | 17,168 | 
|                        |                   |              |        |        |  |   |        |       
|                        |                   | $            | 69,913 |        |  | $ | 20,511 |       
|                        |                   |              |        |        |  |   |        |       
|Short-term investments: |                   |              |        |        |  |   |        |       
|                        | Commercial paper  |              | $      |       |  |   | $      | 9,522  | 
|                        | Corporate notes   |              |        | 1,199  |  |   |        | 14,127 | 
|                        |                   |              |        |        |  |   |        |       
|                        |                   | $            | 1,199  |        |  | $ | 23,649 |       
|                        |                   |              |        |        |  |   |        |       

As of December 31, 2001 and 2000, the
difference between the fair value and the amortized cost of
available-for-sale securities was $15,000 and $25,000 for 2001
and 2000, respectively. As of December 31, 2001, the
average portfolio duration was approximately nine days, and the
contractual maturity of any single investment did not exceed
46 days from the balance sheet date.

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

3.     Property and
Equipment

Property and equipment consist of the following
(amounts in thousands):

|                                               |  |              |         |      |  |   |        |  
|---------------------------------------------- |  | ------------ | ------- | ---- |  | - | ------ | -
|                                               |  |             
|                                               |  | December 31,
|                                               |  |             
|                                               |  | 2001         |         | 2000
|                                               |  |              |         |     
|Machinery and equipment                        |  | $            | 14,053  |      |  | $ | 11,259 |  
|Furniture and fixtures                         |  |              | 1,653   |      |  |   | 1,489  |  
|Lab equipment                                  |  |              | 3,428   |      |  |   | 2,480  |  
|Computer equipment and software                |  |              | 5,073   |      |  |   | 3,095  |  
|Leasehold improvements                         |  |              | 5,055   |      |  |   | 4,848  |  
|                                               |  |              |         |      |  |   |        |  
|                                               |  |              | 29,262  |      |  |   | 23,171 |  
|Less accumulated depreciation and amortization |  |              | (13,186 | )    |  |   | (8,686 | )
|                                               |  |              |         |      |  |   |        |  
|                                               |  |              | 16,076  |      |  |   | 14,485 |  
|Construction in progress                       |  |              | 41,864  |      |  |   | 10,838 |  
|                                               |  |              |         |      |  |   |        |  
|Property and equipment, net                    |  | $            | 57,940  |      |  | $ | 25,323 |  
|                                               |  |              |         |      |  |   |        |  

At December 31, 2001 and 2000, property and
equipment include assets under capitalized leases of
approximately $13,080,000 and $13,675,000, respectively.
Accumulated depreciation related to leased assets at
December 31, 2001 and 2000, was approximately $7,864,000
and $5,209,000, respectively.

4.     Leases and
Commitments

Amounts borrowed under the Companys
equipment lease lines of credit bear interest at rates from 9.8%
to 14.6% and are collateralized by the related equipment. Under
the terms of the lease agreements, the Company has the option to
purchase the leased equipment at a negotiated price at the end
of each lease term. In March 2001, the Company amended its
warehouse facility lease to reduce the leased space by 36,640
square feet. The Company leases its office, laboratory and
manufacturing facilities under several operating leases expiring
through the year 2016.

Future minimum lease payments under noncancelable
operating and capital leases at December 31, 2001 are as
follows (amounts in thousands):

|                                                |                     |           |        |         |  |   |        |       | 
|----------------------------------------------- | ------------------- | --------- | ------ | ------- |  | - | ------ | ----- | 
|                                                |                     | Operating |        | Capital
|                                                |                     | Leases    |        | Leases 
|                                                |                     |           |        |        
|Years ending December 31:                       |                     |           |        |         |  |   |        |      
|                                                | 2002                |           | $      | 4,925   |  |   | $      | 4,006 | 
|                                                | 2003                |           |        | 5,081   |  |   |        | 2,067 | 
|                                                | 2004                |           |        | 5,241   |  |   |        | 513   | 
|                                                | 2005                |           |        | 5,403   |  |   |        |      | 
|                                                | 2006 and thereafter |           |        | 45,887  |  |   |        |      | 
|                                                |                     |           |        |         |  |   |        |      
|Total minimum lease payments                    |                     | $         | 66,537 |         |  |   | 6,586  |      
|                                                |                     |           |        |         |  |   |        |      
|Less amount representing interest               |                     |           |        |         |  |   | (633   | )    
|                                                |                     |           |        |         |  |   |        |      
|Present value of future lease payments          |                     |           |        |         |  |   | 5,953  |      
|Current portion of capital lease obligations    |                     |           |        |         |  |   | (3,526 | )    
|                                                |                     |           |        |         |  |   |        |      
|Noncurrent portion of capital lease obligations |                     |           |        |         |  | $ | 2,427  |      
|                                                |                     |           |        |         |  |   |        |      

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

Certain of the Companys operating leases
have rent escalation clauses and accordingly, the Company
recognizes rent expense on a straight-line basis. At
December 31, 2001, the Company had $300,000 deferred rent
expense, which is included in capital lease obligations on the
balance sheet.

For the years ended December 31, 2001, 2000
and 1999, rent expense under operating leases totaled
$5,476,000, $3,896,000 and $2,449,000, respectively.

5.     Contingencies

In June 1998, Eli Lilly and Company
(Lilly) filed a complaint against the Company in the
United States District Court for the Southern District of
Indiana. The complaint made various allegations against the
Company, arising from the Companys decision to enter into
an exclusive collaboration with Novo Nordisk with respect to the
development and commercialization of a pulmonary delivery system
for insulin and insulin analogs. The Company has sponsored
various studies of the pulmonary delivery of insulin and insulin
analogs using materials supplied by Lilly under a series of
agreements dating from January 1996. The Company and Lilly had
also conducted negotiations concerning a long-term supply
agreement under which Lilly would supply bulk insulin to the
Company for commercialization in the Companys AERx insulin
Diabetes Management System, and a separate agreement under which
the Company would license certain intellectual property to
Lilly. These negotiations were terminated after the Company
proceeded with its agreement with Novo Nordisk. The complaint
sought a declaration that Lilly scientists were co-inventors of
a patent application filed by the Company relating to pulmonary
delivery of an insulin analog or, in the alternative,
enforcement of an alleged agreement to grant Lilly a
nonexclusive license under such patent application. The
complaint also contained allegations of misappropriation of
trade secrets, breach of fiduciary duty, conversion and unjust
enrichment and seeks unspecified damages and injunctive relief.
The Company filed an answer denying all material allegations of
the complaint and a motion for summary judgment directed against
all claims in Lillys complaint. The Court has issued two
written rulings on the Companys motion substantially
limiting the claims against the Company. Specifically, the Court
granted the Companys motion as to Lillys claim to
enforce an alleged license agreement, for misappropriation of
trade secrets, breach of fiduciary duty, conversion, estoppel
and breach of contract (in part) and dismissed those claims from
the case. The Court denied the Companys motion as to
Lillys claims for declaratory relief, unjust enrichment
and breach of contract (in part), based on factual disputes
between the parties, and those issues remain to be resolved. The
Company recently filed a motion asking the Court to reconsider
summary judgment on the inventorship and unjust enrichment
claims, based on evidence recently produced by Lilly; the Court
denied the Companys motion, but the Company may raise
those issues again. Lilly filed a motion seeking to add several
new patents to the case; Lilly withdrew that motion after the
Company filled its opposition papers and after discussion with
the Court. Trial was set for November 2001, but has been
continued to April 22, 2002 due to a conflict on the
Courts calendar. The risks to the Company should Lilly
prevail in this case are that Lilly would be given rights of an
owner, along with the Company, on one of the Companys
patents relating to pulmonary delivery of monomeric insulin
lispro and/or that Lilly would be awarded damages on its
remaining claims for breach of contract and unjust enrichment.
Lilly also contends that factual findings made in any trial of
this case would have some effect on other patents relating to
pulmonary delivery of monomeric insulin lispro. Management
believes that it has meritorious defenses against each of Eli
Lillys remaining claims and that this litigation will not
have a material adverse effect on the Companys financial
position, results of operations or cash flows. However, there
can be no assurance that the Company will prevail in this case.

6.     Redeemable
Convertible Preferred Stock

Redeemable
Convertible Preferred Stock and Common Stock
Warrants

During December 2001, the Company completed a
$48.4 million Series A redeemable convertible
preferred stock (preferred stock) financing. Under
the terms of the financing, the Company sold to a group

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

of investors 2,001,236 shares of preferred stock
at a purchase price of $24.20 per share. Each share of preferred
stock is convertible into four shares of common stock. The
Company also issued warrants to the investors to purchase
5,203,212 shares of common stock at an exercise price of $6.97
per share. Issuance costs of approximately $3.0 million
were accounted for as a reduction to proceeds from the preferred
stock financing.

During the first two years, the preferred stock
is entitled to cumulative dividends, which shall accrue at an
annual rate of 6%, payable only when and if declared by the
Board of Directors. At the option of the Company, dividends may
be paid in either cash or in shares of common stock, which will
be valued at a price equal to the then current market price. The
current market price of the common stock on any dividend payment
date shall be based on the closing price of the Companys
common stock as quoted on the Nasdaq Stock Market. There were no
dividends declared as of December 31, 2001.

Each share of preferred stock, together with
accrued and unpaid dividends, is convertible, at the option of
the holder, into four shares of common stock. The conversion
rate is fixed and not subject to any adjustments except for
stock splits, stock dividends, combinations, reorganizations,
mergers or other similar events. Each share of outstanding
preferred stock will automatically convert into common stock
upon either the closing of a registered underwritten public
offering covering the offer and sale of common stock with gross
proceeds to the Company exceeding $25 million or the date
on which the common stock closing bid price has been above
$10.59 per share for at least twenty consecutive trading days.

Upon any liquidation, dissolution, redemption or
winding up of the Company, whether voluntary or involuntary, the
holders of outstanding preferred stock will be entitled to a
liquidation preference, equal to the original issue price plus
all accrued and unpaid dividends (as adjusted for any stock
dividends, combinations, splits, recapitalizations and other
similar events) to the preferred holders. Any remaining assets
will be available for distribution to holders of common stock.

Each holder of preferred stock shall have a
number of votes equal to the number of shares of common stock
issuable upon conversion of such holders shares of
preferred stock and shall have voting rights and powers equal to
the voting rights and powers of the Companys common stock.

Summary of
Preferred Stock and Warrant Accounting

The net proceeds of the preferred stock offering
were reduced by approximately $14.7 million, representing
the value assigned to the common stock warrants issued with the
preferred stock. The warrants were valued using the Black
Scholes option pricing model with the following assumptions:
estimated volatility of 87%, risk-free interest rate of 4.71%,
no dividend yield, and an expected life of 5 years. After
reducing the $48.4 million proceeds by the value of the
warrants, the remaining proceeds were used to compute a
discounted conversion price in accordance with EITF 00-27,
Application of EITF Issue No. 98-5, Accounting for
Convertible Securities with Beneficial Conversion Features or
Contingently Adjustable Conversion Ratios to Certain Convertible
Instruments. The discounted conversion price is compared
to the fair market value of the Companys common stock on
the issuance date of the preferred stock resulting in a
beneficial conversion feature of approximately
$10.7 million, which represents the difference between the
fair market value of the Companys common stock and the
discounted conversion price. The value of the beneficial
conversion feature is reported on the Statements of Operations
as a deemed dividend and is included in the calculation of net
loss applicable to the common shareholders.

In July 2001, the SEC staff made a staff
announcement, Classification and Measurement of Redeemable
Securities, (EITF D-98) which clarifies
Rule 5-02.28 of Regulation S-X, which was previously
adopted in accounting series Release No. 268,
Presentation in Financial Statements of Redeemable
Preferred Stock. This announcement addresses financial
statement classification and measurement of securities subject
to mandatory redemption requirements or whose redemption is
outside of the control of the issuer. Rule 5-02.28 requires
preferred securities that are redeemable for cash or other
assets to be classified outside of permanent

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

equity if they are redeemable (1) at a fixed
or determinable price on a fixed or determinable date
(2) at the option of the holder, or (3) upon the
occurrence of an event that is not solely within the control of
the issuer.

The preferred stock agreement provides that a
mandatory redemption is triggered if a change in control occurs.
Accordingly the Company has classified the preferred stock
outside of permanent equity.

7.     Shareholders
Equity

In January 2001, the Company raised
$5 million through the sale of 339,961 common shares at a
price of $14.71 per share to GlaxoSmithKline plc
(GlaxoSmithKline). The sale was made pursuant to the
exercise of a put option by the Company under the terms of the
collaboration agreement with GlaxoSmithKline.

In June 2001, the Company raised $5 million
through the sale of 708,216 shares of common stock at a price of
$7.06 per share to Novo Nordisk A/S (Novo Nordisk).
The sale was made pursuant to the exercise of a put option by
the Company under the terms of the collaboration agreement with
Novo Nordisk.

In August 2001, the Company completed a private
placement of shares of common stock for gross proceeds of
$14.6 million to a group of institutional investors. Under
the terms of the private placement, the Company sold 3,639,316
shares of common stock at a price of $4.00 per share.

In October 2001, the Company entered into a
common stock purchase agreement with Novo Nordisk
Pharmaceuticals, Inc., an affiliate of Novo Nordisk A/S. Under
the terms of the agreement, Novo Nordisk Pharmaceuticals has
committed to purchase up to $45 million of the
Companys common stock, in which the initial shares of
$20 million (initial purchase price) was
purchased ten business days after the effective date of the
agreement. The number of initial shares was calculated by
dividing the initial purchase price by the greater of
(a) the average of the closing prices of the Companys
common stock on the Nasdaq for the thirty trading days
immediately prior to the effective date, and (b) the
average of such closing prices for the five trading days
immediately prior to the effective date. In addition, the
Company may elect to sell at its option, subject to certain
conditions, between $5 million and $10 million of
additional shares to Novo Nordisk Pharmaceuticals once every
three months beginning December 1, 2001 until the aggregate
amount of $25 million has been reached. The number of
additional shares shall be calculated by dividing the additional
purchase price by the average closing price of the
Companys common stock on the Nasdaq for the thirty trading
days immediately prior to the date of written notice by the
Company to Novo Nordisk Pharmaceuticals. Novo Nordisk
Pharmaceuticals will hold the shares to be purchased under the
agreement for at least two years from the effective date of each
purchase, subject to certain conditions including, among other
things, Novo Nordisk not owning more than 45% of the
Companys common stock and the accuracy of certain
representations. During October 2001, the Company raised
$20 million through the sale of 5,665,723 shares of common
stock at a price of $3.53 per in accordance with terms of
the agreement.

In April 2000, the Company completed a follow-on
public offering of common stock, which raised approximately
$42.6 million in net proceeds with the issuance of
2,875,000 shares of common stock.

In November 2000, the Company entered into a
common stock purchase agreement (Acqua Agreement)
with Acqua Wellington North American Equities Fund, Ltd
(Acqua), a Bahamas based company, establishing a
common stock equity line. Pursuant to the equity line, Acqua,
subject to the Companys satisfaction of certain
conditions, has committed to purchase up to $50 million of
the Companys common stock over a period not to exceed
20 months, at a discount to a 20-day weighted average
trading price ranging from 5% to 7%. The amount that the Company
may draw down for any draw down pricing period is dependent upon
a number of factors, including the Companys stock price,
trading volume and threshold price set during the draw down
pricing period. The Company has filed a registration statement
with the Securities and Exchange Commission in November 2000
related to the common stock available for sale under the equity
agreement. During December 2000, the Company raised
approximately $2,172,000 through the sale of 114,795 shares of
common stock at an average price of $18.92 per share under the
terms of the Acqua

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

Agreement. The fair market value of the
Companys common stock on the closing date was $15.50 per
share. During February 2001, the Company raised $5 million
through the sale of 436,110 shares of common stock at an average
price of $11.46 per share under the terms of the Acqua
Agreement. The fair market value of the Companys common
stock on the closing date was $13.25 per share. During July
2001, the Company raised $539,000 through the sale of 92,407
shares of common stock at an average price of $5.84 per share
under the terms of the Acqua Agreement. The fair market value of
the Companys common stock on the closing date was $4.80
per share. In August 2001, the Company committed not to use the
equity line.

Reserved
Shares

At December 31, 2001, the Company had
5,835,798 shares of its common stock reserved for issuance upon
exercise of common stock warrants and 4,713,458 shares for
issuance upon exercise of options under all plans.

Other Common
Stock Warrants

In August 2001, the Company issued warrants in
connection with the private placement of common stock that
entitles investors to purchase 363,929 shares of common stock at
an exercise price of $5.41 per share or a 15% premium to the
Nasdaq National Market price on the closing date. The Company
valued the warrants using the Black-Scholes option pricing model
using the following assumptions: estimated volatility of 0.78,
risk-free interest rate of 6.2%, no dividend yield, and an
expected life of 4 years, and recorded approximately
$978,969 as issuance costs related to the private placement.
These warrants are exercisable through August 21, 2005.

During September 2000, the Company issued a
warrant in connection with an operating lease agreement that
entitles the holder to purchase 25,000 shares of common stock at
an exercise price of $21.72. This warrant is fully vested,
nonforfeitable and is exercisable through September 2007. The
Company valued the warrant using the Black-Scholes option
pricing model at $293,000 and is amortizing the warrant over the
term of the operating lease agreement, which is 15 years.

In January 1999, the Company issued a warrant to
the placement agent of the private placement of common stock
that entitles the holder to purchase 36,425 shares of common
stock at an exercise price of $10.50 per share. The Company
valued the warrant using the Black-Scholes option pricing model
and recorded approximately $221,500 as issuance costs related to
the private placement. This warrant is exercisable through June
2004.

In January and December 1998, the Company issued
warrants in connection with an operating lease agreement that
entitles the holder to purchase 50,000 and 60,000 shares of
common stock at an exercise price of $10.94 and $10.16 per
share, respectively. These warrants are fully vested,
nonforfeitable and are exercisable through December 2005. The
Company valued the warrants using the Black-Scholes option
pricing model and is amortizing the warrants over the term of
the operating lease agreement, which is 17 years.

In April 1998, the Company issued warrants to the
placement agents of the private placement of common stock that
entitles the holders to purchase 166,665 shares of common stock
at an exercise price of $12.42 per share. The Company valued the
warrants using the Black-Scholes option pricing model and
recorded approximately $765,000 as issuance costs related to the
private placement. These warrants are exercisable through June
2003. During November 2000, one of the placement agents
exercised 69,433 shares of common stock using a provision of the
warrant that allows the holder to purchase common stock in lieu
of cash or net issue exercise whenever the fair market value of
the Companys common stock exceeds the exercise price of
the warrant. The placement agent received a net issue exercise
of 32,931 shares of common stock.

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

1996
Non-Employee Directors Stock Option Plan

The 1996 Non-Employee Directors Stock
Option Plan (the Directors Plan) authorized
225,000 shares of common stock for issuance under the plan.
Options granted under the Directors Plan expire no later
than ten years from date of grant. The option price shall be at
100% of the fair value on the date of grant as determined by the
Board of Directors. The options generally vest quarterly over a
period of one year. During 2000, the Board of Directors approved
the termination of the Directors Plan. No more options can
be granted under the plan after its termination. The termination
of the Directors Plan will have no effect on the options
already outstanding.

The following is a summary of activity under the
Directors Plan:

|                             |                   |                      |         |           |   |                 |         |                  |   |  |                |                |  |   |       |       | 
|---------------------------- | ----------------- | -------------------- | ------- | --------- | - | --------------- | ------- | ---------------- | - |  | -------------- | -------------- |  | - | ----- | ----- | 
|                             |                   | Shares Available for |         | Number    |   |                 |         | Weighted Average
|                             |                   | Grant of Options     |         | of Shares |   | Price Per Share |         | Exercise Price  
|                             |                   |                      |         |           |   |                 |         |                 
|Balance at December 31, 1998 |                   |                      | 150,000 |           |   |                 | 75,000  |                  |   |  | $6.00 - $14.25 |                |  | $ | 9.30  |      
|                             | Options granted   |                      |         | (21,568   | ) |                 |         | 21,568           |   |  |                | $8.25 - $8.44  |  |   | $     | 8.35  | 
|                             | Options exercised |                      |         |          |   |                 |         | (22,500          | ) |  |                | $6.00          |  |   | $     | 6.00  | 
|                             | Options cancelled |                      |         |          |   |                 |         |                 |   |  |                |               |  |   |       |      | 
|                             |                   |                      |         |           |   |                 |         |                  |   |  |                |                |  |   |       |      
|Balance at December 31, 1999 |                   |                      | 128,432 |           |   |                 | 74,068  |                  |   |  | $6.00 - $14.25 |                |  | $ | 10.03 |      
|                             |                   |                      |         |           |   |                 |         |                  |   |  |                |                |  |   |       |      
|                             | Options granted   |                      |         | (84,356   | ) |                 |         | 84,356           |   |  |                | $6.13 - $24.13 |  |   | $     | 20.43 | 
|                             | Options exercised |                      |         |          |   |                 |         | (27,500          | ) |  |                | $6.00 - $14.25 |  |   | $     | 7.53  | 
|                             | Options cancelled |                      |         | (44,076   | ) |                 |         | (2,500           | ) |  |                | $14.25         |  |   | $     | 14.25 | 
|                             |                   |                      |         |           |   |                 |         |                  |   |  |                |                |  |   |       |      
|Balance at December 31, 2000 |                   |                      |        |           |   |                 | 128,424 |                  |   |  | $6.00 - $24.13 |                |  | $ | 17.31 |      
|                             |                   |                      |         |           |   |                 |         |                  |   |  |                |                |  |   |       |      
|                             | Options granted   |                      |         |          |   |                 |         |                 |   |  |                |               |  |   |       |      | 
|                             | Options exercised |                      |         |          |   |                 |         |                 |   |  |                |               |  |   |       |      | 
|                             | Options cancelled |                      |         |          |   |                 |         |                 |   |  |                |               |  |   |       |      | 
|                             |                   |                      |         |           |   |                 |         |                  |   |  |                |                |  |   |       |      
|Balance at December 31, 2001 |                   |                      |        |           |   |                 | 128,424 |                  |   |  | $6.00 - $24.13 |                |  | $ | 17.31 |      
|                             |                   |                      |         |           |   |                 |         |                  |   |  |                |                |  |   |       |      

|                     |  |                                     |         |                            |  |                  |       |  |  |  |     | 
|-------------------- |  | ----------------------------------- | ------- | -------------------------- |  | ---------------- | ----- |  |  |  | --- | 
|                     |  |                                    
|                     |  | Options Outstanding and Exercisable
|                     |  |                                    
|                     |  |                                     |         | Weighted Average Remaining
|                     |  |                                     |         | Weighted Average           |  | Contractual Life
|Exercise Price Range |  | Number                              |         | Exercise Price             |  | (in years)      
|                     |  |                                     |         |                            |  |                 
|$6.00 - $8.44        |  |                                     | 34,068  |                            |  | $                | 7.82  |  |  |  | 5.8 | 
|$14.25               |  |                                     | 22,500  |                            |  | $                | 14.25 |  |  |  | 2.3 | 
|$21.56 - $24.13      |  |                                     | 71,856  |                            |  | $                | 22.77 |  |  |  | 8.4 | 
|                     |  |                                     |         |                            |  |                  |       |  |  |  |     | 
|$6.00 - $24.13       |  |                                     | 128,424 |                            |  | $                | 17.31 |  |  |  | 6.7 | 
|                     |  |                                     |         |                            |  |                  |       |  |  |  |     | 

1996 Equity
Incentive Plan

In April 1996, the Companys Board of
Directors adopted and the Companys shareholders approved
the 1996 Equity Incentive Plan (the Plan), which
amended and restated the 1992 Stock Option Plan. Options granted
under the Plan may be either incentive or non-statutory stock
options. As of December 31, 2001, the Company had 5,953,312
shares of common stock authorized for issuance under the Plan.
Options granted under the Plan expire no later than ten years
from the date of grant. For incentive and non-statutory stock
option grants, the option price shall be at least 100% and 85%,
respectively, of the fair value on the date of grant, as
determined by the Board of Directors. If at any time the Company
grants an option, and the optionee directly or by attribution
owns stock possessing more than 10% of the total combined voting
power of all classes of stock of the Company, the option price
shall be at least 110% of the fair value and shall not be

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

exercisable more than five years after the date
of grant. During May 2001, the Companys shareholders
approved an amendment to the Plan to include an evergreen
provision. The evergreen provision will automatically increase
the number of shares reserved under the Plan, subject to certain
limitations, by 6% of the issued and outstanding Common Stock of
the Company or such lessor number of shares as determined by the
Board of Directors on the date of the annual meeting of
shareholders of each fiscal year beginning 2001 and ending 2005.
The aggregate increase in the number of shares reserved under
the evergreen provision will not exceed 8,000,000 shares.

Options granted under the 1996 Equity Incentive
Plan are immediately exercisable subject to repurchase
provisions, and the shares acquired generally vest over a period
of four years from the date of grant. The Plan also provides for
a transition from employee to consultant status without
termination of the vesting period as a result of such
transition. Under the Plan, employees may exercise options in
exchange for a note payable to the Company. As of
December 31, 2001 and 2000, notes receivable from
shareholders were outstanding of zero dollars and $131,000,
respectively. These notes generally bear interest at 6% and are
due and payable in regular installments over a five-year period.
Any unvested stock issued is subject to repurchase agreements
whereby the Company has the option to repurchase unvested shares
upon termination of employment at the original issue price. The
common stock has voting rights but does not have resale rights
prior to vesting. The full amount of the notes receivable from
shareholders are secured by a pledge of shares of the
Companys common stock. The Company has repurchased a total
of 38,294 shares in accordance with these agreements. During
2001, the Company granted options to purchase 1,960,310 shares
of common stock, none of which were exercised subject to
repurchase agreements.

The following is a summary of activity under the
Plan:

|                             |                    |                      |           |            |   |                 |           |                  |   |  |                |                 |  |   |       |       | 
|---------------------------- | ------------------ | -------------------- | --------- | ---------- | - | --------------- | --------- | ---------------- | - |  | -------------- | --------------- |  | - | ----- | ----- | 
|                             |                    | Shares Available for |           | Number     |   |                 |           | Weighted Average
|                             |                    | Grant of Options     |           | of Shares  |   | Price Per Share |           | Exercise Price  
|                             |                    |                      |           |            |   |                 |           |                 
|Balance at December 31, 1998 |                    |                      | 251,039   |            |   |                 | 1,719,371 |                  |   |  | $0.10 - $14.63 |                 |  | $ | 9.77  |      
|                             | Options authorized |                      |           | 1,820,000  |   |                 |           |                 |   |  |                |                |  |   |       |      | 
|                             | Options granted    |                      |           | (475,347   | ) |                 |           | 475,347          |   |  |                | $6.19 - $12.00  |  |   | $     | 9.42  | 
|                             | Options exercised  |                      |           |           |   |                 |           | (36,463          | ) |  |                | $0.37 - $12.25  |  |   | $     | 5.19  | 
|                             | Options cancelled  |                      |           | 60,349     |   |                 |           | (60,349          | ) |  |                | $5.33 - $14.63  |  |   | $     | 11.03 | 
|                             |                    |                      |           |            |   |                 |           |                  |   |  |                |                 |  |   |       |      
|Balance at December 31, 1999 |                    |                      | 1,656,041 |            |   |                 | 2,097,906 |                  |   |  | $0.10 - $14.63 |                 |  | $ | 9.72  |      
|                             | Options granted    |                      |           | (1,308,325 | ) |                 |           | 1,308,325        |   |  |                | $10.50 - $24.13 |  |   | $     | 17.29 | 
|                             | Options exercised  |                      |           |           |   |                 |           | (291,176         | ) |  |                | $0.10 - $23.56  |  |   | $     | 9.16  | 
|                             | Options cancelled  |                      |           | 394,577    |   |                 |           | (394,577         | ) |  |                | $5.33 - $22.50  |  |   | $     | 12.24 | 
|                             |                    |                      |           |            |   |                 |           |                  |   |  |                |                 |  |   |       |      
|Balance at December 31, 2000 |                    |                      | 742,293   |            |   |                 | 2,720,478 |                  |   |  | $0.33 - $24.13 |                 |  | $ | 13.05 |      
|                             | Options authorized |                      |           | 1,152,812  |   |                 |           |                 |   |  |                |                |  |   |       |      | 
|                             | Options granted    |                      |           | (1,960,310 | ) |                 |           | 1,960,310        |   |  |                | $3.34 - $12.94  |  |   | $     | 5.36  | 
|                             | Options exercised  |                      |           |           |   |                 |           | (30,549          | ) |  |                | $5.33 - $10.63  |  |   | $     | 6.70  | 
|                             | Options cancelled  |                      |           | 561,215    |   |                 |           | (561,215         | ) |  |                | $3.44 - $23.00  |  |   | $     | 10.77 | 
|                             |                    |                      |           |            |   |                 |           |                  |   |  |                |                 |  |   |       |      
|Balance at December 31, 2001 |                    |                      | 496,010   |            |   |                 | 4,089,024 |                  |   |  | $0.33 - $24.13 |                 |  | $ | 9.74  |      
|                             |                    |                      |           |            |   |                 |           |                  |   |  |                |                 |  |   |       |      

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

|                     |  |                                     |           |                            |  |                  |       |  |  |  |     | 
|-------------------- |  | ----------------------------------- | --------- | -------------------------- |  | ---------------- | ----- |  |  |  | --- | 
|                     |  |                                    
|                     |  | Options Outstanding and Exercisable
|                     |  |                                    
|                     |  |                                     |           | Weighted Average Remaining
|                     |  |                                     |           | Weighted Average           |  | Contractual Life
|Exercise Price Range |  | Number                              |           | Exercise Price             |  | (in years)      
|                     |  |                                     |           |                            |  |                 
|$0.33 - $0.43        |  |                                     | 34,125    |                            |  | $                | 0.37  |  |  |  | 2.2 | 
|$0.57                |  |                                     | 5,874     |                            |  | $                | 0.57  |  |  |  | 4.1 | 
|$2.00                |  |                                     | 3,450     |                            |  | $                | 2.00  |  |  |  | 4.2 | 
|$3.34 - $4.88        |  |                                     | 824,850   |                            |  | $                | 3.74  |  |  |  | 9.7 | 
|$5.11 - $7.44        |  |                                     | 1,105,752 |                            |  | $                | 6.27  |  |  |  | 8.6 | 
|$8.25 - $12.25       |  |                                     | 1,091,675 |                            |  | $                | 10.85 |  |  |  | 5.9 | 
|$12.56 - $18.75      |  |                                     | 703,050   |                            |  | $                | 15.55 |  |  |  | 8.1 | 
|$19.19 - $24.13      |  |                                     | 320,248   |                            |  | $                | 22.20 |  |  |  | 7.6 | 
|                     |  |                                     |           |                            |  |                  |       |  |  |  |     | 
|$0.33 - $24.13       |  |                                     | 4,089,024 |                            |  | $                | 9.72  |  |  |  | 7.9 | 
|                     |  |                                     |           |                            |  |                  |       |  |  |  |     | 

The Company has elected to follow Accounting
Principles Board Opinion No. 25, Accounting for
Stock-Based Compensation (APB 25), which
requires use of option pricing valuation models that were not
developed for use in valuing employee stock options. Under APB
25, the Company has generally recognized no compensation expense
with respect to such awards.

The Company recorded deferred compensation of
approximately $704,000 for the difference between the grant
price and the fair value of certain of the Companys common
stock options granted in 1998. This amount is being amortized
over the vesting period of the individual options. There were no
such grants in 2001, 2000 and 1999. Amortization of deferred
compensation recognized in the years ended December 31,
2001, 2000 and 1999 was approximately $162,000, $163,000 and
$162,000, respectively. The weighted average fair value of
options granted during 2001, 2000 and 1999 with an exercise
price equal to the fair value of the Companys common stock
on the date of grant was $3.59, $11.08 and $4.98, respectively.

Pro forma information regarding net loss and
basic and diluted net loss per share is required by SFAS 123,
which also requires that the information be determined as if the
Company had accounted for its employee and non-employee director
stock options granted subsequent to December 31, 1994 under
the fair value method prescribed by this statement. The fair
value of options was estimated at the date of grant using the
Black-Scholes option pricing model with the following
assumptions: a risk-free interest rate of 4.2%, 6.2% and 5.2%
for the years ended December 31, 2001, 2000 and 1999,
respectively; a dividend yield of 0.0%; the annual volatility
factor of the expected market price of the Companys common
stock for 2001, 2000 and 1999 are 87.0%, 78.0% and 64.1%,
respectively; and a weighted average expected option life of
four years.

For purposes of pro forma disclosure, the
estimated fair value of the options is amortized to expense over
the vesting period of the options using the straight-line
method. Pro forma information on the above basis is as follows
(amounts in thousands, except per share amounts):

|                                                                                      |  |                          |         |      |  |      |         |   |  |   |         |  
|------------------------------------------------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                                                                      |  |                         
|                                                                                      |  | Years ended December 31,
|                                                                                      |  |                         
|                                                                                      |  | 2001                     |         | 2000 |  | 1999
|                                                                                      |  |                          |         |      |  |     
|Net loss applicable to common
	shareholders  as reported                             |  | $                        | (43,079 | )    |  | $    | (35,562 | ) |  | $ | (23,603 | )
|Pro forma net loss applicable to common
	shareholders                                 |  | $                        | (49,314 | )    |  | $    | (39,587 | ) |  | $ | (26,087 | )
|Basic and diluted net loss per share applicable
	to common shareholders  as reported |  | $                        | (1.98   | )    |  | $    | (2.07   | ) |  | $ | (1.66   | )
|Pro forma basic and diluted net loss per share
	applicable to common shareholders     |  | $                        | (2.26   | )    |  | $    | (2.30   | ) |  | $ | (1.85   | )

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

The pro forma impact of options on the net less
applicable to common shareholders for the years ended
December 31, 2001, 2000 and 1999 is not representative of
the effects on the pro forma net income (loss) for future years,
as future years will include the effects of additional years of
stock option grants.

Employee
Stock Purchase Plan

At the Annual Meeting of shareholders held in May
2001, the number of shares under the Employee Stock Purchase
Plan (the Purchase Plan) increased by 250,000 shares
to 750,000 shares of common stock. Shares may be purchased under
the Purchase Plan at 85% of the lesser of the fair market value
of the common stock on the grant date or purchase date. As of
December 31, 2001 a total of 695,131 shares have been
issued under the Purchase Plan.

8.     Collaborative
Agreements

Novo
Nordisk

In June 1998, the Company executed a development
and commercialization agreement with Novo Nordisk to jointly
develop a pulmonary delivery system for administering insulin by
inhalation. In addition, the agreement provides Novo Nordisk
with an option to develop the technology for delivery of other
compounds. Under the terms of the agreement, Novo Nordisk has
been granted exclusive rights to worldwide sales and marketing
rights for any products developed under the terms of the
agreement.

Through December 31, 2001, the Company
received from Novo Nordisk approximately $68.3 million in
product development and milestone payments and, of this amount,
the Company has recognized approximately $55.4 million as
contract revenue. In future periods, the Company could receive
up to $120 million in additional product development and
nonrefundable milestone payments. In 1998, the Company raised
$5.0 million through the sale of common stock to Novo
Nordisk at a 25% premium to the fair market price. In June 2001,
the Company raised an additional $5 million through the
sale of common stock to Novo Nordisk at the fair market price.
In October 2001, the Company entered into a new common stock
purchase agreement with Novo Nordisk Pharmaceuticals, Inc., an
affiliate of Novo Nordisk A/ S. Under the new agreement, Novo
Nordisk Pharmaceuticals has committed to purchase up to
$45 million of the Companys common stock. In October
2001, the Company entered into a common stock purchase agreement
with Novo Nordisk Pharmaceuticals, Inc., an affiliate of Novo
Nordisk A/ S. Under the terms of the agreement, Novo Nordisk
Pharmaceuticals has committed to purchase up to $45 million
of the Companys common stock, in which the initial shares
of $20 million was purchased at fair market value. In
addition, the Company may elect to sell at its option, subject
to certain conditions including among other things, Novo Nordisk
not owning more than 45% of the Companys common stock and
the accuracy of certain representations, between $5 million
and $10 million of additional shares to Novo Nordisk
Pharmaceuticals once every three months beginning
December 1, 2001 until the aggregate amount of
$25 million has been reached. Novo Nordisk will fund all
product development costs incurred by the Company, while Novo
Nordisk and the Company will co-fund final development of the
AERx device. The Company will be the initial manufacturer of all
the products covered by the agreement and will receive a share
of the overall gross profits resulting from Novo Nordisks
sales of the products. For the years ended December 31,
2001, 2000 and 1999, the Company recognized contract revenues of
$26.0 million, $15.4 million and $8.7 million,
respectively.

Glaxo
SmithKline

The Company executed a development and
commercialization agreement with GlaxoSmithKline in September
1997. The agreement covered the use of the AERx Pain Management
System for the delivery of narcotic analgesics and the companies
intended to collaborate on the development of the products
within this field. Under the terms of the agreement,
GlaxoSmithKline was granted exclusive worldwide sales and
marketing rights to the AERx Pain Management System for use with
such analgesics, and the Company

55



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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

retained all manufacturing rights. If the system
received regulatory approval, the Company intended to sell
devices and drug packets to GlaxoSmithKline and would receive
royalties on developed product sold by GlaxoSmithKline.

During December 2000, the Company and
GlaxoSmithKline amended the product development and
commercialization agreement whereby the Company assumed full
control and responsibility for conducting and financing the
remainder of all development activities. Under the amendment,
unless GlaxoSmithKline or the Company terminate the agreement
for other reasons, GlaxoSmithKline can restore its rights and
obligations to participate in and fund development and
commercialization of product under the amended agreement upon
payment of a restoration fee to the Company. In the event
GlaxoSmithKline elects to restore its rights under the amended
agreement, revenue will be recognized for the portion of the
restoration fee that represents reimbursement of development
costs not previously reimbursed by GlaxoSmithKline, but incurred
by the Company through the date of the election. Any remaining
fees will be deferred and amortized over the estimated remaining
development period of the amended development agreement. The
Company anticipates that GlaxoSmithKline will review its
restoration election upon the delivery of Phase 2b trial
results, which will be made available to them in the first half
of 2002, but there can be no assurance that GlaxoSmithKline will
elect to restore its rights. If the Company elects to terminate
the agreement and continues or intends to continue any
development activities, either alone or in collaboration with a
third party, then the Company is required to pay an exit fee to
GlaxoSmithKline. The payment of the exit fee would not have a
material impact on the Companys financial position or
operating results.

Through December 31, 2001, the Company had
received from GlaxoSmithKline and recognized as contract revenue
approximately $23.7 million in product development and
milestone payments. No product development and milestone
payments were received during 2001. In 1997, the Company raised
$5 million through the sale of common stock to
GlaxoSmithKline at a 25% premium to the fair market price. In
January 2001, the Company raised an additional $5 million
through the sale of common stock to GlaxoSmithKline at the fair
market price. For the years ended December 31, 2001, 2000
and 1999, the Company recognized contract revenue of
$1.5 million, $3.4 million and $5.2 million,
respectively.

Genentech

The Company entered into an agreement with
Genentech in May 1999. The agreement was to develop the drug
dornase alfa in the AERx system. Dornase alfa is the active
ingredient in the currently marketed Genentech product,
Pulmozyme. The agreement provided that development expenses
incurred by Aradigm would be reimbursed by Genentech in the form
of loans supported by promissory notes bearing interest at two
percent over the prime rate, which was 11.5% at
December 31, 2000. Principal and unpaid accrued interest
was due at the earlier of 15 days after FDA approval or
seven years after the effective date of the collaborative
agreement or May 21, 2006. The Company would also receive
certain milestone payments at various points of product
development. In September 2000, the Company received a milestone
payment of $500,000 for the successful completion of a U.S.
Phase 2a clinical trial of the AERx Pulmonary Drug Delivery
System for the delivery of dornase alfa to patients with cystic
fibrosis.

In February 2001, the Company announced that it
has mutually agreed with Genentech to discontinue the
development of dornase alfa using the Companys proprietary
AERx system. The companies also announced that they would be
entering into a new agreement allowing Genentech to evaluate
feasibility of using the AERx Pulmonary Drug Delivery System for
pulmonary delivery of other Genentech compounds. Under the terms
of the agreement, Genentech would not require the Company to
repay the loan of funds required to conduct product development
under the discontinued program. Forgiveness of the loan and
accrued interest resulted in an extraordinary gain during the
first quarter of 2001 of approximately $6,675,000. During 2001,
the Company refunded Genentech approximately $773,000 for
unspent project prepayments.

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

The Company receives revenue from other
partner-funded programs. These programs are generally early
stage feasibility programs and may not necessarily develop into
long-term development agreements with the partners.

Significant partner payments, contract and
milestone revenues and deferred revenue are as follows (amounts
in thousands):

|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|-------------------------------------------- |  | ------------ | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                             |  |             
|                                             |  | December 31,
|                                             |  |             
|                                             |  | 2001         |        | 2000 |  | 1999
|                                             |  |              |        |      |  |     
|Deferred revenue  beginning balance         |  | $            | 8,654  |      |  | $    | 11,024 |   |  | $ | 12,673 |  
|Partner payments:                            |  |              |        |      |  |      |        |   |  |   |        |  
|Novo Nordisk                                 |  |              | 32,054 |      |  |      | 13,879 |   |  |   | 9,482  |  
|GlaxoSmithKline                              |  |              |       |      |  |      | 2,617  |   |  |   | 2,040  |  
|Other partner-funded programs                |  |              | 1,650  |      |  |      | 1,437  |   |  |   | 3,641  |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Total partner payments                       |  |              | 33,704 |      |  |      | 17,933 |   |  |   | 15,163 |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Contract revenue recognized:                 |  |              |        |      |  |      |        |   |  |   |        |  
|Novo Nordisk                                 |  |              | 26,030 |      |  |      | 15,411 |   |  |   | 8,692  |  
|GlaxoSmithKline                              |  |              | 1,524  |      |  |      | 3,379  |   |  |   | 5,187  |  
|Other partner-funded programs                |  |              | 1,362  |      |  |      | 1,513  |   |  |   | 2,933  |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Total contract revenue recognized            |  |              | 28,916 |      |  |      | 20,303 |   |  |   | 16,812 |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Deferred revenue  ending balance            |  |              | 13,442 |      |  |      | 8,654  |   |  |   | 11,024 |  
|Less: Noncurrent portion of deferred revenue |  |              | (2,327 | )    |  |      | (2,032 | ) |  |   | (3,663 | )
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Current portion of deferred revenue          |  | $            | 11,115 |      |  | $    | 6,622  |   |  | $ | 7,361  |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  

9.     Income
Taxes

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

Significant components of the Companys
deferred tax assets are as follows (amounts in thousands):

|                                 |  |              |         |      |  |   |         |  
|-------------------------------- |  | ------------ | ------- | ---- |  | - | ------- | -
|                                 |  |             
|                                 |  | December 31,
|                                 |  |             
|                                 |  | 2001         |         | 2000
|                                 |  |              |         |     
|Net operating loss carryforward  |  | $            | 48,000  |      |  | $ | 38,600  |  
|Deferred revenue                 |  |              | 4,400   |      |  |   | 3,461   |  
|Research and development credits |  |              | 6,500   |      |  |   | 3,980   |  
|Other                            |  |              | 700     |      |  |   | 620     |  
|                                 |  |              |         |      |  |   |         |  
|Total deferred tax assets        |  |              | 59,600  |      |  |   | 46,661  |  
|Valuation allowance              |  |              | (59,600 | )    |  |   | (46,661 | )
|                                 |  |              |         |      |  |   |         |  
|Net deferred tax assets          |  | $            |        |      |  | $ |        |  
|                                 |  |              |         |      |  |   |         |  

Realization of deferred tax assets is dependent
upon future earnings, if any, the timing and amount of which are
uncertain. Accordingly, the net deferred tax assets have been
fully offset by a valuation allowance. The valuation allowance
increased by $12,939,000 and $17,033,000 during 2001 and 2000,
respectively.

Deferred tax assets related to carryforwards at
December 31, 2001 include approximately $1,600,000
associated with stock option activity for which any subsequently
recognized tax benefits will be credited directly to
stockholders equity.

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

As of December 31, 2001, the Company had net
operating loss carryforwards for federal income tax purposes of
approximately $121,000,000 which expire in the years 2006
through 2021, and federal research and development tax credits
of approximately $4,600,000, which expire in the years 2006
through 2021.

Utilization of the Companys net operating
loss may be subject to substantial annual limitation due to
ownership change limitations provided by the Internal revenue
Code and similar state provisions. Such an annual limitation
could result in the expiration of the net operating loss before
utilization.

10.     Quarterly
Results of Operations (Unaudited)

Following is a summary of the quarterly results
of operations for the years ended December 31, 2001 and
2000 (amounts in thousands):

|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |        | 
|-------------------------------------------------------------------------------------------- | -------------------------- | --------- | ------ | -------- |  | ------------- | ------ | ------------ |  | - | ------- | ------ |  | - | ------- | ------ | 
|                                                                                             |                            | March 31, |        | June 30, |  | September 30, |        | December 31,
|                                                                                             |                            | 2001      |        | 2001     |  | 2001          |        | 2001        
|                                                                                             |                            |           |        |          |  |               |        |             
|Contract and license revenues                                                                |                            | $         | 6,687  |          |  | $             | 8,520  |              |  | $ | 6,889   |        |  | $ | 6,820   |       
|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|Operating expenses:                                                                          |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|                                                                                             | Research and development   |           |        | 14,160   |  |               |        | 15,298       |  |   |         | 14,890 |  |   |         | 14,488 | 
|                                                                                             | General and administrative |           |        | 2,328    |  |               |        | 2,322        |  |   |         | 2,233  |  |   |         | 2,472  | 
|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|                                                                                             | Total expenses             |           |        | 16,488   |  |               |        | 17,620       |  |   |         | 17,123 |  |   |         | 16,960 | 
|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|Loss from operations                                                                         |                            |           | (9,801 | )        |  |               | (9,100 | )            |  |   | (10,234 | )      |  |   | (10,140 | )     
|Interest income                                                                              |                            |           | 668    |          |  |               | 299    |              |  |   | 167     |        |  |   | 190     |       
|Interest expense and other                                                                   |                            |           | (262   | )        |  |               | (364   | )            |  |   | (216    | )      |  |   | (239    | )     
|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|Net loss before extraordinary gain                                                           |                            |           | (9,395 | )        |  |               | (9,165 | )            |  |   | (10,283 | )      |  |   | (10,189 | )     
|Extraordinary gain                                                                           |                            |           | 6,675  |          |  |               |       |              |  |   |        |        |  |   |        |       
|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|Net loss                                                                                     |                            |           | (2,720 | )        |  |               | (9,165 | )            |  |   | (10,283 | )      |  |   | (10,189 | )     
|Deemed dividend                                                                              |                            |           |       |          |  |               |       |              |  |   |        |        |  |   | (10,722 | )     
|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|Net loss applicable to common stockholders                                                   |                            | $         | (2,720 | )        |  | $             | (9,165 | )            |  | $ | (10,283 | )      |  | $ | (20,911 | )     
|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|Basic and diluted loss per share applicable to
	common shareholders:                         |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|Loss before extraordinary gain                                                               |                            | $         | (0.50  | )        |  | $             | (0.47  | )            |  | $ | (0.48   | )      |  | $ | (0.77   | )     
|Extraordinary gain                                                                           |                            |           | 0.36   |          |  |               |       |              |  |   |        |        |  |   |        |       
|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|Net loss applicable to common shareholders                                                   |                            | $         | (0.14  | )        |  | $             | (0.47  | )            |  | $ | (0.48   | )      |  | $ | (0.77   | )     
|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       
|Shares used in computing basic and diluted loss
	per share applicable to common shareholders |                            |           | 18,838 |          |  |               | 19,338 |              |  |   | 21,581  |        |  |   | 27,319  |       
|                                                                                             |                            |           |        |          |  |               |        |              |  |   |         |        |  |   |         |       

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS
(Continued)

|                                                               |                            |           |        |          |  |               |        |              |  |   |        |        |  |   |         |        | 
|-------------------------------------------------------------- | -------------------------- | --------- | ------ | -------- |  | ------------- | ------ | ------------ |  | - | ------ | ------ |  | - | ------- | ------ | 
|                                                               |                            | March 31, |        | June 30, |  | September 30, |        | December 31,
|                                                               |                            | 2000      |        | 2000     |  | 2000          |        | 2000        
|                                                               |                            |           |        |          |  |               |        |             
|Contract and license revenues                                  |                            | $         | 5,700  |          |  | $             | 4,804  |              |  | $ | 4,715  |        |  | $ | 5,084   |       
|                                                               |                            |           |        |          |  |               |        |              |  |   |        |        |  |   |         |       
|Operating expenses:                                            |                            |           |        |          |  |               |        |              |  |   |        |        |  |   |         |       
|                                                               | Research and development   |           |        | 10,896   |  |               |        | 11,509       |  |   |        | 11,974 |  |   |         | 13,797 | 
|                                                               | General and administrative |           |        | 2,073    |  |               |        | 2,453        |  |   |        | 2,399  |  |   |         | 2,346  | 
|                                                               |                            |           |        |          |  |               |        |              |  |   |        |        |  |   |         |       
|                                                               | Total expenses             |           |        | 12,969   |  |               |        | 13,962       |  |   |        | 14,373 |  |   |         | 16,143 | 
|                                                               |                            |           |        |          |  |               |        |              |  |   |        |        |  |   |         |       
|Loss from operations                                           |                            |           | (7,269 | )        |  |               | (9,158 | )            |  |   | (9,658 | )      |  |   | (11,059 | )     
|Interest income                                                |                            |           | 395    |          |  |               | 969    |              |  |   | 936    |        |  |   | 810     |       
|Interest expense and other                                     |                            |           | (321   | )        |  |               | (367   | )            |  |   | (413   | )      |  |   | (427    | )     
|                                                               |                            |           |        |          |  |               |        |              |  |   |        |        |  |   |         |       
|Net loss                                                       |                            | $         | (7,195 | )        |  | $             | (8,556 | )            |  | $ | (9,135 | )      |  | $ | (10,676 | )     
|                                                               |                            |           |        |          |  |               |        |              |  |   |        |        |  |   |         |       
|Basic and diluted net loss per share                           |                            | $         | (0.48  | )        |  | $             | (0.48  | )            |  | $ | (0.51  | )      |  | $ | (0.59   | )     
|                                                               |                            |           |        |          |  |               |        |              |  |   |        |        |  |   |         |       
|Shares used in computing basic and diluted net
	loss per share |                            |           | 14,846 |          |  |               | 17,810 |              |  |   | 17,967 |        |  |   | 18,141  |       
|                                                               |                            |           |        |          |  |               |        |              |  |   |        |        |  |   |         |       

11.     Subsequent
Events

Increase in Authorized Shares

On February 8, 2002, the Shareholders of
Aradigm Corporation approved an amendment of the Companys
Articles of Incorporation to increase the authorized number of
shares of Common Stock from 40 million to 100 million
shares, and approved the Companys Employee Stock Purchase
Plan, as amended, to increase the aggregate number of shares of
Common Stock authorized for issuance under such plan by
500,000 shares.

Options Granted to Officers and
Directors

During February 2002, the Board of Directors
approved granted under the 1996 Equity Incentive Plan (the
Plan) with an exercise price of $4.82 per share to
several directors and executive officers in an aggregate amount
of 140,000 shares and 1,000,000 shares, respectively.
Options granted under the Plan expire no later than ten years
from the date of grant. The option price was at 100% of the fair
value on the date of grant as determined by the Board of
Directors. Options granted to the directors will vest quarterly
over a period of one year. Options granted to the executive
officers will vest quarterly over a period of four years.

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

None.




PART III




Item 10.     Directors
and Executive Officers Of The Registrant

Identification of Directors

The information required by this Item concerning
the Companys directors is incorporated by reference from
the section captioned Proposal 1: Election of
Directors contained in the Companys Definitive Proxy
Statement related to the Annual Meeting of Shareholders to be
held May 17, 2002, to be filed by the Company with the
Securities and Exchange Commission (the Proxy
Statement).

Identification of Executive Officers

The information required by this Item concerning
our executive officers is set forth in Part I of this
Report.

Section 16(a) Compliance

The information regarding compliance with
Section 16(a) of the Securities Exchange Act of 1934, as
amended, required by this Item is incorporated by reference from
the section captioned Section 16(a) Beneficial
Ownership Reporting Compliance in the Proxy Statement.




Item 11.     Executive
Compensation

The information required by this Item is
incorporated by reference from the section captioned
Executive Compensation contained in the Proxy
Statement.




Item 12.     Security
Ownership Of Certain Beneficial Owners and
Management

The information required by this Item is
incorporated by reference from the section captioned
Security Ownership of Certain Beneficial Owners and
Management contained in the Proxy Statement.




Item 13.     Certain
Relationships and Related Transactions

The information required by this Item is
incorporated by reference from the sections captioned
Certain Transactions and Executive
Compensation contained in the Proxy Statement.

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PART IV






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 14. | Exhibits, Financial Statements Schedules,
	And Reports On Form 8-K

(a)(1) Financial Statements.

Included in Part II of this Report:

|                                                                         |  |           |    | 
|------------------------------------------------------------------------ |  | --------- | -- | 
|                                                                         |  | Page in  
|                                                                         |  | Form 10-K
|                                                                         |  |          
|Report of Ernst & Young LLP, Independent
	Auditors                       |  |           | 38 | 
|Balance Sheets  December 31, 2001
	and 2000.                            |  |           | 39 | 
|Statements of Operations  Years ended
	December 31, 2001, 2000 and 1999 |  |           | 40 | 
|Statements of Redeemable Convertible Preferred
	Stock and Shareholders  |  |           |    | 
|Equity  Years ended December 31,
	2001, 2000 and 1999                   |  |           | 41 | 
|Statements of Cash Flows  Years ended
	December 31, 2000, 2000 and 1999 |  |           | 42 | 
|Notes to Financial Statements                                            |  |           | 43 | 

(2) Financial Statement
Schedules.

None.

(3) Exhibits.

| |       |         |  |                                                                                                                                                                           
| | ----- | ------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3.1   | (1)     |  | Amended and Restated Articles of Incorporation of
	the Company.                                                                                                           
| | 3.2   | (5)     |  | Bylaws of the Company, as amended.                                                                                                                                        
| | 3.3   |         |  | Certificate of Determination of Series A
	Junior Participating Preferred Stock.                                                                                           
| | 3.4   | (14)    |  | Certificate of Determination and Preferences of
	Series A Convertible Preferred Stock.                                                                                    
| | 3.5   |         |  | Certificate of Amendment of Amended and Restated
	Articles of Incorporation of Aradigm Corporation.                                                                       
| | 3.6   |         |  | Certificate of Amendment of Certificate of
	Determination of Series A Junior Participating Preferred
	Stock.                                                              
| | 4.1   |         |  | Reference is made to Exhibits 3.1, 3.2, 3.3,
	3.4, 3.5 and 3.6.                                                                                                           
| | 4.2   | (1)     |  | Specimen common stock certificate.                                                                                                                                        
| | 10.1  | (1)(2)  |  | Form of Indemnity Agreement between the
	Registrant and each of its directors and officers.                                                                               
| | 10.2  | (2)(11) |  | Equity Incentive Plan, as amended (the
	Equity Incentive Plan).                                                                                                         
| | 10.3  | (1)(2)  |  | Form of the Companys Incentive Stock Option
	Agreement under the Equity Incentive Plan.                                                                                  
| | 10.4  | (1)(2)  |  | Form of the Companys Non-statutory Stock
	Option Agreement under the Equity Incentive Plan.                                                                              
| | 10.5  | (1)(2)  |  | Form of the Companys Non-Employee
	Directors Stock Option Plan.                                                                                                         
| | 10.6  | (1)(2)  |  | Form of the Companys Non-statutory Stock
	Option Agreement under the Non-Employee Directors Stock
	Option Plan.                                                         
| | 10.7  | (2)(11) |  | Employee Stock Purchase Plan, as amended.                                                                                                                                 
| | 10.8  | (1)(2)  |  | Form of the Companys Employee Stock
	Purchase Plan Offering Document.                                                                                                    
| | 10.9  | (1)     |  | Master Lease Agreement and Warrant, between the
	Company and Comdisco, Inc., dated June 9, 1995.                                                                          
| | 10.10 | (4)*    |  | Product Development and Commercialization
	Agreement between the Company and SmithKline Beecham PLC.                                                                      
| | 10.11 | (3)     |  | Lease Agreement for the property located at 3911
	Trust Way, Hayward, California, dated March 17, 1997,
	between the Company and Hayward Point Eden I Limited Partnership.

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| |       |       |  |                                                                                                                                                                                                    
| | ----- | ----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10.11 | a(3)  |  | First Amendment to Lease, dated December 22,
	1997, between the Company and Hayward Point Eden I Limited
	Partnership.                                                                             
| | 10.11 | b(3)  |  | Second Amendment to Lease, dated January 28,
	1998, between the Company and Hayward Point Eden I Limited
	Partnership.                                                                             
| | 10.12 | (3)   |  | Lease Agreement for the property located in Phase
	V of the Britannia Point Eden Business Park in Hayward,
	California, dated January 28, 1998, between the Company and
	Britannia Point Eden, LLC.
| | 10.13 | (5)   |  | Common Stock Purchase Agreement, dated
	April 3, 1998, between the Company and the purchasers named
	therein.                                                                                      
| | 10.14 | (5)*  |  | Development and License Agreement, dated
	June 2, 1998, between the Company and Novo Nordisk A/ S.                                                                                                 
| | 10.15 | (6)   |  | Rights Agreement, dated as of August 31,
	1998, between the Company and Bank Boston, N.A.                                                                                                          
| | 10.15 | a     |  | Amendment to Rights Agreement, dated as of
	October 22, 2001, by and between the Company and Fleet
	National Bank.                                                                                 
| | 10.15 | b     |  | Amendment to Rights Agreement, dated as of
	December 6, 2001, by and between the Company and EquiServe
	Trust Company.                                                                             
| | 10.16 | (7)   |  | Common Stock Purchase Agreement, dated
	January 27, 1999, between the Company and the purchasers
	named therein.                                                                                   
| | 10.17 | (8)   |  | Lease Agreement for the property located at 2704
	West Winton Avenue, Hayward, California, dated
	September 11, 2000, between the Company and Winton
	Industrial Center, Inc.                      
| | 10.17 | a(12) |  | Amendment No. 1 to Standard Office/
	Warehouse Lease, dated March 1, 2001, by and between the
	Company and Winton Industrial Center, Inc.                                                          
| | 10.18 | (8)   |  | Lease Agreement for the property located at 3930
	Point Eden Way, Hayward, California, dated July 1, 2000,
	between the Company and Hayward Point Eden I Limited Partnership.                      
| | 10.19 | (9)   |  | Common Stock Purchase Agreement, dated as of
	November 3, 2000, by and between the Company and Acqua
	Wellington North American Equities Fund, Ltd.                                                
| | 10.20 | (10)* |  | Amendment to GlaxoSmithKline agreement executed
	in December 2000.                                                                                                                                 
| | 10.21 | (13)  |  | Securities Purchase Agreement, dated as of
	August 21, 2001, by and among the Company and the
	purchasers named therein.                                                                           
| | 10.22 |       |  | Stock Purchase Agreement, dated as of
	October 22, 2001, by and between the Company and Novo
	Nordisk Pharmaceuticals, Inc.                                                                        
| | 10.23 | *     |  | First Amendment to Development and License
	Agreement, dated as of October 22, 2001, between the
	Company and Novo Nordisk A/ S.                                                                   
| | 10.24 | (14)  |  | Securities Purchase Agreement, dated as of
	December 11, 2001, by and among the Company and the
	purchasers named therein.                                                                         
| | 23.1  |       |  | Consent of Ernst & Young LLP, Independent
	Auditors.                                                                                                                                               
| | 24.1  |       |  | Power of Attorney. Reference is made to page 54.                                                                                                                                                   



---



| |   |                                                                                       
| | - | --------------------------------------------------------------------------------------
| | * | The Company has sought confidential treatment for
	portions of the referenced exhibit.



|    |                                                                                                                                     
|--- | ------------------------------------------------------------------------------------------------------------------------------------
|(1) | Incorporated by reference to the indicated
	exhibit in the Companys Registration Statement on
	Form S-1 (No. 333-4236), as amended.
|   
|(2) | Represents a management contract or compensatory
	plan or arrangement.                                                              
|   
|(3) | Incorporated by reference to Companys
	Annual Report on Form 10-K for the year ended
	December 31, 1997, as amended.               
|   
|(4) | Incorporated by reference to the Companys
	Form 8-K filed on November 7, 1997.                                                     
|   
|(5) | Incorporated by reference to the Companys
	Form 10-Q filed on August 14, 1998.                                                     
|   
|(6) | Incorporated by reference to the Companys
	8-K filed on September 2, 1998.                                                         

62



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##### Table of Contents





|    |                                                                                                                                      
|--- | -------------------------------------------------------------------------------------------------------------------------------------
|(7) | Incorporated by reference to the indicated
	exhibit in the Companys Registration Statement on
	Form S-3 (No. 333-72037), as amended.
|   
|(8) | Incorporated by reference to the Companys
	Form 10-Q filed on November 13, 2000.                                                    
|   
|(9) | Incorporated by reference to the Companys
	Form 8-K filed on December 11, 2000.                                                     



|     |                                                                                                                    
|---- | -------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the Companys
	Annual Report on Form 10-K filed for the year ended
	December 31, 2000.
|    
|(11) | Incorporated by reference to the Companys
	definitive proxy statement filed on April 11, 2001.                    
|    
|(12) | Incorporated by reference to the Companys
	Form 10-Q filed on August 13, 2001.                                    
|    
|(13) | Incorporated by reference to the Companys
	Form S-3 (No. 333-69614), as amended.                                  
|    
|(14) | Incorporated by reference to the Companys
	Form S-3 (No. 333-76584).                                              

(b) Reports on Form 8-K.

The Company did not file any reports on
Form 8-K during the three month period ended
December 31, 2001.

(c) Index to Exhibits.

See Exhibits listed under Item 14(a)(3).

(d) Financial Statement
Schedules.

63



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##### Table of Contents



SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the Registrant
has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Hayward,
State of California, on the 28th day of March, 2002.



| |                                                   
| | --------------------------------------------------
| | ARADIGM CORPORATION 
	 By: /s/ RICHARD P. THOMPSON
| |                                                   
| | Richard P. Thompson                               
| | President and Chief Executive
	Officer            

KNOWN ALL PERSONS BY THESE PRESENTS, that each
person whose signature appears below constitutes and appoints,
jointly and severally, Richard P. Thompson and Michael
Molkentin, and each one of them, attorneys-in-fact for the
undersigned, each with power of substitution, for the
undersigned in any and all capacities, to sign any and all
amendments to this Report on Form 10-K, and to file the
same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby
ratifying and confirming all that each of said
attorneys-in-fact, or their substitutes, may do or cause to be
done by virtue hereof.

IN WITNESS WHEREOF, each of the undersigned has
executed this Power of Attorney as of the date indicated
opposite his name.

Pursuant to the requirements of the Securities
and 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/ RICHARD P. THOMPSONRichard P. Thompson |  | President, Chief Executive
	Officer and Director
	(Principal Executive Officer) |  | March 28, 2002
|                                          
|/s/ MICHAEL MOLKENTINMichael Molkentin     |  | Acting Chief Financial Officer
	(Principal Financial and
	Accounting Officer)   |  | March 28, 2002
|                                          
|/s/ FRANK H. BARKERFrank H. Barker         |  | Director                                                                        |  | March 28, 2002
|                                          
|/s/ STAN M. BENSONStan M. Benson           |  | Director                                                                        |  | March 28, 2002
|                                          
|/s/ IGOR GONDAIgor Gonda                   |  | Director                                                                        |  | March 28, 2002
|                                          
|/s/ JOHN M. NEHRAJohn M. Nehra             |  | Director                                                                        |  | March 28, 2002
|                                          
|/s/ WAYNE L. ROEWayne L. Roe               |  | Director                                                                        |  | March 28, 2002
|                                          
|/s/ VIRGIL D. THOMPSONVirgil D. Thompson   |  | Director                                                                        |  | March 28, 2002

64



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##### Table of Contents



EXHIBIT INDEX

|            |         |                                                                                                                                                                                                     |                                                                                                             
|----------- | ------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------
|Exhibit     |         |                                                                                                                                                                                                    
|Number      |         | Description                                                                                                                                                                                        
|            |         |                                                                                                                                                                                                    
|            | 3.1(1)  |                                                                                                                                                                                                     | Amended and Restated Articles of Incorporation of
	the Company.                                             
|            | 3.2(5)  |                                                                                                                                                                                                     | Bylaws of the Company, as amended.                                                                          
|            | 3.3     |                                                                                                                                                                                                     | Certificate of Determination of Series A
	Junior Participating Preferred Stock.                             
|            | 3.4(14) |                                                                                                                                                                                                     | Certificate of Determination and Preferences of
	Series A Convertible Preferred Stock.                      
|            | 3.5     |                                                                                                                                                                                                     | Certificate of Amendment of Amended and Restated
	Articles of Incorporation of Aradigm Corporation.         
|            | 3.6     |                                                                                                                                                                                                     | Certificate of Amendment of Certificate of
	Determination of Series A Junior Participating Preferred
	Stock.
|            | 4.1     |                                                                                                                                                                                                     | Reference is made to Exhibits 3.1, 3.2, 3.3, 3.4,
	3.5 and 3.6.                                             
|            | 4.2(1)  |                                                                                                                                                                                                     | Specimen common stock certificate.                                                                          
|10.1(1)(2)  |         | Form of Indemnity Agreement between the
	Registrant and each of its directors and officers.                                                                                                        
|10.2(2)(11) |         | Equity Incentive Plan, as amended (the
	Equity Incentive Plan).                                                                                                                                  
|10.3(1)(2)  |         | Form of the Companys Incentive Stock Option
	Agreement under the Equity Incentive Plan.                                                                                                           
|10.4(1)(2)  |         | Form of the Companys Non-statutory Stock
	Option Agreement under the Equity Incentive Plan.                                                                                                       
|10.5(1)(2)  |         | Form of the Companys Non-Employee
	Directors Stock Option Plan.                                                                                                                                  
|10.6(1)(2)  |         | Form of the Companys Non-statutory Stock
	Option Agreement under the Non-Employee Directors Stock
	Option Plan.                                                                                  
|10.7(2)(11) |         | Employee Stock Purchase Plan, as amended.                                                                                                                                                          
|10.8(1)(2)  |         | Form of the Companys Employee Stock
	Purchase Plan Offering Document.                                                                                                                             
|10.9(1)     |         | Master Lease Agreement and Warrant, between the
	Company and Comdisco, Inc., dated June 9, 1995.                                                                                                   
|10.10(4)*   |         | Product Development and Commercialization
	Agreement between the Company and SmithKline Beecham PLC.                                                                                               
|10.11(3)    |         | Lease Agreement for the property located at 3911
	Trust Way, Hayward, California, dated March 17, 1997,
	between the Company and Hayward Point Eden I Limited Partnership.                         
|10.11a(3)   |         | First Amendment to Lease, dated December 22,
	1997, between the Company and Hayward Point Eden I Limited
	Partnership.                                                                             
|10.11b(3)   |         | Second Amendment to Lease, dated January 28,
	1998, between the Company and Hayward Point Eden I Limited
	Partnership.                                                                             
|10.12(3)    |         | Lease Agreement for the property located in Phase
	V of the Britannia Point Eden Business Park in Hayward,
	California, dated January 28, 1998, between the Company and
	Britannia Point Eden, LLC.
|10.13(5)    |         | Common Stock Purchase Agreement, dated
	April 3, 1998, between the Company and the purchasers named
	therein.                                                                                      
|10.14(5)*   |         | Development and License Agreement, dated
	June 2, 1998, between the Company and Novo Nordisk A/ S.                                                                                                 
|10.15(6)    |         | Rights Agreement, dated as of August 31,
	1998, between the Company and Bank Boston, N.A.                                                                                                          
|10.15a      |         | Amendment to Rights Agreement, dated as of
	October 22, 2001, by and between the Company and Fleet
	National Bank.                                                                                 
|10.15b      |         | Amendment to Rights Agreement, dated as of
	December 6, 2001, by and between the Company and EquiServe
	Trust Company.                                                                             
|10.16(7)    |         | Common Stock Purchase Agreement, dated
	January 27, 1999, between the Company and the purchasers
	named therein.                                                                                   



---



##### Table of Contents



|           |  |                                                                                                                                                                              
|---------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit    |  |                                                                                                                                                                              
|Number     |  | Description                                                                                                                                                                  
|           |  |                                                                                                                                                                              
|10.17(8)   |  | Lease Agreement for the property located at 2704
	West Winton Avenue, Hayward, California, dated September 11,
	2000, between the Company and Winton Industrial Center, Inc. 
|10.17a(12) |  | Amendment No. 1 to Standard Office/
	Warehouse Lease, dated March 1, 2001, by and between the
	Company and Winton Industrial Center, Inc.                                    
|10.18(8)   |  | Lease Agreement for the property located at 3930
	Point Eden Way, Hayward, California, dated July 1, 2000,
	between the Company and Hayward Point Eden I Limited Partnership.
|10.19(9)   |  | Common Stock Purchase Agreement, dated as of
	November 3, 2000, by and between the Company and Acqua
	Wellington North American Equities Fund, Ltd.                          
|10.20(10)* |  | Amendment to GlaxoSmithKline agreement executed
	in December 2000.                                                                                                           
|10.21(13)  |  | Securities Purchase Agreement, dated as of
	August 21, 2001, by and among the Company and the
	purchasers named therein.                                                     
|10.22      |  | Stock Purchase Agreement, dated as of
	October 22, 2001, by and between the Company and Novo
	Nordisk Pharmaceuticals, Inc.                                                  
|10.23*     |  | First Amendment to Development and License
	Agreement, dated as of October 22, 2001, between the
	Company and Novo Nordisk A/ S.                                             
|10.24(14)  |  | Securities Purchase Agreement, dated as of
	December 11, 2001, by and among the Company and the
	purchasers named therein.                                                   
|23.1       |  | Consent of Ernst & Young LLP,
	Independent Auditors.                                                                                                                         
|24.1       |  | Power of Attorney. Reference is made to
	page 54.                                                                                                                            



---



| |   |                                                                                       
| | - | --------------------------------------------------------------------------------------
| | * | The Company has sought confidential treatment for
	portions of the referenced exhibit.



| |     |                                                                                                                                      
| | --- | -------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Incorporated by reference to the indicated
	exhibit in the Companys Registration Statement on
	Form S-1 (No. 333-4236), as amended. 
|
| | (2) | Represents a management contract or compensatory
	plan or arrangement.                                                               
|
| | (3) | Incorporated by reference to Companys
	Annual Report on Form 10-K for the year ended
	December 31, 1997, as amended.                
|
| | (4) | Incorporated by reference to the Companys
	Form 8-K filed on November 7, 1997.                                                      
|
| | (5) | Incorporated by reference to the Companys
	Form 10-Q filed on August 14, 1998.                                                      
|
| | (6) | Incorporated by reference to the Companys
	8-K filed on September 2, 1998.                                                          
|
| | (7) | Incorporated by reference to the indicated
	exhibit in the Companys Registration Statement on
	Form S-3 (No. 333-72037), as amended.
|
| | (8) | Incorporated by reference to the Companys
	Form 10-Q filed on November 13, 2000.                                                    
|
| | (9) | Incorporated by reference to the Companys
	Form 8-K filed on December 11, 2000.                                                     



|     |                                                                                                              
|---- | -------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the Companys
	Annual Report on Form 10-K for the year ended
	December 31, 2000.
|    
|(11) | Incorporated by reference to the Companys
	definitive proxy statement filed on April 11, 2001.              
|    
|(12) | Incorporated by reference to the Companys
	Form 10-Q filed on August 13, 2001.                              
|    
|(15) | Incorporated by reference to the Companys
	Form S-3 (No. 333-69614), as amended.                            
|    
|(16) | Incorporated by reference to the Companys
	Form S-3 (No. 333-76584).