<PAGE>   1

--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON D.C. 20549

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

                                   FORM 10-K
                            ------------------------

(MARK ONE)

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

                      FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000

        OR

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

             FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .

                            COMMISSION FILE NUMBER: 0-28402

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

                                  ARADIGM CORPORATION
                 (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S>                                              <C>
                  CALIFORNIA                                       94-3133088
        (STATE OR OTHER JURISDICTION OF                         (I.R.S. EMPLOYER
        INCORPORATION OR ORGANIZATION)                         IDENTIFICATION NO.)
</TABLE>

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

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

                                Yes [X]  No [ ]

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

     As of February 28, 2001, there were 19,065,138 shares of common stock
outstanding. The aggregate market value of voting stock held by non-affiliates
of the Registrant was approximately $157,304,880 based upon the closing price of
the common stock on February 28, 2001 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 18, 2001.

--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
<PAGE>   2

                                     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 the lung. We believe that our non-invasive AERx systems, which
have been shown in clinical studies to achieve performance equivalent 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, two of which are
currently in Phase 2 development. We have attracted the attention of some of the
world's leading pharmaceutical and biotechnology companies, who have contributed
over $75 million for the advancement of our AERx technology. Our most advanced
programs include development partnerships with:

     - Novo Nordisk, the world leader in insulin products, for the needle-free
       delivery of insulin for diabetes; and,

     - SmithKline Beecham, now GlaxoSmithKline, 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 67 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 patch technologies and
pulmonary delivery 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.
                                        2
<PAGE>   3

     Pulmonary delivery systems were originally developed to treat lung diseases
by depositing aerosolized medication in the large airways of the lung. These
aerosols were created in 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 a suspension of drug particles in air, 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 affect 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 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 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

                                        3
<PAGE>   4

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 breathing
patterns while the patient is inhaling through the mouthpiece of the hand-held
device. Indicator lights on the device guide the patient to inhale slowly and
evenly within a predetermined range suitable for drug delivery. When the desired
flow rate is established early in the inspiratory cycle, 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 proteins, peptides, gene vectors and small molecules. 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 is 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

     Initially, our principal commercial development efforts are 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 enter into multiple collaborative
relationships with pharmaceutical and biotech companies for the development and
commercialization of new products utilizing our technologies. Through product
development collaborations, we will seek access to proprietary pharmaceutical
compounds as well as to the resources and

                                        4
<PAGE>   5

expertise necessary to conduct late stage clinical trials and obtain regulatory
approvals. In addition, we will pursue 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, 2001, had 67 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 Diabetes Management System

     We are developing the AERx 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 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

                                        5
<PAGE>   6

Novo Nordisk. Phase 2a clinical trials commenced in October 1998, and are
currently ongoing. There can be no assurance that this development program will
be successful.

  The Market

     In healthy individuals, the pancreas secretes insulin, which helps the body
to regulate blood glucose levels. Unregulated glucose levels in people with
diabetes are associated with short and long-term effects, including blindness,
kidney disease, heart disease, amputation 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 use efficiently the insulin that
their body produces. 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, the inefficiency can be
partially overcome. 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 1999, approximately nine million Americans have been
diagnosed with Type 2 diabetes. These Type 2 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 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 Diabetes Management System is being designed to enable patients with
diabetes to comply more effectively with their insulin therapy, thereby
lessening the risk of long-term complications. We believe that the features of
the AERx 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 delivery has a significant effect on the
pharmacokinetic profile of the delivered insulin. We believe that the
proprietary breath control technology incorporated in the AERx 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. 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 Diabetes Management System.
We believe that our AERx Diabetes Management System can provide a non-invasive
method for delivery of insulin that would be efficacious and reproducible.
Clinical studies conducted by us to date have demonstrated that insulin
delivered via a prototype of the AERx Diabetes Management System achieved
maximum blood glucose reductions in healthy fasting volunteers in half the time
required for subcutaneous 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
                                        6
<PAGE>   7

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 demonstrated a clear linear pharmacokinetic
and pharmacodynamic dose response and efficiency relative to subcutaneous
injections of insulin with the AERx system. 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
high-resolution euglycaemic clamp method used in this study demonstrated a
linear pharmacodynamic 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. 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.

  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 Diabetes Management System for the delivery of blood glucose
regulating medicines. While the collaboration is initially focused on the
delivery of insulin, Novo Nordisk is also obligated to consider with us the
development, under certain conditions, of at least one additional compound in
the field of blood glucose regulation. 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. As of December 2000, we had
received $37.0 million in milestone and product development payments and $5
million from the purchase of our common stock by Novo Nordisk at a 25% premium
to market price. Under certain conditions, a second $5 million equity investment
may be made at our option at the market price at the time of exercise.
Additional milestone payments and product development payments will be paid if
we and Novo Nordisk decide to jointly develop additional AERx products under the
terms of the 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. We are currently engaged in a Phase 2b
clinical trial of the AERx Pain Management System. There can be no assurance
that these clinical trials 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 whom experience multiple
breakthrough pain events each day. Breakthrough pain refers to acute
exacerbations of pain that "break through" the patient's baseline level of pain
medication. The market for potent narcotic analgesics to treat such pain events
in the United States in 1999 was approximately $3.2 billion.

                                        7
<PAGE>   8

     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
requirement for regular and expensive maintenance. 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
ambulation and risk of infection. The AERx system is being designed to be
programmed to allow for patient-activated delivery in accordance with a
physician-directed dosing program. Lock-out 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 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 system to
deliver inhaled morphine to cancer patients and also the results of two
completed clinical studies involving inhaled fentanyl via the AERx System.

     The multicenter, Phase 2b AERx morphine trial is being conducted in the
United States and Australia. The purpose of the study is to evaluate the
efficacy and safety of inhaled morphine via the AERx system for the treatment of
breakthrough pain in patients with cancer. The study is a crossover design using
Roxanol(TM) in the comparator arm. An extension phase allows patients to use the
AERx system for an additional two months after the crossover phase.

     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 system followed
one week later by an intravenous infusion of fentanyl. Results showed a mean
inhaled bioavailability of 67% from the AERx system, with a plasma profile very
similar to that of the intravenous injection. These data were presented at the
29th Annual Meeting of the American College of Clinical Pharmacology held in
September 2000, in Chicago, IL.

     The second trial on fentanyl via the AERx system was an open-label 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 system. The mean time to satisfactory pain relief was 10 minutes (range
6 - 24 minutes). Ninety percent of patients expressed very good to excellent
pain relief on the AERx 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, GA.

                                        8
<PAGE>   9

  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 agreement, as amended, 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. If we elect to terminate the
agreement and continue or intend to continue development of the product, we will
be obligated to pay an exit fee to GlaxoSmithKline. 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. As of February 2001, we
had received $23.7 million in milestone and product development 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.

  AERx Respiratory Management System

     In May 1999, we signed an agreement with Genentech to develop the pulmonary
delivery of dornase alfa to the lung in the AERx system for the treatment of
cystic fibrosis. In October 2000, we successfully completed a Phase 2a clinical
trial using the AERx system for the delivery of dornase alfa to patients with
cystic fibrosis, and received a $500,000 milestone payment from Genentech. In
February 2001, we mutually agreed with Genentech to discontinue the development
program for dornase alfa based on commercial considerations.

     Upon signing the agreement, we received an upfront licensing fee from
Genentech. Genentech also loaned us the funds required to conduct all
development activities up to the discontinuation of the program. As part of the
termination agreement, Genentech will forgive the outstanding loan balance and
accrued interest totaling approximately $6.7 million and no repayment is
required. We will be required to refund Genentech approximately $773,000 for
unspent project prepayments.

  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, macromolecules 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 macromolecules 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 2 grant from
the National Institutes of Health to evaluate the use of the AERx platform for
delivery of gene therapies.

                                        9
<PAGE>   10

     In addition to the above active programs, we have conducted feasibility
testing across a broad range of molecules, including an additional four
compounds with which we have completed Phase 1 clinical trials that we believe
we could pursue in the future. Some of these molecules are listed below:

<TABLE>
<S>                                       <C>
Chronic Bronchitis and Emphysema drugs    Anti-obesity drugs
Antibodies                                Migraine drugs
Gene therapies                            Anti-Parkinson's drugs
Asthma drugs                              Interleukins
Hematopoetic factors                      Interferons
Human growth factors                      Antibiotics
</TABLE>

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.

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 to much higher levels of
scale in a reasonably predictable manner and with minimal risk to our product
development programs.

     We anticipate that the we will complete 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 67 United States patents to date, with 27
United States patent applications pending. In addition, we have purchased three
United States patents covering inventions that are relevant to our technologies.
We have 23 issued foreign patents and 57 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,
                                        10
<PAGE>   11

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 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 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 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

                                        11
<PAGE>   12

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 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 Food and Drug
Administration ("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.
                                        12
<PAGE>   13

     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 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 indications in the approved dosage forms and
at the approved dosage.

                                        13
<PAGE>   14

     Among the other requirements for drug product approval is the requirement
that the prospective manufacturer conform to the FDA's Good Manufacturing
Practices ("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 commencement of marketing of the
product in those countries. The approval process varies from country to country
and the time required may be longer or shorter than that required for FDA
approval.

     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 ("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 or the FDA. 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, financial condition or results of
operations.

     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.

                                        14
<PAGE>   15

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:

<TABLE>
<CAPTION>
                   NAME                              AFFILIATION                  AREA OF EXPERTISE
                   ----                              -----------                  -----------------
<S>                                         <C>                             <C>
Peter Byron, Ph.D.........................  Medical College of Virginia,    Aerosol Science/Pharmaceutics
                                            Virginia Commonwealth
                                            University
Michael Cousins, M.D......................  University of Sydney,           Pain Management
                                            Australia
Peter Creticos, M.D.......................  The Johns Hopkins University    Allergy/Immunology/Asthma
                                            School of Medicine
Lorne Eltherington, M.D., Ph.D............  Sequoia Hospital                Pain Management
Lawrence M. Lichtenstein, M.D., Ph.D......  The Johns Hopkins University    Allergy/Immunology
                                            School of Medicine
Robert Ratner, M.D........................  Medlantic Research Institute    Endocrinology
Christopher Saudek, M.D...................  The Johns Hopkins University    Endocrinology
                                            School of Medicine
Leigh Thompson, M.D., Ph.D................  CEO, Profound Quality           Pharmaceutical Product
                                            Resources                       Development
</TABLE>

EMPLOYEES

     As of February 28, 2001, we had 256 employees, of whom 221 were in research
and development and product development and 35 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.

LEGAL PROCEEDINGS

     In June 1998, Eli Lilly and Company ("Lilly") 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 analogs using materials supplied by Lilly under a series of agreements
dating from January 1996. We and Lilly also conducted negotiations concerning a
long-term supply agreement under which Lilly would supply bulk insulin to us for
commercialization in our AERx 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 seeks 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 contains 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 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. Trial has been set
for November 2001. Management believes that it has meritorious defenses against
each of Lilly's claims and that this litigation will not have a material adverse
effect on our financial position, results of operations or cash flows. However,
there can be no assurance that we will prevail in this case.

                                        15
<PAGE>   16

                                   MANAGEMENT

DIRECTORS AND EXECUTIVE OFFICERS

     The directors and executive officers of the Company and their ages as of
February 28, 2001 are as follows:

<TABLE>
<CAPTION>
                NAME                   AGE                          POSITION
                ----                   ---                          --------
<S>                                    <C>    <C>
Richard P. Thompson..................  49     President, Chief Executive Officer and Director
R. Jerald Beers......................  52     Executive Vice President, Business Development and
                                              Marketing
Bikash K. Chatterjee.................  42     Vice President, Operations
Steven J. Farr, Ph.D.................  41     Vice President, Pharmaceutical Sciences
Maximillian D. Fiore.................  46     Vice President, Engineering
Igor Gonda, Ph.D.....................  53     Vice President, Research & Development
Norman Halleen.......................  47     Vice President, Finance & Administration and Chief
                                              Financial Officer
Norma L. Milligin....................  62     Vice President, Human Resources
Babatunde A. Otulana, M.D............  43     Vice President, Clinical & Regulatory Affairs
Frank H. Barker(1)(2)................  70     Director
Wayne I. Roe(1)(2)...................  50     Director
Virgil D. Thompson(1)(2).............  61     Director
</TABLE>

---------------
(1) Member of the Audit Committee.

(2) Member of the Compensation Committee.

     Richard P. Thompson has been a director and has served as our President and
Chief Executive Officer since 1994 and was Chief Financial Officer from April
1996 until December 1996. From 1991 to 1994, he was President of LifeScan, Inc.,
a Johnson & Johnson Company, a diversified health care company. In 1981, Mr.
Thompson 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.

     R. Jerald Beers has served as our Executive Vice President, Business
Development and Marketing since July 1997. From 1996 until July 1997, Mr. Beers
was an independent consultant. From 1990 to 1996, Mr. Beers held several
positions at Genentech, Inc., a pharmaceutical company, including Vice
President, Marketing, General Manager of Genentech Canada, Inc. and Director,
Marketing Planning and Development. Mr. Beers holds a B.A. in political science
from Brown University and an MBA from the Kellogg School of Management at
Northwestern University.

     Bikash K. Chatterjee has 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.

     Steven J. Farr, Ph.D. has served as our Vice President, Pharmaceutical
Sciences since January 1999. From January 1994 to December 1998, Dr. Farr was
our Senior Director of Pharmaceutical Sciences. From September 1985 to December
1994, Dr. Farr was a Senior Lecturer in the Welsh School of Pharmacy, Cardiff
University, United Kingdom and a director of Cardiff Scintigraphics Ltd. Dr.
Farr holds a B.Sc. in pharmacy from DeMontfort University, a Ph.D. in
biopharmaceutics from the University of Wales and is a member of the Royal
Pharmaceutical Society of Great Britain.

                                        16
<PAGE>   17

     Maximillian D. Fiore has served as our Vice President, Engineering since
September 1994. From January 1991 to September 1994, Mr. Fiore served as
Director of Engineering at LifeScan. From November 1989 to December 1990, Mr.
Fiore held various engineering and management positions with Abbott
Laboratories, a pharmaceuticals and medical device company. Mr. Fiore holds a
B.S.E.E. and a B.S. in engineering from Northwestern University and an M.S.E.E.
in bio-medical/microprocessor-based instrument design from the University of
Wisconsin.

     Igor Gonda, Ph.D. has served as our Vice President, Research and
Development since September 1995. From February 1992 to September 1995, Dr.
Gonda was a Senior Scientist and Group Leader at Genentech. From 1986 to 1992,
Dr. Gonda was a Senior Lecturer in the Department of Pharmacy at the University
of Sydney, Australia. Dr. Gonda holds a B.Sc. in chemistry and a Ph.D. in
physical chemistry from the University of Leeds, United Kingdom.

     Norman Halleen joined the Company in January 2000, as Vice President,
Finance & Administration and Chief Financial Officer. From June 1999 to December
1999, Mr. Halleen worked as Director of Business Development for Guidant
Corporation, a medical device company. From 1997 to October 1998, Mr. Halleen
was the Vice President, Finance and Chief Financial Officer for Collagen
Corporation, a medical device company, and from October 1993 to June 1996 served
as Chief Financial Officer of The Dutra Group, a marine construction company.
Subsequent to his leaving The Dutra Group, the company filed for bankruptcy in
January 1997. From January 1990 to October 1995, Mr. Halleen served as a
consultant in his own business in Hong Kong. He has an A.B. degree from Stanford
University and an MBA from Harvard Business School.

     Norma L. Milligin has 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 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 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, FDA. 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. Barker has 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.

     Wayne I. Roe has been a director since May 1999. He has been Senior Vice
President of United Therapeutics Corporation, a pharmaceutical manufacturer,
since October 1999. He has been the Chairman of Covance Health Economics and
Outcomes Services, Inc., a contract research and developmental services company
to the medical technology marketplace, since March 1996. 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.

     Virgil D. Thompson has been a director since June 1995. Since May 1999, he
has been 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

                                        17
<PAGE>   18

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.

ITEM 2. PROPERTIES

     At December 31, 2000, the Company leased a total of approximately 289,538
square feet of office space in two office parks. The Company leased
approximately 163,658 square feet in three buildings in an office park at 3929
Point Eden Way, Hayward, California and leased 125,880 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 $4.7 million and $ 4.9 million in 2001 and 2002, 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.

ITEM 3. LEGAL PROCEEDINGS

     The information required by this Item concerning legal proceedings is set
forth in Part I of this Report.

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, 2000.

                                        18
<PAGE>   19

                                    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 National 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 National Market for the periods
indicated below.

<TABLE>
<CAPTION>
                                                              HIGH      LOW
                                                             ------    ------
<S>                                                          <C>       <C>
1999
  First Quarter............................................  $14.13    $ 7.63
  Second Quarter...........................................    9.56      5.63
  Third Quarter............................................   12.88      8.00
  Fourth Quarter...........................................   10.50      6.38
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 (through March 22, 2001)...................  $15.25    $ 5.06
</TABLE>

     On February 28, 2001, there were 135 holders of record of our common stock.
On March 22, 2001, the last sale price reported on the Nasdaq National Market
for the common stock was $5.0625 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.

                                        19
<PAGE>   20

ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                           YEARS ENDED DECEMBER 31,
                                             -----------------------------------------------------
                                               2000        1999       1998       1997       1996
                                             ---------   --------   --------   --------   --------
                                                   (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                          <C>         <C>        <C>        <C>        <C>
STATEMENTS OF OPERATIONS DATA:
Contract and license revenues..............  $  20,303   $ 16,812   $ 17,515   $  3,685   $    730
Operating expenses:
  Research and development.................     48,176     33,625     25,549     13,452      7,981
  General and administrative...............      9,271      7,849      8,661      6,012      2,958
                                             ---------   --------   --------   --------   --------
          Total expenses...................     57,447     41,474     34,210     19,464     10,939
                                             ---------   --------   --------   --------   --------
Loss from operations.......................    (37,144)   (24,662)   (16,695)   (15,779)   (10,209)
Interest income............................      3,110      1,947      1,754      1,329      1,179
Interest expense and other.................     (1,528)      (888)      (513)      (234)       (52)
                                             ---------   --------   --------   --------   --------
Net loss...................................  $ (35,562)  $(23,603)  $(15,454)  $(14,684)  $ (9,082)
                                             =========   ========   ========   ========   ========
Basic and diluted net loss per share(1)....  $   (2.07)  $  (1.66)  $  (1.32)  $  (1.43)  $  (1.49)
                                             =========   ========   ========   ========   ========
Shares used in computing basic and diluted
  net loss per share(1)....................     17,196     14,216     11,682     10,280      6,098
                                             =========   ========   ========   ========   ========
BALANCE SHEET DATA:
Cash, cash equivalents and investments.....  $  44,381   $ 31,259   $ 31,036   $ 24,305   $ 28,534
Working capital............................     19,862     22,797     16,483     15,999     23,486
          Total assets.....................     71,371     50,790     44,949     30,294     30,733
Noncurrent portion of notes payable and
  capital lease obligations................      6,230      9,609      4,570      2,139        350
Accumulated deficit........................   (110,441)   (74,904)   (51,279)   (35,827)   (21,144)
          Total shareholders' equity.......     37,785     24,157     21,660     18,659     27,886
</TABLE>

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

                                        20
<PAGE>   21

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, 2000, we had an accumulated
deficit of $110.4 million. We have not been profitable since inception and
expect to incur additional operating losses over the next several years as our
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
significant revenue from product sales in 2001. The sources of working capital
have been equity financings, equipment lease financings, contract research
funding and interest earned on investments.

     We have performed initial feasibility work on a number of compounds and
have been compensated for expenses incurred by us in 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, to manage diabetes using insulin and other
blood glucose regulating compounds and with GlaxoSmithKline, to manage acute and
breakthrough pain using opioid analgesics.

     The collaborative agreement with Novo Nordisk and the collaborative
agreement, as amended, with GlaxoSmithKline provide 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
these development partners based on revenues from partner 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 agreements
as the research and development expenses are incurred, to the extent they are
reimbursable.

     During December 2000, GlaxoSmithKline and we amended the product
development and commercialization agreement whereby we assume 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. The Company anticipates that GlaxoSmithKline will review
its restoration election upon the delivery of Phase 2b trial results, which are
expected to be available during the summer of 2001. 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.

     In February 2001, we announced that we had mutually agreed with Genentech
to discontinue the development of rhDNase using our proprietary AERx system. We
also announced that we would be entering 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 will not require us to repay the loan of funds required to
conduct product development to date under the discontinued program. Forgiveness
of the loan and accrued interest will result in an extraordinary gain during the
first quarter of 2001 of approximately $6,674,000. We will be required to
reimburse Genentech approximately $773,000 for unspent project prepayments.

                                        21
<PAGE>   22

RESULTS OF OPERATIONS

  Years Ended December 31, 2000, 1999 and 1998

     Contract Revenues. We reported revenues from collaborative contracts of
$20.3 million in 2000, compared to $16.8 million in 1999 and $17.5 million in
1998. Revenue increases in 2000 resulted primarily from the expansion of
partner-funded project development revenue from Novo Nordisk and the receipt of
a milestone payment from Genentech offset by a reduction in partner-funded
project development revenue from GlaxoSmithKline. Revenue decreases in 1999
resulted primarily from the completion of certain reimbursable Phase 2
activities associated with the GlaxoSmithKline program. Revenue increases in
1998 resulted from the expansion of our partner-funded project development
programs, primarily the Novo Nordisk agreement signed in June 1998. Costs
associated with contract research revenue are included in research and
development expenses.

     Research and Development Expenses. Research and development expenses have
increased each year since our inception. These expenses were $48.2 million in
2000, compared to $33.6 million in 1999 and $25.5 million in 1998. Research and
development expenses as a percentage of total expenses were 84% in 2000, 81% in
1999 and 75% in 1998. Research and development expenses in 2000 increased by
$14.6 million or 43% over 1999, which was attributable to the expansion of
research and development efforts to support the ongoing programs with Novo
Nordisk and Genentech. Research and development expenses in 1999 increased by
$8.1 million or 32% over 1998, which was attributable to the expansion of
research and development efforts to support the ongoing programs with Novo
Nordisk and GlaxoSmithKline and the addition of the Genentech program.

     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 to increase significantly over the next
few years as 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 future success in pursuing
existing development collaborations, as well as developing and negotiating new
collaborative agreements.

     General and Administrative Expenses. General and administrative expenses
were $9.3 million in 2000 compared to $7.8 million in 1999 and $8.7 million in
1998. General and administrative expenses increased by $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. General and administrative expenses decreased by $812,000 or 9% in
1999 compared to 1998, as a result of the termination of a program to market and
sell a discontinued product during 1998.

     Interest Income. Interest income was $3.1 million in 2000, compared to $1.9
million in 1999 and $1.8 million in 1998. The increases were due to the Company
maintaining larger 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, the
initial sale of common stock using an existing common stock equity line in
December 2000 and the completion of private placements for the Company's common
stock in March 1999 and April 1998.

     Interest Expense and Other. Interest expense was $1.5 million in 2000,
compared to $0.9 million in 1999 and $0.5 million in 1998. The increases
resulted primarily from higher outstanding capital lease and equipment loan
balances under various equipment and lease lines of credit.

                                        22
<PAGE>   23

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, 2000, we had received approximately $148.6 million in net
proceeds from sales of our capital stock. In December 2000, we obtained an
additional $3.0 million equipment line of credit, of which $2.6 million was
funded as of December 31, 2000. As of December 31, 2000, we had cash, cash
equivalents and short-term investments of approximately $44.4 million.

     Net cash used in operating activities in 2000 was $25.8 million, compared
to $27.0 million in 1999 and $4.9 million in 1998. The decrease in cash used
during 2000 resulted primarily from increases in accounts payable, accrued
liabilities and depreciation expense, as well as a decrease in receivables,
partially offset by an increase in net loss and a decrease in deferred revenue.
The increase in cash used during 1999 resulted primarily from increases in the
net loss and receivables, as well as decreases in accrued liabilities and
deferred revenue, partially offset by an increase in depreciation expense.

     Net cash used in investing activities in 2000 was $16.1 million, compared
to net cash used of $6.0 million in 1999 and $21.0 million in 1998. The increase
in cash used in 2000 resulted primarily from higher capital expenditures. The
decrease in cash used in 1999 resulted primarily from reduced capital
expenditures and a decrease in the purchase of short-term investments.

     Net cash provided by financing activities in 2000 was $53.3 million,
consisting 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 using 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 during 2000, which raised proceeds of $4.0 million, notes payable
supporting loans received under a collaborative development agreement with
Genentech and proceeds from equipment loans. Net cash provided by financing
activities in 1999 was $31.6 million, consisting primarily of proceeds from the
completion of a private placement of common stock in March 1999, which raised
net proceeds of approximately $24.8 million, notes payable supporting loans
received under a collaborative development agreement with Genentech and proceeds
from equipment loans. Net cash provided by financing activities in 1998 was
$21.2 million, consisting primarily of proceeds from the completion of a private
placement of common stock in April 1998, which raised net proceeds of $12.0
million, a $5.0 million equity investment by Novo Nordisk in June 1998, and the
receipt of 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 anticipate that we will be able to maintain current and planned
operations, including anticipated capital spending requirements of approximately
$54 million, through the end of 2001 with the proceeds from the follow-on public
offering in April 2000, the sale of common stock to our partners pursuant to the
exercise of put options by us under the terms of various collaboration
agreements, the sale of common stock from the common stock equity line with
Acqua Wellington North American Equities Fund, Ltd., committed funding from our
corporate development partners, primarily Novo Nordisk, and projected interest
income. We expect that our cash requirements will increase in future periods and
there can be no assurance that we will not need to raise substantial additional
capital to fund our operations and capital spending before becoming profitable.
We may seek additional funding through collaborations, debt financing or through
public or private equity. There can be no assurance that additional financing
can be obtained on acceptable terms, or at all. Dilution to
                                        23
<PAGE>   24

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.

                                        24
<PAGE>   25

                                  RISK FACTORS

     Except for historical information contained herein, the discussion in this
section 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. We cannot assure you that:

     - our research and development efforts will be successful;

     - any potential products will be proven safe and effective;

     - regulatory clearance or approval to sell any potential products will be
       obtained; or

     - any of our potential products can be manufactured in commercial
       quantities or at an acceptable cost or marketed successfully.

WE HAVE A HISTORY OF LOSSES AND ANTICIPATE FUTURE LOSSES.

     We have never been profitable, and through December 31, 2000, we have
incurred a cumulative deficit of approximately $110.4 million. 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 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,
including 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 investors that we will be successful in addressing the
design, engineering and manufacturing issues. Additionally, we will need to
formulate and package drugs for delivery by our AERx systems. We cannot assure
investors that we will be able to do this successfully.

                                        25
<PAGE>   26

     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, there can be no assurance 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 UPON 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 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 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.

     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.

                                        26
<PAGE>   27

There can be no assurance 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. Nor can there be any assurance that 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 some
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-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 we expand our production technologies;

                                        27
<PAGE>   28

     - 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, including anticipated capital spending requirements of approximately
$54 million, through the end of 2001 with the proceeds from the follow-on public
offering in April 2000, the sale of common stock to our partners pursuant to the
exercise of put options by us under the terms of various collaboration
agreements, the sale of common stock from the common stock equity line with
Acqua Wellington North American Equities Fund, Ltd., committed funding from our
corporate development partners, primarily Novo Nordisk, and projected interest
income. Depending on the timing and nature of additional development
collaborations, we may need to raise additional funds to finance our operations
beyond the end of 2001. Our cash requirements may change because of our research
and development efforts, including capital expenditures and funding preclinical
and clinical trials and manufacturing capacity. We may seek additional funding
through collaborations or through public or private equity financings. There can
be no assurance that additional financing will be available on acceptable terms
or at all. If we raise additional funds by issuing equity securities,
substantial dilution to shareholders may result. If adequate funds are not
available, we may be required to delay, reduce the scope of, or eliminate one or
more of our research or development programs or obtain funds through
arrangements with collaborative partners or others. Such arrangements might
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 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 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
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.

                                        28
<PAGE>   29

     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. 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.

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 ("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.

     There can be no assurance 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, there can
be no assurance 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, or manufacturers of our
components, 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 ("GMP") requirements, which relate to product testing,
quality assurance and maintaining records and documentation. There can be no
assurance 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.

                                        29
<PAGE>   30

     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 and quality.
There can be no assurance that we will obtain regulatory approvals in such
jurisdictions or that we will not be required to 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 ("DEA") and our facilities are
subject to inspection and DEA export, import, security and production quota
requirements. We cannot assure investors 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, there can be no
assurance 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.
There can be no assurance 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. There can be no assurance
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 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

                                        30
<PAGE>   31

developing competing technologies, obtaining FDA approval for products or
gaining market acceptance more rapidly than we can.

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 we 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 payers such
as government health administration authorities, private health insurers and
other organizations. Third-party payers 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.
There can be no assurance that any of our products will be reimbursable by
third-party payers. In addition, there can be no assurance 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, the risk of accidental contamination or injury from these materials
cannot be completely eliminated. 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;

                                        31
<PAGE>   32

     - market conditions relating to the drug delivery industry;

     - announcements of technological innovations or new commercial products by
       us or our competitors;

     - 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. Such provisions could also limit the price that
certain investors might be willing to pay in the future for shares of 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.

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, 2000, we had cash, cash equivalents and short-term
investments of $44.4 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.

                                        32
<PAGE>   33

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, 2000 and 1999, and the related statements of operations,
shareholders' equity, and cash flows for each of the three years in the period
ended December 31, 2000. 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, 2000 and 1999, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 2000, in conformity
with accounting principles generally accepted in the United States.

                                          /s/ ERNST & YOUNG LLP

Palo Alto, California
February 20, 2001

                                        33
<PAGE>   34

                              ARADIGM CORPORATION

                                 BALANCE SHEETS
                       (IN THOUSANDS, EXCEPT SHARES DATA)

<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                              ---------------------
                                                                2000         1999
                                                              ---------    --------
<S>                                                           <C>          <C>
ASSETS
Current assets:
  Cash and cash equivalents.................................  $  20,732    $  9,347
  Short-term investments....................................     23,649      21,912
  Receivables:
     Billed.................................................         70       1,836
     Unbilled...............................................         --       2,050
  Other current assets......................................        735       1,013
                                                              ---------    --------
          Total current assets..............................     45,186      36,158
Property and equipment, net.................................     25,323      14,160
Notes receivable from officers and employees................        119         130
Other assets................................................        743         342
                                                              ---------    --------
          Total assets......................................  $  71,371    $ 50,790
                                                              =========    ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable..........................................  $   4,894    $  2,240
  Accrued clinical and cost of other studies................        517          95
  Accrued compensation......................................      1,246       1,275
  Deferred revenue..........................................      6,622       7,361
  Other accrued liabilities.................................      2,234         527
  Current portion of notes payable..........................      6,712          --
  Current portion of capital lease obligations..............      3,099       1,863
                                                              ---------    --------
          Total current liabilities.........................     25,324      13,361
Notes payable less current portion..........................         --       3,956
Noncurrent portion of deferred revenue......................      2,032       3,663
Capital lease obligations, less current portion.............      6,230       5,653
Commitments and contingencies
Shareholders' equity:
  Preferred stock, no par value; 5,000,000 shares
     authorized; no shares issued or outstanding............         --          --
  Common stock, no par value, 40,000,000 shares authorized;
     issued and outstanding shares: 2000 -- 18,266,955; 1999
     -- 14,749,777..........................................    148,573      99,603
  Shareholder notes receivable..............................       (131)       (163)
  Deferred compensation.....................................       (216)       (379)
  Accumulated deficit.......................................   (110,441)    (74,904)
                                                              ---------    --------
          Total shareholders' equity........................     37,785      24,157
                                                              ---------    --------
          Total liabilities and shareholders' equity........  $  71,371    $ 50,790
                                                              =========    ========
</TABLE>

                            See accompanying notes.

                                        34
<PAGE>   35

                              ARADIGM CORPORATION

                            STATEMENTS OF OPERATIONS
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                             --------------------------------
                                                               2000        1999        1998
                                                             --------    --------    --------
<S>                                                          <C>         <C>         <C>
Contract and license revenues..............................  $ 20,303    $ 16,812    $ 17,515
Expenses:
  Research and development.................................    48,176      33,625      25,549
  General and administrative...............................     9,271       7,849       8,661
                                                             --------    --------    --------
          Total expenses...................................    57,447      41,474      34,210
                                                             --------    --------    --------
Loss from operations.......................................   (37,144)    (24,662)    (16,695)
Interest income............................................     3,110       1,947       1,754
Interest expense and other.................................    (1,528)       (888)       (513)
                                                             --------    --------    --------
Net loss...................................................  $(35,562)   $(23,603)   $(15,454)
                                                             ========    ========    ========
Basic and diluted net loss per share.......................  $  (2.07)   $  (1.66)   $  (1.32)
                                                             ========    ========    ========
Shares used in computing basic and diluted net loss per
  share....................................................    17,196      14,216      11,682
                                                             ========    ========    ========
</TABLE>

                            See accompanying notes.

                                        35
<PAGE>   36

                              ARADIGM CORPORATION

                       STATEMENTS OF SHAREHOLDERS' EQUITY
                       (IN THOUSANDS, EXCEPT SHARES DATA)

<TABLE>
<CAPTION>
                                                     COMMON STOCK        SHAREHOLDER                                    TOTAL
                                                 ---------------------      NOTES        DEFERRED     ACCUMULATED   SHAREHOLDERS'
                                                   SHARES      AMOUNT    RECEIVABLE    COMPENSATION     DEFICIT        EQUITY
                                                 ----------   --------   -----------   ------------   -----------   -------------
<S>                                              <C>          <C>        <C>           <C>            <C>           <C>
Balances at December 31, 1997..................  10,632,133   $ 54,976      $(386)        $(104)       $ (35,827)     $ 18,659
  Issuance of common stock for cash, net.......   1,450,002     16,988         --            --               --        16,988
  Issuance of common stock under the employee
    stock purchase plan........................      87,887        590         --            --               --           590
  Issuance of common stock upon exercise of
    stock options..............................      28,749        259         --            --               --           259
  Repurchase of common stock...................     (35,155)       (17)        17            --               --            --
  Issuance of warrants for services............          --        268         --            --               --           268
  Repayment of shareholders' notes.............          --         --         81            --               --            81
  Deferred and other compensation..............          --        704         --          (704)              --            --
  Amortization of deferred compensation........          --         --         --           267               --           267
  Comprehensive loss:
    Net loss...................................          --         --         --            --          (15,454)      (15,454)
    Other comprehensive income (loss):
      Net change in unrealized gain on
        available-for-sale investments.........          --         --         --            --                2             2
                                                 ----------   --------      -----         -----        ---------      --------
        Total comprehensive loss...............          --         --         --            --          (15,452)      (15,452)
                                                 ----------   --------      -----         -----        ---------      --------
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
                                                 ==========   ========      =====         =====        =========      ========
</TABLE>

                            See accompanying notes.

                                        36
<PAGE>   37

                              ARADIGM CORPORATION

                            STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                             --------------------------------
                                                               2000        1999        1998
                                                             --------    --------    --------
<S>                                                          <C>         <C>         <C>
Cash flows from operating activities:
Net loss...................................................  $(35,562)   $(23,603)   $(15,454)
Adjustments to reconcile net loss to net cash used in
  operating activities:
  Depreciation and amortization............................     3,213       2,356       1,773
  Loss on sale of equipment................................        --          15          --
  Issuance of warrants and common stock for services.......       296          --         268
  Amortization of deferred compensation....................       163         162         267
  Changes in operating assets and liabilities:
     Receivables...........................................     3,816      (3,112)       (513)
     Other current assets..................................       278        (421)        200
     Other assets..........................................      (401)       (126)         --
     Accounts payable......................................     2,654         261         474
     Accrued compensation..................................       (29)         14         533
     Accrued liabilities...................................     2,129        (902)      1,182
     Deferred revenue......................................    (2,370)     (1,649)      6,334
                                                             --------    --------    --------
Net cash used in operating activities......................   (25,813)    (27,005)     (4,936)
                                                             --------    --------    --------
Cash flows from investing activities:
Capital expenditures.......................................   (14,376)     (4,349)     (9,552)
Proceeds for sale of equipment.............................        --          14          --
Purchases of available-for-sale investments................   (26,764)    (30,841)    (34,940)
Proceeds from maturities of available-for-sale
  investments..............................................    25,052      29,178      23,459
                                                             --------    --------    --------
Net cash used in investing activities......................   (16,088)     (5,998)    (21,033)
                                                             --------    --------    --------
Cash flows from financing activities:
Proceeds from issuance of common stock, net................    48,674      25,835      17,837
Notes payable..............................................     2,756       3,956          --
Proceeds from repayments of shareholder notes..............        32         125          81
Notes receivable from officers.............................        11           5         168
Proceeds from equipment loans..............................     4,051       3,294       4,176
Payments on capital lease obligations and equipment
  loans....................................................    (2,238)     (1,630)     (1,045)
                                                             --------    --------    --------
Net cash provided by financing activities..................    53,286      31,585      21,217
                                                             --------    --------    --------
Net increase (decrease) in cash and cash equivalents.......    11,385      (1,418)     (4,752)
Cash and cash equivalents at beginning of year.............     9,347      10,765      15,517
                                                             --------    --------    --------
Cash and cash equivalents at end of year...................  $ 20,732    $  9,347    $ 10,765
                                                             ========    ========    ========
Supplemental disclosure of cash flow information:
  Cash paid for interest...................................  $    855    $    820    $    513
                                                             ========    ========    ========
Non-cash investing and financing activities:
  Common stock repurchased upon cancellation of shareholder
     notes.................................................  $     --    $     --    $     17
                                                             ========    ========    ========
  Issuance of warrants and common stock for services.......  $    296    $     --    $    268
                                                             ========    ========    ========
</TABLE>

                            See accompanying notes.
                                        37
<PAGE>   38

                              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. Aradigm is
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. Actual results could differ from these estimates.

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, generally three to seven years. Machinery and equipment
acquired under capital leases is amortized over the useful lives of the assets.
Leasehold improvements are amortized over the shorter of the term of the lease
or useful life of the improvement.

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 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.

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, 2000, 1999 and 1998, the
weighted average number of shares subject to repurchase were zero, 48,000 and
158,000, respectively. No diluted loss per share information has

                                        38
<PAGE>   39
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

been presented in the accompanying statements of operations since potential
common shares from stock options and warrants are antidilutive. For the years
ended December 31, 2000, 1999 and 1998, the total number of shares excluded from
diluted loss per share relating to these securities was 2,232,633, 899,319 and
1,234,298 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 will become 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.

Recent Accounting Pronouncements

     In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB
101"). SAB 101 provides guidance on the recognition, presentation and disclosure
of revenue in financial statements of all public registrants. With respect to
the Company's operations, SAB 101 primarily impacts revenue recognition related
to nonrefundable up-front research development fees. SAB 101 generally requires
that such fees be recognized as revenue ratably over the contractual service
period commencing upon the signing of the collaboration agreement. The Company's
revenue recognition has been consistent with the provisions of SAB 101 and,
accordingly, the adoption of SAB 101, which is effective as of January 1, 2000,
had no impact on the Company's financial position or results of operations.

     In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("FAS 133"), which establishes accounting
and reporting standards for derivative instruments and hedging activities. FAS
133 requires that an entity recognize all derivatives as either assets or
liabilities in the balance sheet and measure those instruments at fair value. In
June 1999, the FASB issued Statement No. 137, "Accounting for Derivative
Instruments and Hedging Activities -- Deferral of the Effective Date of FASB
Statement No. 133", which amended FAS 133 by deferring the effective date to the
fiscal year beginning after June 30, 2000. In June 2000, the FASB issued
Statement No. 138, "Accounting for Certain Derivative Instruments and Certain
Hedging Activities -- an Amendment to FASB Statement No. 133", which amended FAS
133 with respect to four specific issues. The Company is required to adopt FAS
133, as amended, for the year ended December 31, 2001. The Company does not
expect that the adoption of this statement will have a material effect on the
financial position, results of operations or cash flows.

     In March 2000, the FASB issued No. 44 ("FIN 44") "Accounting for Certain
Transactions Involving Stock Compensation -- An Interpretation of APB 25." This
Interpretation clarifies (a) the definition of employee for purposes of applying
APB 25, (b) the criteria for determining whether a plan qualifies as a
noncompensatory plan, (c) the accounting consequence of various modifications to
the terms of a previously fixed stock option or award, and (d) the accounting
for an exchange of stock compensation awards in a business combination. This
Interpretation is effective July 1, 2000, but certain conclusions in this
Interpretation cover specific events that occur after December 15, 1998, or
January 12, 2000. To the extent that this Interpretation covers events occurring
during the period after December 15, 1998, or January 12, 2000, but before the
effective date of July 1, 2000, the effects of applying this Interpretation are
recognized on a prospective basis from July 1, 2000. The adoption of FIN 44 does
not have a material impact on the Company's operations and financial position.

                                        39
<PAGE>   40
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

Reclassifications

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

 2. FINANCIAL INSTRUMENTS

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 in the statement of shareholders' equity. 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.

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

<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                           ------------------
                                                            2000       1999
                                                           -------    -------
<S>                                                        <C>        <C>
Cash equivalents:
  Money market fund......................................  $ 3,343    $    52
  Commercial paper.......................................   17,168      8,318
                                                           -------    -------
                                                           $20,511    $ 8,370
                                                           =======    =======
Short-term investments:
  Commercial paper.......................................  $ 9,522    $ 9,304
  Corporate notes........................................   14,127     12,608
                                                           -------    -------
                                                           $23,649    $21,912
                                                           =======    =======
</TABLE>

     As of December 31, 2000 and 1999, the difference between the fair value and
the amortized cost of available-for-sale securities was immaterial. As of
December 31, 2000, the average portfolio duration was approximately three
months, and the contractual maturity of any single investment did not exceed
nine months from the balance sheet date.

                                        40
<PAGE>   41
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 3. PROPERTY AND EQUIPMENT

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

<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                           ------------------
                                                            2000       1999
                                                           -------    -------
<S>                                                        <C>        <C>
Machinery and equipment..................................  $22,097    $13,681
Furniture and fixtures...................................    1,489      1,181
Lab equipment............................................    2,480      2,006
Computer equipment and software..........................    3,095      1,828
Leasehold improvements...................................    4,848        937
                                                           -------    -------
                                                            34,009     19,633
Less accumulated depreciation and amortization...........   (8,686)    (5,473)
                                                           -------    -------
                                                           $25,323    $14,160
                                                           =======    =======
</TABLE>

     At December 31, 2000 and 1999, property and equipment include assets under
capitalized leases of approximately $13,675,000 and $9,890,000, respectively.
Accumulated depreciation related to leased assets at December 31, 2000 and 1999,
was approximately $5,209,000 and $3,667,000, 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 equipment
acquired. 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 September 2000, the Company executed leases for additional space in two
facilities that will be used for clinical manufacturing and manufacturing
support services. 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, 2000 are as follows (amounts in thousands):

<TABLE>
<CAPTION>
                                                          OPERATING    CAPITAL
                                                           LEASES      LEASES
                                                          ---------    -------
<S>                                                       <C>          <C>
Years ending December 31:
  2001..................................................   $ 4,663     $ 3,967
  2002..................................................     4,902       4,282
  2003..................................................     5,048       2,068
  2004..................................................     5,197         513
  2005 and thereafter...................................    48,468          --
                                                           -------     -------
Total minimum lease payments............................   $68,278      10,830
                                                           =======
Less amount representing interest.......................                (1,501)
                                                                       -------
Present value of future lease payments..................                 9,329
Current portion of capital lease obligations............                (3,099)
                                                                       -------
Noncurrent portion of capital lease obligations.........               $ 6,230
                                                                       =======
</TABLE>

     For the years ended December 31, 2000, 1999 and 1998, rent expense under
operating leases totaled $3,896,000, $2,449,000 and $1,157,000, respectively.

                                        41
<PAGE>   42
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 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 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 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 seeks 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 contains
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 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. Trial date has been set for November 2001. Management believes that it
has meritorious defenses against each of Eli Lilly's 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. SHAREHOLDERS' EQUITY

Capital Stock

     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 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 a registration statement
filed 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 sold common stock to Acqua and raised approximately $2,172,000
through the sale of 114,795 shares of common stock at an average price of $18.92
per share. The fair market value of the Company's common stock on the closing
date was $15.50 per share.

     In March 1999, the Company raised approximately $24.8 million in net
proceeds through the private placement of 2,428,338 shares of its common stock.

                                        42
<PAGE>   43
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

     In June 1998, the company raised approximately $5.0 million through a
private sale of 312,396 shares of its common stock to a development partner at a
25% premium to the market price. In April 1998, the Company raised approximately
$12.0 million through a private sale of 1,111,100 shares of its common stock to
a group of institutional investors.

     At December 31, 2000, the Company reserved 268,657 shares of its common
stock for issuance upon exercise of common stock warrants and 3,591,195 shares
for issuance upon exercise of options under all plans.

Stock Warrants

     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 exercisable through
September 2007. The Company valued the warrant using the Black-Scholes option
pricing model and recorded approximately $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 warrants using the Black-Scholes option pricing model and recorded
approximately $221,500 as issuance costs related to the private placement. These
warrants are 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 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.

     In September 1997, in connection with a consulting agreement, the Company
issued a warrant that entitled the holder to purchase 170,000 shares of common
stock at an exercise price of $8.96 per share. In June 1998, the Company and the
holder mutually agreed to cancel 60,000 unvested shares of the original 170,000
shares, leaving an outstanding balance of 110,000 shares. This warrant is
exercisable through August 2003. 26,000 shares vested immediately upon issuance
of the warrant. Another 24,000 shares vested ratably over the first twelve
months after issuance. The Company valued these warrants using the Black-Scholes
option pricing model. 60,000 shares of the 110,000 vested upon certain
contingent events that occurred in 1998. Management valued these shares using
the Black-Scholes option pricing model, resulting in a value of $268,000 that
was fully expensed in 1998. During February 2000, the warrant holder exercised
110,000 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 holder received a net issue exercise of 45,634 shares of
common stock.

                                        43
<PAGE>   44
                              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:

<TABLE>
<CAPTION>
                                   SHARES AVAILABLE FOR     NUMBER                         WEIGHTED AVERAGE
                                     GRANT OF OPTIONS      OF SHARES    PRICE PER SHARE     EXERCISE PRICE
                                   --------------------    ---------    ---------------    ----------------
<S>                                <C>                     <C>          <C>                <C>
Balance at December 31, 1997.....        180,000             45,000         $6.00               $ 6.00
  Options granted................        (30,000)            30,000         $14.25              $14.25
  Options exercised..............             --                 --           --                    --
  Options cancelled..............             --                 --           --                    --
                                         -------            -------
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
                                         =======            =======
</TABLE>

<TABLE>
<CAPTION>
                           OPTIONS OUTSTANDING AND EXERCISABLE
                 -------------------------------------------------------
                                              WEIGHTED AVERAGE REMAINING
EXERCISE PRICE             WEIGHTED AVERAGE        CONTRACTUAL LIFE
     RANGE       NUMBER     EXERCISE PRICE            (IN YEARS)
---------------  -------   ----------------   --------------------------
<S>              <C>       <C>                <C>
$ 6.00 - $ 8.44   34,068        $ 7.82                   7.9
    $14.25        22,500        $14.25                   7.4
$21.56 - $24.13   71,856        $22.77                   9.4
                 -------
$ 6.00 - $24.13  128,424        $17.31                   8.7
                 =======
</TABLE>

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. At December 31, 2000, the
Company had authorized 4,800,000 shares of common stock 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 exercisable more than five years after the date of grant.

                                        44
<PAGE>   45
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

     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, 2000 and 1999, full recourse notes receivable from shareholders were
outstanding of $131,000 and $163,000, 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 Company has repurchased a
total of 38,294 shares in accordance with these agreements. During 2000, the
Company granted options to purchase 1,308,325 shares of common stock, none of
which were exercised subject to repurchase agreements.

     The following is a summary of activity under the Plan:

<TABLE>
<CAPTION>
                               SHARES AVAILABLE FOR    NUMBER          PRICE        WEIGHTED AVERAGE
                                 GRANT OF OPTIONS     OF SHARES      PER SHARE       EXERCISE PRICE
                               --------------------   ---------   ---------------   ----------------
<S>                            <C>                    <C>         <C>               <C>
Balance at December 31,
  1997.......................          153,964          831,133   $ 0.10 - $12.88        $ 7.62
  Options authorized.........        1,000,000               --         --                   --
  Options granted............         (975,300)         975,300   $ 9.13 - $14.63        $11.50
  Options exercised..........               --          (28,749)  $ 6.88 - $12.25        $ 8.99
  Shares repurchased.........           14,062               --   $ 0.43 - $ 4.00        $ 0.58
  Options cancelled..........           58,313          (58,313)  $ 6.88 - $12.88        $ 8.62
                                    ----------        ---------
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
                                    ==========        =========
</TABLE>

<TABLE>
<CAPTION>
                             OPTIONS OUTSTANDING AND EXERCISABLE
                  ---------------------------------------------------------
                                                 WEIGHTED AVERAGE REMAINING
EXERCISE PRICE                WEIGHTED AVERAGE        CONTRACTUAL LIFE
     RANGE         NUMBER      EXERCISE PRICE            (IN YEARS)
---------------   ---------   ----------------   --------------------------
<S>               <C>         <C>                <C>
$ 0.33 - $ 0.43      34,125        $ 0.37                   3.2
    $ 0.57            5,874        $ 0.57                   5.1
    $ 2.00            3,450        $ 2.00                   5.2
$ 4.00 - $ 5.67      90,750        $ 5.21                   4.5
$ 6.75 - $10.06     652,479        $ 8.21                   7.1
$10.50 - $15.38   1,111,914        $12.28                   7.7
$15.94 - $23.56     817,386        $19.46                   9.4
    $24.13            4,500        $24.13                   9.1
                  ---------
$ 0.33 - $24.13   2,720,478        $13.05                   7.9
                  =========
</TABLE>

                                        45
<PAGE>   46
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

     The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" ("APB 25"), and the related
Interpretations in accounting for its employee and non-employee director stock
options because, as discussed below, the alternative fair value accounting
provided for under Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123"), 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
2000 and 1999. Amortization of deferred compensation recognized in the years
ended December 31, 2000, 1999 and 1998 was approximately $163,000, $162,000 and
$267,000, respectively. The weighted average fair value of options granted in
1998 with an exercise price below the deemed fair value of the Company's common
stock on the date of grant was $12.13. The weighted average fair value of
options granted during 2000, 1999 and 1998 with an exercise price equal to the
fair value of the Company's common stock on the date of grant was $11.08, $4.98
and $6.09, 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 6.2%, 5.2% and 5.2% for
the years ended December 31, 2000, 1999 and 1998, respectively; a dividend yield
of 0.0%; the annual volatility factor of the expected market price of the
Company's common stock for 2000, 1999 and 1998 are 78.0%, 64.1% and 62.9%,
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):

<TABLE>
<CAPTION>
                                                         YEARS ENDED DECEMBER 31,
                                                     --------------------------------
                                                       2000        1999        1998
                                                     --------    --------    --------
<S>                                                  <C>         <C>         <C>
Net loss -- as reported............................  $(35,562)   $(23,603)   $(15,454)
Pro forma net loss.................................  $(39,587)   $(26,087)   $(17,254)
Basic and diluted net loss per share -- as
  reported.........................................  $  (2.07)   $  (1.66)   $  (1.32)
Pro forma basic and diluted net loss per share.....  $  (2.30)   $  (1.85)   $  (1.41)
</TABLE>

     The pro forma impact of options on the net less for the years ended
December 31, 2000, 1999 and 1998 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 2000, the number of
shares under the Employee Stock Purchase Plan (the "Purchase Plan") increased by
120,000 shares to 500,000 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, 2000 a total of
337,985 shares have been issued under the Purchase Plan.

                                        46
<PAGE>   47
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 7. COLLABORATIVE AGREEMENTS

     The Company had originally executed 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 is 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 dorname alfa to patients with cystic
fibrosis.

     In February 2001, the Company announced that it has mutually agreed with
Genentech to discontinue the development of rhDNase 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 will 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 will result in an extraordinary gain during the first quarter of 2001
of approximately $6,674,000. The Company will be required to refund Genentech
approximately $773,000 for unspent project prepayments.

     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.

     During 2000 and 1999, pursuant to the Novo Nordisk agreement, the Company
received payments for product development of approximately $13.9 million in each
year. In future periods, the Company could receive up to $43 million in
additional product development and nonrefundable milestone payments and $5.0
million in equity investment. During 1998, the Company received approximately
$8.5 million in product development and nonrefundable milestone payments and
$5.0 million for the purchase of Company common stock at a 25% premium to the
fair market price. 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, 2000, 1999 and 1998, the Company recognized
contract revenues of $15.4 million, $8.7 million and $5.3 million, respectively.

     The Company had originally executed the 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 had been granted
exclusive worldwide sales and marketing rights to the AERx Pain Management
System for use with such analgesics, and the Company 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 assumes full
control and responsibility for conducting and financing the remainder of all
development activities. Under the amendment, unless GlaxoSmithKline or

                                        47
<PAGE>   48
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

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. The Company anticipates that GlaxoSmithKline
will review its restoration election upon the delivery of Phase 2b trial
results. 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 shall pay an exit fee to GlaxoSmithKline.

     Through December 31, 2000, the Company had received from GlaxoSmithKline
approximately $23.7 million in product development and milestone payments and $5
million from the purchase of shares of Aradigm common stock at a 25% premium to
the fair market price. The Company has the rights to receive an additional $5
million equity investment from GlaxoSmithKline. For the years ended December 31,
2000, 1999 and 1998, the Company recognized contract revenue of $3.4 million,
$5.2 million and $11.0 million, respectively.

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

<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                         --------------------
                                                           2000        1999
                                                         --------    --------
<S>                                                      <C>         <C>
Net operating loss carryforward........................  $ 38,600    $ 21,340
Deferred revenue.......................................     3,461       4,410
Research and development credits.......................     3,980       2,575
Other..................................................       620       1,303
                                                         --------    --------
Total deferred tax assets..............................    46,661      29,628
Valuation allowance....................................   (46,661)    (29,628)
                                                         --------    --------
Net deferred tax assets................................  $     --    $     --
                                                         ========    ========
</TABLE>

     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 $17,033,000 and $8,909,000 during 2000 and 1999,
respectively.

     As of December 31, 2000, the Company had net operating loss carryforwards
for federal income tax purposes of approximately $98,000,000, which expire in
the years 2006 through 2020, and federal research and development tax credits of
approximately $2,900,000, which expire in the years 2006 through 2020.

     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.

                                        48
<PAGE>   49
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 9. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

     Following is a summary of the quarterly results of operations for the year
ended December 31, 2000:

<TABLE>
<CAPTION>
                                               MARCH 31,    JUNE 3,     SEPTEMBER 30,    DECEMBER 31,
                                                 2000         2000          2000             2000
                                               ---------    --------    -------------    ------------
<S>                                            <C>          <C>         <C>              <C>
Contract and license revenues................   $ 5,700     $ 4,804        $ 4,715         $  5,084
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
                                                =======     =======        =======         ========
</TABLE>

<TABLE>
<CAPTION>
                                               MARCH 31,    JUNE 30,    SEPTEMBER 30,    DECEMBER 31,
                                                 1999         1999          1999             1999
                                               ---------    --------    -------------    ------------
<S>                                            <C>          <C>         <C>              <C>
Contract and license revenues................   $ 3,586     $ 3,551        $ 5,017         $ 4,658
Expenses:
  Research and development...................     7,587       7,620          9,155           9,263
  General and administrative.................     1,609       2,312          2,227           1,701
                                                -------     -------        -------         -------
          Total expenses.....................     9,196       9,932         11,382          10,964
                                                -------     -------        -------         -------
Loss from operations.........................    (5,610)     (6,381)        (6,365)         (6,306)
Interest income..............................       420         574            500             453
Interest expense and other...................      (289)       (220)          (183)           (196)
                                                -------     -------        -------         -------
Net loss.....................................   $(5,479)    $(6,027)       $(6,048)        $(6,049)
                                                =======     =======        =======         =======
Basic and diluted net loss per share.........   $ (0.43)    $ (0.41)       $ (0.41)        $ (0.41)
                                                =======     =======        =======         =======
Shares used in computing basic and diluted
  net loss per share.........................    12,737      14,661         14,693          14,746
                                                =======     =======        =======         =======
</TABLE>

10. SUBSEQUENT EVENTS

EXERCISE OF PUT OPTION BY COMPANY

     In January 2001, the Company raised $5 million through the sale of 339,961
common shares at an average price of $14.71 per share to 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.

SALE OF COMMON STOCK THROUGH COMMON STOCK EQUITY LINE

     In February 2001, the Company had a second sale of common stock to Acqua
Wellington North American Equities Fund, Ltd. The Company raised $5 million
through the sale of 436,110 common shares at an average price of $11.46 per
share.

                                        49
<PAGE>   50

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 18, 2001, 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 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.

                                        50
<PAGE>   51

                                    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:

<TABLE>
<CAPTION>
                                                               PAGE IN
                                                              FORM 10-K
                                                              ---------
<S>                                                           <C>
Report of Ernst & Young LLP, Independent Auditors...........     33
Balance Sheets -- December 31, 2000 and 1999................     34
Statements of Operations -- Years ended December 31, 2000,
  1999 and 1998.............................................     35
Statements of Shareholders' Equity -- Years ended December
  31, 2000, 1999 and 1998...................................     36
Statements of Cash Flows -- Years ended December 31, 2000,
  1999 and 1998.............................................     37
Notes to Financial Statements...............................     38
</TABLE>

(2) FINANCIAL STATEMENT SCHEDULES.

     None.

(3) EXHIBITS.

<TABLE>
    <S>           <C>
     3.1(1)       Amended and Restated Articles of Incorporation of the
                  Company.
     3.2(1)       Bylaws of the Company.
     4.1          Reference is made to Exhibits 3.1 and 3.2.
     4.2(1)       Specimen stock certificate.
     4.3(1)       Amended and Restated Investor Rights Agreement, dated
                  December 22, 1995, among the Company and certain of its
                  shareholders.
    10.1(9)       Employee Stock Purchase Plan, as amended.
    10.1(1)(2)    Form of Indemnity Agreement between the Registrant and each
                  of its directors and officers.
    10.2(1)(2)    The Company's 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(1)(2)    Form of the Company's Employee Stock Purchase Plan.
    10.8(1)(2)    Form of the Company's Employee Stock Purchase Plan Offering
                  Document.
    10.9(1)       Lease Agreement for the property located at 26219 Eden
                  Landing Road, Hayward, California, dated November 1992 and
                  amended November 29, 1994, between the Company and Hayward
                  Point Eden I Limited Partnership.
    10.9a(3)      Second Amendment to Lease, dated December 22, 1997, between
                  the Company and Hayward Point Eden I Limited Partnership.
    10.9b(3)      Third Amendment to Lease, dated January 28, 1998, between
                  the Company and Hayward Point Eden I Limited Partnership.
</TABLE>

                                        51
<PAGE>   52
<TABLE>
    <S>           <C>
    10.10(3)      Lease Agreement for the property located at 26224 Executive
                  Place, Hayward, California, dated January 28, 1998, between
                  the Company and Hayward Point Eden I Limited Partnership.
    10.11(1)      Lease Agreement for the property located at 3930 Point Eden
                  Way, Hayward, California, dated February 21, 1996, between
                  the Company and Hayward Point Eden I Limited Partnership.
    10.11a(3)     First Amendment to Lease, dated June 10, 1996, between the
                  Company and Hayward Point Eden I Limited Partnership.
    10.11b(3)     Second Amendment to Lease, dated December 22, 1997, between
                  the Company and Hayward Point Eden I Limited Partnership.
    10.11c(3)     Third Amendment to Lease, dated January 28, 1998, between
                  the Company and Hayward Point Eden I Limited Partnership.
    10.12(1)(2)   Stock Purchase Agreement and related agreements, including
                  Promissory Note, dated May 19, 1994, between the Company and
                  Richard P. Thompson.
    10.13(1)(2)   Stock Purchase Agreement and related agreements, including
                  Promissory Note, dated May 23, 1995, between the Company and
                  R. Ray Cummings.
    10.14(1)(2)   Note Agreement and Promissory Note Secured by Deed of Trust,
                  dated May 1, 1995, between the Company and R. Ray Cummings.
    10.15(1)(2)   Promissory Note, dated October 26, 1995, between the Company
                  and Igor Gonda.
    10.16(1)(2)   Promissory Note, dated December 27, 1995, between the
                  Company and Igor Gonda.
    10.17(1)      Master Lease Agreement and Warrant, between the Company and
                  Comdisco, Inc., dated June 9, 1995.
    10.18(4)(5)   Product Development and Commercialization Agreement between
                  the Company and SmithKline Beecham PLC.
    10.19(4)(5)   Stock Purchase Agreement between the Company and SmithKline
                  Beecham PLC.
    10.20(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.
    10.20a(3)     First Amendment to Lease, dated December 22, 1997, between
                  the Company and Hayward Point Eden I Limited Partnership.
    10.20b(3)     Second Amendment to Lease, dated January 28, 1998, between
                  the Company and Hayward Point Eden I Limited Partnership.
    10.21(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.
    10.22(6)      Common Stock Purchase Agreement, dated April 3, 1998,
                  between the Company and the purchasers named therein.
    10.23(6)      Development and License Agreement, dated June 2, 1998,
                  between the Company and Novo Nordisk A/S.
    10.24(7)      Rights Agreement, dated as of August 31, 1998, between the
                  Company and Bank Boston, N.A.
    10.25(8)      Common Stock Purchase Agreement, dated January 27, 1999,
                  between the Company and the purchasers named therein.
    10.26(10)     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.
</TABLE>

                                        52
<PAGE>   53
<TABLE>
    <S>           <C>
    10.27(10)     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.
    10.28(11)     Common Stock Purchase Agreement, dated as of November 3,
                  2000, by and between the Company and Acqua Wellington North
                  American Equities Fund, Ltd.
    10.29(12)     Amendment to GlaxoSmithKline agreement executed in December
                  2000.
    23.1          Consent of Ernst & Young LLP, Independent Auditors.
    24.1          Power of Attorney. Reference is made to page 54.
</TABLE>

---------------
 (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 the indicated exhibit in the 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 11,
     1997.

 (5) Confidential treatment requested.

 (6) Incorporated by reference to the indicated exhibit in the Company's Form
     10-Q filed on August 14, 1998.

 (7) Incorporated by reference to the Company's 8-K filed on September 2, 1998.

 (8) Incorporated by reference to the indicated exhibit in the Company's
     Registration Statement on Form S-3 (No. 333-72037), as amended.

 (9) Incorporated by reference to the Company's Proxy Statement filed April 19,
     2000.

(10) Incorporated by reference to the indicated exhibit in the Company's Form
     10-Q filed on November 13, 2000.

(11) Incorporated by reference to the indicated exhibit in the Company's Form
     8-K filed on December 11, 2000.

(12) The Company has sought confidential treatment for portions of the
     referenced exhibit.

(B) REPORTS ON FORM 8-K.

     During the three month period ended December 31, 2000, one Current Report
was filed on Form 8-K under Item 7 -- Financial Statements, Pro Forma Financial
Information and Exhibits. This report was dated December 11, 2000 and was filed
on the same date.

(C) INDEX TO EXHIBITS.

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

(D) FINANCIAL STATEMENT SCHEDULES.

                                        53
<PAGE>   54

                                   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 29th day of March, 2001.

                                          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 Norman Halleen, 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.

<TABLE>
<CAPTION>
                      SIGNATURE                                     TITLE                    DATE
                      ---------                                     -----                    ----
<C>                                                      <C>                            <S>
               /s/ RICHARD P. THOMPSON                   President, Chief Executive     March 29, 2000
-----------------------------------------------------       Officer and Director
                 Richard P. Thompson                        (Principal Executive
                                                                  Officer)

                 /s/ NORMAN HALLEEN                      Vice President, Finance and    March 29, 2000
-----------------------------------------------------        Administration and
                   Norman Halleen                          Chief Financial Officer
                                                          (Principal Financial and
                                                             Accounting Officer)

                 /s/ FRANK H. BARKER                              Director              March 29, 2000
-----------------------------------------------------
                   Frank H. Barker

                  /s/ WAYNE L. ROE                                Director              March 29, 2000
-----------------------------------------------------
                    Wayne L. Roe

               /s/ VIRGIL D. THOMPSON                             Director              March 29, 2000
-----------------------------------------------------
                 Virgil D. Thompson
</TABLE>

                                        54
<PAGE>   55

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
  EXHIBIT
  NUMBER                             DESCRIPTION
  -------                            -----------
<S>          <C>
 3.1(1)      Amended and Restated Articles of Incorporation of the
             Company.
 3.2(1)      Bylaws of the Company.
 4.1         Reference is made to Exhibits 3.1 and 3.2.
 4.2(1)      Specimen stock certificate.
 4.3(1)      Amended and Restated Investor Rights Agreement, dated
             December 22, 1995, among the Company and certain of its
             shareholders.
10.1(9)      Employee Stock Purchase Plan, as amended.
10.1(1)(2)   Form of Indemnity Agreement between the Registrant and each
             of its directors and officers.
10.2(1)(2)   The Company's 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(1)(2)   Form of the Company's Employee Stock Purchase Plan.
10.8(1)(2)   Form of the Company's Employee Stock Purchase Plan Offering
             Document.
10.9(1)      Lease Agreement for the property located at 26219 Eden
             Landing Road, Hayward, California, dated November 1992 and
             amended November 29, 1994, between the Company and Hayward
             Point Eden I Limited Partnership.
10.9a(3)     Second Amendment to Lease, dated December 22, 1997, between
             the Company and Hayward Point Eden I Limited Partnership.
10.9b(3)     Third Amendment to Lease, dated January 28, 1998, between
             the Company and Hayward Point Eden I Limited Partnership.
10.10(3)     Lease Agreement for the property located at 26224 Executive
             Place, Hayward, California, dated January 28, 1998, between
             the Company and Hayward Point Eden I Limited Partnership.
10.11(1)     Lease Agreement for the property located at 3930 Point Eden
             Way, Hayward, California, dated February 21, 1996, between
             the Company and Hayward Point Eden I Limited Partnership.
10.11a(3)    First Amendment to Lease, dated June 10, 1996, between the
             Company and Hayward Point Eden I Limited Partnership.
10.11b(3)    Second Amendment to Lease, dated December 22, 1997, between
             the Company and Hayward Point Eden I Limited Partnership.
10.11c(3)    Third Amendment to Lease, dated January 28, 1998, between
             the Company and Hayward Point Eden I Limited Partnership.
10.12(1)(2)  Stock Purchase Agreement and related agreements, including
             Promissory Note, dated May 19, 1994, between the Company and
             Richard P. Thompson.
10.13(1)(2)  Stock Purchase Agreement and related agreements, including
             Promissory Note, dated May 23, 1995, between the Company and
             R. Ray Cummings.
10.14(1)(2)  Note Agreement and Promissory Note Secured by Deed of Trust,
             dated May 1, 1995, between the Company and R. Ray Cummings.
</TABLE>

                                        55
<PAGE>   56

<TABLE>
<CAPTION>
  EXHIBIT
  NUMBER                             DESCRIPTION
  -------                            -----------
<S>          <C>
10.15(1)(2)  Promissory Note, dated October 26, 1995, between the Company
             and Igor Gonda.
10.16(1)(2)  Promissory Note, dated December 27, 1995, between the
             Company and Igor Gonda.
10.17(1)     Master Lease Agreement and Warrant, between the Company and
             Comdisco, Inc., dated June 9, 1995.
10.18(4)(5)  Product Development and Commercialization Agreement between
             the Company and SmithKline Beecham PLC.
10.19(4)(5)  Stock Purchase Agreement between the Company and SmithKline
             Beecham PLC.
10.20(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.
10.20a(3)    First Amendment to Lease, dated December 22, 1997, between
             the Company and Hayward Point Eden I Limited Partnership.
10.20b(3)    Second Amendment to Lease, dated January 28, 1998, between
             the Company and Hayward Point Eden I Limited Partnership.
10.21(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.
10.22(6)     Common Stock Purchase Agreement, dated April 3, 1998,
             between the Company and the purchasers named therein.
10.23(6)     Development and License Agreement, dated June 2, 1998,
             between the Company and Novo Nordisk A/S.
10.24(7)     Rights Agreement, dated as of August 31, 1998, between the
             Company and Bank Boston, N.A.
10.25(8)     Common Stock Purchase Agreement, dated January 27, 1999,
             between the Company and the purchasers named therein.
10.26(10)    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.
10.27(10)    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.
10.28(11)    Common Stock Purchase Agreement, dated as of November 3,
             2000, by and between the Company and Acqua Wellington North
             American Equities Fund, Ltd.
10.29(12)    Amendment to GlaxoSmithKline agreement executed in December
             2000.
23.1         Consent of Ernst & Young LLP, Independent Auditors.
24.1         Power of Attorney. Reference is made to page 54.
</TABLE>

---------------
 (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 the indicated exhibit in the 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 11,
     1997.

 (5) Confidential treatment requested.

 (6) Incorporated by reference to the indicated exhibit in the Company's Form
     10-Q filed on August 14, 1998.

 (7) Incorporated by reference to the Company's 8-K filed on September 2, 1998.

 (8) Incorporated by reference to the indicated exhibit in the Company's
     Registration Statement on Form S-3 (No. 333-72037), as amended.

                                        56
<PAGE>   57

 (9) Incorporated by reference to the Company's Proxy Statement filed April 19,
     2000.

(10) Incorporated by reference to the indicated exhibit in the Company's Form
     10-Q filed on November 13, 2000.

(11) Incorporated by reference to the indicated exhibit in the Company's Form
     8-K filed on December 11, 2000.

(12) The Company has sought confidential treatment for portions of the
     referenced exhibit.

                                        57