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UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington D.C. 20549




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Form 10-K



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|           |  |                                                                                                                                                                       
|---------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                                                                                                       
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2002
    or                       
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period
    from                to                .

Commission File Number: 0-28402



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Aradigm Corporation

(Exact Name of Registrant as Specified in Its
Charter)


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

3929 Point Eden Way, Hayward, CA
94545

(Address of Principal Executive
Offices)


Registrants telephone number, including
area code:

(510) 265-9000


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

None


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

Common Stock, no par value




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Indicate by check mark whether the registrant:
(1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the
past
90 days.     Yes þ     No o

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Act)     Yes oNo þ

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

As of February 28, 2003, there were
50,168,003 shares of common stock outstanding. The aggregate
market value of common stock held by non-affiliates of the
registrant as of June 28, 2002, was approximately
$60,332,000. 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 15, 2003.



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TABLE OF CONTENTS



|              |                                                                                                         |  |  |  |  |  |  | 
|------------- | ------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I       
|              | Item 1. Business                                                                                       
|              | Item 2. Properties                                                                                     
|              | Item 3. Legal Proceedings                                                                              
|              | Item 4. Submission of Matters to a Vote of Security Holders                                            
|PART II      
|              | Item 5. Market for the Registrants Common Stock and Related Stockholder Matters                       
|              | Item 6. Selected Financial Data                                                                        
|              | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations          
|RISK FACTORS 
|              | Item 7A. Quantitative and Qualitative Disclosure About Market Risk                                     
|              | Item 8. Financial Statements and Supplementary Data                                                    
|              | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure           
|PART III     
|              | Item 10. Directors and Executive Officers of the Registrant                                            
|              | Item 11. Executive Compensation                                                                        
|              | Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
|              | Item 13. Certain Relationships and Related Transactions                                                
|              | Item 14. Control Procedures                                                                            
|PART IV      
|              | Item 15. Exhibits, Financial Statements Schedules, and Reports on Form 8-K                             
|SIGNATURES   
|EXHIBIT INDEX
|EXHIBIT 23.1 
|EXHIBIT 99.1 



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PART I






|        |         
|------- | --------
|Item 1. | Business

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

Overview

Aradigm Corporation is a leading developer of
advanced pulmonary drug delivery systems for the treatment of
systemic conditions as well as lung diseases. Our hand-held AERx
platform is being designed for the rapid and reproducible
delivery of a wide range of pharmaceutical drugs and biotech
compounds via pulmonary delivery or through the lung. We believe
that our non-invasive AERx systems, which have been shown in
clinical studies to achieve performance 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 and biologics was
approximately $34.6 billion in 2002. We believe that many
of these molecules could potentially be delivered using the AERx
platform.

We have tested 13 compounds in more than 55 human
clinical trials involving over 1,400 patients worldwide. In
September 2002, Aradigm and our partner, Novo Nordisk A/S
announced the initiation of the first study of the Phase 3
clinical trials of the AERx insulin Diabetes Management System,
our most advanced program. This 24-month, 300 patient study is
designed to examine the long-term safety and efficacy of the
system in patients with type-1 diabetes. We have been successful
in attracting the attention of some of the worlds leading
pharmaceutical and biotechnology companies. Together, our
partners have contributed cumulatively over $117 million in
contract and license revenues for the advancement of our AERx
technology. Our most advanced programs are based on development
partnerships with:



| |   |                                                                                                                           
| | - | --------------------------------------------------------------------------------------------------------------------------
| |  | Novo Nordisk A/S, the world leader in insulin
    products, for the needle-free delivery of insulin for diabetes;
    and,
|
| |  | GlaxoSmithKline plc
    (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 84 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

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and risk of infection. These limitations have
prompted drug manufacturers to explore alternatives such as
improved oral delivery formulations, transdermal, or through the
skin, patch technologies and pulmonary delivery systems. Due to
the natural ability of the lung to transfer molecules into the
bloodstream, pulmonary drug delivery systems are now being
pursued as an alternative to injection.


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

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

Recent advances in dry powder formulation
technology have made possible the creation of smaller particle
aerosols suitable for more efficient deep lung delivery and
several companies are developing systems based on this approach.
However, most drugs being considered for pulmonary delivery are
currently marketed in stable liquid formulations. We believe the
extra steps involved in making dry powder formulations of these
drugs will make them more difficult and costly to produce than
liquid-based formulations. In addition, todays dry powder
delivery systems under development continue to rely on
individual patient breathing technique for 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 formulation technology of the AERx platform
allows us to use conventional, 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.

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| |                                          
| | -----------------------------------------
| | Efficient, Precise Aerosol
    Generation

Our proprietary technology produces the
low-velocity, small-particle aerosols necessary for efficient
deposition of a drug in the deep lung. Liquid drug formulations
are aerosolized from pre-packaged, single-use, disposable
packets using the hand-held AERx device. Each disposable packet
is comprised of a small blister package of drug adjacent to an
aerosolization nozzle. The AERx device compresses the packet to
push the 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 wearing that would degenerate aerosol
quality if reused. Through this technology, we believe we can
achieve highly efficient and reproducible aerosols.



| |                                         
| | ----------------------------------------
| | Automated Breath-Controlled
    Delivery

Studies have shown that even well trained
patients tend to develop improper inhalation technique over
time, resulting in less effective therapy. The AERx electronic
platform employs a patented technology to measure the
patients inhalation flow rate through the mouthpiece of
the hand-held device. Indicator lights on the device guide the
patient to inhale slowly and evenly for optimal drug delivery.
When the desired flow rate is established early in the breath,
drug delivery is automatically initiated. As a result, a
consistent dose of medication is delivered each time the product
is used. The flow rate can be adjusted for different patient
needs; for example, a low-flow device has been developed for use
by cystic fibrosis patients. Novel flow-rate controls have also
been developed for Aradigms AERx EssenceTM, a
new, second generation all-mechanical delivery device designed
for topical lung delivery and systematic delivery of small
molecules.

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. In addition to our publicly
announced late stage programs in diabetes and pain management
potential applications for AERx-delivered therapy include
cardiovascular disease, oncology, endocrine disorders,
infections, neurological diseases, inflammatory conditions and
respiratory diseases. 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. 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.

In addition, our work on proteins and gene vector
delivery anticipates the role that genomics and proteomics are
expected to play in future drug discovery. Pulmonary drug
delivery may be an attractive alternative to injectable delivery
of novel therapies. We believe that the capabilities of the AERx
platform will make it particularly appropriate for these
potential future applications.



| |                                                                
| | ---------------------------------------------------------------
| | Expand Existing and Develop New
    Collaborative Relationships

In order to enhance our commercial opportunities
and effectively leverage our core scientific resources, we
intend to continue entering into multiple collaborative
relationships with pharmaceutical and biotech companies for the
development and commercialization of new products utilizing our
technologies. Through product development collaborations, we
seek access to proprietary pharmaceutical compounds as well as
to the resources necessary to conduct late stage clinical
programs and obtain regulatory approvals. In addition, we will
continue pursuing relationships with companies with established
sales forces and distribution channels in our target markets.
Where consistent with other objectives, we plan to give
preference to development partners whose pipelines contain
multiple products whose value could be enhanced by our AERx
pulmonary drug delivery technology. By establishing such
collaborative

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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 devices
are being designed to 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 devices by pricing them
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 devices 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, 2003, had 84 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 develop next-generation delivery
devices. We are supported by the International Scientific
Advisory Board whose members are global leaders in drug delivery
and clinical specialties of key interest to Aradigm.

Aradigm Product Applications

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

AERx insulin Diabetes Management
System

We are developing the AERx insulin Diabetes
Management System to permit patients with diabetes to
non-invasively self-administer insulin. We believe that
patients, when provided with a non-invasive delivery alternative
to injection, will be more likely to self-administer insulin as
often as needed to keep tight control of their blood glucose
levels. We are developing and planning to commercialize this
product in collaboration with Novo Nordisk A/S, a leader in the
field of diabetes care. During the third quarter of 2002, we
initiated the first study in our Phase 3 clinical program.
There can be no assurance that this development program will be
successful.

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| |           
| | ----------
| | The Market

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

Approximately 800,000 Americans suffer from
Type 1 diabetes. All of these patients either self-inject
insulin multiple times a day or use external insulin pumps
Approximately 16 million Americans have Type 2
diabetes, and the prevalence of Type 2 diabetes has
increased dramatically over the past decade due to lifestyle
factors such as obesity and inactivity. 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 reluctance to
utilize insulin-therapies contributes to approximately
$45.0 billion in annual direct costs associated with the
treatment of diabetes. Through our convenient, non-invasive AERx
insulin Diabetes Management System, we believe we can address
this patient reluctance, reduce overall treatment costs and grow
the total worldwide insulin market beyond its current level of
$3.7 billion. The leading suppliers of insulin worldwide
are Novo Nordisk A/S and Eli Lilly.



| |            
| | -----------
| | The Product

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

Standard insulin therapies presently require that
doses of insulin given by injection be adjusted in increments of
one international unit, which is a standard unit of measure for
insulin. We are not aware of any competitive products under
development that are being designed to provide the same one unit
dosing adjustability as the AERx insulin Diabetes Management
System. We believe that our AERx insulin Diabetes Management
System can provide a non-invasive method for delivery of insulin
that would be very efficient and easily reproduced. Clinical
studies conducted by us to date have demonstrated that insulin
delivered via a prototype of the AERx insulin Diabetes
Management System achieved maximum blood glucose reductions in
healthy fasting volunteers in half the time required for
subcutaneous, or under the skin, insulin injections. We believe
this more rapid onset of action could allow people with diabetes
to

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dose themselves closer to mealtimes, better
matching insulin levels to caloric intake. The reductions in
blood glucose levels were also at least as reproducible in both
magnitude and time to maximum reduction as subcutaneous
injections.




| |                     
| | --------------------
| | Clinical Development

In November 2001, we successfully completed
Phase 2b clinical trials for our AERx insulin Diabetes
Management System, which showed that the product may be
successfully used to treat Type 2 diabetes patients with
insulin delivered via the pulmonary route. The Phase 2 trial was
designed to investigate the safety and efficacy of pulmonary
insulin via the AERx insulin Diabetes Management System compared
to intensified treatment with insulin injections in patients
with Type 2 diabetes. Approximately 100 patients were
included for a twelve-week period in the study. The results of
the study announced in June 2002 at the Annual Meeting of the
American Diabetes Association in San Francisco, California
showed the safety and efficacy of the AERx insulin Diabetes
Management System to be comparable to an intensive subcutaneous
injection regimen of insulin.

In September 2002, we, and Novo Nordisk A/S,
initiated the first study in our Phase 3 clinical program for
the AERx insulin Diabetes Management System. This two-year study
is examining the long-term safety and efficacy of inhaled
insulin in patients with Type 1 diabetes. Additional trials
are scheduled to run concurrently with both Type 1 and
Type 2 diabetes patients.



| |                  
| | -----------------
| | The Collaboration

In June 1998, we entered into a product
development and commercialization agreement with Novo Nordisk
A/S, the world leader in diabetes care, covering the use of the
AERx insulin Diabetes Management System for the delivery of
blood glucose regulating medicines. Novo Nordisk A/S 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 that receives regulatory approval, we expect to
receive a share of gross profit on the sales of such products by
Novo Nordisk A/S.

Pursuant to the Novo Nordisk A/S agreement, we
could receive approximately $38.0 million in milestone
payments in addition to reimbursement for product development
expenses and $10.0 million in equity investments by the
time the first product from the collaboration is commercialized.
From the inception of partnership in June 1998 through
December 31, 2002, we have received from Novo Nordisk A/S
approximately $86.1 million in product development
payments, approximately $13.0 million in milestone payments
and $10.0 million from the purchase of our common stock by
Novo Nordisk A/S. From the inception of partnership in June 1998
through December 31, 2002, of the payments received
approximately $77.5 million of product development and
$4.8 million of milestone payments have been recognized as
contract revenue. Additional milestone payments and product
development payments will be paid by Novo Nordisk A/S if Novo
Nordisk A/S and we decide to jointly develop additional AERx
products under the terms of the agreement.

In October 2001, we entered into a common stock
purchase agreement with Novo Nordisk Pharmaceuticals, an
affiliate of Novo Nordisk A/S, pursuant to which Novo Nordisk
Pharmaceuticals purchased $20.0 million of our common stock
at the fair market value. We also received the option under the
agreement to sell an aggregate of up to $25.0 million
additional shares to Novo Nordisk Pharmaceuticals for the
purchase price provided in the agreement by delivering written
notice, or a share sales notice, to Novo Nordisk Pharmaceuticals
of our election to sell additional shares. Under the terms of
the agreement the number of additional shares shall be
calculated by dividing the additional purchase price by the
average closing price of the Companys common stock on the
Nasdaq for the thirty trading days immediately prior to the date
of written notice by the Company to Novo Nordisk
Pharmaceuticals. Subject to certain restrictions, we may deliver
a sale shares notice specifying an amount between
$5.0 million and $10.0 million for Novo Nordisk
Pharmaceuticals to purchase once every three months until we
have sold an aggregate of $25.0 million worth of additional
shares of common stock to Novo

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Nordisk Pharmaceuticals. In addition, the sale of
shares of common stock to Novo Nordisk Pharmaceuticals is
subject to certain conditions, including, if applicable,
obtaining any requisite shareholder approval. In July 2002, we
issued 1,182,034 shares of common stock to Novo Nordisk
Pharmaceuticals for an aggregate purchase price of
$5.0 million. Novo Nordisk A/S with its affiliates own
approximately 20% of our total outstanding common stock on an
as-converted basis as on December 31, 2002 and is
considered a related party. In a separate agreement, we and Novo
Nordisk A/S agreed to share manufacturing responsibilities
where Novo Nordisk A/S has accepted all responsibility for
high volume production beyond the capacity of our first factory.
This has potentially shifted a significant future investment in
additional manufacturing capacity to Novo Nordisk A/S and
was accomplished without changing the basic economic
arrangements of the original agreement.




| |                            
| | ---------------------------
| | AERx Pain Management System

We are developing the hand-held AERx Pain
Management System as a non-invasive, patient-controlled
pulmonary drug delivery product for treatment of severe pain. In
December 2001, we successfully completed Phase 2b clinical
trials of the AERx Pain Management System incorporating morphine
sulfate for the treatment of cancer and post-operative pain. We
have also evaluated in a Phase 1 clinical trial the AERx
Pain Management System incorporating fentanyl. Future progress
for these programs is contingent on either
GlaxoSmithKlines recommitment or a new partner entering
into another development agreement with us. If we enter into a
development agreement with a new partner or with recommitment of
GlaxoSmithKline, we will continue to pursue this program. There
can be no assurance that this development program will be
successful.



| |           
| | ----------
| | The Market

We have targeted breakthrough cancer pain as the
first application for the AERx Pain Management System. More than
four million cancer patients worldwide suffer from pain, a
majority of which experience multiple breakthrough pain events
each day. Breakthrough pain is defined as a sudden episode of
severe pain that breaks through the pain level being
managed by long-acting medication. We believe that the market
potential for treatment of such pain events in the United States
was approximately $300.0 million in 2002.

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



| |            
| | -----------
| | The Product

We believe that a patient-controlled,
non-invasive drug delivery system that enables rapid uptake of
medication could significantly expand the market for pain
management in the outpatient setting. The AERx Pain Management
System is expected to have features similar to current
intravenous patient-controlled analgesia systems, but without
the need for intravenous access and the resulting impairment of
patient mobility and risk of infection. The AERx Pain Management
device is being designed for patient-activated delivery in
accordance with a physician-directed dosing program. The
systems lockout mechanisms should reduce the risk of
inappropriate dosing and a patented electronic patient
identification feature should help prevent unauthorized use of
the device. Dosing event are automatically recorded by the AERx
devices microprocessor, allowing health care professionals
to monitor patient use. We believe that these features of the
AERx Pain Management System, combined with the speed of onset of
pulmonary delivery, should provide a significant advance in pain
management.

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| |                     
| | --------------------
| | Clinical Development

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

If we enter into a development agreement with a
new partner or with recommitment of GlaxoSmithKline, we will
continue to pursue this program. There can be no assurance that
this development program will be successful.



| |                  
| | -----------------
| | The Collaboration

In September 1997, we entered into a product
development and worldwide commercialization agreement with
SmithKline Beecham (now GlaxoSmithKline) covering the use of the
AERx Pain Management System for the delivery of narcotic
analgesics. In December 2000, the agreement was amended to
transfer control of further development and provide certain
other new rights to us. We also assumed responsibility for
financing the remainder of all development activities under the
agreement, as amended. Under the terms of the amended agreement,
unless GlaxoSmithKline or we have terminated the agreement,
GlaxoSmithKline can restore its rights and obligations to
participate in and fund development and commercialization of the
AERx Management System upon payment of a restoration fee. We
have made available to GlaxoSmithKline all of the Phase 2b
trial results and await their decision on further development
plans. There can be no assurance that GlaxoSmithKline will elect
to restore its rights. If we elect to terminate the agreement
and continue or intend to continue any development activities,
either alone or in collaboration with a third party, then we
will be required to pay an exit fee to GlaxoSmithKline. The
payment of the exit fee would not have a material impact on our
financial position or operating results. We have the right to
explore partnering options with other companies while this
agreement is in effect. We are currently in active discussions
with several alternate partners that could participate in this
product if GlaxoSmithKline does not continue in its capacity. If
GlaxoSmithKline elects to restore its rights under the agreement
and if this system receives regulatory approval, we would expect
to sell AERx hand-held devices and drug packets to, and to
receive royalties on sales by, GlaxoSmithKline. Through
December 31, 2001, we had received from GlaxoSmithKline and
recognized as contract revenue approximately $23.7 million
in product development and milestone payments and
$10.0 million from the purchase of our common stock by
GlaxoSmithKline, $5.0 million of which was sold to
GlaxoSmithKline at a 25% premium to market price. No additional
product development or milestone payments were received during
2002.



| |                                           
| | ------------------------------------------
| | Additional Potential AERx
    Applications

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

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

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We currently have eight programs, in addition to
our collaboration with Novo Nordisk in which the use of the AERx
delivery technology is being developed or evaluated across a
range of drug therapies.

In addition, we have performed proactive
targeting evaluations of molecules in development to determine
their suitability for delivery via the AERx technology. We have
identified approximately 50 candidates in the following
therapeutic areas:

|                        |  |                    
|----------------------- |  | -------------------
|Cardiovascular disease  |  | Endocrine disorder 
|Oncology                |  | Infections         
|Neurological disease    |  | Respiratory disease
|Inflammatory conditions |  |                    

Sales and Marketing

We plan to establish additional collaborative
relationships 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
20 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 completed the construction of a new facility
for commercial scale production in 2001. We plan to internally
produce the disposable nozzles, assemble the disposable
unit-dose packets and fill the drug into the unit-dose packets.
We will look to contract manufacturers to produce the main
components and subassemblies for the AERx devices, but we plan
to perform final assembly, calibration, testing and packaging of
these devices ourselves. All of our manufacturing capabilities
are being established at our facilities in Hayward, 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 84 United States
patents to date, with 37 United States patent applications
pending. In addition, we have purchased three United States
patents covering inventions that are relevant to our
technologies. We have 73 issued foreign patents and 108 foreign
patent applications pending.

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

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



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

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 brought an action against us
seeking to have one or more employees of Eli Lilly named as
co-inventors on some 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

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invention if we wish to pursue such protection.
There can be no assurance, however, that these agreements will
provide meaningful protection for our inventions, trade secrets
or other proprietary information in the event of unauthorized
use or disclosure of such information.


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

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

Competition

We are in competition with pharmaceutical,
biotechnology and drug delivery companies, hospitals, research
organizations, individual scientists and nonprofit organizations
engaged in the development of alternative drug delivery systems
or new drug research and testing, as well as with entities
producing and developing injectable drugs. We are aware of a
number of companies currently seeking to develop new products
and non-invasive alternatives to injectable drug delivery,
including oral delivery systems, intranasal delivery systems,
transdermal systems, buccal, or mouth cavity, 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 Nektar Therapeutics (formerly
Inhale Therapeutics Systems) and Alkermes Pharmaceuticals, Inc.
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,

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product recalls or seizures, injunctions,
refusals to permit products to be imported into or exported out
of the United States, refusals of the FDA to grant approval of
drugs or to allow us to enter into government supply contracts,
withdrawals of previously approved marketing applications and
criminal prosecutions.


The activities required before a new drug product
may be marketed in the United States include preclinical and
clinical testing. Preclinical tests include laboratory
evaluation of product chemistry and other characteristics and
animal studies to assess the potential safety and efficacy of
the product as formulated. Many preclinical studies are
regulated by the FDA under a series of regulations called the
current Good Laboratory Practice regulations. Violations of
these regulations can, in some cases, lead to invalidation of
the studies, requiring such studies to be replicated.

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

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

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years and involves expenditure of substantial
resources. There is no guarantee that any approval will be
granted on a timely basis, or at all. Upon approval, a
prescription drug may only be marketed for the approved symptoms
in the approved dosage forms and at the approved dosage.


Among the other requirements for drug product
approval is the requirement that the prospective manufacturer
conform to the FDAs Good Manufacturing Practices
(GMP) regulations for drugs. In complying with the
GMP regulations, manufacturers must continue to expend time,
money and effort in production, record keeping and quality
control to assure that the product meets applicable
specifications and other requirements. The FDA periodically
inspects manufacturing facilities in the United States to assure
compliance with applicable GMP requirements. A companys
failure to comply with the GMP regulations or other FDA
regulatory requirements could have a material adverse effect on
that companys business.

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

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



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

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. There can
be no assurance that we will not be required to incur
significant costs to comply with such laws and regulations in
the future or that such laws or regulations will not have a
material adverse effect upon our business.

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

International Scientific Advisory
Board

We have assembled an International Scientific
Advisory Board comprised of scientific and development advisors
that provide expertise, on a consulting basis, in the areas of
pain management, allergy and immunology, pharmaceutical
development and drug delivery, but are employed elsewhere on a

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full time basis. As a result, they can only spend
a limited amount of time on our affairs. The International
Scientific Advisory Board assists us on issues related to
potential product applications, product development and clinical
testing. Its members, and their affiliations and areas of
expertise, include:


|                                      |  |                                                                   |  |                                   
|------------------------------------- |  | ----------------------------------------------------------------- |  | ----------------------------------
|Name                                  |  | Affiliation                                                       |  | Area of Expertise                 
|                                      |  |                                                                   |  |                                   
|Peter R. Byron, Ph.D.                 |  | Medical College of Virginia, Virginia
    Commonwealth University |  | Aerosol Science/ Pharmaceutics    
|Michael J. Cousins, M.D.              |  | University of Sydney, Australia                                   |  | Pain Management                   
|Peter S. Creticos, M.D.               |  | The Johns Hopkins University School of Medicine                   |  | Allergy/ Immunology/ Asthma       
|Lorne G. Eltherington, M.D., Ph.D.    |  | Sequoia Hospital                                                  |  | Pain Management                   
|Igor Gonda, Ph.D.                     |  | Acrux Limited                                                     |  | Drug Delivery                     
|Henrik Egesborg Hansen                |  | Novo Nordisk A/ S                                                 |  | Device Technology                 
|Vincent H.L. Lee, Ph.D.               |  | University of Southern California                                 |  | Pharmaceutics/ Drug Delivery      
|Lawrence M. Lichtenstein, M.D., Ph.D. |  | The Johns Hopkins University School of Medicine                   |  | Allergy/ Immunology               
|Robert E. Ratner, M.D.                |  | MedStar Research Institute                                        |  | Endocrinology                     
|W. Leigh Thompson, M.D., Ph.D.        |  | CEO, Profound Quality Resources                                   |  | Pharmaceutical Product Development

Employees

As of February 28, 2003, we had
285 employees, of whom 240 were in research and development
and product development and 45 were in business development,
finance and administration. We believe that our future success
is dependent on attracting and retaining highly skilled
scientific, sales and marketing and senior management personnel.
Competition for such skills is intense, and there is no
assurance that we will continue to be able to attract and retain
high-quality employees. Our employees are not represented by any
collective bargaining agreement. We consider our relations with
our employees to be good.

Corporate History and Website
Information

We were incorporated in California in 1991. Our
principal executive offices are located at 3929 Point Eden
Way, Hayward, California 94545, and our main telephone number is
(510) 265-9000. Investors can obtain access to this annual
report on Form 10-K, our quarterly reports on
Form 10-Q, our current reports on Form 8-K and all
amendments to these reports, free of charge, on our website at
http://www.aradigm.com as soon as reasonably practicable after
such filings are electronically filed with the SEC. The public
may read and copy any material we file with the SEC at the
SECs Public Reference Room at 450 Fifth Street, N.W.,
Washington, D.C., 20549. The public may obtain information on
the operations of the Public Reference Room by calling the SEC
at 1-800-SEC-0330. The SEC maintains an Internet site,
http://www.sec.gov, that contains reports, proxy and information
statements and other information regarding issuers that file
electronically with the SEC.

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MANAGEMENT

Directors and Executive Officers

The directors and executive officers of the
Company and their ages as of February 28, 2003 are as
follows:

|                           |  |     |    |          |  |                                                                 
|-------------------------- |  | --- | -- | -------- |  | ----------------------------------------------------------------
|Name                       |  | Age |    | Position
|                           |  |     |    |         
|Richard P. Thompson        |  |     | 51 |          |  | President, Chief Executive Officer and Chairman
    of the Board
|Bikash K. Chatterjee       |  |     | 44 |          |  | Vice President, Pharmaceutical Operations                       
|Thomas C. Chesterman       |  |     | 43 |          |  | Senior Vice President and Chief Financial Officer               
|Steven J. Farr, Ph.D.      |  |     | 44 |          |  | Vice President, Research and Development                        
|Maximillian D. Fiore       |  |     | 48 |          |  | Vice President, Engineering                                     
|Klaus D. Kohl, Ph.D.       |  |     | 52 |          |  | Senior Vice President and Technical Director,
    iDMS program  
|V. Bryan Lawlis, Ph.D.     |  |     | 51 |          |  | Chief Operating Officer                                         
|Daniel P. Maher            |  |     | 46 |          |  | Vice President, Program Management                              
|Norma L. Milligin          |  |     | 64 |          |  | Vice President, Human Resources                                 
|Babatunde A. Otulana, M.D. |  |     | 46 |          |  | Vice President, Clinical & Regulatory
    Affairs               
|Frank H. Barker(1)         |  |     | 72 |          |  | Director                                                        
|Stan M. Benson(2)          |  |     | 52 |          |  | Director                                                        
|Igor Gonda(2)              |  |     | 55 |          |  | Director                                                        
|John Nehra(1)              |  |     | 54 |          |  | Director                                                        
|Wayne I. Roe(1)            |  |     | 53 |          |  | Director                                                        
|Virgil D. Thompson(2)      |  |     | 63 |          |  | Director                                                        



---



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

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

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

Thomas C. Chestermanhas served as our Senior Vice
President and Chief Financial Officer since August 2002. From
1996 to 2002, Mr. Chesterman was Vice President and Chief
Financial Officer at Bio-Rad Laboratories, a life science
research products and clinical diagnostics company. From 1993 to
1996, Mr. Chesterman was Vice President of Strategy and
Chief Financial Officer of Europolitan AB, a
telecommunications company. Mr. Chesterman holds a B.A.
from Harvard University and an MBA, Finance and Accounting, from
the University of California at Davis.

Stephen J.
Farr,Ph.D., has served as
our Vice President, Research and Development since July 2000.
From January 1999 to June 2000, Dr. Farr was Vice
President, Pharmaceutical Sciences and from January 1995 to
December 1998, he was Senior Director of Pharmaceutical
Sciences. From September 1985 to

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December 1994, Dr. Farr was Lecturer and
later Senior Lecturer in the Welsh School of Pharmacy, Cardiff
University, United Kingdom. He was a founder and director of
Cardiff Scintigraphics Ltd., a pharmaceutical company.
Dr. Farr holds a B.Sc. in pharmacy from DeMontfort
University, a Ph.D. in pharmaceutics from the University of
Wales and is a Visiting Associate Professor in the Department of
Pharmaceutics, School of Pharmacy, Virginia Commonwealth
University, Richmond, Virginia.


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

Klaus D.
Kohl,Ph.D., has served as
our Senior Vice President and Technical Director, iDMS program
since August 2002. From January 2002 to August 2002, he served
as Vice President, Quality. From October 2000 to December 2001,
he held the position of Vice President, Quality. From 1998 to
2000, Dr. Kohl was Quality Manager of GE Bayer Silicones, a
joint venture of General Electric and Bayer Corporation. From
1996 to 1998, he was Vice President of Quality Assurance,
Pharmaceutical Division, Bayer Corporation North America.
Dr. Kohl joined Bayer in 1985 and held various positions in
quality assurance/drug product development in the United States
and in Europe. Previously, Dr. Kohl spent more than seven
years in basic research at the Research Center Juelich, Germany
and the Max Planck Institute, Dortmund Germany. Dr. Kohl
received his undergraduate degree in mathematics and physics
from the University of Marburg, Germany and his Ph.D. from the
University of Aachen, Germany.

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

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

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

Babatunde A.
Otulana,M.D., has served
as our Vice President, Clinical and Regulatory Affairs since
October 1997. From 1991 to September 1997, Dr. Otulana was
a Medical Reviewer in the Division of Pulmonary Drug Products at
the Center for Drug Evaluation and Research, Food and Drug
Administration. Dr. Otulana currently serves as an Assistant
Clinical Professor in Pulmonary Medicine at the school of
Medicine, University of California, Davis. Dr. Otulana
obtained his M.D. from the

17



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University of Ibadan, Nigeria and completed a
Pulmonary Fellowship at Papworth Hospital, University of
Cambridge, U.K. and at Howard University Hospital, Washington,
D.C.


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

Stan M. Bensonhas been a director since April
2001. Mr. Benson served as Senior Vice President, Sales and
Marketing of Amgen, Inc., a biotechnology company from 1995 to
2001. Prior to joining Amgen, Mr. Benson worked at Pfizer,
Inc., a pharmaceutical company, for 19 years in various
senior management positions. Mr. Benson received a B.A. and
an M.S. from New York University. Mr. Benson is now retired.

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

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

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

Virgil D. Thompsonhas been a director since June
1995. Since November 2002, Mr. Thompson has been President
and Chief Executive Officer of Angstrom Pharmaceuticals, a
pharmaceutical company. From September 2000 to November 2002, he
was President, Chief Executive Officer and Director of Chimeric
Therapies, Inc., a biotechnology company. From May 1999 until
September 2000, he was the President, Chief Operating Officer
and a Director of Bio-Technology General Corp., a pharmaceutical
company. From January 1996 to April 1999, he was the President
and Chief Executive Officer and a Director of Cytel Corporation,
a biopharmaceutical company. From 1994 to 1996, he was President
and Chief Executive Officer of Cibus Pharmaceuticals, Inc., a
drug delivery device company. From 1991 to 1993 he was President
of Syntex Laboratories, Inc., a pharmaceutical company.
Mr. Thompson holds a B.S. in pharmacy from Kansas
University and a J.D. from The George Washington University Law
School. He is also a director of Questcor Pharmaceutical
Corporation and Bio-Technology General Corporation.

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##### Table of Contents






Item 2.     Properties

At December 31, 2002, we leased a total of
approximately 253,898 square feet of office space in two
office parks. We leased approximately 163,658 square feet
in three buildings in an office park at 3929 Point Eden
Way, Hayward, California and leased 90,240 square feet in
one building in an office park located at 2704 West Winton
Avenue, Hayward, California. The leases for the various office
spaces expire at various times through the year 2016. Minimum
annual payments under these leases will be approximately
$5.2 million in 2003 and $5.3 million in 2004. 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

In June 1998, Eli Lilly and Company filed a
complaint against us in the United States District Court for the
Southern District of Indiana. The complaint made various
allegations against us, arising from our decision to enter into
an exclusive collaboration with Novo Nordisk A/S with respect to
the development and commercialization of a pulmonary delivery
system for insulin and insulin analogs. We sponsored various
studies of the pulmonary delivery of insulin and insulin analogs
using materials supplied by Lilly under a series of agreements
dating from January 1996. We and Lilly had also conducted
negotiations concerning a long-term supply agreement under which
Lilly would supply bulk insulin to us for commercialization in
our AERx insulin Diabetes Management System, and a separate
agreement under which we would license certain intellectual
property to Lilly. These negotiations were terminated after we
proceeded with our agreement with Novo Nordisk A/S. The
complaint sought a declaration that Lilly scientists were
co-inventors of patent applications filed by us relating to
pulmonary delivery of an insulin analog or, in the alternative,
enforcement of an alleged agreement to grant Lilly a
nonexclusive license under such patent application. The
complaint also contained allegations of misappropriation of
trade secrets, breach of fiduciary duty, conversion and unjust
enrichment and seeks unspecified damages and injunctive relief.
We filed an answer denying all material allegations of the
complaint and a motion for summary judgment directed against all
claims in Lillys complaint. The Court 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. After trial of
the remaining claims in April 2002, the jury returned verdicts
in favor of Aradigm and against Lilly on three of four of
Lillys asserted claims on co-inventorship and on
Lillys unjust enrichment claim. The jury returned verdicts
in favor of Lilly on one of Lillys claims of
co-inventorship and on two breaches of contract claims, awarding
Lilly damages of $1 for each breach of contract claim. In June
2002, the Court entered a judgment based on and incorporating
the jurys verdict. In March 2003, following disposition of
various post-trial motions, the court entered final judgment
based on and incorporating the jurys verdict. Either party
may appeal from that Final Judgment; the deadline for such
appeal is April 4, 2003. If the present final judgment is
upheld, a Lilly scientist would be named co-inventor thereby
giving Lilly rights of an owner, along with us, on one of our
patents relating to pulmonary delivery of monomeric insulin
lispro. Should Lilly appeal and ultimately succeed in that
appeal, the possible consequences include reversal of the
Courts decision granting Aradigm summary judgment on
several of Lillys claims or reversal of the Courts
refusal to grant Lilly certain post-judgment relief it had
requested. Lilly also contends that factual findings made in any
trial of this case would have some effect on other patents
relating to pulmonary delivery of monomeric insulin lispro.
Management believes that this litigation will not have a
material adverse effect on our business.




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, 2002.

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PART II




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

Market Information

Our common stock is traded on The Nasdaq 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 Stock Market for the periods
indicated below.

|     |                                           |      |   |       |  |  |   |      | 
|---- | ----------------------------------------- | ---- | - | ----- |  |  | - | ---- | 
|     |                                           | High |   | Low  
|     |                                           |      |   |      
|2001 |                                           |      |   |       |  |  |   |     
|     | First Quarter                             |      | $ | 15.25 |  |  | $ | 4.28 | 
|     | Second Quarter                            |      |   | 8.56  |  |  |   | 4.88 | 
|     | Third Quarter                             |      |   | 6.92  |  |  |   | 3.02 | 
|     | Fourth Quarter                            |      |   | 7.10  |  |  |   | 3.15 | 
|2002 |                                           |      |   |       |  |  |   |     
|     | First Quarter                             |      | $ | 7.29  |  |  | $ | 4.01 | 
|     | Second Quarter                            |      |   | 4.61  |  |  |   | 3.43 | 
|     | Third Quarter                             |      |   | 3.99  |  |  |   | 1.94 | 
|     | Fourth Quarter                            |      |   | 2.81  |  |  |   | 1.30 | 
|2003 |                                           |      |   |       |  |  |   |     
|     | First Quarter (through February 28, 2003) |      | $ | 1.85  |  |  | $ | 0.75 | 

On February 28, 2003, there were 165 holders
of record of our common stock.

Dividend Policy

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

Recent Sales of Unregistered
Securities

As of February 10, 2003, we issued
18,992,391 shares of our common stock at $0.79 per share and
warrants to purchase 4,273,272 shares of our common stock
at $1.07 per share to certain investors for an aggregate
purchase price of approximately $15.0 million in a private
placement. The warrants are exercisable at the election of the
warrant holders for a four-year term. In addition, in connection
with this private placement, we have issued to certain of the
investors in the private placement warrants to purchase an
aggregate of 4,016,024 shares of our common stock at $1.12
per share in exchange for the cancellation of an equal number of
warrants to purchase our common stock at $6.97 per share, held
by the same investors. These securities have not been registered
under the Securities Act of 1933, as amended, by virtue of
Regulation D promulgated under such Act.

For information regarding securities authorized
for issuance under equity compensation plans, see Item 12.

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##### Table of Contents






Item 6.Selected
Financial Data

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

|                                                                           |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |        |  
|-------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------- | ---------------------------------------- | -------- | ------ | - | ---- | -------- | ------ | - | ---- | -------- | ------ | - | - | ------- | ------ | - | - | ------- | ------ | -
|                                                                           |                                                                                                    |                                         
|                                                                           |                                                                                                    | Years Ended December 31,                
|                                                                           |                                                                                                    |                                         
|                                                                           |                                                                                                    | 2002                                     |          | 2001   |   | 2000 |          | 1999   |   | 1998
|                                                                           |                                                                                                    |                                          |          |        |   |      |          |        |   |     
|                                                                           |                                                                                                    |                                         
|                                                                           |                                                                                                    | (In thousands, except per share amounts)
|Statements of Operations Data:                                             |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|Contract and license revenues                                              |                                                                                                    | $                                        | 28,967   |        |   | $    | 28,916   |        |   | $    | 20,303   |        |   | $ | 16,812  |        |   | $ | 17,515  |       
|Operating expenses:                                                        |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|                                                                           | Research and development                                                                           |                                          |          | 54,680 |   |      |          | 58,836 |   |      |          | 48,176 |   |   |         | 33,625 |   |   |         | 25,549 |  
|                                                                           | General and administrative                                                                         |                                          |          | 10,394 |   |      |          | 9,355  |   |      |          | 9,271  |   |   |         | 7,849  |   |   |         | 8,661  |  
|                                                                           |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|                                                                           | Total expenses                                                                                     |                                          |          | 65,074 |   |      |          | 68,191 |   |      |          | 57,447 |   |   |         | 41,474 |   |   |         | 34,210 |  
|                                                                           |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|Loss from operations                                                       |                                                                                                    |                                          | (36,107  | )      |   |      | (39,275  | )      |   |      | (37,144  | )      |   |   | (24,662 | )      |   |   | (16,695 | )     
|Interest income                                                            |                                                                                                    |                                          | 818      |        |   |      | 1,324    |        |   |      | 3,110    |        |   |   | 1,947   |        |   |   | 1,754   |       
|Other income(2)                                                            |                                                                                                    |                                          |         |        |   |      | 6,675    |        |   |      |         |        |   |   |        |        |   |   |        |       
|Interest expense and other                                                 |                                                                                                    |                                          | (642     | )      |   |      | (1,081   | )      |   |      | (1,528   | )      |   |   | (888    | )      |   |   | (513    | )     
|                                                                           |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|Net loss                                                                   |                                                                                                    |                                          | (35,931  | )      |   |      | (32,357  | )      |   |      | (35,562  | )      |   |   | (23,603 | )      |   |   | (15,454 | )     
|Deemed dividend                                                            |                                                                                                    |                                          |         |        |   |      | (10,722  | )      |   |      |         |        |   |   |        |        |   |   |        |       
|                                                                           |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|Net loss applicable to common shareholders                                 |                                                                                                    | $                                        | (35,931  | )      |   | $    | (43,079  | )      |   | $    | (35,562  | )      |   | $ | (23,603 | )      |   | $ | (15,454 | )     
|                                                                           |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|Basic and diluted loss per share applicable to
    common shareholders(1): |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|                                                                           | Net loss applicable to common shareholders                                                         |                                          | $        | (1.19  | ) |      | $        | (1.98  | ) |      | $        | (2.07  | ) |   | $       | (1.66  | ) |   | $       | (1.32  | )
|                                                                           |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|                                                                           | Shares used in computing basic and diluted loss
    per share applicable to common shareholders(1) |                                          |          | 30,261 |   |      |          | 21,792 |   |      |          | 17,196 |   |   |         | 14,216 |   |   |         | 11,682 |  
|                                                                           |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|Balance Sheet Data:                                                        |                                                                                                    |                                          |          |        |   |      |          |        |   |      |          |        |   |   |         |        |   |   |         |       
|Cash, cash equivalents and short term investments                          |                                                                                                    | $                                        | 29,890   |        |   | $    | 71,164   |        |   | $    | 44,381   |        |   | $ | 31,259  |        |   | $ | 31,036  |       
|Working capital                                                            |                                                                                                    |                                          | 14,486   |        |   |      | 48,308   |        |   |      | 19,862   |        |   |   | 22,797  |        |   |   | 16,620  |       
|Total assets                                                               |                                                                                                    |                                          | 97,129   |        |   |      | 132,100  |        |   |      | 71,371   |        |   |   | 50,790  |        |   |   | 44,949  |       
|Noncurrent portion of notes payable and capital
    lease obligations      |                                                                                                    |                                          | 497      |        |   |      | 2,427    |        |   |      | 6,230    |        |   |   | 9,609   |        |   |   | 4,570   |       
|Redeemable convertible preferred stock                                     |                                                                                                    |                                          | 30,665   |        |   |      | 30,735   |        |   |      |         |        |   |   |        |        |   |   |        |       
|Accumulated deficit                                                        |                                                                                                    |                                          | (189,443 | )      |   |      | (153,535 | )      |   |      | (110,441 | )      |   |   | (74,904 | )      |   |   | (51,279 | )     
|Total shareholders equity                                                 |                                                                                                    |                                          | 41,410   |        |   |      | 71,149   |        |   |      | 37,785   |        |   |   | 24,157  |        |   |   | 21,660  |       



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | See Note 1 of Notes to Financial Statements
    for an explanation of shares used in computing basic and diluted
    net loss per share.                                                                                                                                                                                                                                                                                                                                              
|   
|(2) | Other income consists of the gain related to
    forgiveness of outstanding notes and interests by Genentech,
    previously classified as an extraordinary item. The Company
    early adopted Statement of Financial Accounting Standard
    (SFAS) 145, Rescission of FASB Statements
    No. 4, 44 and 64, Amendment of FASB 13 and Technical
    Corrections, which requires the reclassification of this
    type of extraordinary item as a component of operating results.

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

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

Overview

Since our inception in 1991, we have been engaged
in the development of pulmonary drug delivery systems. As of
December 31, 2002, we had an accumulated deficit of
$189.4 million. We have not been profitable since inception
and expect to incur additional operating losses over the next
several years as research and development efforts, preclinical
and clinical testing activities and manufacturing scale-up
efforts expand and as we plan and build our late-stage clinical
and early commercial production capabilities. To date, we have
not had any material product sales and do not anticipate
receiving any revenue from the sale of products for the next
several years. The sources of working capital have been equity
financings, equipment lease financings, contract and license
revenues and interest earned on investments.

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

The collaborative agreement with Novo Nordisk A/S
provides for reimbursement of research and development expenses
as well as additional payments to us as we achieve certain
significant milestones. We also expect to receive royalties from
this development partner based on revenues from sales of product
and to receive revenue from the manufacturing of unit dose
packets and hand-held devices. We recognize revenues under the
terms of our collaborative agreement as the research and
development expenses are incurred, to the extent they are
reimbursable. During 2002, this partner-funded program has
contributed approximately 93% of our total contract revenues.
Novo Nordisk A/S with its subsidiary is considered a related
party.

During December 2000, GlaxoSmithKline and we
amended the product development and commercialization agreement
whereby we assumed full control and responsibility for
conducting and financing the remainder of all development
activities. Under the amendment, unless we have terminated the
agreement, GlaxoSmithKline can restore its rights to participate
in development and commercialization of the product upon payment
of a restoration fee to us. We have made available to
GlaxoSmithKline all of the Phase 2b trial results and await
their decision on further development plans. There can be no
assurance that GlaxoSmithKline will elect to restore its rights.
If we elect to terminate the agreement and continue or intend to
continue any development activities, either alone or in
collaboration with a third party, we will be obligated to pay an
exit fee to GlaxoSmithKline at which time all rights related to
development and commercialization of the product will be
returned to us. If we elect to pay the exit fee it will not have
a material impact on our financial position or operating
results. If we enter into a development agreement with a new
partner or with recommitment of GlaxoSmithKline, we will
continue to pursue this program.

In February 2001, we announced that Genentech had
discontinued the development of dornase alfa using our
proprietary AERx Respiratory Management System. We also entered
into a new agreement allowing Genentech to evaluate the
feasibility of using the AERx Pulmonary Drug Delivery System for
pulmonary delivery of other Genentech compounds. Under the terms
of the agreement, Genentech did not require us to repay the loan
of funds required to conduct product development under the
discontinued

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program. As a result of forgiveness of the loan
and accrued interest the company recorded during the first
quarter of 2001 approximately $6.7 million as a component
of operating results. During 2001, we reimbursed Genentech
$773,000 for unspent project prepayments.


In addition to the diabetes and pain programs, we
have six additional programs in development, five of which are
partner funded. It is our policy not to disclose the partner
and/or the drug until a long-term development agreement has been
established; both parties agree to highlight a clinical
advancement in the program or under special circumstances in
which both parties agree to disclosure. In 2002, we announced
successful clinical results from one partnered trial with
interferon alpha when an abstract was accepted at a leading
scientific session, in which the partner was not disclosed. In
addition, a gene therapy collaboration with geneRx+ was
disclosed which hold certain potentially beneficial licensing
rights to Aradigm.

Critical Accounting Policies

We consider certain accounting policies related
to revenue recognition, impairment of long-lived assets and the
use of estimates to be critical accounting policies.



| |                    
| | -------------------
| | Revenue Recognition

Contract revenues consist of revenue from
collaboration agreements and feasibility studies. We recognize
revenue under the provisions of the Securities and Exchange
Commission issued Staff Accounting Bulletin No. 101,
Revenue Recognition in Financial Statements
(SAB 101). Under the agreements, revenue is
recognized as costs are incurred. Deferred revenue represents
the portion of all refundable and nonrefundable research
payments received that have not been earned. In accordance with
contract terms, milestone payments from collaborative research
agreements are considered reimbursements for costs incurred
under the agreements and, accordingly, are generally recognized
as revenue either upon the completion of the milestone effort
when payments are contingent upon completion of the effort or
are based on actual efforts expended over the remaining term of
the agreements when payments precede the required efforts. Costs
of contract revenues approximate such revenue and are included
in research and development expenses. Refundable development and
license fee payments are deferred until the specified
performance criteria are achieved. Refundable development and
license fee payments are generally not refundable once the
specific performance criteria are achieved.



| |                                    
| | -----------------------------------
| | Impairment of Long-Lived
    Assets

We adopted SFAS 144, Accounting for
the Impairment or Disposal of Long-Lived Assets, on
January 1, 2002. SFAS 144 superseded SFAS 121,
Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of. The primary
objectives of SFAS 144 are to develop one accounting model
based on the framework established in SFAS 121 for
long-lived assets to be disposed of by sale, and to address
significant implementation issues. Our adoption of SFAS 144
did not have a material impact on our financial position or
results of operations.

The Company reviews for impairment whenever
events or changes in circumstances indicate that the carrying
amount of property and equipment may not be recoverable.
Determination of recoverability is based on an estimate of
undiscounted future cash flows resulting from the use of the
asset and its eventual disposition. In the event that such cash
flows are not expected to be sufficient to recover the carrying
amount of the assets, the assets are written down to their
estimated fair values and the loss is recognized on the
Statements of Operations.



| |                 
| | ----------------
| | Use of Estimates

The preparation of financial statements in
conformity with generally accepted accounting principles
requires us to make estimates and assumptions that affect the
amounts reported in the financial statements and accompanying
notes to the financial statements. These estimates include
useful lives for property and equipment and related depreciation
calculations, estimated amortization period for payments
received from

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product development and license agreements as
they relate to the revenue recognition of deferred revenue and
assumptions for valuing options and warrants. Actual results
could differ from these estimates.


Results of Operations



| |                                                 
| | ------------------------------------------------
| | Years Ended December 31, 2002, 2001
    and 2000

Contract Revenues.We reported revenues from
collaborative contracts of $29.0 million in 2002, compared
to $28.9 million in 2001 and $20.3 million in 2000.
The marginal increase in revenue in 2002 compared to 2001 is
primarily due to increases in partner-funded project development
revenue from Novo Nordisk A/S, which was $26.9 million in
2002 compared to $26.0 million in 2001 and contract revenue
from other partner-funded programs, which was $2.1 million
in 2002 and $1.4 million in 2001. The increase in revenue
was offset by no partner-funded project development revenue from
GlaxoSmithKline in 2002 compared to $1.5 million in 2001.
The revenue in 2000 consisted of $15.4 million from
partner-funded project development revenue from Novo Nordisk A/
S, $3.4 million from partner-funded project development
revenue from GlaxoSmithKline, and $1.5 million from
contract revenue from other partner-funded programs. Costs
associated with contract research revenue are included in
research and development expenses.

Research and Development Expenses.Research and development expenses
decreased in 2002 compared to 2001 and 2000. These expenses were
$54.7 million in 2002 compared to $58.8 million in
2001 and $48.2 million in 2000. Research and development
expenses as a percentage of total operating expenses were 84% in
2002, 86% in 2001, and 84% in 2000. Research and development
expenses in 2002 decreased by $4.2 million or 7% compared
to 2001, primarily due to a reduction in development efforts to
support the ongoing program with Novo Nordisk A/S and the pain
management program and a reduction in manufacturing scale-up
efforts, but offset by increases in expenses in other funded and
unfunded development programs. Research and development expenses
associated with collaborative agreements approximate contract
revenue as these expenses are incurred under the program
agreements. Research and development expenses in 2001 increased
by $10.6 million or 22% over 2000, which was primarily due
to the expansion of development efforts to support the ongoing
program with Novo Nordisk A/S and, to a lesser extent, increases
in development efforts for other funded and unfunded development
areas including manufacturing scale-up efforts.

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

Our lead development program is targeted at the
pulmonary delivery of insulin in patients with diabetes with our
partner Novo Nordisk A/S. Since the successful completion of
Phase 2b clinical studies in 2001 and formal presentation of
those results in 2002, we and Novo Nordisk A/S have initiated
Phase 3 clinical studies in the third quarter of 2002.

Our next most advanced program is in the area of
pain management with our partner GlaxoSmithKline pursuant to our
development agreement for the AERx Pain Management System and
the delivery of narcotic analgesics. During December 2001, we
successfully completed Phase 2b clinical trial results for
the AERx System in the administration of morphine. As part of
our agreement with GlaxoSmithKline, we are working with them as
well as presenting this data to other interested parties on
taking this program forward into further clinical development.
If we enter into a development agreement with a new partner or
with recommitment of GlaxoSmithKline, we will continue to pursue
this program.

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We have six other programs in clinical
development, five of which are partner funded. In 2002, one
program in our pipeline completed Phase 1 studies. Future
research and development efforts for these partner-funded
programs are difficult to predict at this time due to their
early stage of development. During the year, Phase 1
results from our self-funded trial of testosterone in
post-menopausal women were announced. Any additional clinical
development on this program will come from a partner, which we
are currently seeking.

General and Administrative Expenses.General and administrative expenses
were $10.4 million in 2002 compared to $9.4 million in
2001 and $9.3 million in 2000. General and administrative
expenses increased by approximately $1.0 million or 11% in
2002 compared to 2001, as a result of higher business
development expenses, including the hiring of additional
personnel, and higher facility support costs. General and
administrative expenses remained relatively unchanged in 2001
compared to 2000.

Interest Income.Interest income was approximately
$800,000 in 2002 compared to $1.3 million in 2001 and
$3.1 million in 2000. The decrease in 2001 and again in
2002 was primarily due a combination of interest income being
earned on lower average cash and investment balances and a
decrease in interest rates earned on invested cash balances. The
contribution to interest income due to the funds received from
the preferred stock financing in December 2001 was not material.

Interest Expense and Other.Interest expense was approximately
$600,000 in 2002 compared to $1.1 million in 2001 and
$1.5 million in 2000. The decrease in 2002 is primarily due
to lower outstanding capital lease and equipment loan balances
under various equipment and lease lines of credit. The decrease
in 2001 is primarily due to the forgiveness of the loan made by
Genentech in connection with product development that had been
funded by them.

Other Income.As a
result of adopting SFAS 145 Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections during 2002 we
reclassified approximately $6.7 million as a component of
operating results, which was reported as an extraordinary gain
in 2001. The amount resulted from the forgiveness of outstanding
loans and accrued interest required to conduct development for
the program that had been funded by Genentech.

Net Loss.We
reported a net loss of $35.9 million in 2002 compared
$32.4 million in 2001 and $35.6 million in 2000. The
lower net loss for 2001 is due to the $6.7 million of other
income included in 2001 that resulted from the forgiveness of
outstanding loans and accrued interest required to conduct
product development under the program funded by Genentech.

Deemed Dividend.We
reported a deemed dividend of $10.7 million in 2001, which
related to the Series A redeemable convertible preferred
stock financing completed in December 2001. The deemed dividend
represents the discounted conversion price of the financing
compared to the fair market value of our common stock on the
issuance date of the preferred stock resulting in a beneficial
conversion to the preferred stockholders. The value of the
beneficial conversion feature is reported as a deemed dividend
and is included in the calculation of net loss applicable to the
common shareholders. No such deemed dividend was reported in
2002 or 2000.

Net Loss Applicable to Common Shareholders.We reported a net loss applicable to
common shareholders of $35.9 million in 2002 compared to
$43.1 million in 2001 and $35.6 million in 2000. Net
loss applicable to common shareholders in 2001 included a deemed
dividend to the Series A redeemable convertible preferred
stock financing completed in December 2001. The net loss
applicable to common shareholders is used in the calculation for
basic and diluted loss per share applicable to common
shareholders.

Liquidity and Capital Resources

Since inception, we have financed our operations
primarily through private placements and public offerings of our
capital stock, proceeds from equipment lease financings,
contract research funding and interest earned on investments. As
of December 31, 2002, we had cash, cash equivalents and
short-term investments of approximately $29.9 million.

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Net cash used in operating activities in 2002 was
$30.9 million compared to $29.1 million in 2001 and
$25.8 million in 2000. The increase in net cash used in
2002 resulted primarily from an increase in net loss, decreases
in accounts payable, other accrued liabilities and deferred
revenue, offset by a decrease in account receivable. The
decrease in accounts payable and other accrued liabilities
results primarily from increased payments for expenses
associated with our development programs and capital
expenditures, while the decrease in deferred revenue is due
primarily to our partners funding future development at a lower
level. The decrease in receivables is due to the receipt of
payments from our partners for billings associated with our
development activities. The increase in net cash used in 2001
compared to in 2000 resulted primarily from a decrease in net
loss combined with an increase in receivables offset by an
increase in deferred revenue. The increase in receivables was
due to invoiced, but unpaid, amounts due from partners for
development activities. The increase in deferred revenue was due
to payments received from our major partner to fund future
program development.

Net cash used in investing activities in 2002 was
$18.6 million compared to $14.7 million in 2001 and
$16.1 million in 2000. The increase in cash used in 2002
resulted from a combination of reductions in capital
expenditures and proceeds from maturing investments offset by an
increase in the purchase of investments. Capital expenditures
for the current year of approximately $11.2 million relate
primarily to the acquisition of manufacturing production
equipment while capital expenditures in 2001 of approximately
$37.1 million related primarily to the construction of our
large-scale commercial manufacturing facility. The increase in
cash used in 2001 resulted primarily from higher capital
expenditures offset by a net increase in proceeds from
investments of $22.4 million.

Net cash provided by financing activities in 2002
was $2.3 million compared to $93.0 million in 2001 and
$53.3 million in 2000. The decrease in net cash provided by
financing activities in 2002 was primarily due to a significant
reduction in proceeds from the issuance of equity and an
increase in principal payments on lease obligations and
equipment loans. The net proceeds from issuances of common stock
in 2002 were approximately $6.1 million. The increase in
net cash provided by financing activities in 2001 consisted
primarily of proceeds from the exercise of two put options
during the year from two of our partners, which raised net
proceeds of approximately $10.0 million, the sale of common
stock during the year using a common stock equity line, which
raised net proceeds of approximately $5.5 million, the sale
of common stock through a private placement in August 2001,
which raised net proceeds of approximately $13.8 million,
the sale of common stock to a major partner in October 2001,
which raised net proceeds of approximately $19.9 million
and the sale of redeemable convertible preferred stock in
December 2001, which raised net proceeds of approximately
$45.4 million offset by payments on equipment loans. Net
cash provided by financing activities in 2000 consisted
primarily of proceeds from the completion of a follow-on public
offering in April 2000, which raised net proceeds of
$42.6 million, the initial sale of common stock under a
common stock equity line in December 2000, which raised proceeds
of $2.2 million, the sale of common stock through our
employee benefit plans, which raised proceeds of
$4.0 million, notes payable supporting loans received under
a collaborative development agreement with Genentech and
proceeds from equipment loans.

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

We continue to review our planned operations
through the end of 2003, and beyond. We particularly focus on
capital spending requirements to ensure that capital outlays are
not expended sooner than necessary. We expect our total capital
outlays for 2003 will be approximately $20.0 million and
for 2004

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will be approximately $15.0 million.
Thereafter, we would anticipate that annual capital expenditures
would decrease significantly. Currently, we are contractually
committed to approximately $3.6 million of the anticipated
2003 capital outlays. We believe that approximately $15.0
million worth of common stock issued in a private placement in
February 2003, together with our existing cash balances at
December 31, 2002, the $20.0 million unused common
stock purchase commitment from Novo Nordisk A/S, funding
commitments from corporate development partners and interest
earned on our investments should be sufficient to meet our needs
for at least the next 18 months. The sale of additional common
stock to Novo Nordisk A/S is subject to certain conditions. In
addition, there can be no assurance that our funding commitments
from corporate development partners will not be amended or
terminated. If we cannot exercise our option to sell additional
shares of common stock to Novo Nordisk A/S or if our current
funding commitments from corporate development partners are
amended or terminated, we will need to obtain additional sources
of capital.


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

The following summarizes our contractual
obligations at December 31, 2002, and the effect such
obligations are expected to have on our liquidity and cash flows
in future periods (In thousands):

|                                   |  |                       |        |           |  |           |        |         |  |   |        |  |  |   |        | 
|---------------------------------- |  | --------------------- | ------ | --------- |  | --------- | ------ | ------- |  | - | ------ |  |  | - | ------ | 
|                                   |  |                      
|                                   |  | Payment Due by Period
|                                   |  |                      
|                                   |  |                       |        | Less than |  |           |        | After 3
|Contractual Obligations            |  | Total                 |        | 1 year    |  | 1-3 years |        | years  
|                                   |  |                       |        |           |  |           |        |        
|Capital Lease Obligations          |  | $                     | 2,403  |           |  | $         | 1,890  |         |  | $ | 513    |  |  | $ |       | 
|Unconditional Purchase Obligations |  |                       | 4,519  |           |  |           | 3,717  |         |  |   | 802    |  |  |   |       | 
|Operating Lease Obligations        |  |                       | 62,826 |           |  |           | 5,171  |         |  |   | 15,478 |  |  |   | 42,177 | 
|                                   |  |                       |        |           |  |           |        |         |  |   |        |  |  |   |        | 
|Total Contractual Commitments      |  | $                     | 69,748 |           |  | $         | 10,778 |         |  | $ | 16,793 |  |  | $ | 42,177 | 
|                                   |  |                       |        |           |  |           |        |         |  |   |        |  |  |   |        | 

Recent Accounting Pronouncements

In June 2002, the Financial Accounting Standards
Board (FASB) issued SFAS 146, Accounting
for Costs Associated with Exit or Disposal Activities. The
standard requires companies to recognize costs associated with
exit or disposal activities when they are incurred rather than
at the date of a commitment to an exit or disposal plan.
Examples of costs covered by the standard include lease
termination costs and certain employee severance costs that are
associated with a restructuring, discontinued operation, plant
closing, or other exit or disposal activity. SFAS 146 is to
be applied prospectively to exit or disposal activities
initiated after December 31, 2002. We believe that the
adoption of this standard will not have a material impact on our
financial position and results of operations.

In November 2002, the FASB issued FIN 45,
Guarantors Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of
Others. FIN 45 elaborates on the existing disclosure
requirements for most guarantees, including residual value
guarantees issued in conjunction with operating lease
agreements. It also clarifies that at the time a company issues
a guarantee, the company must recognize an initial liability for
the fair value of the obligation it assumes under that guarantee
and must disclose that information in its interim and annual
financial statements. The initial recognition and measurement
provisions apply on a prospective basis to guarantees issued or
modified after December 31, 2002. The disclosure
requirements are effective for financial statements of

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interim or annual periods ending after
December 15, 2002. The adoption of FIN 45 is not expected
to have a significant impact on our financial position and
results of operations.


In December 2002, the FASB issued SFAS 148,
Accounting for Stock-Based Compensation 
Transition and Disclosure. SFAS 148 amends
SFAS 123 Accounting for Stock-Based
Compensation to provide alternative methods of transition
for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition,
SFAS 148 amends the disclosure requirements of SFAS 123 to
require more prominent disclosures in both annual and interim
financial statements about the method of accounting for
stock-based employee compensation and the effect of the method
used on reported results. The additional disclosure requirements
of SFAS 148 are effective for fiscal years ending after
December 15, 2002. The adoption of SFAS 148 did not
have a significant impact on our financial statements. We
continue to follow the intrinsic value method of accounting as
prescribed by APB 25, Accounting for Stock Issued to
Employees, to account for employee stock options.




RISK FACTORS

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

We are an early stage company.

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

We have a history of losses and anticipate
future losses.

We have never been profitable, and through
December 31, 2002, we have incurred a cumulative deficit of
approximately $189.4 million. We have not had any material
product sales and do not anticipate receiving any revenue from
product sales in 2003. 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.

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We may not be able to develop our products
successfully.

Many of our products are at an early stage of
development. Before we can begin to sell our products
commercially, we will need to invest in substantial additional
development and conduct clinical testing. In order to further
develop many of our products, we will need to address
engineering and design issues. We cannot assure you that we will
be successful in addressing these designs, engineering and
manufacturing issues. Additionally, we will need to formulate
and package drugs for delivery by our AERx systems. We cannot
assure you that we will be able to do this successfully.

Even if our pulmonary delivery technology has
been successfully developed and is commercially feasible, for a
range of large and small molecule drugs, we cannot assure you
that such applications will be commercially acceptable. For the
AERx systems to be commercially viable, we will need to
demonstrate that drugs delivered by the AERx systems:



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

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

We may not be able to commercialize products
successfully.

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



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

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

We depend on collaborative partners and need
additional collaborative partners.

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

Novo Nordisk A/S has agreed to:



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

The development and commercialization of the AERx
insulin Diabetes Management System will be delayed if Novo
Nordisk A/S fails to conduct these collaborative activities
in a timely manner or at all. In

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addition, our development partners could
terminate these agreements and we have no assurance that we will
receive any development and milestone payments. If we do not
receive development funds or achieve milestones set forth in the
agreements, or if any of our development partners breach or
terminate their agreement, our business will be impaired.


Although we have development arrangements with
other collaborative partners, our arrangement with Novo
Nordisk A/S is our only active funded development
agreement. For the year ended December 31, 2002, this
partner-funded program contributed approximately 93% of our
total contract revenues. Our agreement with Novo
Nordisk A/S can be terminated under certain conditions,
including by either party on limited written notice, by Novo
Nordisk A/S by limited prior written notice upon the
occurrence of certain events, and by either party upon
30 days written notice in the event that the other
party commits a material breach under the agreement and fails to
remedy such breach within 60 days notice of such
breach.

We will also need to enter into agreements with
other corporate partners to conduct the clinical trials,
manufacturing, marketing and sales necessary to commercialize
other potential products. In addition, our ability to apply the
AERx system to any proprietary drugs will depend on our ability
to establish and maintain corporate partnerships or other
collaborative arrangements with the holders of proprietary
rights to such drugs. We cannot assure you that we will be able
to establish such additional corporate partnerships or
collaborative arrangements on favorable terms or at all, or that
our existing or future corporate partnerships or collaborative
arrangements will be successful. In December 2000, our agreement
with GlaxoSmithKline was amended and we assumed full control and
responsibility for conducting and financing the remainder of all
development activities. In February 2001, we mutually agreed
with Genentech to discontinue our development program for
dornase alfa. We also can not assure you that our existing or
future corporate partners or collaborators will not pursue
alternative technologies or develop alternative products either
on their own or in collaboration with others, including our
competitors. We could have disputes with our existing or future
corporate partners or collaborators. Any such disagreements
could lead to delays in the research, development or
commercialization of any potential products or could result in
time-consuming and expensive litigation or arbitration, which
may not be resolved in our favor. If any of our corporate
partners or collaborators do not develop or commercialize any
product to which it has obtained rights from us, our business
could be impaired.

We have limited manufacturing
experience.

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



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

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

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

We intend to use contract manufacturers to
produce key components, assemblies and subassemblies in the
clinical and commercial manufacturing of our AERx devices. There
can be no assurance that we will

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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 at which we
    expand our production technologies;      
|
| |  | costs of preparing, filing, prosecuting,
    maintaining and enforcing patent claims; and  
|
| |  | our need to acquire licenses or other rights to
    technology.                            

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

We anticipate that we will be able to maintain
current and planned operations for at least the next
18 months, including capital spending requirements of
approximately $20 million in 2003, with approximately
$15 million worth of common stock issued in a private
placement in February 2003, together with our existing cash
balance at December 31, 2002, the $20 million unused
common stock purchase commitment from Novo Nordisk A/S,
funding commitments from corporate development partners, and
projected interest; however, there can be no assurances that
these sources of funding will be sufficient or that our cash
requirements will not change. The sale of additional common
stock to Novo Nordisk A/S is subject to certain conditions,
including, if applicable, obtaining any requisite shareholder
approval. In addition, there can be no assurance that our
funding commitments from corporate development partners will not
be amended or terminated. If we cannot exercise our option to
sell additional shares of common stock to Novo Nordisk A/S
or if our current funding commitments from corporate development
partners are amended or terminated, we will need to obtain
additional sources of capital.

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

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

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

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

We also seek to protect some of these inventions
through foreign counterpart applications in selected other
countries. Statutory differences in patentable subject matter
may limit the protection we can obtain on some of our inventions
outside of the United States. For example, methods of treating
humans are not patentable in many countries outside of the
United States. These and other issues may limit the patent
protection we will be able to secure outside of the United
States.

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

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

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

We may incur substantial costs if we are required
to defend ourselves in patent suits brought by third parties.
These legal actions could seek damages and seek to enjoin
testing, manufacturing and marketing of

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the accused product or process. In addition to
potential liability for significant damages, we could be
required to obtain a license to continue to manufacture or
market the accused product or process and we cannot assure you
that any license required under any such patent would be made
available to us on acceptable terms, if at all. Litigation may
also be necessary to enforce our patents against others or to
protect our know-how or trade secrets. Such litigation could
result in substantial expense, and we cannot assure you that any
litigation would be resolved in our favor.


We may not 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
FDA, and by state and local government agencies. Such
regulations govern the development, testing, manufacture,
labeling, storage, approval, advertising, promotion, sale and
distribution of such products. Medical devices or drug products
that are marketed abroad are also subject to regulation by
foreign governments.

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

The activities required before a new drug product
may be marketed in the United States include pre-clinical and
clinical testing and submission of a new drug application with
the FDA. Preclinical tests include laboratory evaluation of
product chemistry and other characteristics and animal studies
to assess the potential safety and efficacy of the product as
formulated. Clinical testing involves the administration of the
drug to healthy human volunteers or to patients under the
supervision of a qualified principal investigator, usually a
physician, pursuant to a FDA reviewed protocol.

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

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



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

Manufacturers of drugs also are required to
comply with the applicable GMP requirements, which relate to
product testing, quality assurance and maintaining records and
documentation. We cannot assure

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you that we will be able to comply with the
applicable GMP and other FDA regulatory requirements for
manufacturing as we expand our manufacturing operations, which
would impair our business.


In addition, to market our products in foreign
jurisdictions, we and our partners must obtain required
regulatory approvals from foreign regulatory agencies and comply
with extensive regulations regarding safety and quality. We
cannot assure you that we will obtain regulatory approvals in
such jurisdictions or that we will not incur significant costs
in obtaining or maintaining any foreign regulatory approvals. If
approvals to market our products are delayed, if we fail to
receive these approvals, or if we lose previously received
approvals, our business would be impaired.

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

The results of preclinical and clinical
testing are uncertain.

Before we can file for regulatory approval for
the commercial sale of our potential AERx products, the FDA will
require extensive preclinical and clinical testing to
demonstrate their safety and efficacy. To date, we have tested
prototype patient-operated versions of our AERx systems with
morphine, insulin and dornase alfa on a limited number of
individuals in Phase 1 and Phase 2 clinical trials and
have initiated a Phase 3 clinical trial for our AERx
insulin Diabetes Management System. If we do not or cannot
complete these trials or progress to more advanced clinical
trials, we may not be able to commercialize our AERx products.

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

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

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

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

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

We are in competition with pharmaceutical,
biotechnology and drug delivery companies, hospitals, research
organizations, individual scientists and nonprofit organizations
engaged in the development of alternative drug delivery systems
or new drug research and testing, as well as with entities
producing and developing injectable drugs. We are aware of a
number of companies such as Alkermes Pharmaceuticals,

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Inc. and Nektar Therapeutics (formerly Inhale
Therapeutic Systems) that are currently seeking to develop new
products and non-invasive alternatives to injectable drug
delivery, including oral delivery systems, intranasal delivery
systems, transdermal systems, buccal and colonic absorption
systems. Several of these companies may have developed or are
developing dry powder devices that could be used for pulmonary
delivery. Many of these companies and entities have greater
research and development capabilities, experience,
manufacturing, marketing, financial and managerial resources
than we do. Accordingly, our competitors may succeed in
developing competing technologies, obtaining FDA approval for
products or gaining market acceptance more rapidly than we can.


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

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

We may be exposed to product
liability.

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

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

Third-party reimbursement for our products is
uncertain.

In both domestic and foreign markets, sales of
our potential products depend in part on the availability of
reimbursement from third-party 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. We cannot assure you that any of
our products will be reimbursable by third-party payers. In
addition, we cannot assure you that our products will be
considered cost-effective or that adequate third-party
reimbursement will be available to enable us to maintain price
levels sufficient to realize a profit. Legislation and
regulations affecting the pricing of pharmaceuticals may change
before our products are approved for marketing and any such
changes could further limit reimbursement.

We use hazardous materials.

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

Our stock price is likely to remain
volatile.

The market prices for securities of many
companies in the drug delivery industry, including ours, have
historically been highly volatile, and the market from time to
time has experienced significant price and

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volume fluctuations unrelated to the operating
performance of particular companies. Prices for our common stock
may be influenced by many factors, including:




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

Our common stock has traded below one dollar
and may become subject to de-listing from the Nasdaq National
Market.

The Nasdaq has a $1.00 per share minimum bid
requirement, pursuant to which our common stock could be
de-listed from the Nasdaq National Market if it trades below
$1.00 for 30 consecutive trading days and does not subsequently
trade above $1.00 for 10 consecutive days. If we are unable to
meet the Nasdaq requirements to maintain listing on the Nasdaq
National Market our common stock could trade on the OTC Bulletin
Board or in the pink sheets maintained by the
National Quotation Bureau, Inc. Such alternatives are generally
considered to be less efficient markets, and our stock price, as
well as the liquidity of our common stock, will be adversely
impacted as a result.

We have implemented certain anti-takeover
provisions.

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

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

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|         |                                                              
|-------- | -------------------------------------------------------------
|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, 2002, we had cash, cash
equivalents and short-term investments of $29.9 million
consisting of cash and highly liquid, short-term investments.
The market value of our short-term investments will decline by
an immaterial amount if market interest rates increase, and
therefore, our exposure to interest rate changes has been
immaterial. Declines of interest rates over time will, however,
reduce our interest income from our short-term investments. Our
outstanding equipment lease lines and capital lease obligations
are all at fixed interest rates and, therefore, have minimal
exposure to changes in interest rates.

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|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

REPORT OF ERNST & YOUNG LLP, INDEPENDENT
AUDITORS

The Board of Directors and Shareholders

Aradigm Corporation


We have audited the accompanying balance sheets
of Aradigm Corporation as of December 31, 2002 and 2001,
and the related statements of operations, redeemable convertible
preferred stock and shareholders equity, and cash flows
for each of the three years in the period ended
December 31, 2002. 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, 2002 and
2001, and the results of its operations and its cash flows for
each of the three years in the period ended December 31,
2002, in conformity with accounting principles generally
accepted in the United States.



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

Palo Alto, California

February 7, 2003


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ARADIGM CORPORATION

BALANCE SHEETS

|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        |          |     |        |        |          |     |         | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------- | --------------------- | -------------------------------------------------------------------------------------- | -------- | --- | ------ | ------ | -------- | --- | ------- | 
|                                                                                                                                                                                                             |                                                                                                                                          |                      
|                                                                                                                                                                                                             |                                                                                                                                          | December 31,         
|                                                                                                                                                                                                             |                                                                                                                                          |                      
|                                                                                                                                                                                                             |                                                                                                                                          | 2002                  |                                                                                        | 2001    
|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        |         
|                                                                                                                                                                                                             |                                                                                                                                          |                      
|                                                                                                                                                                                                             |                                                                                                                                          | (In thousands, except
|                                                                                                                                                                                                             |                                                                                                                                          | shares data)         
|ASSETS                                                                                                                                                                                                      
|Current assets:                                                                                                                                                                                              |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|                                                                                                                                                                                                             | Cash and cash equivalents                                                                                                                |                       | $                                                                                      | 22,800   |     |        | $      | 69,965   |    
|                                                                                                                                                                                                             | Short-term investments                                                                                                                   |                       |                                                                                        | 7,090    |     |        |        | 1,199    |    
|                                                                                                                                                                                                             | Receivables                                                                                                                              |                       |                                                                                        |          |     |        |        |          |    
|                                                                                                                                                                                                             |                                                                                                                                          | Related parties       |                                                                                        |          |    |        |        |          | 631 |        
|                                                                                                                                                                                                             |                                                                                                                                          | Unrelated parties     |                                                                                        |          | 282 |        |        |          | 718 |        
|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        | 282      |     |        |        | 1,349    |    
|                                                                                                                                                                                                             | Current portion of notes receivable from officers
    and employees                                                                      |                       |                                                                                        | 136      |     |        |        | 145      |    
|                                                                                                                                                                                                             | Prepaid and other current assets                                                                                                         |                       |                                                                                        | 1,457    |     |        |        | 812      |    
|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|                                                                                                                                                                                                             |                                                                                                                                          |                       | Total current assets                                                                   |          |     | 31,765 |        |          |     | 73,470  | 
|Property and equipment, net                                                                                                                                                                                  |                                                                                                                                          |                       | 63,233                                                                                 |          |     |        | 57,940 |         
|Noncurrent portion of notes receivable from
    officers and employees                                                                                                                                       |                                                                                                                                          |                       | 169                                                                                    |          |     |        | 160    |         
|Long-term investments                                                                                                                                                                                        |                                                                                                                                          |                       | 1,553                                                                                  |          |     |        |       |         
|Other assets                                                                                                                                                                                                 |                                                                                                                                          |                       | 409                                                                                    |          |     |        | 530    |         
|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|                                                                                                                                                                                                             |                                                                                                                                          |                       | Total assets                                                                           |          | $   | 97,129 |        |          | $   | 132,100 | 
|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED
    STOCK AND
    SHAREHOLDERS EQUITY                                                                                                                        
|Current liabilities:                                                                                                                                                                                         |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|                                                                                                                                                                                                             | Accounts payable                                                                                                                         |                       | $                                                                                      | 1,951    |     |        | $      | 5,297    |    
|                                                                                                                                                                                                             | Accrued clinical and cost of other studies                                                                                               |                       |                                                                                        | 291      |     |        |        | 703      |    
|                                                                                                                                                                                                             | Accrued compensation                                                                                                                     |                       |                                                                                        | 2,195    |     |        |        | 1,761    |    
|                                                                                                                                                                                                             | Deferred revenue                                                                                                                         |                       |                                                                                        | 10,682   |     |        |        | 11,115   |    
|                                                                                                                                                                                                             | Current portion of capital lease obligations                                                                                             |                       |                                                                                        | 1,753    |     |        |        | 3,526    |    
|                                                                                                                                                                                                             | Other accrued liabilities                                                                                                                |                       |                                                                                        | 407      |     |        |        | 2,760    |    
|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|                                                                                                                                                                                                             |                                                                                                                                          |                       | Total current liabilities                                                              |          |     | 17,279 |        |          |     | 25,162  | 
|Noncurrent portion of deferred revenue                                                                                                                                                                       |                                                                                                                                          |                       | 6,170                                                                                  |          |     |        | 2,327  |         
|Capital lease obligations, less current portion                                                                                                                                                              |                                                                                                                                          |                       | 497                                                                                    |          |     |        | 2,427  |         
|Noncurrent portion of deferred rent                                                                                                                                                                          |                                                                                                                                          |                       | 1,108                                                                                  |          |     |        | 300    |         
|Commitments and contingencies                                                                                                                                                                                |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|Redeemable convertible preferred stock, no par
    value; 5,000,000 shares authorized; issued and outstanding
    shares: 2,001,236 in 2002 and 2001; liquidation preference of
    $48,430 in 2002 and 2001 |                                                                                                                                          |                       | 30,665                                                                                 |          |     |        | 30,735 |         
|Shareholders equity:                                                                                                                                                                                        |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|                                                                                                                                                                                                             | Common stock, no par value, 100,000,000 shares
    authorized; issued and outstanding shares: 31,157,612 in 2002;
    29,536,383 in 2001 |                       |                                                                                        | 230,853  |     |        |        | 224,738  |    
|                                                                                                                                                                                                             | Deferred compensation                                                                                                                    |                       |                                                                                        |         |     |        |        | (54      | )  
|                                                                                                                                                                                                             | Accumulated deficit                                                                                                                      |                       |                                                                                        | (189,443 | )   |        |        | (153,535 | )  
|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|                                                                                                                                                                                                             |                                                                                                                                          |                       | Total shareholders equity                                                             |          |     | 41,410 |        |          |     | 71,149  | 
|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         
|                                                                                                                                                                                                             |                                                                                                                                          |                       | Total liabilities, redeemable convertible
    preferred stock and shareholders equity |          | $   | 97,129 |        |          | $   | 132,100 | 
|                                                                                                                                                                                                             |                                                                                                                                          |                       |                                                                                        |          |     |        |        |         

See accompanying notes.

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ARADIGM CORPORATION

STATEMENTS OF OPERATIONS

|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |        |        | 
|----------------------------------------------------------------------------------------------- | -------------------------- | ------------------------------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                                                                |                            |                                      
|                                                                                                |                            | Years Ended December 31,             
|                                                                                                |                            |                                      
|                                                                                                |                            | 2002                                  |         | 2001   |        | 2000
|                                                                                                |                            |                                       |         |        |        |     
|                                                                                                |                            |                                      
|                                                                                                |                            | (In thousands, except per share data)
|Contract and license revenues                                                                   |                            |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                                                | Related parties            |                                       | $       | 26,864 |        |      | $       | 26,031 |        |   | $       | 15,410 |       
|                                                                                                | Unrelated parties          |                                       |         | 2,103  |        |      |         | 2,885  |        |   |         | 4,893  |       
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                                                |                            | Total revenues                        |         |        | 28,967 |      |         |        | 28,916 |   |         |        | 20,303 | 
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                                                | Research and development   |                                       |         | 54,680 |        |      |         | 58,836 |        |   |         | 48,176 |       
|                                                                                                | General and administrative |                                       |         | 10,394 |        |      |         | 9,355  |        |   |         | 9,271  |       
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                                                |                            | Total expenses                        |         |        | 65,074 |      |         |        | 68,191 |   |         |        | 57,447 | 
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Loss from operations                                                                            |                            |                                       | (36,107 | )      |        |      | (39,275 | )      |        |   | (37,144 | )     
|Interest income                                                                                 |                            |                                       | 818     |        |        |      | 1,324   |        |        |   | 3,110   |       
|Other income related to forgiveness of Genentech
    note                                       |                            |                                       |        |        |        |      | 6,675   |        |        |   |        |       
|Interest expense and other                                                                      |                            |                                       | (642    | )      |        |      | (1,081  | )      |        |   | (1,528  | )     
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Net loss                                                                                        |                            |                                       | (35,931 | )      |        |      | (32,357 | )      |        |   | (35,562 | )     
|Deemed dividend                                                                                 |                            |                                       |        |        |        |      | (10,722 | )      |        |   |        |       
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Net loss applicable to common shareholders                                                      |                            | $                                     | (35,931 | )      |        | $    | (43,079 | )      |        | $ | (35,562 | )     
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Basic and diluted loss per share applicable to
    common shareholders:                         |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Net loss applicable to common shareholders                                                      |                            | $                                     | (1.19   | )      |        | $    | (1.98   | )      |        | $ | (2.07   | )     
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Shares used in computing basic and diluted loss
    per share applicable to common shareholders |                            |                                       | 30,261  |        |        |      | 21,792  |        |        |   | 17,196  |       
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       

See accompanying notes.

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ARADIGM CORPORATION

STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED
STOCK AND SHAREHOLDERS EQUITY

|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |        |         |     |         |  
|---------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------ | ---------------------------------- | ------------------------------------------------------------------- | ------------------------------------------------------------------- | - | ----------- | ------ | -------- | - | ----------- | ---------- | ------------- | - | ------- | ------- | ------ | - | - | ---- | --- | - | - | ---- | --- | - | - | -------- | - | ------- | --- | ------- | ------ | ------- | --- | ------- | -
|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |        
|                                                                       |                                                                                                                                                        | Redeemable Convertible             |                                                                     |                                                                     |   |             |        |          |   |             |            |              
|                                                                       |                                                                                                                                                        | Preferred Stock                    |                                                                     | Common Stock                                                        |   | Shareholder |        |          |   |             |            | Total        
|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   | Notes       |        | Deferred |   | Accumulated |            | Shareholders
|                                                                       |                                                                                                                                                        | Shares                             |                                                                     | Amount                                                              |   | Shares      |        | Amount   |   | Receivable  |            | Compensation  |   | Deficit |         | Equity
|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |       
|                                                                       |                                                                                                                                                        |                                   
|                                                                       |                                                                                                                                                        | (In thousands, except shares data)
|Balances at December 31, 1999                                          |                                                                                                                                                        |                                    |                                                                    |                                                                     |   | $           |       |          |   |             | 14,749,777 |               |   | $       | 99,603  |        |   | $ | (163 | )   |   | $ | (379 | )   |   | $ | (74,904  | ) |         | $   | 24,157  |       
|                                                                       | Issuance of common stock for cash, Net                                                                                                                 |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 2,989,795     |   |         |         | 44,676 |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 44,676 |        
|                                                                       | Issuance of common stock under the employee stock
    purchase plan                                                                                    |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 129,414       |   |         |         | 1,058  |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 1,058  |        
|                                                                       | Issuance of common stock upon exercise of stock
    options                                                                                            |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 318,676       |   |         |         | 2,940  |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 2,940  |        
|                                                                       | Issuance of common stock for services                                                                                                                  |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 728           |   |         |         | 3      |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 3      |        
|                                                                       | Issuance of warrants for services                                                                                                                      |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            |              |   |         |         | 293    |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 293    |        
|                                                                       | Issuance of common stock for warrants                                                                                                                  |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 78,565        |   |         |         |       |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         |       |        
|                                                                       | Repayment of shareholders notes                                                                                                                       |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      | 32  |   |   |      |    |   |   |          |  |         |     |         | 32     |        
|                                                                       | Amortization of deferred compensation                                                                                                                  |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      |    |   |   |      | 163 |   |   |          |  |         |     |         | 163    |        
|                                                                       | Comprehensive loss:                                                                                                                                    |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |        |        
|                                                                       |                                                                                                                                                        | Net loss                           |                                                                     |                                                                     |  |             |        |          |  |             |            |               |  |         |         |        |  |   |      |     |  |   |      |     |  |   |          |   | (35,562 | )   |         |        | (35,562 | )  
|                                                                       |                                                                                                                                                        | Other comprehensive income (loss): |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |        |         |    
|                                                                       |                                                                                                                                                        |                                    | Net change in unrealized gain on
    Available-for-sale investments |                                                                     |   |            |        |          |   |            |            |               |   |        |         |        |   |  |      |     |   |  |      |     |   |  |          |   |         | 25  |         |        |         | 25  |        
|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |       
|                                                                       |                                                                                                                                                        |                                    |                                                                     | Total comprehensive loss                                            |   |             |       |          |   |             |           |               |   |         |        |        |   |   |     |     |   |   |     |     |   |   |         |   |         |     | (35,537 | )      |         |     | (35,537 | )
|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |       
|Balances at December 31, 2000                                          |                                                                                                                                                        |                                    |                                                                    |                                                                     |   |             |       |          |   |             | 18,266,955 |               |   |         | 148,573 |        |   |   | (131 | )   |   |   | (216 | )   |   |   | (110,441 | ) |         |     | 37,785  |       
|                                                                       | Issuance of common stock for cash, net of
    issuance costs of $956                                                                                   |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 10,881,733    |   |         |         | 49,189 |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 49,189 |        
|                                                                       | Issuance of common stock under the employee stock
    purchase plan                                                                                    |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 357,146       |   |         |         | 1,326  |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 1,326  |        
|                                                                       | Issuance of common stock upon exercise of stock
    options                                                                                            |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 30,549        |   |         |         | 204    |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 204    |        
|                                                                       | Issuance of redeemable convertible preferred
    stock for cash, net of issuance costs of $3,000 and proceeds
    from issuance of warrants of $14,724 |                                    |                                                                     | 2,001,236                                                           |   |             |        | 30,735   |   |             |            |              |   |         |         | 14,724 |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 14,724 |        
|Deemed non-cash dividend on redeemable
    convertible preferred stock |                                                                                                                                                        |                                    |                                                                    |                                                                     |   |             |       |          |   |             |           |               |   |         | 10,722  |        |   |   |     |     |   |   |     |     |   |   | (10,722  | ) |         |     |        |       
|                                                                       | Repayment of shareholders notes                                                                                                                       |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      | 131 |   |   |      |    |   |   |          |  |         |     |         | 131    |        
|                                                                       | Amortization of deferred compensation                                                                                                                  |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      |    |   |   |      | 162 |   |   |          |  |         |     |         | 162    |        
|                                                                       | Comprehensive loss:                                                                                                                                    |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |        |        
|                                                                       |                                                                                                                                                        | Net loss                           |                                                                     |                                                                     |  |             |        |          |  |             |            |               |  |         |         |        |  |   |      |     |  |   |      |     |  |   |          |   | (32,357 | )   |         |        | (32,357 | )  
|                                                                       |                                                                                                                                                        | Other comprehensive income (loss): |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |        |         |    
|                                                                       |                                                                                                                                                        |                                    | Net change in unrealized loss on
    available-for-sale investments |                                                                     |   |            |        |          |   |            |            |               |   |        |         |        |   |  |      |     |   |  |      |     |   |  |          |   |         | (15 | )       |        |         | (15 | )      
|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |       
|                                                                       |                                                                                                                                                        |                                    |                                                                     | Total comprehensive loss                                            |   |             |       |          |   |             |           |               |   |         |        |        |   |   |     |     |   |   |     |     |   |   |         |   |         |     | (32,372 | )      |         |     | (32,372 | )
|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |       
|Balances at December 31, 2001                                          |                                                                                                                                                        |                                    | 2,001,236                                                           |                                                                     |   | $           | 30,735 |          |   |             | 29,536,383 |               |   | $       | 224,738 |        |   |   |     |     |   |   | (54  | )   |   |   | (153,535 | ) |         |     | 71,149  |       
|                                                                       | Issuance of common stock for cash, net of
    issuance costs of $79                                                                                    |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 1,182,034     |   |         |         | 4,921  |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 4,921  |        
|                                                                       | Issuance of common stock under the employee stock
    purchase plan                                                                                    |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 431,695       |   |         |         | 1,157  |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 1,157  |        
|                                                                       | Issuance of common stock upon exercise of stock
    options                                                                                            |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            | 7,500         |   |         |         | 26     |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 26     |        
|                                                                       | Issuance of options to purchase common stock for
    services                                                                                          |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            |              |   |         |         | 11     |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         | 11     |        
|                                                                       | Issuance costs related to prior years sale
    of convertible preferred stock                                                                         |                                    |                                                                     |                                                                    |   |             |        | (70      | ) |             |            |              |   |         |         |       |   |   |      |    |   |   |      |    |   |   |          |  |         |     |         |       |        
|                                                                       | Amortization of deferred compensation                                                                                                                  |                                    |                                                                     |                                                                    |   |             |        |         |   |             |            |              |   |         |         |       |   |   |      |    |   |   |      | 54  |   |   |          |  |         |     |         | 54     |        
|                                                                       | Comprehensive loss:                                                                                                                                    |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |        |        
|                                                                       |                                                                                                                                                        | Net loss                           |                                                                     |                                                                     |  |             |        |          |  |             |            |               |  |         |         |        |  |   |      |     |  |   |      |     |  |   |          |   | (35,931 | )   |         |        | (35,931 | )  
|                                                                       |                                                                                                                                                        |                                    | Other comprehensive income (loss):                                  |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |        |         |     |        
|                                                                       |                                                                                                                                                        |                                    |                                                                     | Net change in unrealized loss on
    available-for-sale investments |   |             |       |          |   |             |           |               |   |         |        |        |   |   |     |     |   |   |     |     |   |   |         |   |         |     | 23      |        |         |     | 23      |  
|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |       
|                                                                       |                                                                                                                                                        |                                    |                                                                     | Total comprehensive loss                                            |   |             |       |          |   |             |           |               |   |         |        |        |   |   |     |     |   |   |     |     |   |   |         |   |         |     | (35,908 | )      |         |     | (35,908 | )
|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |       
|Balances at December 31, 2002.                                         |                                                                                                                                                        |                                    | 2,001,236                                                           |                                                                     |   | $           | 30,665 |          |   |             | 31,157,612 |               |   | $       | 230,853 |        |   | $ |     |     |   | $ |     |     |   | $ | (189,443 | ) |         | $   | 41,410  |       
|                                                                       |                                                                                                                                                        |                                    |                                                                     |                                                                     |   |             |        |          |   |             |            |               |   |         |         |        |   |   |      |     |   |   |      |     |   |   |          |   |         |     |         |       

See accompanying notes.

41



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##### Table of Contents



ARADIGM CORPORATION

STATEMENTS OF CASH FLOWS

|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |       |        |  
|------------------------------------------------------------------------------- | ------------------------------------------------------------- | ------------------------ | ------- | ----- | ------ | ---- | ------- | ------ | ------ | - | ------- | ----- | ------ | -
|                                                                                |                                                               |                         
|                                                                                |                                                               | Years Ended December 31,
|                                                                                |                                                               |                         
|                                                                                |                                                               | 2002                     |         | 2001  |        | 2000
|                                                                                |                                                               |                          |         |       |        |     
|                                                                                |                                                               |                         
|                                                                                |                                                               | (In thousands)          
|Cash flows from operating activities:                                           |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Net loss                                                                        |                                                               | $                        | (35,931 | )     |        | $    | (32,357 | )      |        | $ | (35,562 | )    
|Adjustments to reconcile net loss to net cash
    used in operating activities: |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|                                                                                | Depreciation and amortization                                 |                          |         | 5,749 |        |      |         | 4,500  |        |   |         | 3,213 |       
|                                                                                | Other income related to forgiveness of Genentech
    note     |                          |         |      |        |      |         | (6,675 | )      |   |         |      |       
|                                                                                | Retirement of capital assets                                  |                          |         | 114   |        |      |         |       |        |   |         |      |       
|                                                                                | Issuance of warrants and common stock for services            |                          |         | 11    |        |      |         | 48     |        |   |         | 296   |       
|                                                                                | Amortization of deferred compensation                         |                          |         | 54    |        |      |         | 162    |        |   |         | 163   |       
|                                                                                | Changes in operating assets and liabilities:                  |                          |         |       |        |      |         |        |        |   |         |       |       
|                                                                                |                                                               | Receivables              |         |       | 1,067  |      |         |        | (1,279 | ) |         |       | 3,816  |  
|                                                                                |                                                               | Other current assets     |         |       | (645   | )    |         |        | (77    | ) |         |       | 278    |  
|                                                                                |                                                               | Other assets             |         |       | 121    |      |         |        | 213    |   |         |       | (401   | )
|                                                                                |                                                               | Accounts payable         |         |       | (3,346 | )    |         |        | 403    |   |         |       | 2,654  |  
|                                                                                |                                                               | Accrued compensation     |         |       | 434    |      |         |        | 515    |   |         |       | (29    | )
|                                                                                |                                                               | Accrued liabilities      |         |       | (2,765 | )    |         |        | 375    |   |         |       | 2,129  |  
|                                                                                |                                                               | Deferred rent            |         |       | 808    |      |         |        | 300    |   |         |       |       |  
|                                                                                |                                                               | Deferred revenue         |         |       | 3,410  |      |         |        | 4,788  |   |         |       | (2,370 | )
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Net cash used in operating activities                                           |                                                               |                          | (30,919 | )     |        |      | (29,084 | )      |        |   | (25,813 | )    
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Cash flows from investing activities:                                           |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Capital expenditures                                                            |                                                               |                          | (11,157 | )     |        |      | (37,117 | )      |        |   | (14,376 | )    
|Purchases of available-for-sale investments                                     |                                                               |                          | (12,105 | )     |        |      | (5,732  | )      |        |   | (26,764 | )    
|Proceeds from maturities of available-for-sale
    investments                  |                                                               |                          | 4,685   |       |        |      | 28,167  |        |        |   | 25,052  |      
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Net cash used in investing activities                                           |                                                               |                          | (18,577 | )     |        |      | (14,682 | )      |        |   | (16,088 | )    
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Cash flows from financing activities:                                           |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Proceeds from issuance of common stock, net                                     |                                                               |                          | 6,104   |       |        |      | 50,671  |        |        |   | 48,674  |      
|Proceeds from issuance of redeemable convertible
    preferred stock, net       |                                                               |                          | (70     | )     |        |      | 45,459  |        |        |   |        |      
|Notes payable                                                                   |                                                               |                          |        |       |        |      |        |        |        |   | 2,756   |      
|Proceeds from repayments of shareholder notes                                   |                                                               |                          |        |       |        |      | 131     |        |        |   | 32      |      
|Notes receivable from officers and employees                                    |                                                               |                          |        |       |        |      | (186    | )      |        |   | 11      |      
|Proceeds from equipment loans                                                   |                                                               |                          |        |       |        |      |        |        |        |   | 4,051   |      
|Payments on capital lease obligations and
    equipment loans                   |                                                               |                          | (3,703  | )     |        |      | (3,076  | )      |        |   | (2,238  | )    
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Net cash provided by financing activities                                       |                                                               |                          | 2,331   |       |        |      | 92,999  |        |        |   | 53,286  |      
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|                                                                               
|Net increase (decrease) in cash and cash
    equivalents                        |                                                               |                          | (47,165 | )     |        |      | 49,233  |        |        |   | 11,385  |      
|Cash and cash equivalents at beginning of year                                  |                                                               |                          | 69,965  |       |        |      | 20,732  |        |        |   | 9,347   |      
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Cash and cash equivalents at end of year                                        |                                                               | $                        | 22,800  |       |        | $    | 69,965  |        |        | $ | 20,732  |      
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Supplemental disclosure of cash flow information:                               |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|                                                                                | Cash paid for interest                                        |                          | $       | 499   |        |      | $       | 899    |        |   | $       | 855   |       
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Non-cash investing and financing activities:                                    |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|                                                                                | Issuance of options to purchase common stock for
    services |                          | $       | 11    |        |      | $       | 48     |        |   | $       | 296   |       
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Issuance of warrants in conjunction with private
    placement of common stock  |                                                               | $                        |        |       |        | $    | 979     |        |        | $ |        |      
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      
|Redeemable convertible preferred stock deemed,
    non-cash dividend            |                                                               | $                        |        |       |        | $    | 10,722  |        |        | $ |        |      
|                                                                                |                                                               |                          |         |       |        |      |         |        |        |   |         |      

See accompanying notes.

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##### Table of Contents



ARADIGM CORPORATION

NOTES TO FINANCIAL STATEMENTS

1.     Summary of
Significant Accounting Policies

Organization
and Basis of Presentation

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

Use of
Estimates

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

Cash and 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,
corporate notes and market auction preferreds. The
Companys short-term investments consist of commercial
paper and corporate notes with maturities ranging from three to
twelve months. The Companys long-term investments consist
of a corporate note with maturity of 413 days from purchase
date.

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

Depreciation
and Amortization

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

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

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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

Impairment of
Long-Lived Assets

The Company reviews for impairment whenever
events or changes in circumstances indicate that the carrying
amount of property and equipment may not be recoverable.
Determination of recoverability is based on an estimate of
undiscounted future cash flows resulting from the use of the
asset and its eventual disposition. In the event that such cash
flows are not expected to be sufficient to recover the carrying
amount of the assets, the assets are written down to their
estimated fair values and the loss is recognized on the
Statements of Operations.

The Company adopted Statement of Financial
Accounting Standards (SFAS) No. 144,
Accounting for the Impairment or Disposal of Long-Lived
Assets, on January 1, 2002. SFAS 144 superseded
SFAS 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of. The
primary objectives of SFAS 144 are to develop one
accounting model based on the framework established in
SFAS 121 for long-lived assets to be disposed of by sale,
and to address significant implementation issues. Our adoption
of SFAS 144 did not have a material impact on our financial
position or results of operations.

Revenue
Recognition

Contract revenues consist of revenue from
collaboration agreements and feasibility studies. The Company
recognizes its revenue under the provisions of the Securities
and Exchange Commission issued Staff Accounting Bulletin
No. 101 (SAB 101), Revenue
Recognition in Financial Statements Under the agreements,
revenue is recognized as costs are incurred. Deferred revenue
represents the portion of all refundable and nonrefundable
research payments received that have not been earned. In
accordance with contract terms, milestone payments from
collaborative research agreements are considered reimbursements
for costs incurred under the agreements and, accordingly, are
generally recognized as revenue either upon the completion of
the milestone effort when payments are contingent upon
completion of the effort or are based on actual efforts expended
over the remaining term of the agreements when payments precede
the required efforts. Costs of contract revenues approximate
such revenue and are included in research and development
expenses. Refundable development and license fee payments are
deferred until the specified performance criteria are achieved.
Refundable development and license fee payments are generally
not refundable once the specific performance criteria are
achieved.

Research and
Development

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

Stock Based
Compensation

The Company has elected to follow Accounting
Principles Board Opinion No. (APB) 25,
Accounting for Stock Issued to Employees, and
related interpretations in accounting for its employee stock
options, including Financial Accounting Standard Board
Interpretation (FIN) 44 Accounting for Certain
Transactions Involving Stock Compensation. Compensation
expense is based on the difference, if any, between the fair
value of the Companys common stock and the exercise price
of the option or share right on the measurement date, which is
typically the date of grant. This amount is recorded as
Deferred stock compensation in the Balance Sheets
and amortized as a charge to operations over the vesting period
of the applicable options or share rights. In accordance with
SFAS 123, Accounting for Stock-Based
Compensation, as amended by SFAS 148,
Accounting for Stock-Based Compensation 
Transition and

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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

Disclosure, the Company has provided,
below, the pro forma disclosures of the effect on net loss and
loss per share as if SFAS 123 had been applied in measuring
compensation expense for all periods presented.

|                                                                             |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |        |  
|---------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | ------------------------ | ------- | ------ | - | ---- | ------- | ------ | - | - | ------- | ------ | -
|                                                                             |                                                                                                             |                         
|                                                                             |                                                                                                             | Years ended December 31,
|                                                                             |                                                                                                             |                         
|                                                                             |                                                                                                             | 2002                     |         | 2001   |   | 2000
|                                                                             |                                                                                                             |                          |         |        |   |     
|Net loss applicable to common
    shareholders  as reported                 |                                                                                                             | $                        | (35,931 | )      |   | $    | (43,079 | )      |   | $ | (35,562 | )     
|Add:                                                                         |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |       
|                                                                             | Stock-based employee compensation expense
    included in reported net income                               |                          |         | 54     |   |      |         | 162    |   |   |         | 163    |  
|Less:                                                                        |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |       
|                                                                             | Total stock-based employee compensation expense
    determined under fair value based method for all awards |                          |         | (7,455 | ) |      |         | (6,397 | ) |   |         | (4,188 | )
|                                                                             |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |       
|Pro forma net loss applicable to common
    shareholders                     |                                                                                                             | $                        | (43,332 | )      |   | $    | (49,314 | )      |   | $ | (39,587 | )     
|                                                                             |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |       
|Basic and diluted net loss per share applicable
    to common shareholders  |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |       
|                                                                             | As reported                                                                                                 |                          | $       | (1.19  | ) |      | $       | (1.98  | ) |   | $       | (2.07  | )
|                                                                             | Pro forma                                                                                                   |                          | $       | (1.43  | ) |      | $       | (2.26  | ) |   | $       | (2.30  | )

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

Income
Taxes

The Company uses the liability method to account
for income taxes as required by SFAS 109, Accounting
for Income Taxes. Under this method, deferred income taxes
reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes.

Net Loss Per
Share

Historical net loss per share has been calculated
under SFAS 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. There were no shares subject to repurchase in the
years ended December 31, 2002, 2001 and 2000. No diluted
loss per share information has been presented in the
accompanying statements of operations since potential common
shares from stock options, warrants and redeemable convertible
preferred stocks are antidilutive. For the years ended
December 31, 2002, 2001 and 2000, the total number of
shares excluded from diluted loss per share relating to these
securities was 8,283,600, 10,038,525 and 2,232,633 shares,
respectively.

Employee
Benefit Plans

The Company has a 401(k) Plan which stipulated
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.
During December 2000, the Company approved a change to the
employment qualification period from three months to one month
of employment and approved an employer match program that became
effective during 2001. Subject to a maximum dollar match
contribution of $5,250 per year, the Company will match 50% of
the first 6% of the employees contribution on a pretax
basis. The Company expensed total employer matching
contributions of $527,000, $273,000 and $0 in 2002, 2001 and
2000, respectively.

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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

Significant
Concentrations

Although the Company has had development
arrangements with other collaborative partners, the arrangement
with Novo Nordisk A/ S is its only active, funded development
agreement. For the year ended December 31, 2002, this
partner-funded program contributed approximately 93% of total
contract revenues. The agreement with Novo Nordisk A/ S can be
terminated under certain conditions, including by either party
on limited written notice, by Novo Nordisk A/ S by limited prior
written notice upon the occurrence of certain events, and by
either party upon 30 days written notice in the event
that the other party commits a material breach under the
agreement and fails to remedy such breach within
60 days notice of such breach. Novo Nordisk A/ S is
considered to be a related party due to its ownership interest
in the Company.

Comprehensive
Income (Loss)

SFAS 130, Reporting Comprehensive
Income, requires unrealized gains or losses on the
Companys available-for-sales securities to be recorded in
other comprehensive income (loss). Total comprehensive loss has
been disclosed in the statement of redeemable convertible
preferred stock and shareholders equity.

Changes in
Accounting Principles

In December 2002, the Company adopted
SFAS 145, Rescission of FASB Statements No. 4,
44, and 64, Amendment of FASB Statement No. 13, and
Technical Corrections. Previous to the issuance of
SFAS 145, SFAS 4 had required that all gains and
losses from extinguishment of debt were to be aggregated and, if
material, classified as an extraordinary item, net of related
income tax effect. SFAS 145 rescinds SFAS 4 and the
related required classification of extraordinary items.
Companies are required to retroactively adopt SFAS 145 for
fiscal years beginning after May 15, 2002, and interim
periods within those fiscal years, although early adoption is
permitted. As a result of adopting SFAS 145, the Company
reclassified the $6.7 million previously recorded in 2001
as extraordinary gain related to forgiveness of outstanding
notes and interest by Genentech, as a component of operating
results.

Recent
Accounting Pronouncements

In October 2001, the Financial Accounting
Standards Board issued SFAS 144, Accounting for the
Impairment or Disposal of Long-Lived Assets
(SFAS 144), which addresses financial
accounting and reporting for the impairment or disposal of
long-lived assets and supersedes SFAS 121, Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of, and the accounting and reporting
provisions of APB Opinion No. 30, Reporting the
Results of Operations for a disposal of a segment of a
business. SFAS 144 is effective for fiscal years
beginning after December 15, 2001. The Company adopted
SFAS 144 on January 1, 2002 and has determined that
SFAS 144 does not have a significant impact on the
Companys historical financial position and results of
operations.

In July 2002, the FASB issued SFAS 146,
Accounting for Costs Associated with Exit or Disposal
Activities. The standard requires companies to recognize
costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or
disposal plan. Examples of costs covered by the standard include
lease termination costs and certain employee severance costs
that are associated with a restructuring, discontinued
operation, plant closing, or other exit or disposal activity.
SFAS 146 is to be applied prospectively to exit or disposal
activities initiated after December 31, 2002. The Company
believes that the adoption of this standard will not have a
material impact on the Companys financial position and
results of operations.

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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

In November 2002, the FASB issued FIN 45,
Guarantors Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of
Others. FIN 45 elaborates on the existing disclosure
requirements for most guarantees, including residual value
guarantees issued in conjunction with operating lease
agreements. It also clarifies that at the time a company issues
a guarantee, the company must recognize an initial liability for
the fair value of the obligation it assumes under that guarantee
and must disclose that information in its interim and annual
financial statements. The initial recognition and measurement
provisions apply on a prospective basis to guarantees issued or
modified after December 31, 2002. The disclosure
requirements are effective for financial statements of interim
or annual periods ending after December 15, 2002. The
adoption of FIN 45 is not expected to have a significant
impact on the companys financial position and results of
operations.

In December 2002, the FASB issued SFAS 148,
Accounting for Stock-Based Compensation 
Transition and Disclosure. SFAS 148 amends
SFAS 123 Accounting for Stock-Based
Compensation to provide alternative methods of transition
for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition,
SFAS 148 amends the disclosure requirements of
SFAS 123 to require more prominent disclosures in both
annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect
of the method used on reported results. The adoption of
SFAS 148 did not have a significant impact on the
companys financial statements. The company continues to
follow the intrinsic value method of accounting as prescribed by
APB 25, Accounting for Stock Issued to
Employees, to account for employee stock options.

In January 2003, the FASB issued FIN 46,
Consolidation of Variable Interest Entities.
FIN 46 requires a variable interest entity to be
consolidated by a company if that company is subject to a
majority of the risk of loss from the variable interest
entitys activities or entitled to receive a majority of
the entitys residual returns or both. A variable interest
entity is a corporation, partnership, trust, or any other legal
structures used for business purposes that either (a) does
not have equity investors with voting rights or (b) has
equity investors that do not provide sufficient financial
resources for the entity to support its activities. A variable
interest entity often holds financial assets, including loans or
receivables, real estate or other property. A variable interest
entity may be essentially passive or it may engage in research
and development or other activities on behalf of another
company. The consolidation requirements of FIN 46 apply
immediately to variable interest entities created after
January 31, 2003. The consolidation requirements apply to
older entities in the first fiscal year or interim period
beginning after June 15, 2003. Certain of the disclosure
requirements apply to all financial statements issued after
January 31, 2003, regardless of when the variable interest
entity was established. The Company has evaluated the impact of
FIN 46 and does not believe that it has any investment in
variable interest entity.

Reclassifications

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

47



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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

2.     Financial
Instruments

Cash
Equivalents and Investments

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

|                        |                           |              |        |        |  |   |        |        | 
|----------------------- | ------------------------- | ------------ | ------ | ------ |  | - | ------ | ------ | 
|                        |                           |             
|                        |                           | December 31,
|                        |                           |             
|                        |                           | 2002         |        | 2001  
|                        |                           |              |        |       
|Cash equivalents:       |                           |              |        |        |  |   |        |       
|                        | Money market fund         |              | $      | 4,903  |  |   | $      | 2,845  | 
|                        | Commercial paper          |              |        | 17,846 |  |   |        | 67,068 | 
|                        |                           |              |        |        |  |   |        |       
|                        |                           | $            | 22,749 |        |  | $ | 69,913 |       
|                        |                           |              |        |        |  |   |        |       
|Short-term investments: |                           |              |        |        |  |   |        |       
|                        | Corporate notes           |              | $      | 4,590  |  |   | $      | 1,199  | 
|                        | Market auction preferreds |              |        | 2,500  |  |   |        |       | 
|                        |                           |              |        |        |  |   |        |       
|                        |                           | $            | 7,090  |        |  | $ | 1,199  |       
|                        |                           |              |        |        |  |   |        |       
|Long-term investments:  |                           |              |        |        |  |   |        |       
|                        | Corporate notes           |              | $      | 1,553  |  |   | $      |       | 
|                        |                           |              |        |        |  |   |        |       
|                        |                           | $            | 1,553  |        |  | $ |       |       
|                        |                           |              |        |        |  |   |        |       

As of December 31, 2002 and 2001, the
difference between the fair value and the amortized cost of
available-for-sale securities was $23,000 and $15,000 for 2002
and 2001, respectively. As of December 31, 2002, the
average portfolio duration was approximately 130 days, and
the contractual maturity of all short-term investments did not
exceed 105 days from the balance sheet date.

3.     Property and
Equipment

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

|                                               |  |              |         |      |  |   |         |  
|---------------------------------------------- |  | ------------ | ------- | ---- |  | - | ------- | -
|                                               |  |             
|                                               |  | December 31,
|                                               |  |             
|                                               |  | 2002         |         | 2001
|                                               |  |              |         |     
|Machinery and equipment                        |  | $            | 17,807  |      |  | $ | 14,053  |  
|Furniture and fixtures                         |  |              | 1,862   |      |  |   | 1,653   |  
|Lab equipment                                  |  |              | 3,986   |      |  |   | 3,428   |  
|Computer equipment and software                |  |              | 5,654   |      |  |   | 5,073   |  
|Leasehold improvements                         |  |              | 11,600  |      |  |   | 5,055   |  
|                                               |  |              |         |      |  |   |         |  
|                                               |  |              | 40,909  |      |  |   | 29,262  |  
|Less accumulated depreciation and amortization |  |              | (17,944 | )    |  |   | (13,186 | )
|                                               |  |              |         |      |  |   |         |  
|                                               |  |              | 22,965  |      |  |   | 16,076  |  
|Construction in progress                       |  |              | 40,268  |      |  |   | 41,864  |  
|                                               |  |              |         |      |  |   |         |  
|Property and equipment, net                    |  | $            | 63,233  |      |  | $ | 57,940  |  
|                                               |  |              |         |      |  |   |         |  

At December 31, 2002 and 2001, property and
equipment include assets under capitalized leases of
approximately $11,936,000 and $13,080,000, respectively.
Accumulated depreciation related to leased assets at
December 31, 2002 and 2001, was approximately $9,377,000
and $7,864,000, respectively.

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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

4.     Leases and
Commitments

Amounts borrowed under the Companys
equipment lease lines of credit bear interest at rates ranging
from 9.8% to 14.6% and are collateralized by the related
equipment. Under the terms of the lease agreements, the Company
has the option to purchase the leased equipment at a negotiated
price at the end of each lease term. 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, 2002 are as
follows (amounts in thousands):

|                                                |  |           |        |         |  |   |        |  
|----------------------------------------------- |  | --------- | ------ | ------- |  | - | ------ | -
|                                                |  | Operating |        | Capital
|                                                |  | Leases    |        | Leases 
|                                                |  |           |        |        
|Years ending December 31:                       |  |           |        |         |  |   |        |  
|2003                                            |  | $         | 5,171  |         |  | $ | 1,890  |  
|2004                                            |  |           | 5,334  |         |  |   | 513    |  
|2005                                            |  |           | 5,499  |         |  |   |       |  
|2006                                            |  |           | 4,645  |         |  |   |       |  
|2007 and thereafter                             |  |           | 42,177 |         |  |   |       |  
|                                                |  |           |        |         |  |   |        |  
|Total minimum lease payments                    |  | $         | 62,826 |         |  |   | 2,403  |  
|                                                |  |           |        |         |  |   |        |  
|Less amount representing interest               |  |           |        |         |  |   | (153   | )
|                                                |  |           |        |         |  |   |        |  
|Present value of future lease payments          |  |           |        |         |  |   | 2,250  |  
|Current portion of capital lease obligations    |  |           |        |         |  |   | (1,753 | )
|                                                |  |           |        |         |  |   |        |  
|Noncurrent portion of capital lease obligations |  |           |        |         |  | $ | 497    |  
|                                                |  |           |        |         |  |   |        |  

Certain of the Companys operating leases
have rent escalation clauses and accordingly, the Company
recognizes rent expense on a straight-line basis. At
December 31, 2002, the Company had $1,100,000 of deferred
rent.

For the years ended December 31, 2002, 2001
and 2000, rent expense under operating leases totaled
$5,898,000, $5,476,000, and $3,896,000, respectively.

At December 31, 2002, the Company is
contractually committed to $4,519,000 of the anticipated 2003
capital outlays.

5.     Contingencies

In June 1998, Eli Lilly and Company filed a
complaint against us in the United States District Court for the
Southern District of Indiana. The complaint made various
allegations against us, arising from our decision to enter into
an exclusive collaboration with Novo Nordisk A/S with respect to
the development and commercialization of a pulmonary delivery
system for insulin and insulin analogs. We sponsored various
studies of the pulmonary delivery of insulin and insulin analogs
using materials supplied by Lilly under a series of agreements
dating from January 1996. We and Lilly had also conducted
negotiations concerning a long-term supply agreement under which
Lilly would supply bulk insulin to us for commercialization in
our AERx insulin Diabetes Management System, and a separate
agreement under which we would license certain intellectual
property to Lilly. These negotiations were terminated after we
proceeded with our agreement with Novo Nordisk A/S. The
complaint sought a declaration that Lilly scientists were
co-inventors of patent applications filed by us relating to
pulmonary delivery of an insulin analog or, in the alternative,
enforcement of an alleged agreement to grant Lilly a
nonexclusive license under such patent application. The
complaint also contained allegations of misappropriation of trade

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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

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 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. After trial of
the remaining claims in April 2002, the jury returned verdicts
in favor of Aradigm and against Lilly on three of four of
Lillys asserted claims on co-inventorship and on
Lillys unjust enrichment claim. The jury returned verdicts
in favor of Lilly on one of Lillys claims of
co-inventorship and on two breaches of contract claims, awarding
Lilly damages of $1 for each breach of contract claim. In June
2002, the Court entered a judgment based on and incorporating
the jurys verdict. In March 2003, following disposition of
various post-trial motions, the court entered final judgment
based on and incorporating the jurys verdict. Either party
may appeal from that Final Judgment; the deadline for such
appeal is April 4, 2003. If the present final judgment is
upheld, a Lilly scientist would be named co-inventor thereby
giving Lilly rights of an owner, along with us, on one of our
patents relating to pulmonary delivery of monomeric insulin
lispro. Should Lilly appeal and ultimately succeed in that
appeal, the possible consequences include reversal of the
Courts decision granting Aradigm summary judgment on
several of Lillys claims or reversal of the Courts
refusal to grant Lilly certain post-judgment relief it had
requested. Lilly also contends that factual findings made in any
trial of this case would have some effect on other patents
relating to pulmonary delivery of monomeric insulin lispro.
Management believes that this litigation will not have a
material adverse effect on our business.

6.     Redeemable
Convertible Preferred Stock



| |                                                                     
| | --------------------------------------------------------------------
| | Redeemable Convertible Preferred Stock and
    Common Stock Warrants

During December 2001, the Company completed a
$48.4 million Series A redeemable convertible
preferred stock (preferred stock) financing. Under
the terms of the financing, the Company sold to a group of
investors 2,001,236 shares of preferred stock at a purchase
price of $24.20 per share. Each share of preferred stock is
convertible into four shares of common stock. The Company also
issued warrants to the investors to purchase 5,203,212 shares of
common stock at an exercise price of $6.97 per share. Issuance
costs of approximately $3.0 million were accounted for as a
reduction to proceeds from the preferred stock financing.

During the first two years, the preferred stock
is entitled to cumulative dividends, which shall accrue at an
annual rate of 6%, payable only when and if declared by the
Board of Directors. At the option of the Company, dividends may
be paid in either cash or in shares of common stock, which will
be valued at a price equal to the then current market price. The
current market price of the common stock on any dividend payment
date shall be based on the closing price of the Companys
common stock as quoted on the Nasdaq Stock Market. There were no
dividends declared as of December 31, 2002.

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

Upon any liquidation, dissolution, redemption or
winding up of the Company, whether voluntary or involuntary, the
holders of outstanding preferred stock will be entitled to a
liquidation preference, equal to the original issue price plus
all accrued and unpaid dividends (as adjusted for any stock
dividends,

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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

combinations, splits, recapitalizations and other
similar events) to the preferred holders. Any remaining assets
will be available for distribution to holders of common stock.

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



| |                                                      
| | -----------------------------------------------------
| | Summary of Preferred Stock and Warrant
    Accounting

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

In July 2001, the SEC staff made a staff
announcement, Classification and Measurement of Redeemable
Securities, (EITF D-98) which clarifies Rule #5-02.28
of Regulation S-X, which was previously adopted in
accounting series Release No. 268, Presentation in
Financial Statements of Redeemable Preferred Stock. This
announcement addresses financial statement classification and
measurement of securities subject to mandatory redemption
requirements or whose redemption is outside of the control of
the issuer. Rule 5-02.28 requires preferred securities that
are redeemable for cash or other assets to be classified outside
of permanent equity if they are redeemable (1) at a fixed
or determinable price on a fixed or determinable date
(2) at the option of the holder, or (3) upon the
occurrence of an event that is not solely within the control of
the issuer.

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

7.     Shareholders
Equity

In July 2002, the Company raised $5 million
through the sale of 1,182,034 shares of common stock at a price
of $4.23 per share to Novo Nordisk Pharmaceuticals, Inc.
(Novo Nordisk Pharmaceuticals), an affiliate of Novo
Nordisk A/ S. This sale was made under the terms of the Stock
Purchase Agreement entered into in October 2001 with Novo
Nordisk Pharmaceuticals.

In February 2002, the Company filed a Certificate
of Amendment to the Companys amended and restated Articles
of Incorporation with the Secretary of State of the State of
California to increase the Companys authorized number of
shares of common stock from 40,000,000 to 100,000,000 shares.
The additional shares of common stock authorized by the
amendment have rights identical to the common stock of the
Company outstanding immediately before the filing of the
amendment. Issuances of common stock from the additional
authorized shares do not affect the rights of the holders of the
Companys common stock and preferred stock outstanding
immediately before the filing of the amendment, except for

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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

effects that may be incidental to increasing the
number of shares of the Companys common stock outstanding,
such as dilution of the earnings per share and voting rights of
holders of other common stock.

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

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

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

In October 2001, the Company entered into a
common stock purchase agreement with Novo Nordisk
Pharmaceuticals. Under the terms of the agreement, Novo Nordisk
Pharmaceuticals committed to purchase up to $45 million of
the Companys common stock, of which 5,665,723 shares for
$3.53 per share, were purchased for a total purchase price of
$20 million, ten business days after the effective date of
the agreement. The number of initial shares was calculated by
dividing the initial purchase price by the average of the
closing prices of the Companys common stock on the Nasdaq
for the thirty trading days immediately prior to the effective
date. Pursuant to the terms of the agreement, the Company may
elect to sell at its option, subject to certain conditions,
between $5 million and $10 million of additional
shares to Novo Nordisk Pharmaceuticals once every three months
beginning December 1, 2001 until the remaining
$25 million has been invested. The number of additional
shares shall be calculated by dividing the additional purchase
price by the average closing price of the Companys common
stock on the Nasdaq for the thirty trading days immediately
prior to the date of written notice by the Company to Novo
Nordisk Pharmaceuticals. Novo Nordisk Pharmaceuticals will hold
the shares to be purchased under the agreement for at least two
years from the effective date of each purchase, subject to
certain conditions.

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

In November 2000, the Company entered into a
common stock purchase agreement (Acqua Agreement)
with Acqua Wellington North American Equities Fund, Ltd
(Acqua), a Bahamas based company, establishing a
common stock equity line. Pursuant to the equity line, Acqua,
subject to the Companys satisfaction of certain
conditions, had 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
could 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 filed a registration statement
with the Securities and Exchange Commission in November 2000
related to the common stock available for sale under the equity
agreement. During December 2000, the Company raised
approximately $2,172,000 through the sale of 114,795 shares of
common stock at an average price of $18.92 per share under the
terms of the Acqua Agreement. The fair market value of the
Companys common stock on the closing date was $15.50 per
share. During February 2001, the Company raised $5 million
through the sale of 436,110 shares of common stock at an average
price of $11.46 per share under the terms of the Acqua
Agreement. The fair market value of the Companys common
stock on the closing date was $13.25 per share. During July
2001, the Company raised $539,000 through the sale of 92,407
shares of common stock at an average price of $5.84 per share
under the terms of the Acqua

52



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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

Agreement. The fair market value of the
Companys common stock on the closing date was $4.80 per
share. The Acqua Agreement was terminated pursuant to its terms
on July 3, 2002.



| |                
| | ---------------
| | Reserved Shares

At December 31, 2002, the Company had
5,910,798 shares of its common stock reserved for issuance upon
exercise of common stock warrants, 6,466,851 shares for issuance
upon exercise of options under all plans, 8,004,944 shares
for issuance upon conversion of preferred stock and 123,174
available authorized shares under the Employee Stock Purchase
Plan.



| |                            
| | ---------------------------
| | Other Common Stock Warrants

In October 2002, the Company issued warrants in
connection with a financial relations service agreement that
entitles the holder to purchase 75,000 shares of common stock,
25,000 of which are exercisable at $1.99 per share, 25,000
shares of which are exercisable at $2.39 per share and 25,000
shares of which are exercisable at $2.79 per share. 15,000
shares vested at the execution of the agreement and the
remaining shares shall vest based on the achievement of various
performance benchmarks set forth in the agreement. The Company
valued the vested warrants using the Black-Scholes option
pricing model and deemed the amount to be immaterial. The
warrants are exercisable through October 1, 2007.

In August 2001, the Company issued warrants in
connection with the private placement of common stock that
entitles investors to purchase 363,929 shares of common stock at
an exercise price of $5.41 per share or a 15% premium to the
Nasdaq National Market price on the closing date. The Company
valued the warrants using the Black-Scholes option pricing model
using the following assumptions: estimated volatility of 78%,
risk-free interest rate of 6.2%, no dividend yield, and an
expected life of 4 years, and recorded approximately
$978,969 as issuance costs related to the private placement.
These warrants are exercisable through August 21, 2005.

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

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

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

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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

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.



| |                                                   
| | --------------------------------------------------
| | 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:

|                             |                   |                      |         |           |   |                 |         |                  |   |   |               |               |  |   |       |       | 
|---------------------------- | ----------------- | -------------------- | ------- | --------- | - | --------------- | ------- | ---------------- | - | - | ------------- | ------------- |  | - | ----- | ----- | 
|                             |                   |                     
|                             |                   | Options Outstanding 
|                             |                   |                     
|                             |                   | Shares Available for |         | Number    |   |                 |         | Weighted Average
|                             |                   | Grant of Options     |         | of Shares |   | Price Per Share |         | Exercise Price  
|                             |                   |                      |         |           |   |                 |         |                 
|Balance at December 31, 1999 |                   |                      | 128,432 |           |   |                 | 74,068  |                  |   | $ | 6.00  $14.25 |               |  | $ | 10.03 |      
|                             | Options granted   |                      |         | (84,356   | ) |                 |         | 84,356           |   |   | $             | 6.13  $24.13 |  |   | $     | 20.43 | 
|                             | Options exercised |                      |         |          |   |                 |         | (27,500          | ) |   | $             | 6.00  $14.25 |  |   | $     | 7.53  | 
|                             | Options cancelled |                      |         | (44,076   | ) |                 |         | (2,500           | ) |   |               | $14.25        |  |   | $     | 14.25 | 
|                             |                   |                      |         |           |   |                 |         |                  |   |   |               |               |  |   |       |      
|Balance at December 31, 2000 |                   |                      |        |           |   |                 | 128,424 |                  |   | $ | 6.00  $24.13 |               |  | $ | 17.31 |      
|                             |                   |                      |         |           |   |                 |         |                  |   |   |               |               |  |   |       |      
|                             | Options granted   |                      |         |          |   |                 |         |                 |   |   |               |              |  |   |       |      | 
|                             | Options exercised |                      |         |          |   |                 |         |                 |   |   |               |              |  |   |       |      | 
|                             | Options cancelled |                      |         |          |   |                 |         |                 |   |   |               |              |  |   |       |      | 
|                             |                   |                      |         |           |   |                 |         |                  |   |   |               |               |  |   |       |      
|Balance at December 31, 2001 |                   |                      |        |           |   |                 | 128,424 |                  |   | $ | 6.00  $24.13 |               |  | $ | 17.31 |      
|                             |                   |                      |         |           |   |                 |         |                  |   |   |               |               |  |   |       |      
|                             | Options granted   |                      |         |          |   |                 |         |                 |   |   |               |              |  |   |       |      | 
|                             | Options exercised |                      |         |          |   |                 |         |                 |   |   |               |              |  |   |       |      | 
|                             | Options cancelled |                      |         |          |   |                 |         | (22,500          | ) |   | $             | 6.00  $14.25 |  |   | $     | 11.50 | 
|                             |                   |                      |         |           |   |                 |         |                  |   |   |               |               |  |   |       |      
|Balance at December 31, 2002 |                   |                      |        |           |   |                 | 105,924 |                  |   | $ | 8.25  $24.13 |               |  | $ | 18.55 |      
|                             |                   |                      |         |           |   |                 |         |                  |   |   |               |               |  |   |       |      

|                     |  |                                     |         |                  |  |                             |       |  |  |  |     | 
|-------------------- |  | ----------------------------------- | ------- | ---------------- |  | --------------------------- | ----- |  |  |  | --- | 
|                     |  |                                    
|                     |  | Options Outstanding and Exercisable
|                     |  |                                    
|                     |  |                                     |         | Weighted Average |  | Weighted Average Remaining 
|Exercise Price Range |  | Number                              |         | Exercise Price   |  | Contractual Life (in years)
|                     |  |                                     |         |                  |  |                            
|$ 8.25  $ 8.44      |  |                                     | 26,568  |                  |  | $                           | 8.33  |  |  |  | 6.3 | 
|$14.25               |  |                                     | 7,500   |                  |  | $                           | 14.25 |  |  |  | 5.4 | 
|$21.56  $24.13      |  |                                     | 71,856  |                  |  | $                           | 22.77 |  |  |  | 7.4 | 
|                     |  |                                     |         |                  |  |                             |       |  |  |  |     | 
|                     |  |                                     | 105,924 |                  |  | $                           | 18.55 |  |  |  | 7.0 | 
|                     |  |                                     |         |                  |  |                             |       |  |  |  |     | 



| |                           
| | --------------------------
| | 1996 Equity Incentive Plan

In April 1996, the Companys Board of
Directors adopted and the Companys shareholders approved
the 1996 Equity Incentive Plan (the Plan), which
amended and restated the 1992 Stock Option Plan. Options granted
under the Plan may be either incentive or non-statutory stock
options. As of

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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

December 31, 2002, the Company had
7,736,705 shares of common stock authorized for issuance
under the Plan. Options granted under the Plan expire no later
than ten years from the date of grant. For incentive and
non-statutory stock option grants, the option price shall be at
least 100% and 85%, respectively, of the fair value on the date
of grant, as determined by the Board of Directors. If at any
time the Company grants an option, and the optionee directly or
by attribution owns stock possessing more than 10% of the total
combined voting power of all classes of stock of the Company,
the option price shall be at least 110% of the fair value and
shall not be exercisable more than five years after the date of
grant. During May 2001, the Companys shareholders approved
an amendment to the Plan to include an evergreen provision. The
evergreen provision will automatically increase the number of
shares reserved under the Plan, subject to certain limitations,
by 6% of the issued and outstanding Common Stock of the Company
or such lesser number of shares as determined by the Board of
Directors on the date of the annual meeting of shareholders of
each fiscal year beginning 2001 and ending 2005. The aggregate
increase in the number of shares reserved under the evergreen
provision will not exceed 8,000,000 shares.

Options granted under the 1996 Equity Incentive
Plan are immediately exercisable subject to repurchase
provisions, and the shares acquired generally vest over a period
of four years from the date of grant. The Plan also provides for
a transition from employee to consultant status without
termination of the vesting period as a result of such
transition. Under the Plan, employees may exercise options in
exchange for a note payable to the Company. As of December 31,
2002 and 2001, there were no outstanding notes receivable from
shareholders. 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 2002, the Company granted options to purchase
2,149,280 shares of common stock, none of which were
exercised subject to repurchase agreements.

The following is a summary of activity under the
Plan:

|                             |                    |                      |           |            |   |                 |           |                  |   |   |               |                |  |   |       |       | 
|---------------------------- | ------------------ | -------------------- | --------- | ---------- | - | --------------- | --------- | ---------------- | - | - | ------------- | -------------- |  | - | ----- | ----- | 
|                             |                    |                     
|                             |                    | Options Outstanding 
|                             |                    |                     
|                             |                    | Shares Available for |           | Number of  |   |                 |           | Weighted Average
|                             |                    | Grant of Options     |           | Shares     |   | Price Per Share |           | Exercise Price  
|                             |                    |                      |           |            |   |                 |           |                 
|Balance at December 31, 1999 |                    |                      | 1,656,041 |            |   |                 | 2,097,906 |                  |   | $ | 0.10  $14.63 |                |  | $ | 9.72  |      
|                             | Options granted    |                      |           | (1,308,325 | ) |                 |           | 1,308,325        |   |   | $             | 10.50  $24.13 |  |   | $     | 17.29 | 
|                             | Options exercised  |                      |           |           |   |                 |           | (291,176         | ) |   | $             | 0.10  $23.56  |  |   | $     | 9.16  | 
|                             | Options cancelled  |                      |           | 394,577    |   |                 |           | (394,577         | ) |   | $             | 5.33  $22.50  |  |   | $     | 12.24 | 
|                             |                    |                      |           |            |   |                 |           |                  |   |   |               |                |  |   |       |      
|Balance at December 31, 2000 |                    |                      | 742,293   |            |   |                 | 2,720,478 |                  |   | $ | 0.33  $24.13 |                |  | $ | 13.05 |      
|                             | Options authorized |                      |           | 1,152,812  |   |                 |           |                 |   |   |               |               |  |   |       |      | 
|                             | Options granted    |                      |           | (1,960,310 | ) |                 |           | 1,960,310        |   |   | $             | 3.34  $12.94  |  |   | $     | 5.36  | 
|                             | Options exercised  |                      |           |           |   |                 |           | (30,549          | ) |   | $             | 5.33  $10.63  |  |   | $     | 6.70  | 
|                             | Options cancelled  |                      |           | 561,215    |   |                 |           | (561,215         | ) |   | $             | 3.44  $23.00  |  |   | $     | 10.77 | 
|                             |                    |                      |           |            |   |                 |           |                  |   |   |               |                |  |   |       |      
|Balance at December 31, 2001 |                    |                      | 496,010   |            |   |                 | 4,089,024 |                  |   | $ | 0.33  $24.13 |                |  | $ | 9.74  |      
|                             | Options authorized |                      |           | 1,783,393  |   |                 |           |                 |   |   |               |               |  |   |       |      | 
|                             | Options granted    |                      |           | (2,149,280 | ) |                 |           | 2,149,280        |   |   | $             | 1.42  $ 4.82  |  |   | $     | 4.20  | 
|                             | Options exercised  |                      |           |           |   |                 |           | (7,500           | ) |   |               | $3.44          |  |   | $     | 3.44  | 
|                             | Options cancelled  |                      |           | 457,970    |   |                 |           | (457,970         | ) |   | $             | 1.42  $23.00  |  |   | $     | 6.19  | 
|                             |                    |                      |           |            |   |                 |           |                  |   |   |               |                |  |   |       |      
|Balance at December 31, 2002 |                    |                      | 588,093   |            |   |                 | 5,772,834 |                  |   | $ | 0.33  $24.13 |                |  | $ | 7.86  |      
|                             |                    |                      |           |            |   |                 |           |                  |   |   |               |                |  |   |       |      

55



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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

|                     |  |                                     |           |                  |  |                             |       |  |  |  |     | 
|-------------------- |  | ----------------------------------- | --------- | ---------------- |  | --------------------------- | ----- |  |  |  | --- | 
|                     |  |                                    
|                     |  | Options Outstanding and Exercisable
|                     |  |                                    
|                     |  |                                     |           | Weighted Average |  | Weighted Average Remaining 
|Exercise Price Range |  | Number                              |           | Exercise Price   |  | Contractual Life (in years)
|                     |  |                                     |           |                  |  |                            
|$ 0.33  $ 0.43      |  |                                     | 33,375    |                  |  | $                           | 0.37  |  |  |  | 1.3 | 
|$ 0.57               |  |                                     | 5,874     |                  |  | $                           | 0.57  |  |  |  | 3.1 | 
|$ 1.42  $ 2.00      |  |                                     | 11,450    |                  |  | $                           | 1.67  |  |  |  | 7.9 | 
|$ 2.60  $ 3.73      |  |                                     | 1,360,475 |                  |  | $                           | 3.44  |  |  |  | 9.2 | 
|$ 4.00  $ 6.00      |  |                                     | 2,139,830 |                  |  | $                           | 5.13  |  |  |  | 8.6 | 
|$ 6.53  $ 9.75      |  |                                     | 614,872   |                  |  | $                           | 8.08  |  |  |  | 6.5 | 
|$ 9.88  $14.50      |  |                                     | 818,972   |                  |  | $                           | 12.07 |  |  |  | 5.6 | 
|$14.88  $22.00      |  |                                     | 544,362   |                  |  | $                           | 17.10 |  |  |  | 7.6 | 
|$22.50  $24.13      |  |                                     | 243,624   |                  |  | $                           | 22.58 |  |  |  | 7.2 | 
|                     |  |                                     |           |                  |  |                             |       |  |  |  |     | 
|                     |  |                                     | 5,772,834 |                  |  | $                           | 7.86  |  |  |  | 7.9 | 
|                     |  |                                     |           |                  |  |                             |       |  |  |  |     | 

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 2002, 2001 and 2000. Amortization of deferred
compensation recognized in the years ended December 31,
2002, 2001 and 2000 was approximately $54,000, $162,000 and
$163,000, respectively. The weighted average fair value of
options granted during 2002, 2001 and 2000 with an exercise
price equal to the fair value of the Companys common stock
on the date of grant was $2.67, $3.59 and $11.08, 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 3.9%,
4.2%, and 6.2% for the years ended December 31, 2002, 2001
and 2000, respectively; a dividend yield of 0.0%; the annual
volatility factor of the expected market price of the
Companys common stock for 2002, 2001 and 2000 are 87.0%,
87.0%, and 78.0% respectively; and a weighted average expected
option life of four years.



| |                             
| | ----------------------------
| | Employee Stock Purchase Plan

At a Special Meeting of Shareholders held in
February 2002, the number of shares under the Purchase Plan
increased by 500,000 shares to 1,250,000 shares of
common stock. Employees generally will be eligible to
participate in the Purchase Plan if they have been continuously
employed by the Company for at least ten days prior to the first
day of the offering period and are customarily employed at least
20 hours per week and at least five months per calendar
year and are not a 5% or greater stockholder. 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. Employee contributions, through payroll
deductions, are limited to fifteen percent of earnings or
$25,000, whichever is less.

As of December 31, 2002 a total of 1,126,826
shares have been issued under the Purchase Plan, leaving a
balance of 123,174 available authorized shares. Due to the low
number of shares available, employee payroll deductions were
frozen in November 2002, pending shareholder approval of
additional shares under the Purchase Plan.

Under SFAS No. 123, pro forma
compensation cost is reported for the fair value of the
employees purchase rights, which was estimated using the
Black-Scholes model and the following assumptions for

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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

2002; expected volatility of 87.0%; risk-free
interest rates of 3.9%; an average expected life of four years
and a dividend yield of 0.0%. The weighted-average fair value of
the purchase rights granted was $2.70 per share in 2002.

8.     Collaborative
Agreements



| |                 
| | ----------------
| | Novo Nordisk A/S

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

Through December 31, 2002, the Company
received from Novo Nordisk A/S approximately
$99.1 million in product development and milestone payments
and, of this amount, the Company has recognized approximately
$82.3 million as contract revenue. In future periods, the
Company could receive up to $124 million in additional
product development and nonrefundable milestone payments.

In 1998, the Company raised $5.0 million
through the sale of common stock to Novo Nordisk A/S at a
25% premium to the fair market price. In June 2001, the Company
raised an additional $5 million through the sale of common
stock to Novo Nordisk A/S at the fair market price. In
October 2001, the Company entered into a new common stock
purchase agreement with Novo Nordisk Pharmaceuticals. Under the
new agreement, Novo Nordisk Pharmaceuticals committed to
purchase up to $45 million of the Companys common
stock at fair market value specified in the agreement of, which
$20 million was invested initially. The Company has the
right at its option, subject to certain conditions, to sell
between $5 million and $10 million of additional
shares to Novo Nordisk Pharmaceuticals once every three months
beginning December 1, 2001 until the remaining amount of
$25 million has been invested. In July 2002, the Company
raised $5 million through the sale of common stock to Novo
Nordisk Pharmaceuticals under the terms of the agreement. At
December 31, 2002, Novo Nordisk A/S and its affiliates
currently own approximately 20% of the Companys total
outstanding common stock on an as-converted basis. Novo
Nordisk A/S will fund all product development costs
incurred by the Company under the terms of the agreement, while
Novo Nordisk A/S 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 A/Ss sales of the products. For the
years ended December 31, 2002, 2001 and 2000, the Company
recognized contract revenues of $26.9 million,
$26.0 million and $15.4 million, respectively.



| |                
| | ---------------
| | GlaxoSmithKline

The Company executed a development and
commercialization agreement with GlaxoSmithKline in September
1997. The agreement covered the use of the AERx Pain Management
System for the delivery of narcotic analgesics and the companies
intended to collaborate on the development of the products
within this field. Under the terms of the agreement,
GlaxoSmithKline was granted exclusive worldwide sales and
marketing rights to the AERx Pain Management System for use with
such analgesics, and the Company retained all manufacturing
rights. If the system received regulatory approval, the Company
intended to sell devices and drug packets to GlaxoSmithKline and
would receive royalties on developed product sold by
GlaxoSmithKline.

During December 2000, the Company and
GlaxoSmithKline amended the product development and
commercialization agreement whereby the Company assumed full
control and responsibility for conducting

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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

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

Through December 31, 2001, the Company had
received from GlaxoSmithKline and recognized as contract revenue
approximately $23.7 million in product development and
milestone payments. No product development and milestone
payments were received during 2002. In 1997, the Company raised
$5 million through the sale of common stock to
GlaxoSmithKline at a 25% premium to the fair market price. In
January 2001, the Company raised an additional $5 million
through the sale of common stock to GlaxoSmithKline at the fair
market price. For the years ended December 31, 2002, 2001
and 2000, the Company recognized contract revenue of zero
dollars, $1.5 million and $3.4 million, respectively.



| |          
| | ---------
| | Genentech

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

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

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

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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

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

|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|-------------------------------------------- |  | ------------ | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                             |  |             
|                                             |  | December 31,
|                                             |  |             
|                                             |  | 2002         |        | 2001 |  | 2000
|                                             |  |              |        |      |  |     
|Deferred revenue  beginning balance         |  | $            | 13,442 |      |  | $    | 8,654  |   |  | $ | 11,024 |  
|Partner payments:                            |  |              |        |      |  |      |        |   |  |   |        |  
|Novo Nordisk A/ S                            |  |              | 30,794 |      |  |      | 32,054 |   |  |   | 13,879 |  
|GlaxoSmithKline                              |  |              |       |      |  |      |       |   |  |   | 2,617  |  
|Other partner-funded programs                |  |              | 1,583  |      |  |      | 1,650  |   |  |   | 1,437  |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Total partner payments                       |  |              | 32,377 |      |  |      | 33,704 |   |  |   | 17,933 |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Contract revenue recognized:                 |  |              |        |      |  |      |        |   |  |   |        |  
|Novo Nordisk A/S                             |  |              | 26,864 |      |  |      | 26,030 |   |  |   | 15,411 |  
|GlaxoSmithKline                              |  |              |       |      |  |      | 1,524  |   |  |   | 3,379  |  
|Other partner-funded programs                |  |              | 2,103  |      |  |      | 1,362  |   |  |   | 1,513  |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Total contract revenue recognized            |  |              | 28,967 |      |  |      | 28,916 |   |  |   | 20,303 |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Deferred revenue  ending balance            |  |              | 16,852 |      |  |      | 13,442 |   |  |   | 8,654  |  
|Less: Noncurrent portion of deferred revenue |  |              | (6,170 | )    |  |      | (2,327 | ) |  |   | (2,032 | )
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Current portion of deferred revenue          |  | $            | 10,682 |      |  | $    | 11,115 |   |  | $ | 6,622  |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  

9.     Related Party
Transactions

Novo Nordisk A/S and its affiliate, Novo Nordisk
Pharmaceuticals, Inc., are considered related parties and at
December 31, 2002 own approximately 20% of the
Companys total outstanding common stock (on an
as-converted basis).

Development
and License Agreement

In June 1998, the Company executed a development
and commercialization agreement with Novo Nordisk A/S to jointly
develop a pulmonary delivery system for administering insulin by
inhalation. Under the terms of the agreement, Novo Nordisk A/S
has been granted exclusive rights to worldwide sales and
marketing rights for any products developed under the terms of
the agreement. Through December 31, 2002, the Company
received from Novo Nordisk A/S approximately $99.1 million
in product development and milestone payments and, of this
amount, the Company has recognized approximately
$82.3 million as contract revenue. In future periods, the
Company could receive up to $124 million in additional
product development and nonrefundable milestone payments. Novo
Nordisk A/S will fund all product development costs incurred by
the Company under the terms of the agreement, while Novo Nordisk
A/S 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 A/Ss
sales of the products. For the years ended December 31,
2002, 2001 and 2000, the Company recognized contract revenues of
$26.9 million, $26.0 million and $15.4 million,
respectively. Receivable due to the Company from Novo Nordisk
A/S was $0 and $631,000 at December 31, 2002 and 2001,
respectively.

59



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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

Securities
Purchase Agreements

Since the inception of the collaboration in June
1998 through December 31, 2002, the Company raised
$10 million through the sale of common stock to Novo
Nordisk A/S. In October 2001, the Company entered into a
new common stock purchase agreement with Novo Nordisk
Pharmaceuticals. Under the new agreement, Novo Nordisk
Pharmaceuticals has committed to purchase up to $45 million
of the Companys common stock, at fair market value
specified in the agreement of which $20 million was
invested initially. The Company has the right at its option,
subject to certain conditions, to sell between $5 million
and $10 million of additional shares to Novo Nordisk
Pharmaceuticals once every three months beginning
December 1, 2001 until the remaining amount of
$25 million has been invested. In July 2002, the Company
raised $5 million through the sale of common stock to Novo
Nordisk Pharmaceuticals under the terms of the agreement.

10.     Income
Taxes

There is no provision for income taxes because
the Company has incurred operating losses. Deferred income taxes
reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial
reporting and the amounts used for tax purposes.

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

|                                     |  |              |         |      |  |   |         |  
|------------------------------------ |  | ------------ | ------- | ---- |  | - | ------- | -
|                                     |  |             
|                                     |  | December 31,
|                                     |  |             
|                                     |  | 2002         |         | 2001
|                                     |  |              |         |     
|Net operating loss carryforward      |  | $            | 54,900  |      |  | $ | 48,000  |  
|Deferred revenue                     |  |              | 6,700   |      |  |   | 4,400   |  
|Research and development credits     |  |              | 9,200   |      |  |   | 6,500   |  
|Capitalized research and development |  |              | 2,000   |      |  |   |        |  
|Other                                |  |              | 1,200   |      |  |   | 700     |  
|                                     |  |              |         |      |  |   |         |  
|Total deferred tax assets            |  |              | 74,000  |      |  |   | 59,600  |  
|Valuation allowance                  |  |              | (74,000 | )    |  |   | (59,600 | )
|                                     |  |              |         |      |  |   |         |  
|Net deferred tax assets              |  | $            |        |      |  | $ |        |  
|                                     |  |              |         |      |  |   |         |  

Realization of deferred tax assets is dependent
upon future earnings, if any, the timing and amount of which are
uncertain. Accordingly, the net deferred tax assets have been
fully offset by a valuation allowance. The valuation allowance
increased by $14,400,000 and $12,939,000 during 2002 and 2001,
respectively.

Deferred tax assets related to carryforwards at
December 31, 2002 include approximately $1,600,000
associated with stock option activity for which any subsequently
recognized tax benefits will be credited directly to
stockholders equity.

As of December 31, 2002, the Company had net
operating loss carryforwards for federal income tax purposes of
approximately $151,000,000 which expire in the years 2006
through 2022, and federal research and development tax credits
of approximately $6,000,000, which expire in the years 2006
through 2022. As of December 31, 2002, the Company had net
operating loss carryforwards for state income tax purposes of
approximately $59,000,000 which expire in the years 2004 through
2013 and state research and development tax credits of
approximately $4,700,000 which do not expire.

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.

60



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ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

11.     Quarterly
Results of Operations (Unaudited)

Following is a summary of the quarterly results
of operations for the years ended December 31, 2002 and
2001 (amounts in thousands):

|                                                                        |                                                                                                 |           |        |          |   |               |         |              |   |   |         |        |   |   |        |        |  
|----------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------- | --------- | ------ | -------- | - | ------------- | ------- | ------------ | - | - | ------- | ------ | - | - | ------ | ------ | -
|                                                                        |                                                                                                 | March 31, |        | June 30, |   | September 30, |         | December 31,
|                                                                        |                                                                                                 | 2002      |        | 2002     |   | 2002          |         | 2002        
|                                                                        |                                                                                                 |           |        |          |   |               |         |             
|Contract and license revenues                                           |                                                                                                 | $         | 8,118  |          |   | $             | 7,295   |              |   | $ | 5,951   |        |   | $ | 7,603  |       
|                                                                        |                                                                                                 |           |        |          |   |               |         |              |   |   |         |        |   |   |        |       
|Operating expenses:                                                     |                                                                                                 |           |        |          |   |               |         |              |   |   |         |        |   |   |        |       
|                                                                        | Research and development                                                                        |           |        | 14,313   |   |               |         | 14,588       |   |   |         | 13,660 |   |   |        | 12,119 |  
|                                                                        | General and administrative                                                                      |           |        | 2,458    |   |               |         | 2,809        |   |   |         | 2,636  |   |   |        | 2,491  |  
|                                                                        |                                                                                                 |           |        |          |   |               |         |              |   |   |         |        |   |   |        |       
|                                                                        | Total expenses                                                                                  |           |        | 16,771   |   |               |         | 17,397       |   |   |         | 16,296 |   |   |        | 14,610 |  
|                                                                        |                                                                                                 |           |        |          |   |               |         |              |   |   |         |        |   |   |        |       
|Loss from operations                                                    |                                                                                                 |           | (8,653 | )        |   |               | (10,102 | )            |   |   | (10,345 | )      |   |   | (7,007 | )     
|Interest income                                                         |                                                                                                 |           | 291    |          |   |               | 210     |              |   |   | 164     |        |   |   | 154    |       
|Interest expense and other                                              |                                                                                                 |           | (166   | )        |   |               | (84     | )            |   |   | (100    | )      |   |   | (293   | )     
|                                                                        |                                                                                                 |           |        |          |   |               |         |              |   |   |         |        |   |   |        |       
|Net loss                                                                |                                                                                                 | $         | (8,528 | )        |   | $             | (9,976  | )            |   | $ | (10,281 | )      |   | $ | (7,146 | )     
|                                                                        |                                                                                                 |           |        |          |   |               |         |              |   |   |         |        |   |   |        |       
|Basic and diluted loss per share applicable to
    common shareholders: |                                                                                                 |           |        |          |   |               |         |              |   |   |         |        |   |   |        |       
|                                                                        | Net loss                                                                                        |           | $      | (0.29    | ) |               | $       | (0.34        | ) |   | $       | (0.34  | ) |   | $      | (0.23  | )
|                                                                        |                                                                                                 |           |        |          |   |               |         |              |   |   |         |        |   |   |        |       
|                                                                        | Shares used in computing basic and diluted loss
    per share applicable to common shareholders |           |        | 29,544   |   |               |         | 29,723       |   |   |         | 30,597 |   |   |        | 31,158 |  
|                                                                        |                                                                                                 |           |        |          |   |               |         |              |   |   |         |        |   |   |        |       

|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |        |  
|----------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------- | --------- | ------ | -------- | - | ------------- | ------ | ------------ | - | - | ------- | ------ | - | - | ------- | ------ | -
|                                                                        |                                                                                                 | March 31, |        | June 30, |   | September 30, |        | December 31,
|                                                                        |                                                                                                 | 2001      |        | 2001     |   | 2001          |        | 2001        
|                                                                        |                                                                                                 |           |        |          |   |               |        |             
|Contract and license revenues                                           |                                                                                                 | $         | 6,687  |          |   | $             | 8,520  |              |   | $ | 6,889   |        |   | $ | 6,820   |       
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |       
|Operating expenses:                                                     |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |       
|                                                                        | Research and development                                                                        |           |        | 14,160   |   |               |        | 15,298       |   |   |         | 14,890 |   |   |         | 14,488 |  
|                                                                        | General and administrative                                                                      |           |        | 2,328    |   |               |        | 2,322        |   |   |         | 2,233  |   |   |         | 2,472  |  
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |       
|                                                                        | Total expenses                                                                                  |           |        | 16,488   |   |               |        | 17,620       |   |   |         | 17,123 |   |   |         | 16,960 |  
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |       
|Loss from operations                                                    |                                                                                                 |           | (9,801 | )        |   |               | (9,100 | )            |   |   | (10,234 | )      |   |   | (10,140 | )     
|Interest income                                                         |                                                                                                 |           | 668    |          |   |               | 299    |              |   |   | 167     |        |   |   | 190     |       
|Other income(1)                                                         |                                                                                                 |           | 6,675  |          |   |               |       |              |   |   |        |        |   |   |        |       
|Interest expense and other                                              |                                                                                                 |           | (262   | )        |   |               | (364   | )            |   |   | (216    | )      |   |   | (239    | )     
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |       
|Net loss                                                                |                                                                                                 |           | (2,720 | )        |   |               | (9,165 | )            |   |   | (10,283 | )      |   |   | (10,189 | )     
|Deemed dividend                                                         |                                                                                                 |           |       |          |   |               |       |              |   |   |        |        |   |   | (10,722 | )     
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |       
|Net loss applicable to common stockholders                              |                                                                                                 | $         | (2,720 | )        |   | $             | (9,165 | )            |   | $ | (10,283 | )      |   | $ | (20,911 | )     
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |       
|Basic and diluted loss per share applicable to
    common shareholders: |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |       
|                                                                        | Net loss applicable to common shareholders                                                      |           | $      | (0.14    | ) |               | $      | (0.47        | ) |   | $       | (0.48  | ) |   | $       | (0.77  | )
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |       
|                                                                        | Shares used in computing basic and diluted loss
    per share applicable to common shareholders |           |        | 18,838   |   |               |        | 19,338       |   |   |         | 21,581 |   |   |         | 27,319 |  
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |         |        |   |   |         |       



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Other income consists of the gain related to
    forgiveness of outstanding notes and interests by Genentech,
    previously classified as an extraordinary item. The Company
    early adopted Statement of Financial Accounting Standard
    (SFAS) 145, Rescission of FASB Statements
    No. 4, 44 and 64, Amendment of FASB 13 and Technical
    Corrections, which requires the reclassification of this
    type of extraordinary item as a component of operating results.

61



---



##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL
STATEMENTS  (Continued)

12.     Subsequent
Events (unaudited)



| |                                     
| | ------------------------------------
| | Sales of Unregistered
    Securities

As of February 10, 2003, the Company issued
18,992,391 shares of common stock at $0.79 per share
and warrants to purchase 4,273,272 shares of the common
stock at $1.07 per share to certain investors for an
aggregate purchase price of approximately $15.0 million in
a private placement. The warrants are exercisable at the
election of the warrant holders for a four-year term. In
addition, in connection with this private placement, the Company
has issued to certain of the investors in the private placement
warrants to purchase an aggregate of 4,016,024 shares of
its common stock at $1.12 per share in exchange for the
cancellation of an equal number of warrants to purchase the
common stock at $6.97 per share, held by the same
investors. These securities have not been registered under the
Securities Act of 1933, as amended, by virtue of
Regulation D promulgated under such Act.

62



---



##### Table of Contents






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 15, 2003, to be filed by the Company with the
Securities and Exchange Commission (the Proxy
Statement).

Identification of Executive Officers

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

Section 16(a) Compliance

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




Item 11.     Executive
Compensation

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




Item 12.     Security
Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters

The information required by this Item is
incorporated by reference from the section captioned
Security Ownership of Certain Beneficial Owners and
Management and Equity Compensation Plan
Information 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.




Item 14.     Control
Procedures

(a) Evaluation of disclosure controls and
procedures: Our chief executive officer and chief financial
officer evaluated the effectiveness of our disclosure controls
and procedures (as defined in Rule 13a-14)(c) and
15(d)-14(c) under the Securities Exchange Act of 1934, as
amended) within 90 days of filing of this Form 10-K
(the Evaluation Date) and, based on that evaluation,
concluded that, as of the Evaluation Date, our disclosure
controls and procedures are effective to timely alert management
to material information relating to Aradigm Corporation during
the period when our periodic reports are being prepared.

(b) Changes in internal controls:
There were no significant changes in the Companys internal
controls or other factors that could significantly affect those
controls subsequent to the date of the Companys
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.

63



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##### Table of Contents






PART IV




Item 15.     Exhibits,
Financial Statements Schedules, and Reports on
Form 8-K

(a)(1) Financial Statements.

Included in Part II of this Report:

|                                                                                                                                     |  |           |    | 
|------------------------------------------------------------------------------------------------------------------------------------ |  | --------- | -- | 
|                                                                                                                                     |  | Page in  
|                                                                                                                                     |  | Form 10-K
|                                                                                                                                     |  |          
|Report of Ernst & Young LLP, Independent
    Auditors                                                                                |  |           | 38 | 
|Balance Sheets  December 31, 2002
    and 2001                                                                                      |  |           | 39 | 
|Statements of Operations  Years ended
    December 31, 2002, 2001 and 2000                                                          |  |           | 40 | 
|Statements of Redeemable Convertible Preferred
    Stock and Shareholders Equity  Years ended
    December 31, 2002, 2001 and 2000 |  |           | 41 | 
|Statements of Cash Flows  Years ended
    December 31, 2002, 2001 and 2000                                                          |  |           | 42 | 
|Notes to Financial Statements                                                                                                        |  |           | 43 | 

(2) Financial Statement
Schedules.

None.

(3) Exhibits.

|            |             |             |  |                                                                                                                                                                                     
|----------- | ----------- | ----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |             | Description
|            |             |            
|            | 3.1(1)      |             |  | Amended and Restated Articles of Incorporation of
    the Company.                                                                                                                  
|            | 3.2(5)      |             |  | Bylaws of the Company, as amended.                                                                                                                                                  
|            | 3.3(15)     |             |  | Certificate of Determination of Series A
    Junior Participating Preferred Stock.                                                                                                  
|            | 3.4(14)     |             |  | Certificate of Determination and Preferences of
    Series A Convertible Preferred Stock.                                                                                           
|            | 3.5(15)     |             |  | Certificate of Amendment of Amended and Restated
    Articles of Incorporation of the Company.                                                                                      
|            | 3.6(15)     |             |  | Certificate of Amendment of Certificate of
    Determination of Series A Junior Participating Preferred
    Stock.                                                                  
|            | 4.1         |             |  | Reference is made to Exhibits 3.1, 3.2, 3.3,
    3.4, 3.5 and 3.6.                                                                                                                  
|            | 4.2(1)      |             |  | Specimen common stock certificate.                                                                                                                                                  
|            | 10.1(1)(2)  |             |  | Form of Indemnity Agreement between the
    Registrant and each of its directors and officers.                                                                                      
|            | 10.2(2)(11) |             |  | Equity Incentive Plan, as amended (the
    Equity Incentive Plan).                                                                                                                
|            | 10.3(1)(2)  |             |  | Form of the Companys Incentive Stock Option
    Agreement under the Equity Incentive Plan.                                                                                         
|            | 10.4(1)(2)  |             |  | Form of the Companys Non-statutory Stock
    Option Agreement under the Equity Incentive Plan.                                                                                     
|            | 10.5(1)(2)  |             |  | Form of the Companys Non-Employee
    Directors Stock Option Plan.                                                                                                                
|            | 10.6(1)(2)  |             |  | Form of the Companys Non-statutory Stock
    Option Agreement under the Non-Employee Directors Stock
    Option Plan.                                                             
|            | 10.7(2)(16) |             |  | Employee Stock Purchase Plan, as amended.                                                                                                                                           
|            | 10.8(1)(2)  |             |  | Form of the Companys Employee Stock
    Purchase Plan Offering Document.                                                                                                           
|            | 10.9(1)     |             |  | Master Lease Agreement and Warrant, between the
    Company and Comdisco, Inc., dated June 9, 1995.                                                                                 
|            | 10.11(4)*   |             |  | Product Development and Commercialization
    Agreement between the Company and SmithKline Beecham PLC.                                                                             
|            | 10.11(3)    |             |  | Lease Agreement for the property located at 3911
    Trust Way, Hayward, California, dated March 17, 1997,
    between the Company and Hayward Point Eden I Limited
    Partnership.

64



---



##### Table of Contents



|            |            |             |  |                                                                                                                                                                                                             
|----------- | ---------- | ----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |            | Description
|            |            |            
|            | 10.11a(3)  |             |  | First Amendment to Lease dated December 22,
    1997, between the Company and Hayward Point Eden I Limited
    Partnership.                                                                                 
|            | 10.11b(3)  |             |  | Second Amendment to Lease, dated January 28,
    1998, between the Company and Hayward Point Eden I Limited
    Partnership.                                                                                
|            | 10.12(3)   |             |  | Lease Agreement for the property located in
    Phase V of the Britannia Point Eden Business Park in
    Hayward, California, dated January 28, 1998, between the
    Company and Britannia Point Eden, LLC.
|            | 10.13(5)   |             |  | Common Stock Purchase Agreement dated
    April 3, 1998, between the Company and the purchasers named
    therein.                                                                                          
|            | 10.14(5)*  |             |  | Development and License Agreement, dated
    June 2, 1998, between the Company and Novo Nordisk A/S.                                                                                                        
|            | 10.15(6)   |             |  | Rights Agreement, dated as of August 31,
    1998, between the Company and Bank Boston, N.A.                                                                                                                
|            | 10.15a(15) |             |  | Amendment to Rights Agreement, dated as of
    October 22, 2001, by and between the Company and Fleet
    National Bank.                                                                                    
|            | 10.15b(15) |             |  | Amendment to Rights Agreement, dated as of
    December 6, 2001, by and between the Company and EquiServe
    Trust Company.                                                                                
|            | 10.16(7)   |             |  | Common Stock Purchase Agreement dated
    January 27, 1999, between the Company and the purchasers
    named therein.                                                                                       
|            | 10.17(8)   |             |  | Lease Agreement for the property located at 2704
    West Winton Avenue, Hayward, California, dated
    September 11, 2000, between the Company and Winton
    Industrial Center, Inc.                      
|            | 10.17a(12) |             |  | Amendment No. 1 to Standard Office/
    Warehouse Lease, dated March 1, 2001, by and between the
    Company and Winton Industrial Center, Inc.                                                             
|            | 10.18(8)   |             |  | Lease Agreement for the property located at 3930
    Point Eden Way, Hayward, California, dated July 1, 2000,
    between the Company and Hayward Point Eden I Limited Partnership.                         
|            | 10.19(9)   |             |  | Common Stock Purchase Agreement, dated as of
    November 3, 2000, by and between the Company and Acqua
    Wellington North American Equities Fund, Ltd.                                                   
|            | 10.20(10)* |             |  | Amendment to GlaxoSmithKline agreement executed
    in December 2000.                                                                                                                                       
|            | 10.21(13)  |             |  | Securities Purchase Agreement, dated as of
    August 21, 2001, by and among the Company and the
    purchasers named therein.                                                                              
|            | 10.22(15)  |             |  | Stock Purchase Agreement, dated as of
    October 22, 2001, by and between the Company and Novo
    Nordisk Pharmaceuticals, Inc.                                                                           
|            | 10.23*(15) |             |  | First Amendment to Development and License
    Agreement, dated as of October 22, 2001, between the
    Company and Novo Nordisk A/S.                                                                       
|            | 10.24(14)  |             |  | Securities Purchase Agreement, dated as of
    December 11, 2001, by and among the Company and the
    purchasers named therein.                                                                            
|            | 23.1       |             |  | Consent of Ernst & Young LLP,
    Independent Auditors.                                                                                                                                                     
|            | 24.1       |             |  | Power of Attorney. Reference is made to the
    signature page.                                                                                                                                             
|            | 99.1       |             |  | Certifications of Chief Executive Officer and
    Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
    as adopted pursuant to Section 906 of the Sarbanes-Oxley
    Act of 2002.                 



---



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



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

65



---



##### Table of Contents





| |     |                                                                                                                                            
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------
| | (5) | Incorporated by reference to the Companys
    Form 10-Q filed on August 14, 1998.                                                         
|
| | (6) | Incorporated by reference to the Companys
    8-K filed on September 2, 1998.                                                             
|
| | (7) | Incorporated by reference to the indicated
    exhibit in the Companys Registration Statement on
    Form S-3 (No. 333-72037), as amended.
|
| | (8) | Incorporated by reference to the Companys
    Form 10-Q filed on November 13, 2000.                                                       
|
| | (9) | Incorporated by reference to the Companys
    Form 8-K filed on December 11, 2000.                                                        



|     |                                                                                                     
|---- | ----------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the Companys
    Form 10-K filed for the year ended December 31, 2000.
|    
|(11) | Incorporated by reference to the Companys
    definitive proxy statement filed on April 11, 2001.  
|    
|(12) | Incorporated by reference to the Companys
    Form 10-Q filed on August 13, 2001.                  
|    
|(13) | Incorporated by reference to the Companys
    Form S-3 (No. 333-69614), as amended.                
|    
|(14) | Incorporated by reference to the Companys
    Form S-3 (No. 333-76584).                            
|    
|(15) | Incorporated by reference to the Companys
    Form 10-K filed for the year ended December 31, 2001.
|    
|(16) | Incorporated by reference to the Companys
    definitive proxy statement filed on January 4, 2002. 

(b) Reports on Form 8-K.

None.

(c) Index to Exhibits.

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

(d) Financial Statement
Schedules.

66



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the Registrant
has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Hayward,
State of California, on the 19th day of March 2003.



| |                    
| | -------------------
| | 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 Thomas C.
Chesterman, and each one of them, attorneys-in-fact for the
undersigned, each with power of substitution, for the
undersigned in any and all capacities, to sign any and all
amendments to this Report on Form 10-K, and to file the
same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby
ratifying and confirming all that each of said
attorneys-in-fact, or their substitutes, may do or cause to be
done by virtue hereof.

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

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

|                                             |  |                                                                                         |  |                |  | 
|-------------------------------------------- |  | --------------------------------------------------------------------------------------- |  | -------------- |  | 
|                                             |  |                                                                                         |  |               
|Signature                                    |  | Title                                                                                   |  | Date          
|                                             |  |                                                                                         |  |               
|                                            
|/s/ RICHARD P. THOMPSONRichard P. Thompson   |  | President, Chief Executive
    Officer and Director
    (Principal Executive Officer)   |  | March 19, 2003
|                                            
|/s/ THOMAS C. CHESTERMANThomas C. Chesterman |  | Sr. VP and Chief Financial Officer
    (Principal Financial and
    Accounting Officer) |  | March 19, 2003
|                                            
|/s/ FRANK H. BARKERFrank H. Barker           |  | Director                                                                                |  | March 19, 2003
|                                            
|/s/ STAN M. BENSONStan Benson                |  | Director                                                                                |  | March 19, 2003
|                                            
|/s/ IGOR GONDAIgor Gonda                     |  | Director                                                                                |  | March 19, 2003
|                                            
|/s/ JOHN M. NEHRAJohn M. Nehra               |  | Director                                                                                |  | March 19, 2003
|                                            
|/s/ WAYNE L. ROEWayne L. Roe                 |  | Director                                                                                |  | March 19, 2003
|                                            
|/s/ VIRGIL D. THOMPSONVirgil D. Thompson     |  | Director                                                                                |  | March 19, 2003

67



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##### Table of Contents



CERTIFICATION

I, Richard P. Thompson, certify that:

1.     I have reviewed
this annual report on Form 10-K of Aradigm Corporation;

2.     Based on my
knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this annual
report;

3.     Based on my
knowledge, the financial statements, and other financial
information included in this annual report, fairly present in
all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this annual report;

4.     The
registrants other certifying officers and I are
responsible for establishing and maintaining disclosure controls
and procedures (as defined in Exchange Act Rules 13a-14 and
15d-14) for the registrant and have:



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                

5.     The
registrants other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrants auditors and the audit committee of
registrants board of directors (or persons performing the
equivalent functions):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6.     The
registrants other certifying officers and I have indicated
in this annual report whether there were significant changes in
internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most
recent evaluation, including any corrective actions with regard
to significant deficiencies and material weaknesses.



| |                                          
| | -----------------------------------------
| | /s/ RICHARD P. THOMPSON                  
| |                                          
| | Richard P. Thompson                      
| | President and Chief Executive
    Officer

Date: March 19, 2003

68



---



##### Table of Contents



CERTIFICATION

I, Thomas C. Chesterman, certify that:

1.     I have reviewed
this annual report on Form 10-K of Aradigm Corporation;

2.     Based on my
knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this annual
report;

3.     Based on my
knowledge, the financial statements, and other financial
information included in this annual report, fairly present in
all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this annual report;

4.     The
registrants other certifying officers and I are
responsible for establishing and maintaining disclosure controls
and procedures (as defined in Exchange Act Rules 13a-14 and
15d-14) for the registrant and have:



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                

5.     The
registrants other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrants auditors and the audit committee of
registrants board of directors (or persons performing the
equivalent functions):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | d) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | e) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6.     The
registrants other certifying officers and I have indicated
in this annual report whether there were significant changes in
internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most
recent evaluation, including any corrective actions with regard
to significant deficiencies and material weaknesses.



| |                                                      
| | -----------------------------------------------------
| | /s/ THOMAS C. CHESTERMAN                             
| |                                                      
| | Thomas C. Chesterman                                 
| | Senior Vice President and Chief Financial
    Officer

Date: March 19, 2003

69



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##### Table of Contents






EXHIBIT INDEX

|            |             |             |  |                                                                                                                                                                                                             
|----------- | ----------- | ----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |             | Description
|            |             |            
|            | 3.1(1)      |             |  | Amended and Restated Articles of Incorporation of
    the Company.                                                                                                                                          
|            | 3.2(5)      |             |  | Bylaws of the Company, as amended.                                                                                                                                                                          
|            | 3.3(15)     |             |  | Certificate of Determination of Series A
    Junior Participating Preferred Stock.                                                                                                                          
|            | 3.4(14)     |             |  | Certificate of Determination and Preferences of
    Series A Convertible Preferred Stock.                                                                                                                   
|            | 3.5(15)     |             |  | Certificate of Amendment of Amended and Restated
    Articles of Incorporation of the Company.                                                                                                              
|            | 3.6(15)     |             |  | Certificate of Amendment of Certificate of
    Determination of Series A Junior Participating Preferred
    Stock.                                                                                          
|            | 4.1         |             |  | Reference is made to Exhibits 3.1, 3.2, 3.3,
    3.4, 3.5 and 3.6.                                                                                                                                          
|            | 4.2(1)      |             |  | Specimen common stock certificate.                                                                                                                                                                          
|            | 10.1(1)(2)  |             |  | Form of Indemnity Agreement between the
    Registrant and each of its directors and officers.                                                                                                              
|            | 10.2(2)(11) |             |  | Equity Incentive Plan, as amended (the
    Equity Incentive Plan).                                                                                                                                        
|            | 10.3(1)(2)  |             |  | Form of the Companys Incentive Stock Option
    Agreement under the Equity Incentive Plan.                                                                                                                 
|            | 10.4(1)(2)  |             |  | Form of the Companys Non-statutory Stock
    Option Agreement under the Equity Incentive Plan.                                                                                                             
|            | 10.5(1)(2)  |             |  | Form of the Companys Non-Employee
    Directors Stock Option Plan.                                                                                                                                        
|            | 10.6(1)(2)  |             |  | Form of the Companys Non-statutory Stock
    Option Agreement under the Non-Employee Directors Stock
    Option Plan.                                                                                     
|            | 10.7(2)(16) |             |  | Employee Stock Purchase Plan, as amended.                                                                                                                                                                   
|            | 10.8(1)(2)  |             |  | Form of the Companys Employee Stock
    Purchase Plan Offering Document.                                                                                                                                   
|            | 10.9(1)     |             |  | Master Lease Agreement and Warrant, between the
    Company and Comdisco, Inc., dated June 9, 1995.                                                                                                         
|            | 10.11(4)*   |             |  | Product Development and Commercialization
    Agreement between the Company and SmithKline Beecham PLC.                                                                                                     
|            | 10.11(3)    |             |  | Lease Agreement for the property located at 3911
    Trust Way, Hayward, California, dated March 17, 1997,
    between the Company and Hayward Point Eden I Limited Partnership.                            
|            | 10.11a(3)   |             |  | First Amendment to Lease dated December 22,
    1997, between the Company and Hayward Point Eden I Limited
    Partnership.                                                                                 
|            | 10.11b(3)   |             |  | Second Amendment to Lease, dated January 28,
    1998, between the Company and Hayward Point Eden I Limited
    Partnership.                                                                                
|            | 10.12(3)    |             |  | Lease Agreement for the property located in
    Phase V of the Britannia Point Eden Business Park in
    Hayward, California, dated January 28, 1998, between the
    Company and Britannia Point Eden, LLC.
|            | 10.13(5)    |             |  | Common Stock Purchase Agreement dated
    April 3, 1998, between the Company and the purchasers named
    therein.                                                                                          
|            | 10.14(5)*   |             |  | Development and License Agreement, dated
    June 2, 1998, between the Company and Novo Nordisk A/S.                                                                                                        
|            | 10.15(6)    |             |  | Rights Agreement, dated as of August 31,
    1998, between the Company and Bank Boston, N.A.                                                                                                                
|            | 10.15a(15)  |             |  | Amendment to Rights Agreement, dated as of
    October 22, 2001, by and between the Company and Fleet
    National Bank.                                                                                    
|            | 10.15b(15)  |             |  | Amendment to Rights Agreement, dated as of
    December 6, 2001, by and between the Company and EquiServe
    Trust Company.                                                                                
|            | 10.16(7)    |             |  | Common Stock Purchase Agreement dated
    January 27, 1999, between the Company and the purchasers
    named therein.                                                                                       
|            | 10.17(8)    |             |  | Lease Agreement for the property located at 2704
    West Winton Avenue, Hayward, California, dated
    September 11, 2000, between the Company and Winton
    Industrial Center, Inc.                      



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##### Table of Contents



|            |            |             |  |                                                                                                                                                                                            
|----------- | ---------- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |            | Description
|            |            |            
|            | 10.17a(12) |             |  | Amendment No. 1 to Standard Office/Warehouse
    Lease, dated March 1, 2001, by and between the Company and
    Winton Industrial Center, Inc.                                             
|            | 10.18(8)   |             |  | Lease Agreement for the property located at 3930
    Point Eden Way, Hayward, California, dated July 1, 2000,
    between the Company and Hayward Point Eden I Limited
    Partnership.    
|            | 10.19(9)   |             |  | Common Stock Purchase Agreement, dated as of
    November 3, 2000, by and between the Company and Acqua
    Wellington North American Equities Fund, Ltd.                                  
|            | 10.20(10)* |             |  | Amendment to GlaxoSmithKline agreement executed
    in December 2000.                                                                                                                      
|            | 10.21(13)  |             |  | Securities Purchase Agreement, dated as of
    August 21, 2001, by and among the Company and the
    purchasers named therein.                                                             
|            | 10.22(15)  |             |  | Stock Purchase Agreement, dated as of
    October 22, 2001, by and between the Company and Novo
    Nordisk Pharmaceuticals, Inc.                                                          
|            | 10.23*(15) |             |  | First Amendment to Development and License
    Agreement, dated as of October 22, 2001, between the
    Company and Novo Nordisk A/ S.                                                     
|            | 10.24(14)  |             |  | Securities Purchase Agreement, dated as of
    December 11, 2001, by and among the Company and the
    purchasers named therein.                                                           
|            | 23.1       |             |  | Consent of Ernst & Young LLP,
    Independent Auditors.                                                                                                                                    
|            | 24.1       |             |  | Power of Attorney. Reference is made to the
    signature page.                                                                                                                            
|            | 99.1       |             |  | Certifications of Chief Executive Officer and
    Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
    as adopted pursuant to Section 906 of the Sarbanes-Oxley
    Act of 2002.



---



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



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



|     |                                                                                                     
|---- | ----------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the Companys
    Form 10-K filed for the year ended December 31, 2000.
|    
|(11) | Incorporated by reference to the Companys
    definitive proxy statement filed on April 11, 2001.  
|    
|(12) | Incorporated by reference to the Companys
    Form 10-Q filed on August 13, 2001.                  
|    
|(13) | Incorporated by reference to the Companys
    Form S-3 (No. 333-69614), as amended.                
|    
|(14) | Incorporated by reference to the Companys
    Form S-3 (No. 333-76584).                            
|    
|(15) | Incorporated by reference to the Companys
    Form 10-K filed for the year ended December 31, 2001.
|    
|(16) | Incorporated by reference to the Companys
    definitive proxy statement filed on January 4, 2002.