<PAGE>   1


                                  United States
                       Securities and Exchange Commission
                              Washington D.C. 20549

                                    FORM 10-K

[X]  Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
     Act of 1934 (Fee Required) For the Fiscal Year Ended December 31, 1998

                                       or

[ ]  Transition Report Pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934 (Fee Not Required) For the Transition Period From
     _________ to __________.

                         Commission File Number: 0-28402

                               ARADIGM CORPORATION

California                                                       94-3133088 
(State or other jurisdiction of                               (I.R.S. Employer
incorporation or organization)                               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

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

                                 Yes [X] No [ ]

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

  
      As of March 5, 1999, there were 12,171,584 shares of common stock
outstanding. The aggregate market value of voting stock held by non-affiliates
of the Registrant was approximately $22,325,919 based upon the closing price of
the common stock on MARCH 5, 1999 on The Nasdaq Stock Market. Shares of common
stock held by each officer, director and holder of five percent or more of the
outstanding common stock have been excluded in that such persons may be deemed
to be affiliates. This determination of affiliate status is not necessarily a
conclusive determination for other purposes.



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                       DOCUMENTS INCORPORATED BY REFERENCE


      Portions of the Proxy Statement of the Registrant for the 1999 Annual
Meeting of Shareholders to be filed with the Securities and Exchange Commission
not later than 120 days after the close of the Registrant's fiscal year are
incorporated into Part III of this Form 10-K.




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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 the Company's products
and the timing of the Company's 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 is engaged in the development of novel pulmonary drug delivery
systems designed to enhance the delivery and effectiveness of a number of
existing development-stage drugs and reduce the need for injectable drug
delivery. Aradigm's principal product development programs are based on its
AERx(TM) Pulmonary Drug Delivery System, which uses proprietary technologies to
create aerosols from liquid drug formulations for delivery locally to the lung
or systemically via the lung. The Company believes that its systems can
potentially be used to deliver a number of existing drugs for a variety of
applications and may also offer a promising means of delivery for many new drugs
being developed by pharmaceutical and biotechnology companies.

    The Company's lead AERx product under development is the AERx Pain
Management System, which is designed to deliver narcotic analgesics systemically
by inhalation for the treatment of chronic and acute pain. This system is being
developed in collaboration with SmithKline Beecham under an agreement entered
into in September 1997. The Company has completed two Phase I clinical trials
and commenced Phase II clinical trials of the AERx Pain Management System in
March 1998. There can be no assurance that these clinical trials will be
successful. The Company also has established a second major collaboration with
Novo Nordisk A/S, the world's leading diabetes therapy company, to develop the
AERx Diabetes Management System to permit diabetes patients to self-administer
insulin without needles. The Company has completed four clinical feasibility
studies with the AERx Diabetes Management System, and commenced Phase II testing
for the product in October, 1998. The Company believes that its current and
potential products can improve the management of certain diseases by reducing
the overall cost of therapy, enhancing patient management and compliance and
providing an improved means to administer drugs outside of the hospital setting.

    The Company's plans and intentions with respect to the development and
commercialization of its technologies are subject to a number of risks and
uncertainties. There can be no assurance that the Company will obtain required
regulatory clearances and approvals or that the Company will be able to
successfully develop and commercialize any of its products or potential
products.

BACKGROUND -- PULMONARY DRUG DELIVERY

    Pulmonary drug delivery is widely used to treat respiratory diseases by
delivering pharmaceuticals locally to the lung and may have utility in the
delivery of drugs for systemic application by using the lung's natural ability
to transfer molecules into the bloodstream. The potential for pulmonary delivery
to the bloodstream for systemic effect offers a non-invasive alternative to
injection that may achieve a more rapid speed of onset and superior
bio-availability than has been shown with other approaches, such as oral,
transdermal or nasal delivery. Speed of onset is an important therapeutic
element for many drugs, including morphine for pain management and insulin for
diabetes. Pulmonary delivery of drugs for the treatment of respiratory diseases
has proven desirable because topical application to affected lung tissues
promotes a rapid therapeutic effect and minimizes the side effects of several
important pulmonary drugs. The Company believes that the reproducibility of
pulmonary drug delivery is a critical part of achieving therapeutic effect and
can best be realized by regulating particle size and velocity and activating
drug delivery at the appropriate point in the inspiratory cycle.

    To deliver pharmaceuticals to or through the lungs, drugs must be
transformed into a low velocity aerosol (a suspension of drug particles in air)
that can be inhaled by the patient. Small particles (i.e., less than four
 



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microns in diameter) are able to pass through the lung's airways and be
dispersed in the alveoli, where they may enter the bloodstream for systemic
effect. Larger particles (i.e., greater than four microns in diameter) typically
get deposited in the large airways, where they may be useful in treating
diseases of the lung.

    Three aerosol-generating technologies currently are being used for pulmonary
drug delivery: nebulizers, metered dose inhalers ("MDIs") and dry powder
inhalers ("DPIs"). Each of these systems was originally developed to treat lung
diseases and produces a local therapeutic effect by depositing aerosolized
medication in the large airways of the lung. The effectiveness of these devices
depends upon proper inhalation technique to produce a consistent, reproducible
dose. In addition, the ability of these technologies to improve the management
of major pulmonary diseases has been limited by their inability to correct poor
patient technique automatically or to provide physicians with information on
patient inhalation and dosing patterns.

    Nebulizers. Nebulizers are primarily used in hospitals for the treatment of
respiratory diseases, such as asthma. Liquid drug is loaded into the nebulizer
prior to each use, and the patient breaths through a mouthpiece or mask as a
continuous fog of drug particles is produced. Because nebulizers require an
external power source or compressed gas supply, they are not easily portable.
Although drugs in liquid form are easily converted to an aerosol, nebulizers are
inefficient and require several minutes to administer a single dose of
medication. Because nebulizers produce a wide range of particle sizes, these
devices are impractical for systemic delivery.

    MDIs. Metered dose inhalers, the most widely used system for pulmonary drug
delivery, have been in existence for over 40 years and are used to deliver
asthma drugs. The drug is packaged in a portable canister as a suspension or
solution in a volatile propellant, typically CFCs. To self-administer a drug,
the patient must depress the canister, releasing a high-velocity jet of
aerosolized drug, while inhaling slowly and evenly. Although widely used, there
are certain inherent problems with the use of MDIs. A patient must properly
coordinate inhalation and activation of the aerosol jet to optimize the
effectiveness of treatment. Several clinical studies have demonstrated that
patients routinely use MDIs improperly, resulting in ineffective delivery. Much
of the drug is deposited at the back of the throat and swallowed, rather than
reaching the desired location in the lung. Moreover, MDIs also produce a wide
range of particle sizes and are not optimal for the delivery of systemic
therapies.

    DPIs. Dry powder inhalers, which are also used to deliver drugs locally to
the lung, have been and are being developed by pharmaceutical companies to
replace CFC-based MDI systems. DPI drugs are formulated in solid form and
packaged in portable containers. Patients self-administer the drug by inhaling
small, dry particles. Dry powder drug formulations present a considerable
challenge for pharmaceutical chemists because drugs must be prepared as solids,
must tolerate storage in a solid phase and must facilitate rapid and complete
dispersion as an aerosol at the point of delivery. To date, DPIs have been used
for the local delivery of some drugs to the lung, although several companies are
now exploring the development of DPIs for the systemic delivery of other
compounds, including proteins and peptides.

ARADIGM APPROACH

    The Company believes that its pulmonary drug delivery technology will
produce precise, reproducible delivery of the desired drug dose, either
systemically or locally, and that its systems may be capable of improving or
enabling a wide range of pulmonary drug delivery applications. Aradigm has
combined core competencies in physics, electrical engineering, mechanical
engineering and pharmaceutical sciences to overcome the limitations of
conventional pulmonary drug delivery systems. Through this integrated approach,
the Company has developed technologies that address each of the four key
elements that it believes are required for the development of effective
pulmonary drug delivery products:

    -   Ease of Drug Formulation: The Aradigm systems take advantage of existing
        drug formulations, primarily liquid drug formulations (aqueous or
        ethanol-aqueous mixtures), thereby potentially reducing the time, cost
        and risk of formulation development compared to other pulmonary delivery
        technologies. Many drugs being considered for pulmonary delivery,
        including macromolecules, are currently marketed in stable liquid
        formulations. In addition, liquid formulations facilitate the generation
        of small particle aerosols necessary for efficient delivery deep into
        the lung.



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    -   Efficient Precision Aerosol Generation: Aradigm has developed a
        proprietary aerosolization technology capable of producing low velocity,
        small particle aerosols at the point of delivery necessary for efficient
        deposition of drug in the lung. Through this technology, the Company
        believes it is able to overcome the limitations of conventional
        pulmonary drug delivery systems in which particle size and velocity
        cannot be optimized for systemic delivery.

    -   Automated Breath-Controlled Delivery: Since proper inhalation technique
        is needed to achieve effective pulmonary drug delivery, Aradigm's
        systems are designed to guide the patient to inhale slowly and evenly
        and to automatically deliver a drug aerosol at the correct point early
        in the inspiratory cycle. Studies have shown that most patients use
        improper inhalation technique, resulting in less effective therapy, and
        that patient training becomes ineffective over time. The Company
        believes that its breath control technology will result in improved
        patient inhalation techniques.

    -   Patient Compliance Monitoring: Because patient adherence to prescribed
        dosing regimens is an important determinant of therapeutic benefit,
        Aradigm's systems are also being designed to record drug administration,
        inhalation patterns and other relevant physiological information for use
        by physicians to analyze and optimize patient treatment regimens and
        improve patient outcomes.

    Aradigm is seeking to exploit various combinations of these four elements to
develop pulmonary drug delivery systems that overcome the limitations of
existing systems or enable pulmonary delivery of drugs that are currently not
deliverable systemically via the lung.

ARADIGM TECHNOLOGY PLATFORM

    The Company's principal product platform, the AERx system, is a novel drug
delivery system that is being developed to enable pulmonary delivery of a wide
range of liquid pharmaceuticals for local or systemic effect. The AERx system is
based on a proprietary aerosol generation technology capable of producing low
velocity, small particles suitable for efficient and reproducible pulmonary
delivery. By also incorporating the Company's proprietary breath control and
compliance monitoring technologies, the AERx system is designed to optimize the
delivery of aerosolized medications to the lung for local or systemic effect.
The AERx system aerosolizes liquid drug formulations that are pre-packaged in
proprietary unit-dose packets for inhalation. Each unit-dose packet is comprised
of (a) a small blister package which stores a liquid drug formulation and (b) an
aerosolization nozzle consisting of a membrane incorporating an array of laser
drilled holes.

    The AERx device creates a respirable aerosol by releasing a mechanical
actuator that is activated automatically when the patient's inhalation is
optimal for drug delivery. The actuator compresses the blister packet, thereby
forcing open the sealed channel and extruding the liquid drug through the
aerosolization nozzle. The aerosolized drug produced by this process is then
inhaled through the mouthpiece of the AERx device. The aerosolization of the
liquid drug via the disposable nozzle takes approximately one second and
produces a low velocity, fine particle aerosol necessary for optimized
deposition within the lung. The size of the droplets or particles that form the
emitted aerosol is dependent on the diameter of the nozzle holes. The diameter
of the micromachined holes within the nozzle can be sized for each specific
clinical application, including the creation of larger particles for delivery of
drug to the large airways of the lung for local effect or smaller particles for
delivery of drug deep into the lung for systemic effect.

    Many drugs being considered for pulmonary delivery, including macromolecules
and the majority of commercial biotech products, are currently marketed in
stable liquid formulations. Formulations developed for use in the AERx system
are in liquid form, typically employing aqueous-based solvents, similar to those
used for injections. No propellants are required since mechanical pressure is
used to generate the aerosol. Moreover, since the drug is stored in unit-dose
packets, preservatives should not be needed for most applications, further
simplifying the formulation process.

    The AERx system employs a patented technology to measure precisely the
airflow while the patient is inhaling through the mouthpiece of the device.
Indicator lights on the device guide the patient to inhale slowly and evenly
within a predetermined range suitable for drug delivery. When the desired flow
rate is established early in the inspiratory cycle, the device is activated.
Breath control ensures that the patient is breathing correctly each time a 



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dose of aerosolized drug is delivered. As a result, a consistent dose of
medication is delivered each time the product is used.

    The AERx system can automatically record information about each drug
administration, including dosage, breathing technique and other relevant
physiological parameters, for later review by the patient and health care
professionals. The Company intends to customize the software embedded in each
AERx system for the particular therapeutic application in order to collect and
present the data most relevant for managing each patient type. Electronic
patient identification and lockout mechanisms can also be incorporated in the
AERx system to prevent unauthorized use or overdose. The Company believes that
the combined features of the AERx system, optimized for each application, will
make the individual AERx products effective disease management tools.


STRATEGY

    Aradigm's goal is to become the leader in the development and
commercialization of pulmonary drug delivery products. The Company's strategy
incorporates the following principal elements:

    Focus on Early Product Opportunities: The Company is focusing its initial
commercial development efforts on product opportunities that have the potential
to reach the market quickly. The Company's lead product is expected to be the
AERx Pain Management System for the delivery of morphine. Because morphine is a
well characterized drug with a demonstrated safety profile, the Company believes
the AERx Pain Management System carries less development risk than new drug
development projects and may require less time for regulatory approval.
Similarly, the AERx Diabetes Management System is being developed around the
pulmonary delivery of insulin, the use to treat diabetes is well-established.
Nevertheless, there can be no assurance that the Company can secure regulatory
approval for its potential products or that the Company can successfully develop
or market any such products.

    Establish Broad Applicability: The Company believes that its AERx technology
can effectively deliver many pharmaceutical products. The Company is conducting
feasibility studies on a number of compounds to demonstrate the applicability of
the AERx system to a broad range of molecule sizes and types, including
proteins, peptides, gene vectors and small molecules. The Company plans to
publish results from these and other studies to promote the acceptance of the
AERx system as a viable pulmonary drug delivery technology for a wide variety of
compounds. The Company believes this strategy will maximize the number of
commercial product opportunities for Aradigm and will increase the interest of
potential partners to develop drugs for the AERx system, thereby reducing the
Company's dependence on any single product.

    Establish Collaborative Relationships: In order to enhance its commercial
opportunities and effectively leverage its core scientific resources, Aradigm
intends to enter into multiple collaborative relationships for the development
and commercialization of new products utilizing its technologies. Through
product development collaborations, Aradigm will seek access to proprietary
pharmaceutical compounds as well as to the resources and expertise necessary to
conduct late stage clinical trials and obtain regulatory approvals. In addition,
the Company will pursue relationships with pharmaceutical and device companies
with established sales forces and distribution channels in the Company's target
markets. By establishing such collaborative relationships, Aradigm intends to
introduce multiple new products while avoiding the need to establish drug
discovery research and sales and marketing capabilities for each target market.
The Company has established such relationships with SmithKline Beecham, covering
the development and marketing of the AERx Pain Management System and with Novo
Nordisk A/S, for the development and marketing of the AERx Diabetes Management
System. However, the Company will need to establish additional corporate
development collaborations and there can be no assurance that it will be able to
do so on reasonable terms, or at all.

    Build Strong Proprietary Position: The Company believes that establishing a
strong proprietary position in pulmonary drug delivery could provide an
important competitive advantage in its target markets. The Company has
aggressively pursued patent protection of its technology and as of February 28,
1999 has over 40 issued United States patents with a number of additional United
States patent applications pending. When appropriate, the Company also seeks
international patent protection. While there can be no assurance that any of the
Company's patents will provide a significant commercial advantage, these patents
are intended to provide protection for important aspects of the Company's
technology, including aerosol generation, breath control, compliance 



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monitoring and unit-dose formulation. In addition, the Company is developing
in-house manufacturing capability for the production of certain components of
its products, including the disposable unit-dose packet for the AERx system, to
further protect its core technologies.

ARADIGM PRODUCT APPLICATIONS

    The Company is developing the AERx platform based on a comprehensive
approach to pulmonary drug delivery that includes drug formulation, aerosol
generation, patient breath control and compliance monitoring technologies. The
Company believes that the AERx platform will be broadly applicable to drugs that
are intended for systemic delivery, for local delivery to the lung and for
pulmonary diagnostics. The Company currently is developing AERx products for
pain management and diabetes management. In addition, the Company is planning to
develop AERx systems for the non-invasive delivery of certain other drugs,
including proteins, peptides, gene vectors and small molecules.

AERx Pain Management System

    The Company is developing the AERx Pain Management System as a non-invasive,
patient-controlled pulmonary drug delivery product for treatment of chronic and
acute pain. The Company is developing and plans to commercialize this product in
collaboration with SmithKline Beecham. The Company has completed two Phase I
clinical trials and commenced Phase II clinical trials of the AERx Pain
Management System in March 1998. There can be no assurance that these clinical
trials will be successful.

    SmithKline Beecham and Aradigm have targeted cancer pain and post-operative
pain as the first two applications for the AERx Pain Management System. Among
cancer patients, more than four million people worldwide suffer from pain, a
majority of whom experience multiple "breakthrough" pain events each day.
Breakthrough pain refers to acute exacerbations of pain that "breakthrough" the
patient's baseline level of pain medication. In the postoperative arena, 20
million patients worldwide each year require treatment with narcotic analgesics
after surgery.

    Products currently available for pain management deliver the analgesic
substance by oral, transdermal, intravenous, intramuscular or subcutaneous
routes. Available patient-controlled analgesia ("PCA") products allow patients
to self-administer pain medication on demand from a microprocessor-controlled
intravenous infusion pump. PCA systems are frequently used for intravenous
delivery in the hospital setting. Widespread adoption of PCA outside the
hospital, however, has been limited by the requirement for an intravenous
delivery site that requires regular and expensive maintenance. Home use of PCA
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 Company believes that a patient-controlled, non-invasive drug delivery
system that provides for rapid uptake of medication could significantly expand
the market for pain management in the outpatient setting and improve the
management of pain in the hospital. The AERx Pain Management System is expected
to have features similar to current PCA systems, but without the need for
intravenous access and the resulting impairment of patient ambulating. The AERx
system is being designed to be programmed to allow for patient- activated
delivery in accordance with a physician-directed dosing program. Lockout
mechanisms being designed for the product should eliminate the risk of
inappropriate dosing, and a patented electronic patient identification feature
should prevent unauthorized use of the device. An automatically maintained
dosing event diary kept by the AERx system is designed to allow the physician to
closely monitor patient use. The Company believes that these features of the
AERx Pain Management System, combined with the inherent speed of onset of
pulmonary delivery, should provide a significant advance in pain management with
important applications in both the home and hospital settings.

    The Company has completed two U.S. Phase I clinical trials covering the use
of the AERx system to deliver morphine. The first study, conducted at Harris
Laboratories in Lincoln, Nebraska, involved 16 healthy volunteers given
increasing doses of morphine via the AERx system and, on separate days,
intravenous injection. At all doses investigated, the speed and reproducibility
of morphine delivery to the bloodstream were comparable between the AERx system
and intravenous administration. The second Phase I study, conducted with 12
 



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healthy volunteers at Massachusetts General Hospital, showed comparable
pharmacokinetic and pharmacodynamic responses between AERx delivery and
intravenous administration of morphine. Based on the results obtained in these
two Phase I clinical trials, Aradigm initiated Phase II clinical testing in
March 1998. There can be no assurance that the Company will be able to commence
these clinical trials on a timely basis or that such trials, if commenced, will
be successful.

    In September 1997, Aradigm entered into a product development and
commercialization agreement with SmithKline Beecham covering the use of the AERx
Pain Management System for the delivery of narcotic analgesics. The Company and
SmithKline Beecham will collaborate on the development of the products within
this field. Under the terms of the agreement, SmithKline Beecham has been
granted worldwide sales and marketing rights to the AERx Pain Management System
for use with such analgesics, and Aradigm retains all manufacturing rights. If
this system receives regulatory approval, Aradigm expects to sell devices and
drug packets to, and to receive royalties on sales by, SmithKline Beecham.

    Pursuant to the SmithKline Beecham agreement, Aradigm could receive
approximately $30 million in milestone and product development payments and
approximately $10 million in equity investments by the time the first product
from the collaboration is commercialized. As of December 1998, the Company had
received $19 million in milestone and product development payments and $5.0
million from the purchase of Aradigm Common Stock by SmithKline Beecham.
Additional milestone payments and product development payments will be paid if
Aradigm and SmithKline Beecham decide to jointly develop additional AERx
products that incorporate other narcotic analgesics. There can be no assurance
that the Company will be able to meet the milestones under this agreement on a
timely basis, if at all.

AERx Diabetes Management System

    The Company is developing the AERx Diabetes Management System to permit
diabetes patients to non-invasively self-administer insulin. The Company
believes 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. The Company is developing
and plans to commercialize this product in collaboration with Novo Nordisk A/S.
The Company conducted four Phase I clinical trials and commenced Phase II
clinical trials of the AERx Diabetes Management System in October 1998. There
can be no assurance that these clinical trials will be successful.

    In healthy individuals, the pancreas secretes insulin, which helps the body
to regulate blood glucose levels. Patients with Type 1 diabetes do not have the
ability to produce their own insulin and must self-inject insulin regularly to
control their disease. Patients with Type 2 diabetes are unable to use
efficiently the insulin that their body produces. While they may have some
impairment in their ability to produce insulin as well, it is the defect in
their ability to use insulin efficiently that leads to the addition of insulin
to their treatment program. By increasing the circulating insulin concentration,
the inefficiency can be partially overcome. The Diabetes Control and
Complications Trial ("DCCT") 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
DCCT study showed that keeping blood glucose levels as close to normal as
possible slows the onset and progression of eye, kidney and nerve diseases often
caused by diabetes. In fact, the DCCT study demonstrated that any sustained
lowering of blood glucose levels is beneficial, even if the person has a history
of poor blood glucose control. The United Kingdom Prospective Diabetes Study
(UKPDS) has independently demonstrated essentially the same benefit of tighter
blood glucose control for patients with Type 2 diabetes.

    The Company believes that approximately 700,000 Americans suffer from Type 1
diabetes. Virtually all of them are on daily insulin injection therapy, and most
are currently monitoring their own blood glucose level. According to the Center
for Disease Control, as of 1997, approximately eight to nine million Americans
have been diagnosed with Type 2 diabetes. Although most patients with Type 2
diabetes do not currently use insulin as part of their therapy, in aggregate
they consume the majority of insulin used in the United States, due to their
larger numbers. The insulin market in the United States exceeded $870 million in
1997. The direct costs associated with diabetes are estimated to be greater than
$45 billion annually.



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

    The AERx Diabetes Management System is being designed to enable patients
with diabetes to comply more effectively with their insulin therapy, thereby
lessening the risk of long-term complications. A clinical study conducted by the
Company in healthy fasting volunteers has shown that the way an individual
breathes during delivery has a significant effect on the pharmacokinetic profile
of the delivered insulin. The Company believes that its proprietary breath
control technology can be employed in the AERx Diabetes Management System to
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. The AERx
Diabetes Management System is being designed to provide the same one unit dosing
adjustability. The Company believes that the combined features of the AERx
Diabetes Management System will allow people with diabetes to achieve more
consistent and precise control over their blood glucose levels.

    In June 1998, Aradigm entered into a product development and
commercialization agreement with Novo Nordisk covering the use of the AERx
Diabetes Management System for the delivery of blood glucose regulating
medicines. Under the agreement, Novo Nordisk also has a two year option to
collaborate with Aradigm on the development of products based on the AERx
Pulmonary Drug Delivery System in two additional, unnamed fields. Novo Nordisk
is also obligated, under certain conditions, to develop at least one additional
compound in the field of blood glucose regulation. The Company and Novo Nordisk
will collaborate on product development. Under the terms of the agreement, Novo
Nordisk has been granted worldwide sales and marketing rights to any products
developed under the terms of the agreement, and Aradigm retains all
manufacturing rights. For any system developed under the collaboration that
receives regulatory approval, Aradigm expects to receive a share of gross
profits on the sales of such products by Novo Nordisk. Gross profits is defined
as Novo Nordisk's sales of delivery devices and packets, less both companies
costs of manufacturing the devices, packets and drug included in the packets.

    Pursuant to the Novo Nordisk agreement, Aradigm could receive approximately
$75 million in milestone and product development payments and approximately $10
million in equity investments by the time the first product from the
collaboration is commercialized. As of December 1998, the Company had received
$12.5 million in milestone and product development payments and $5.0 million
from the purchase of Aradigm Common Stock by Novo Nordisk. Additional milestone
payments and product development payments will be paid if Aradigm and Novo
Nordisk decide to jointly develop additional AERx products under the terms of
the agreement. There can be no assurance that the Company will be able to meet
the milestones under this agreement on a timely basis, if at all.



Additional Potential AERx Applications

    As of December 31, 1998, the Company had six externally funded programs to
develop or evaluate the use of its AERx delivery technology. In addition to the
AERx Pain Management System, being developed with SmithKline Beecham, and the
AERx Diabetes Management System, being developed with Novo Nordisk A/S, the
Company was evaluating the use of its technology to deliver gene therapies under
a grant from the National Institutes of Health. Of the remaining three
externally funded programs, two involved Phase I clinical studies, and the other
is in preclinical testing.

    The Company is evaluating the use of AERx systems to deliver a variety of
additional pharmaceutical compounds and has successfully evaluated a number of
drugs via in vitro and in vivo feasibility studies. Aradigm has carried out 12
human clinical trials using an early prototype AERx system to study morphine
sulfate, insulin, 



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the diagnostic agent (99m) Tc-DTPA, and several partners' proprietary molecules
(proteins, peptides and a small molecule). In addition, preclinical feasibility
research has been carried out on a number of small molecules, proteins and
non-viral gene vectors.

    A partial list of compounds that have been evaluated or may be evaluated
appears below:

<TABLE>
<CAPTION>
PHARMACEUTICAL                              BIOLOGICALS
--------------                              -----------
<S>                    <C>                  <C>                   <C>
Albuterol*             Midazolam*           Alpha Interferon      Gamma Interferon
Beclomethasone*        NSAIDs               Calcitonin            Gene Vectors*
Cromolyn*              Pentamidine          Condensed DNA         Growth Hormone
Fentanyl*              Sumatriptan          DNAse*                IGF-1
Levorphanol            Triamcinolone        Erythropoietin*
</TABLE>

----------

* Indicates compounds that the Company has successfully aerosolized.

    The Company has not yet acquired rights to develop applications for any of
the proprietary compounds listed above and may not pursue or be successful in
acquiring such rights.

    The Company believes that the AERx system may have applicability for a range
of compounds developed by pharmaceutical and biotechnology companies, including
many compounds that cannot be delivered orally. Due to their large size and poor
oral bioavailability, macromolecules developed by the biotechnology industry are
typically developed in liquid formulations and delivered by injection. The
Company believes that the AERx platform can potentially provide for improved
delivery and broader applications of these therapies or potential therapies.

    The Company's AERx technology can be used to deliver both small molecules
and macromolecules. Moreover, AERx technology can target either diseases of the
lung itself or, by delivering medicines through the lung, systemic diseases. As
of the end of 1998, the Company had externally-funded development programs in
the areas shown below:

<TABLE>
<CAPTION>
                                Local Lung Delivery                             Systemic Delivery
-----------------    -------------------------------------       ---------------------------------------------
<S>                  <C>                                         <C>
Small Molecule       Phase I program                             AERx Pain Management System (Phase II)

                                                                 Feasibility program

Macromolecule        Phase I program                             AERx Diabetes Management System (Phase II)

                     Gene therapy program (funded by NIH)        Gene therapy program (funded by NIH)
</TABLE>


SALES AND MARKETING

    The Company plans to establish collaborative relationships, such as its
agreements with SmithKline Beecham and Novo Nordisk A/S, to develop and
commercialize its AERx products. Through these collaborations, Aradigm intends
to access resources and expertise to conduct late stage clinical development and
to market and sell AERx products. The Company's preferred 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 drug delivery
technology. Where consistent with its other objectives, Aradigm plans to give
preference to potential partners whose pipelines contain multiple products whose
value could be enhanced by the Company's AERx pulmonary drug delivery
technology.

MANUFACTURING

    The Company is building its own manufacturing capabilities for the
production of key components of its AERx drug delivery systems. The Company
plans to internally produce the disposable nozzles, assemble the disposable
unit-dose packets and fill the drug into the unit-dose packets. The Company also
plans to manufacture AERx devices with the assistance of contract manufacturers
who are providing the main components and subassemblies. The Company plans to
perform final assembly, calibration, testing and packaging of the AERx devices
 



                                                                         Page 10
<PAGE>   11
currently under development. All of the Company's manufacturing capabilities
are being established at its facilities in California.

    The Company believes that it is capable of producing the AERx unit-dose
packets in volumes adequate to support all of its current and anticipated
clinical trials, as well as the initial commercial production requirements for
the AERx Pain Management System. The Company's pilot packet manufacturing
facility was completed and validated in July, 1998.

    The Company anticipates making significant expenditures to provide for the
high volume manufacturing required to support multiple AERx products, including
the AERx Diabetes Management System. There can be no assurance that the Company
will be able to complete the scale-up process in a timely manner or at a
commercially reasonable cost.

    Although the majority of the materials used in the Company's AERx products
are readily available from multiple sources, certain materials, including the
ASICs, microprocessors, plastics and plastic laminates, are or will be available
initially only from single sources. While the Company has contingency plans for
alternate suppliers, there can be no assurance that the Company could find
alternate manufacturers for such components. Even if new suppliers are secured,
there can be no assurance that this would not significantly reduce the Company's
ability to supply product during any transition.

COMPETITION

    The Company faces intense competition. The Company believes that its
products will compete on the basis of dosage reproducibility, safety, system
efficiency, patient convenience, ability to provide compliance data and cost.
Several companies are developing and marketing nebulizer, MDI and DPI devices as
well as other drug delivery approaches, including aerosolization technologies.
Aradigm is aware that a number of pharmaceutical and biotechnology companies and
research institutions are working on the pulmonary delivery of peptide and
protein dry powders. There can be no assurance that competitors will not
introduce products or processes competitive with, or superior to, those under
development by the Company. Many of the Company's competitors are much larger
and have far greater resources than Aradigm. These competitors include companies
working on developing systems for other non-invasive routes of delivery, such as
oral, transdermal and intranasal administration, as well as companies working on
pulmonary delivery systems. New drugs or further developments in alternative
drug delivery methods may provide greater therapeutic benefits for a specific
drug or indication or may offer comparable performance at lower cost than the
Company's pulmonary drug delivery systems under development.


INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS

    The Company's business and competitive position is dependent upon its
ability to protect its proprietary technology and avoid infringing the
proprietary rights of others.

    The Company relies on patents, patent applications and trade secret law to
protect its proprietary technology. As of February, 1999, the Company had over
40 United States patents with additional United States patent applications
pending. There can be no assurance that any of the Company's patent applications
will issue or, if issued, will later be found valid if challenged. Further,
there can be no assurance that any issued patents, or applications that might
later issue as patents, will provide the Company with a degree of market
exclusivity sufficient for the Company to compete profitably against its
competitors. Patents can not prevent others from developing alternative
technologies that are used for aerosolized drug delivery and patent applications
do not provide any exclusivity until and if they are issued as a patent. Because
the general idea of aerosolized drug delivery is well established, no entity may
obtain patent protection covering all forms of aerosolized delivery of all types
of drugs. There can be no assurance that others have not independently developed
or will not develop devices, components and methods of aerosolized drug
delivery, and obtained or will obtain patents on such, which patents could be
used to prevent the Company from making, using or selling its patented
technology.

    The Company's success will depend on its ability to obtain patents, maintain
trade secrets and operate without infringing upon the proprietary rights of
others. A substantial number of patents have been issued to competitors in 



                                                                         Page 11
<PAGE>   12
the field of aerosolized drug delivery. These and other competitors and
institutions may have applied for other patents and may obtain additional
patents and proprietary rights relating to products or processes similar to
those of the Company. The Company may not be able to obtain a license under any
such patent and therefore could be prevented from making products or carrying
out processes that may be important to the business of the Company.

    The Company has carried out and continues to carry out searches of
publications, including patents and scientific papers relating to the business
of the Company. These searches are supplemented by searches done by examiners in
the United States Patent Office and other patent offices reviewing patent
applications of the Company. Many entities are obtaining patents and publishing
papers in the field of aerosolized delivery and there can be no assurance that
the searches carried out by the Company have found the most relevant
publications. Thus, patents may exist that would provide competitors with the
ability to prevent the Company from making or selling its products. Further,
existing and future patents or other publications may hinder or prevent the
Company from obtaining patents or draw into question the validity of patents
already issued to the Company.

    The Company's current policy is to file patent applications on what it deems
to be important technological developments that might relate to products of the
Company or methods of using such products. To date all inventions have
originated in the United States and all patent applications were originally
filed in the United States. The Company also seeks to protect some of these
inventions through foreign counterpart applications in selected other countries.
The Company currently has National Phase applications pending in patent offices
outside of the United States. Statutory differences in patentable subject matter
may limit the protection the Company can obtain on some of its 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 prevent the Company from obtaining patent protection outside of the
United States. Further, competitors may have obtained or could later obtain
patent protection outside of the United States which would prevent the Company
from making, using or selling products or processes of its business in countries
other than the United States.

    The Company's policy is to require its officers, employees, consultants and
advisors to execute proprietary information and invention and assignment
agreements upon commencement of their relationships with the Company. 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 the Company shall be
assigned to the Company and that the individual will cooperate with the Company
in connection with securing patent protection on the invention if the Company
wishes to pursue such protection. There can be no assurance, however, that these
agreements will provide meaningful protection for the Company's inventions,
trade secrets or other proprietary information in the event of unauthorized use
or disclosure of such information.

GOVERNMENT REGULATION

    All medical devices and drugs, including the Company's 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 (the "FDC Act"), the Public Health Service Act, The Controlled Substances
Act, as amended, 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 the Company or the manufacturers of its products, including warning
letters, fines, product recalls or seizures, injunctions, refusals to permit
products to be imported into or exported out of the United States, refusals of
the FDA to grant premarket clearance or premarket approval of medical devices
and drugs or to allow the Company to enter into government supply contracts,
withdrawals of previously approved marketing applications and criminal
prosecutions.

    The FDA and other regulatory agency requirements for manufacturing, product
testing and marketing can vary depending upon whether the product is a medical
device or a drug. The Company believes, based on discussions with FDA personnel,
that its insulin and morphine products generally will be subject to regulation
as drugs, although each of the products could be considered to be a combination
of a drug and a medical device. The delivery systems for drugs that the Company
utilizes typically are medical devices if marketed without drugs.



                                                                         Page 12
<PAGE>   13
Generally, drugs, particularly biological drugs, are regulated more rigorously
than medical devices, although a product that is a combination of a drug and a
medical device could be subject to both drug and medical device approval
requirements. No assurances exist that the Company's products will be regulated
as drugs, or that they will not be subject to both medical device and drug
approval requirements. Sales of the Company's products outside of the United
States are subject to foreign regulatory requirements that may vary from country
to country. The time required to obtain clearance from a foreign country may be
longer or shorter than that required by the FDA, and clearance or approval or
other product requirements may differ. There can be no assurance that the
Company will be able to obtain necessary regulatory clearances or approvals on a
timely basis, if at all, for any of its 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 the
Company.

Regulation of Drugs

    Different types of FDA regulations apply to various drug products, depending
upon whether they are marketed only upon the order of a physician (i.e., they
are prescription drugs) or over-the-counter, or are biological, or controlled
drugs, such as narcotics. Product development and approval within this
regulatory framework takes a number of years, involves the expenditure of
substantial resources and 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 the Company's product
development that may affect approval, delay the submission or review of an
application or require additional expenditures by the Company.

    The activities required before a new drug product may be marketed in the
United States include pre-clinical 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 IND application to the FDA. FDA regulations provide
that human clinical trials may begin 30 days following receipt of an IND
application, unless the FDA advises otherwise or requests additional
information. There is no assurance that the submission of an IND will eventually
allow a company to commence clinical trials. Once trials have commenced, the FDA
may stop the trials 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 an FDA reviewed protocol. Each
clinical study is conducted under the auspices of an IRB at each of the
institutions at which the study will be conducted. An IRB 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 I 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 II clinical trials, in addition to safety, the
efficacy of the product is usually evaluated in a patient population. Phase III
trials typically involve additional testing for safety and clinical efficacy in
an expanded population at geographically dispersed sites. All of the phases of
clinical studies must be conducted in conformance with FDA's bioresearch
monitoring regulations.

    A company seeking FDA approval to market a new drug, including insulin and
controlled substances, must file a new drug application ("NDA") with the FDA
pursuant to the FDC Act. In addition to reports of the preclinical and clinical
trials conducted under an effective IND application, the NDA 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 NDA does
not assure FDA approval for marketing. The application review process generally
 



                                                                         Page 13
<PAGE>   14
takes several years to complete, although reviews of treatments for cancer and
other life-threatening diseases may be accelerated, or expedited, or subject to
fast track procedure. 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 IV clinical trials) following NDA 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 are not
maintained or if problems occur after the product reaches the market. The FDA
also requires reporting of certain safety and other information that becomes
known to a manufacturer of an approved drug. The product testing and approval
process is likely to take a substantial number of years and involves expenditure
of substantial resources. There is no guarantee that any approval will be
granted on a timely basis, or at all. Upon approval, a prescription drug may
only be marketed for the approved indications in the approved dosage forms and
at the approved dosage.

     Among the other requirements for drug product approval is the requirement
that the prospective manufacturer conform to the FDA's and cGMP regulations for
drugs. In complying with the cGMP 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 cGMP requirements. A
company's failure to comply with the cGMP regulations or other FDA regulatory
requirements could have a material adverse effect on the 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. The Company also would be
subject to foreign regulatory requirements governing clinical trials and medical
device and drug product sales if products were marketed abroad. Whether or not
FDA approval has been obtained, approval of a product by the comparable
regulatory authorities of foreign countries usually must be obtained prior to
commencement of marketing of the product in those countries. The approval
process varies from country to country and the time required may be longer or
shorter than that required for FDA approval.

    The Company is subject to numerous federal, state and local laws relating to
such matters as controlled drug substances, safe working conditions,
manufacturing practices, environmental protection, fire hazard control and
disposal of hazardous or potentially hazardous substances. For example, the
United States Drug Enforcement Agency ("DEA") regulates controlled drug
substances, such as morphine and other narcotics. Establishments handling
controlled drug substances such as morphine must, for example, 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 relating to medical devices and drugs are, in certain instances,
subject to regulation by the Federal Trade Commission or the FDA. There can be
no assurance that the Company 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 the Company's business,
financial condition or results of operations.

INTERNATIONAL SCIENTIFIC ADVISORY BOARD

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




                                                                         Page 14
<PAGE>   15

<TABLE>
<CAPTION>
                 NAME                                AFFILIATION                    AREA OF EXPERTISE
                 ----                                -----------                    -----------------
<S>                                           <C>                                   <C>

Peter Byron, Ph.D.........................    Medical College of Virginia,           Aerosol Science/Pharmaceutics
                                              Virginia Commonwealth University

Michael Cousins, M.D......................    University of Sydney, Australia        Pain Management

Peter Creticos, M.D.......................    The Johns Hopkins University           Allergy/Immunology/Asthma
                                              School of Medicine

Stanley S. Davis, Ph.D....................    Professor of Pharmacy,                 Drug Delivery
                                              University of Nottingham

Jeffrey Drazen, M.D.......................    Harvard University Medical             Pulmonary Medicine
                                              School

Lorne Eltherington, M.D., Ph.D............    Sequoia Hospital                       Pain Management

Richard Kitz, M.D.........................    Harvard University Medical             Anesthesiology
                                              School, Massachusetts General
                                              Hospital

Lawrence M. Lichtenstein, M.D., Ph.D......    The Johns Hopkins University           Allergy/Immunology
                                              School of Medicine

Christopher Saudek, M.D...................    The Johns Hopkins University           Endocrinology
                                              School of Medicine

Leigh Thompson, M.D., Ph.D................    CEO, Profound Quality                  Pharmaceutical Product
                                              Resources, former Chief                Development
                                              Scientific Officer, Eli Lilly
                                              and Company
</TABLE>



EMPLOYEES

    As of December 31, 1998, the Company had 148 employees, of whom 127 were in
product development and 21 were in business development, finance and
administration. The Company believes that its 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 the Company will continue to be able to attract and retain
high-caliber employees. The Company's employees are not represented by any
collective bargaining agreement. The Company considers its relations with its
employees to be good.

EXECUTIVE OFFICERS OF THE COMPANY

         The following table sets forth certain information with respect to the
executive officers of the Company as of December 31, 1998:

<TABLE>
<CAPTION>
           NAME                             AGE                    POSITION
------------------------------             -----    ----------------------------------------------
<S>                                        <C>      <C>                                              
Richard P. Thompson                         47      President, Chief Executive Officer and Director

R. Jerald Beers                             50      Executive Vice President, Marketing and
                                                    Business Development

Bikash K. Chatterjee                        40      Vice President, Operations

Maximillian D. Fiore                        43      Vice President, Engineering

Igor Gonda, Ph.D.                           51      Vice President, Research & Development

Mark A. Olbert                              43      Vice President,  Finance & Administration  and
                                                    Chief Financial Officer
</TABLE>



                                                                         Page 15
<PAGE>   16
<TABLE>
<S>                                        <C>      <C>
Norma L. Milligin                           60      Vice President, Human Resources

John Parker, Ph.D.                          60      Vice President, Quality

Babatunde A. Otulana, M.D.                  42      Vice President, Clinical Affairs

Reid M. Rubsamen, M.D.                      42      Vice  President, Medical Affairs, Secretary
                                                    and Director
</TABLE>


    Richard P. Thompson has been a director of the Company and has served as
the Company's President and Chief Executive Officer since 1994 and was Chief
Financial Officer from April 1996 until December 1996. From 1991 to 1994, he was
President of LifeScan, Inc., a Johnson & Johnson Company, a medical device
manufacturing and development company. Mr. Thompson was a founder of LifeScan
and between 1981 and 1991 he held the positions of Vice President, Operations,
and later Vice President, Sales and Marketing, at LifeScan. Mr. Thompson holds a
B.S. in biological sciences from the University of California at Irvine and an
M.B.A. from California Lutheran College.

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

    Bikash K. Chatterjee has served as the Company's Vice President,
Pharmaceutical Operations since March, 1998. From September 1997 until March
1998, Mr. Chatterjee was the Company's Director of Pharmaceutical Operations.
Prior to joining the Company, Mr. Chatterjee was the plant manager for
manufacturing Boehringer-Mannheim's disposable coagulation testing system. He
has also held a number of senior manufacturing positions at various
pharmaceutical companies, including Syntex Corporation. Mr. Chatterjee holds a
BA in Biochemistry and a BS in Chemical Engineering from University of
California at San Diego.

    Maximillian D. Fiore has served as the Company's Vice President, Engineering
since 1994. From 1991 to 1994, Mr. Fiore served as Director of Engineering at
Lifescan, Inc. From 1990 to 1991, Mr. Fiore was the IMX(TM) Business Unit
Research & Development Manager for Abbott Laboratories, a pharmaceuticals and
medical device company. Mr. Fiore holds a B.S.E.E. and a B.S. in engineering
from Northwestern University and an M.S.E.E. in bio-medical/microprocessor-based
instrument design from University of Wisconsin.

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

    Norma L. Milligin has served as the Company's Vice President, Human
Resources, since September, 1998. Prior to her joining the Company, Ms. Milligin
worked as a consultant in the human resources area for a number of firms,
including the Company. She has previously held positions as Vice President of
Human Resources at LifeScan, now a division of Johnson & Johnson, and Chemtrak.
She has also held a number of senior human resource positions at Syntex
Corporation. Ms. Milligin has taught organizational behavior at Pepperdine
University, and holds a BS in Business from University of Colorado and an MBA
from Pepperdine University.

    John Parker, Ph.D. has served as the Company's Vice President, Quality,
since October, 1998. Prior to joining the Company, Dr. Parker was Vice President
of Quality Assurance and Compliance at Centocor. He has also held a number of
senior quality, compliance, validation and regulatory positions at various
pharmaceutical companies, including Centocor and Merck. Dr. Parker was also the
Responsible Head for Compliance while at Centocor. He holds a Ph.D. in Radiation
Biology from the School of Medicine at University of Rochester



                                                                         Page 16
<PAGE>   17

    Mark A. Olbert joined the Company in late 1996 as Chief Financial Officer
and Vice President, Finance and Administration. Prior to joining the Company,
Mr. Olbert was with Amgen Inc., a biotechnology company, where he spent six
years in finance operations and was most recently the Director of Mergers &
Acquisitions. Prior to joining Amgen, Mr. Olbert held financial management
positions at Ashton-Tate and Atlantic Richfield. Mr. Olbert holds a B.A. in
molecular biology from the State University of New York at Buffalo and an M.B.A.
from the Amos Tuck School of Business Administration at Dartmouth College.

    Babatunde A. Otulana, M.D. has served as the Company's Vice President,
Clinical Affairs since October 1997. From 1991 to 1997, Dr. Otulana was a
Medical Reviewer in the Division of Pulmonary Drug Products at the Center for
Drug Evaluation and Research, FDA. From 1992 to 1997, Dr. Otulana also served as
an Assistant Professor of Medicine in the Division of Pulmonary and Critical
Care Medicine, Howard University Hospital. Dr. Otulana obtained his M.D from
University of Ibadan, Nigeria and completed a Pulmonary Fellowship at Paparuth
Hospital, University of Cambridge, United Kingdom.

    Reid M. Rubsamen, M.D., founder of the Company, has been a director of the
Company and has served as the Company's Vice President, Medical Affairs and
Secretary since 1991. Dr. Rubsamen is a Board Certified anesthesiologist having
received his medical training at Pacific Medical Center, San Francisco and
Massachusetts General Hospital, where in 1989 he served as Chief Resident in
Anesthesia. He was also a doctoral candidate in the computer science department
at the Massachusetts Institute of Technology, leaving in 1990 to found the
Company. Dr. Rubsamen holds an A.B. in biochemistry and computer science from
the University of California, Berkeley, and an M.S. in computer science and an
M.D. from Stanford University.



                                                                         Page 17
<PAGE>   18


ITEM 2.    PROPERTIES

           At December 31, 1998, Aradigm leased approximately 72,000 square feet
of office space in seven buildings in an office park at 3929 Point Eden Way,
Hayward, California. In addition, the Company has negotiated leases for an
additional 39,000 net square feet of space at its current site. The Company's
leases for such office space expire at various times through the year 2016.
Minimum annual payments under these leases will be approximately $1.7 million
and $1.8 million in 1999 and 2000, respectively. The Company uses this space for
general administrative, product development, clinical, manufacturing and
research and development purposes. The Company believes that its existing
facilities are adequate to meet its 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 ("Lilly") filed a complaint
against the Company in the United States District Court for the Southern
District of Indiana. The complaint made various allegations against the Company,
arising from the Company's decision to enter into an exclusive collaboration
with Novo Nordisk A/S with respect to the development and commercialization of a
pulmonary delivery system for insulin and insulin analogs. The Company has
sponsored various studies of the pulmonary delivery of insulin and insulin
analogs using materials supplied by Lilly under a series of agreements dating
from January 1996. The Company and Lilly had also conducted negotiations
concerning a long-term supply agreement under which Lilly would supply bulk
insulin to the Company for commercialization in the Company's AERx Diabetes
Management System, and a separate agreement under which the Company would
license certain intellectual property to Lilly. These negotiations were
terminated after the Company proceeded with its agreement with Novo Nordisk A/S.
The complaint seeks a declaration that Lilly scientists are co-inventors of a
patent application filed by the Company relating to pulmonary delivery of an
insulin analog or, in the alternative, enforcement of an alleged agreement to
grant Lilly an nonexclusive license under such patent application. The complaint
also contains allegations of misappropriation of trade secrets, breach of
fiduciary duty, conversion and unjust enrichment and seeks unspecified damages
and injunctive relief. Management believes that Lilly's claims are without merit
and that this litigation will not have a material adverse effect on the
Company's results of operations, cash flows or financial position. The Company
recently filed an answer denying all material allegations of the complaint.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

           No matters were submitted to a vote of the Company's security holders
during the quarter ended December 31, 1998.



                                                                         Page 18
<PAGE>   19


                                     PART II

ITEM 5.    MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
           MATTERS

MARKET INFORMATION

    The Company's common stock trades on The Nasdaq National Market under the
symbol "ARDM". Public trading of the common stock commenced on June 20, 1996.
Prior to that, there was no public market for the common stock. The following
table sets forth, for the periods indicated, the high and low sales prices per
share (excluding retail markup, markdowns and commissions) of the common stock
on The Nasdaq National Market:

<TABLE>
<CAPTION>
                                                HIGH             LOW
<S>                                           <C>                <C>   
           1997

           First quarter                      $ 10.00            $ 8.25
           Second quarter                        8.75              5.63
           Third quarter                        14.25              5.63
           Fourth quarter                       15.13              8.13

           1998

           First quarter                      $ 13.06            $ 8.00
           Second quarter                       15.06             12.31
           Third quarter                        13.88              7.00
           Fourth quarter                       14.00              7.88
</TABLE>

    As of February 28, 1999, there were approximately 181 shareholders of record
and approximately 1,000 beneficial holders of the Company's common stock.

DIVIDEND POLICY

    The Company has never paid cash dividends on its capital stock and does not
anticipate paying cash dividends in the foreseeable future, but intends to
retain its capital resources for reinvestment in its business. Any future
determination to pay cash dividends will be at the discretion of the Board of
Directors and will be dependent upon the Company's financial condition, results
of operations, capital requirements and other such factors as the Board of
Directors deems relevant.


RECENT SALES

     In June 1998, Aradigm entered into a product development and
commercialization agreement with Novo Nordisk covering the use of the AERx
Diabetes Management System for the delivery of blood glucose regulating
medicines. Under the agreement, Novo Nordisk also has a two year option to
collaborate with Aradigm on the development of products based on the AERx
Pulmonary Drug Delivery System in two additional, unnamed fields. Novo Nordisk
is also obligated, under certain conditions, to develop at least one additional
compound in the field of blood glucose regulation. The Company and Novo Nordisk
will collaborate on product development. Under the terms of the agreement, Novo
Nordisk has been granted worldwide sales and marketing rights to any products
developed under the terms of the agreement, and Aradigm retains all
manufacturing rights. For any system developed under the collaboration that
receives regulatory approval, Aradigm expects to receive a share of gross
profits on the sales of such products by Novo Nordisk. Gross profits is defined
as Novo Nordisk's sales of delivery devices and packets, less both companies
costs of manufacturing the devices, packets and drug included in the packets.

    Pursuant to the Novo Nordisk agreement, Aradigm could receive approximately
$75 million in milestone and product development payments and approximately $10
million in equity investments by the time the first product from the
collaboration is commercialized. As of December 1998, the Company had received
$12.5 million in milestone and product development payments and $5.0 million
 

                                                                         Page 19
<PAGE>   20
from the purchase of Aradigm Common Stock by Novo Nordisk. Additional milestone
payments and product development payments will be paid if Aradigm and Novo
Nordisk decide to jointly develop additional AERx products under the terms of
the agreement. There can be no assurance that the Company will be able to meet
the milestones under this agreement on a timely basis, if at all.

           On January 27, 1999, the Company entered into a binding,
non-cancelable agreement to sell 2,428,338 shares of its Common Stock subject to
meeting certain closing conditions, including the effectiveness of a
registration statement. The gross proceeds to the Company are expected to be
approximately $25.5 million.


                                                                         Page 20
<PAGE>   21


ITEM 6.    SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
(In thousands, except per share amounts)                1998           1997           1996           1995           1994
----------------------------------------------      --------       --------       --------       --------       --------
<S>                                                 <C>            <C>            <C>            <C>            <C>     

STATEMENTS OF OPERATIONS DATA:

Contract and license revenues                       $ 17,515       $  3,685       $    730       $    155       $    125
Operating expenses:
    Research and development                          25,549         12,732          7,981          3,440          2,198
    General and administrative                         8,661          6,732          2,958          2,334          1,664
                                                    --------       --------       --------       --------       --------
       Total expenses                                 34,210         19,464         10,939          5,774          3,862
                                                    --------       --------       --------       --------       --------
Loss from operations                                 (16,695)       (15,779)       (10,209)        (5,619)        (3,737)
Interest income                                        1,754          1,329          1,179            206             38
Interest expense                                        (513)          (234)           (52)           (20)           (34)
                                                    ========       ========       ========       ========       ========
Net loss                                            $(15,454)      $(14,684)      $ (9,082)      $ (5,433)      $ (3,733)
                                                    ========       ========       ========       ========       ========
Basic and diluted net loss per share (1)            $  (1.32)      $  (1.43)      $  (1.49)      $  (5.41)      $  (4.40)
Shares used in computing basic and diluted net
loss per share (1)                                    11,682         10,280          6,098          1,004            849

BALANCE SHEET DATA:

Cash, cash equivalents and investments              $ 31,036       $ 24,305       $ 28,534       $ 12,117       $  6,087
Working capital                                       16,620         15,999         23,486         11,594          5,739
Total assets                                          44,949         30,294         30,733         13,306          6,343
Long-term debt                                         4,570          2,139            350            490             --
Accumulated deficit                                  (51,279)       (35,827)       (21,144)       (12,069)        (6,636)
Total shareholders' equity                            21,660         18,659         27,886         12,121          5,960
</TABLE>


-----------

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



                                                                         Page 21
<PAGE>   22


ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND 
           RESULTS OF OPERATIONS

         The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the Financial
Statements and the related Notes thereto included elsewhere in this Form 10-K.
Except for historical information contained herein, the discussion in this
section contains forward-looking statements, including, without limitation,
statements regarding timing and results of clinical trials, the timing of
regulatory approvals the establishment of corporate partnering arrangements, the
anticipated commercial introduction of the Company's products and the timing of
the Company's 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 in Part II, under the heading "Risk Factors".

OVERVIEW

         Since its inception in 1991, Aradigm has been engaged in the
development of pulmonary drug delivery systems. As of December 31, 1998, the
Company had an accumulated deficit of $51.3 million. The Company has been
unprofitable since inception and expects to incur additional operating losses
over at least the next several years as the Company's research and development
efforts, preclinical and clinical testing activities and manufacturing scale-up
efforts expand and as the Company plans and builds its late-stage clinical and
early commercial production capabilities. To date, Aradigm has not sold any
products and does not anticipate receiving significant revenue from sale of
products in 1999. The sources of working capital have been equity financing,
financing of equipment acquisitions, interest earned on investments of cash and
revenues from research and feasibility agreements and development and
collaborative contracts.

RESULTS OF OPERATIONS

         Years Ended December 31, 1998, 1997 and 1996

         Contract and License Revenues. The Company reported revenues from
collaborative contracts of $17.5 million in 1998 compared to $3.7 million in
1997 and $730,000 in 1996. The increases in 1998 and 1997 revenues were due
primarily to increased partner-funded product development activities. The
Company is developing pulmonary delivery systems with SmithKline Beecham, PLC,
to manage acute and breakthrough pain using narcotic analgesics, and with Novo
Nordisk A/S, to manage diabetes using insulin and other blood glucose regulating
compounds. Costs of contract research revenue approximate such revenue and are
included in research and development expense. 1996 revenues consisted of
$500,000 of license fees from a human clinical feasibility testing agreement and
$230,000 of contract research revenues.

         Research and Development Expenses. Research and development expenses
have increased each year since the Company's inception; these expenses were
$25.5 million in 1998 compared to $12.7 million in 1997 and $8.0 million in
1996. Research and development expenses in 1998, 1997 and 1996 represented 75%,
65%, and 73% of total expenses, respectively. Research and development expenses
in 1998 increased by 101% over 1997, attributable primarily to hiring of
additional scientific personnel and expenses associated with the expansion of
research and development efforts to support the Company's increased
partner-funded activities. Research and development expenses in 1997 increased
60% over 1996, similarly attributable to the hiring additional scientific
personnel, increased costs associated with the expansion of research and
development efforts of the AERx system and the initiation of additional clinical
testing of the AERx system.

         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. The
Company expects research and development spending to increase significantly over
the next few years as the Company continues to expand its research and
development activities to support current and potential future collaborations
and initiates commercial manufacturing of the AERx system. The increase in
research and development expenditures cannot be predicted accurately as it
depends in part upon future success in obtaining new collaborative agreements.



                                                                         Page 22
<PAGE>   23

         General and Administrative Expenses. General and administrative
expenses were $8.7 million in 1998 compared to $6.7 million in 1997 and $3.0
million in 1996. General and administrative expenses increased by 29% in 1998
compared to 1997 and 128% in 1997 compared to 1996, attributable primarily to
support of the Company's increased research efforts, additional facilities
expense, administrative staffing, business development and marketing activities.
The Company expects to incur greater general and administrative expenses in the
future as it expands its operations and increases its efforts to develop
collaborative relationships with corporate partners.

         Interest Income. Interest income increased to $1.8 million in 1998 from
$1.3 million in 1997 and $1.2 million in 1996. These increases were due to the
Company maintaining larger cash and investment balances. The higher cash and
investment balances are a result of the Company's receipt of research funding
and milestone payments from collaborative partners, the completion of a private
placement of the Company's Common Stock in April 1998, which raised net proceeds
of $12.0 million, and Novo Nordisk A/S making a $5.0 million equity investment
in Aradigm at a 25% premium-to-market price in conjunction with the June 1998
development agreement between the Company and Novo Nordisk A/S to develop
insulin products using Aradigm's non-invasive pulmonary drug delivery system.
Interest income in 1997 was consistent with that in 1996 due to similar average
cash balances during those two years.

         Interest Expense. Interest expense was $513,000 in 1998 compared to
$234,000 in 1997 and $52,000 in 1996. These increases resulted primarily from
higher outstanding capital lease and equipment loan balances under the Company's
equipment and lease lines of credit.

         Net Operating Loss Tax Carryforwards. As of December 31, 1998, the
Company had federal net operating loss tax carryforwards of approximately $41
million. These carryforwards will expire beginning in the year 2006. Utilization
of net operating loss carryforwards may be subject to substantial annual
limitation due to the ownership change limitation provided for by the Internal
Revenue Code of 1986. The annual limitation may result in the expiration of net
operating loss carryforwards before utilization.

LIQUIDITY AND CAPITAL RESOURCES

         The Company has financed its operations since inception primarily
through private placements and public offerings of its capital stock, and
proceeds from financings of equipment acquisitions, contract research revenue
and interest earned on investments. As of December 31, 1998, the Company had
received approximately $72.9 million in net proceeds from sales of its capital
stock. In December 1998, the Company negotiated an additional $3.0 million
equipment line of credit of which approximately $1.7 million remained available
at December 31, 1998. As of December 31, 1998, the Company had cash, cash
equivalents and short-term investments of approximately $31.0 million. The
Company also has the right to sell $5.0 million of common stock to each of
SmithKline Beecham, PLC (at the then market price) and to Novo Nordisk A/S (at
25% premium to the market price) when certain conditions have been met.

         In January 1999, the Company entered into a binding, noncancelable
agreement to raise approximately $25.5 million through a private sale of
2,428,338 newly-issued shares of its common stock to a select group of
institutional investors, including the Kaufman Fund, Inc., Hambrecht & Quist
Capital Management, Inc., Bank Invest, Delta Opportunity Fund (a fund managed by
Diaz & Altschul Advisors) and Zesiger Capital Group, LLC. Piper Jaffray Inc. and
Petkevich & Partners, LLC served as financial advisors to the company on the
transaction. This financing is expected to give the company the additional
flexibility in the development of both its existing and future AERX Pulmonary
Drug Delivery products.

         Net cash used in operating activities in 1998 was $4.9 million compared
to $7.8 million in 1997. The decrease in cash used resulted primarily from
increases in deferred revenue, accrued liabilities and depreciation offset
partially by an increase in the net loss. Net cash used in operating activities
in 1997 was $7.8 million compared to $7.1 million in 1996. The increase resulted
primarily from an increase in net loss of $5.6 million and increases in current
assets, largely offset by net increases in accrued liabilities and deferred
revenue.

         Net cash used in investing activities in 1998 was $21.0 million
compared to $463,000 used in 1997. The increase in cash used resulted primarily
from the Company's increased net purchases of short-term investments and
increased expenditures made for capital equipment. Net cash used in investing
activities in 1997 was $463,000 


                                                                         Page 23
<PAGE>   24

compared to $11.9 million net cash used in 1996. The decrease resulted primarily
from the Company's receipt of net proceeds from investment maturities partially
offset by increased expenditures made for capital equipment.

         Net cash provided by financing activities in 1998 was $21.2 million
primarily from the Company's receipt of proceeds from the completion of a
private placement of Common Stock in April 1998, which raised net proceeds of
$12.0 million, a $5.0 million equity investment by Novo Nordisk A/S at a 25%
premium-to-market price in June 1998, and the receipt of proceeds from equipment
loans, offset partially by repayment of capital lease obligations. Net cash
provided by financing activities in 1997 was $6.4 million primarily from the
receipt of proceeds from equipment loans and issuances of common stock partially
offset by repayment of capital lease obligations and equipment loans. Net cash
provided by financing activities in 1996 of $24.3 million was due primarily to
the receipt of net proceeds from the Company's initial public offering.

         The development of the Company's technology and proposed products will
require a commitment of substantial funds to conduct the costly and
time-consuming research and preclinical and clinical testing activities
necessary to develop and refine such technology and proposed products and to
bring any such products to market. The Company's future capital requirements
will depend on many factors, including continued progress in the research and
development of the Company's technology and drug delivery systems, the ability
of the Company to establish and maintain favorable collaborative arrangements
with others, progress with preclinical studies and clinical trials, the time and
costs involved in obtaining regulatory approvals, the cost of development and
the rate of scale up of the Company's 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.

         The Company expects its cash requirements to increase due to expected
increases in expenses related to the further research and development of its
technologies resulting from a larger number of collaborative partnerships,
process development for the manufacture of AERx systems, and general and
administrative costs. These expenses include, but are not limited to, increases
in personnel and personnel-related costs, purchases of capital equipment,
construction of prototype devices and facilities expansion including the
planning and building of a late-stage clinical and early-stage commercial
manufacturing facility.

         The Company expects that its existing capital resources, committed
funding from its existing corporate partnerships and projected interest income
will enable the Company to maintain current and planned operations through 2000.
However, there can be no assurance that the Company will not need to raise
substantial additional capital to fund its operations prior to such time. There
can be no assurance that additional financing will be available on acceptable
terms or at all. The Company's cash requirements, however, may vary materially
from those now planned because of results of research and development efforts,
including capital expenditures and funding preclinical and clinical trials, and
manufacturing capacity for preclinical, clinical and full scale manufacturing
requirements of the AERx system. The Company may seek additional funding through
collaborations or through public or private equity or debt financings. However,
there cannot be any assurance that additional financing can be obtained on
acceptable terms, or at all. If additional funds are raised by issuing equity
securities, dilution to shareholders may result. If adequate funds are not
available, the Company may be required to delay, to reduce the scope of, or to
eliminate one or more of its research and development programs, or to obtain
funds through arrangements with collaborative partners or other sources that may
require the Company to relinquish rights to certain of its technologies or
products that the Company would not otherwise relinquish.

                                                                         Page 24
<PAGE>   25



         Except for historical information contained herein, the discussion in
this section contains forward-looking statements, including, without limitation,
statements regarding timing and results of clinical trials, the establishment of
corporate partnering arrangements, the anticipated commercial introduction of
the Company's products and the timing of the Company's 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.

WE HAVE A LIMITED OPERATING HISTORY

         We were incorporated in January 1991 and we have a limited operating
history and have generated only limited revenues to date. Virtually all of our
potential products are in an early stage of research or development. We cannot
assure you that:

        -   our research and development efforts will be successful;

        -   any potential products will be proven safe and effective;

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

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

WE HAVE A HISTORY OF LOSSES AND ANTICIPATE FUTURE LOSSES

         We have never been profitable, and through December 31, 1998, we have
incurred a cumulative deficit of approximately $51.3 million. We expect to
continue to incur substantial losses over at least the next several years as we:

        -   expand our research and development efforts;

        -   expand our preclinical and clinical testing activities;

        -   expand our manufacturing efforts; and

        -   plan and build our clinical and initial commercial production
            capabilities.


WE MAY NOT BE ABLE TO DEVELOP PRODUCTS SUCCESSFULLY

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

         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 investors 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.



                                                                         Page 25
<PAGE>   26

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 show them that our
products' ability to compete with alternate delivery systems with respect to:

        -   safety;

        -   efficacy;

        -   ease of use; and

        -   price.

         We cannot assure investors that our products will be competitive with
respect to these factors or that our partners will be able to successfully
market any of them in a timely manner.

WE DEPEND UPON COLLABORATIVE PARTNERS AND NEED ADDITIONAL COLLABORATIVE PARTNERS

         Our commercialization strategy depends on our ability to enter into
agreements with collaborative partners. In particular, our ability to
successfully develop and commercialize the AERx Pain Management System depends
on our corporate partnership with SmithKline Beecham and our ability to
successfully develop and commercialize the AERx Diabetes Management System
depends on our corporate partnership with Novo Nordisk.
SmithKline Beecham and Novo Nordisk have 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 these systems will be delayed
if SmithKline Beecham or Novo Nordisk fail to conduct these collaborative
activities in a timely manner or at all. In addition, SmithKline Beecham or Novo
Nordisk could terminate these agreements and we cannot assure investors 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
SmithKline Beecham or Novo Nordisk breach or terminate either agreement, our
business will be impaired.

         We will also need to enter into agreements with other corporate
partners to conduct the clinical trials, manufacturing, marketing and sales
necessary to commercialize other potential products. In addition, our ability to
apply the AERx system to any proprietary drugs will depend on our ability to
establish and maintain corporate partnerships or other collaborative
arrangements with the holders of proprietary rights to such drugs. We cannot
assure investors that we will be able to establish such additional corporate
partnerships or collaborative arrangements on favorable terms or at all, or that
our existing or future corporate partnerships or collaborative arrangements will
be successful. Nor can we assure investors that existing or future corporate
partners or collaborators will not pursue alternative technologies or develop
alternative products either on their own or in collaboration with others,
including our competitors. We could have disputes with our existing or future
corporate partners or collaborators. Any such disagreements could lead to delays
in the research, development or commercialization of any potential products or
could result in time-consuming and expensive litigation or arbitration. If any
of our corporate partners or collaborators do not develop or commercialize any
product to which it has obtained rights from us, our business could be impaired.

WE HAVE LIMITED MANUFACTURING EXPERIENCE

         We have only limited manufacturing experience. We have validated only a
single pilot-scale facility for manufacturing disposable packets for our various
 



                                                                         Page 26
<PAGE>   27
AERx systems. We anticipate spending significant amounts to attempt to provide
for the high-volume manufacturing required for multiple AERx products, and some
of this spending will occur before our products are approved. We cannot assure
investors that:

        -   we will be able to manufacture sufficient quantities of our products
            to support any future clinical trials;

        -   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.

         Our manufacturing facilities and our contract manufacturers' facilities
will be subject to periodic regulatory inspections by the Food and Drug
Administration (FDA) and other federal and state regulatory agencies. These
facilities must comply with the good manufacturing practice (GMP) requirements
of the FDA. We cannot assure investors that we will satisfy such regulatory
requirements, and any failure to satisfy GMP and other requirements could impair
our business.

         We intend to use contract manufacturers to produce key components,
assemblies and subassemblies in the clinical and commercial manufacturing of our
AERx devices. We cannot assure investors that we will be able to enter into or
maintain satisfactory contract manufacturing arrangements. Certain components of
our products may be available, at least initially, only from single sources. We
cannot assure investors that we could find alternate suppliers for any of these
components. A delay of or interruption in production resulting from any supply
problem could have a material adverse effect on our business.

WE WILL NEED ADDITIONAL CAPITAL AND OUR ABILITY TO FIND ADDITIONAL FUNDING IS
UNCERTAIN

         Our operations to date have consumed substantial and increasing amounts
of cash. We expect the negative cash flow from operations to continue in the
foreseeable future. We will need to commit substantial funds to develop our
technology and proposed products. We will have to continue to conduct costly and
time-consuming research and preclinical and clinical testing to develop, refine
and commercialize our technology and proposed products. Our future capital
requirements will depend on many factors, including:

        -   progress in researching and developing our technology and drug
            delivery systems;

        -   our ability to establish and maintain favorable collaborative
            arrangements with others;

        -   progress with preclinical studies and clinical trials;

        -   time and costs to obtain regulatory approvals;

        -   costs of development and the rate we expand our production
            technologies;

        -   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 equity
financings, financings of equipment acquisitions, contract research revenue and
interest earned on investments.

         We anticipate that we will be able to maintain our current and planned
operations through 2000 with our existing resources, anticipated payments from
our existing corporate partners and projected interest income. Depending on the
timing and nature of additional development collaborations, we may need to raise
additional funds to fund operations beyond that period. Our cash requirements
may change because of our research and development efforts, including capital
expenditures and funding preclinical and clinical trials and manufacturing
capacity. We may seek additional funding through collaborations or through
public or private equity financings. We cannot assure investors that additional
financing will be available on acceptable terms or at all. If we raise
additional funds by issuing equity securities, substantial dilution to
shareholders may result. If adequate funds are not available, we may be required
to delay, reduce the scope of, or eliminate one or more of our research or
development programs or obtain funds through arrangements with collaborative
 



                                                                         Page 27
<PAGE>   28
partners or others. Such arrangements might require us to relinquish rights to
certain of our technologies, product candidates or products that we would not
otherwise relinquish.

WE DEPEND UPON PROPRIETARY TECHNOLOGY; THE STATUS OF PATENTS AND PROPRIETARY
TECHNOLOGY IS UNCERTAIN

         The field of aerosolized drug delivery is crowded and a substantial
number of patents have been issued. Competitors and institutions may have
applied for and may obtain additional patents and proprietary rights relating to
competing products or processes.

         Patents or other publications may hinder us from obtaining patent
protection or draw into question the validity of patents already issued to us.
In addition, patents issued to others might allow competitors to prevent us from
making our products or carrying out processes necessary to use our products. We
may not be able to obtain a license under any such patent and may be prevented
from making products or carrying out processes that are important or essential
to our business. We cannot assure investors that any of our patents would be
upheld as valid if challenged in litigation. There also can be no assurance that
any of our patent applications will issue or, if issued, will later be found
valid if challenged. Furthermore, we cannot assure investors that any issued
patents or patent applications will provide us with sufficient market
exclusivity to profitably compete against our competitors. In the United States,
patent applications are secret until they are issued. As a result, we cannot
know what patents others may have applied for. We may take actions now that
create infringement issues if and when a pending application covering similar
technology is subsequently issued. Furthermore, patents already issued to us or
our pending applications may become subject to dispute, and any disputes could
be resolved against us. Whether or not we are successful, any dispute could
involve the expenditure of substantial financial and human resources.

         We require our officers, employees, consultants and advisors to execute
proprietary information and invention assignment agreements when they began
their relationships with us. We cannot assure investors, 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. Violations of such agreements are difficult to police.

OUR BUSINESS IS REGULATED BY THE GOVERNMENT; RESULTS OF PRECLINICAL AND CLINICAL
TESTING ARE UNCERTAIN

         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 governments. Such
regulations govern the development, testing, manufacture, labeling, storage,
premarket clearance or 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 premarket clearances or approvals for
medical devices and drug products is generally lengthy, expensive and uncertain.
Securing FDA marketing clearances and 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.

         We cannot assure investors that we will be able to obtain necessary
regulatory clearances or approvals on a timely basis, if at all, for any of our
potential products. Our business would suffer if:

        -   receipt of clearances or approvals is delayed;

        -   we fail to receive such clearances or approvals; or

        -   we fail to comply with existing or future regulatory requirements.

         Even if granted, regulatory clearances or approvals may include
significant limitations on the uses for which products may be marketed. Certain
changes to marketed medical devices and new drugs are subject to additional FDA
review and clearance or approval.



                                                                         Page 28
<PAGE>   29

         We cannot assure investors that any required clearances or 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;

        -   FDA refusal to grant premarket clearance or premarket approval of
            medical devices and drugs;

        -   FDA refusal to allow us to enter into government supply contracts;

        -   withdrawals of previously approved marketing applications; and

        -   criminal prosecutions.

         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 and
insulin on a limited number of individuals in Phase I and Phase II clinical
trials in the United States and with insulin on a limited number of individuals
in Phase I and Phase II trials in Australia. 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.

         We are also developing applications of our AERx system for the delivery
of other compounds. These applications are in an early stage 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 investors that these applications will prove to be viable or
that any necessary regulatory approvals will be obtained in a timely manner, if
at all. Although we believe the data 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
investors 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.

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

         Manufacturers of medical devices and 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 investors
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 and clearances from
foreign regulatory agencies and comply with extensive regulations regarding
safety and quality. We cannot assure investors that we will obtain regulatory
approvals in such countries or that we will not be required to incur significant
costs in obtaining or maintaining our foreign regulatory 


                                                                         Page 29
<PAGE>   30

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 our AERx Pain Management System clinical studies involve
morphine, we are registered with the Drug Enforcement Agency (DEA) and our
facilities are subject to inspection and DEA export, import, security and
production quota requirements. We cannot assure investors that we will not be
required to incur significant costs to comply with DEA regulations in the future
or that such regulations will not otherwise harm our business.

WE ARE IN A HIGHLY COMPETITIVE MARKET AND OUR COMPETITORS MAY DEVELOP
ALTERNATIVE THERAPIES

         The medical device, pharmaceutical and biotechnology industries are
highly competitive and rapidly evolving. Our success depends on our ability to
successfully develop products and technologies for pulmonary drug delivery. If a
competing company were to develop or acquire rights to a better pulmonary
delivery device, our business would be harmed.

         We compete with pharmaceutical, biotechnology and drug delivery
companies and other entities 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. There are a number of companies
currently seeking to develop new products and non-invasive alternatives to
injectable drug delivery, including oral, intranasal and transdermal delivery
systems and colonic absorption systems. A competitor of the Company has recently
received approval for fentanyl, a narcotic analgesic, to treat rapid-onset pain
in certain types of patients. Other companies are currently developing and
commercializing enhanced injectable drug delivery systems and pulmonary drug
delivery systems. Many of our competitors have greater research and development
capabilities, experience, manufacturing, marketing, sales, financial and
managerial resources than we do, and they represent significant competition for
our business. Our competitors' financial, marketing and other resources could be
further enhanced if they are acquired by large pharmaceutical companies or if
they enter into partnering arrangements.

         Our competitors may succeed in developing competing technologies,
obtaining FDA approval for products more rapidly than us and in gaining greater
market acceptance of their products than our products. We cannot assure
investors that developments by others will not render some or all of our
proposed products or technologies uncompetitive or obsolete.

WE DEPEND ON KEY PERSONNEL

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

WE MAY BE EXPOSED TO PRODUCT LIABILITY

         Researching, developing and commercializing medical devices and
therapeutic products entails 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, we
cannot assure investors 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



                                                                         Page 30
<PAGE>   31

         In both domestic and foreign markets, sales of our potential products,
if any, depend in part on the availability of reimbursement from third-party
payors such as government health administration authorities, private health
insurers and other organizations. Third-party payors are increasingly
challenging 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 investors that any of our products will
be reimbursable by third-party payors. In addition, we cannot assure investors
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 the controlled use of hazardous materials,
chemicals and various radioactive compounds. Although we believe that our safety
procedures for handling and disposing of such materials comply with the state
and federal regulations standards, the risk of accidental contamination or
injury from these materials cannot be completely eliminated. In the event of
such an accident, we could be held liable for any damages that result and such
liability could exceed the resources of our business.

OUR STOCK PRICE MAY BE VOLATILE

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

        -   investor perception of us;

        -   analyst recommendations;

        -   fluctuations in our operating results;

        -   market conditions relating to the pharmaceutical 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;

        -   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 technologies;

        -   period-to-period fluctuations in financial results;

        -   future sales of substantial amounts of common stock by existing
            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.

YEAR 2000 ISSUE.

         As the year 2000 approaches, a "Year 2000" issue has arisen because
many existing application software programs, operating systems and manufacturing
equipment containing computer-related components (Systems) were designed to use
only the last two digits to represent a year (e.g., the year 1998 is represented
by "98" on the system or in the program). As a result, the year 1999 (i.e.,
"99") could be the maximum date value Systems will be able to process
accurately. If not corrected, the Year 2000 problem could cause system failures
or miscalculations resulting in inaccuracies in computer output or disruptions
of operations, including inaccurate processing of financial, personnel and other
information as well as the inability to process transactions or engage in
similar normal business activities.



                                                                         Page 31
<PAGE>   32

         We are currently developing a strategy to address the potential
exposures related to the impact of the Year 2000 exposures on our Systems. We
have appointed a project manager to lead our assessment of the Year 2000
exposures. We have begun an initial inventory of our key internal financial,
informational and operational systems, including manufacturing control systems,
to identify those areas that may be affected by the Year 2000 issues. We intend
to complete this inventory by the end of the first quarter of fiscal 1999. We
are in the stages of developing plans for implementing and testing any necessary
modifications to these key Systems to ensure Year 2000 compliance. We currently
estimate that any required remediation programs will be completed by the third
quarter of fiscal 1999.

         In addition to the risks associated with our own Systems, we have
relationships with, and are to varying degrees dependent upon, a large number of
third parties that provide us with information, goods and services. If
significant numbers of these third parties experience failures in their own
Systems due to the Year 2000 problem, it could affect our ability to process
transactions or engage in similar normal business activities. We have not yet
determined the impact on our operations, if any, if key third parties fail to
take necessary actions. We have initiated formal communications with significant
third parties to assess their Year 2000 compliance and determine the extent to
which we may be vulnerable to those third parties' failure to remedy their own
Year 2000 issues.

         We do not yet know the total cost associated with becoming Year 2000
compliant. To date, we have not incurred, and we do not anticipate that we will
incur, significant operating expenses that would be material to our business.
While we plan to complete modifications of our business-critical Systems prior
to the Year 2000, if we (or our third-party providers) do not complete such
modifications in a timely manner, the Year 2000 problem could impair our
business. We cannot predict the extent of any such impact. We cannot assure
investors that we or any third party will not encounter any unforeseen problems
with respect to any Systems, and these unforeseen problems will not impair our
business. We currently have no contingency plans to deal with any major Year
2000 non-compliance, though we will develop such plans over the coming quarters.

                           FORWARD-LOOKING STATEMENTS

         This Section contains forward looking statements, which include
statements based on our current expectations, assumptions, estimates and
projections about our Company and our industry, including statements about the
timing and results of clinical trials, regulatory approval, the establishment of
corporate partnering arrangements, the anticipated commercial introduction of
our products and the timing of our cash requirements. Words such as "believes,"
"anticipates," "expects," "intends," "plans" and similar expressions are
intended to identify forward-looking statements, but are not the exclusive means
of identifying these statements. Actual results could differ materially from
those projected in any forward-looking statements for the reasons detailed in
"Risk Factors" or elsewhere in this Section. We assume no obligation to update
any forward-looking statement.


ITEM 7A.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

         Market Risk Disclosures

         In the normal course of business, the financial position of the Company
is routinely subject to variety of risks including market risk associated with
interest rate movement. The Company regularly assesses these risks and has
established policies and business practices to protect against these and other
exposures. As the result, the Company does not anticipate material potential
losses in these areas.

         The following table provides information about the Company's financial
instruments that are sensitive to changes in interest rates. For investment
securities and debt obligations, the table presents principal cash flows and
related weighted-average interest rates by expected maturity dates.
Additionally, the Company has assumed its available for sale securities,
comprised of corporate notes and commercial paper are similar enough to
aggregate those securities for presentation purposes. The average interest rate
was calculated using the weighted average fixed rates under all contracts with
Comdisco and Transamerica.


                                                                         Page 32
<PAGE>   33




<TABLE>
<CAPTION>
DISCLOSURE                             1999       2000        2001       2002       2003      THEREAFTER       TOTAL     FAIR VALUE
                                                                                                                         AT 12/31/98
<S>                                   <C>         <C>       <C>       <C>        <C>          <C>           <C>         <C>
Available for sale securities          9,180                                                                   9,180

Cash and Cash Equivalents                  1          0          0          0          0              0               
                                                                                                                           9,180
Avg.                                   2.70%          0          0          0          0              0
Interest
rate

Short-term investments                20,264          0          0          0          0              0        20,264  
                                                                                                                          20,271
Average interest rate                  5.50%          0          0          0          0              0

Long -term debt, including current
portion
Fixed rate payments                                                                                      
                                       1,282      1,387       1,557      1,626                                  5,852
Average interest rate                   12.0%      12.0%       13.5%      13.5%
</TABLE>



                                                                         Page 33
<PAGE>   34

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, 1998 and 1997, and the related statements of
operations, shareholders' equity, and cash flows for each of the three years in
the period ended December 31, 1998. 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 generally accepted
auditing standards. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

           In our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of Aradigm Corporation
at December 31, 1998 and 1997, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 1998, in
conformity with generally accepted accounting principles.


                                                               ERNST & YOUNG LLP


Palo Alto, California
February 12, 1999


                                                                         Page 34
<PAGE>   35
                               ARADIGM CORPORATION

                                 BALANCE SHEETS
                        (IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
                                                                     DECEMBER 31,
                                                               -----------------------
                                                                 1998           1997
                                                               --------       --------
<S>                                                            <C>            <C>     
ASSETS
Current assets:
   Cash and cash equivalents                                   $ 10,765       $ 15,517
   Short-term investments                                        20,271          8,788
   Receivables                                                      774            261
   Other current assets and inventories                             729            929
                                                               --------       --------
     Total current assets                                        32,539         25,495

Property and equipment, net                                      12,196          4,417
Notes receivable from officers                                      135            303
Other assets                                                         79             79
                                                               --------       --------
     Total assets                                              $ 44,949       $ 30,294
                                                               ========       ========

LIABILITIES AND SHAREHOLDERS' EQUITY 
Current liabilities:
   Accounts payable                                            $  1,979       $  1,505
   Accrued clinical and cost of other studies                       633            -
   Accrued compensation                                           1,261            728
   Deferred revenue                                               9,873          6,339
   Other accrued liabilities                                        891            342
   Current portion of capital lease obligations                   1,282            582
                                                               --------       --------
     Total current liabilities                                   15,919          9,496

Noncurrent portion of deferred revenue                            2,800            -
Capital lease obligations, less current portion
                                                                  4,570          2,139

Commitments and contingencies

Shareholders' equity:
   Preferred stock, no par value; 5,000,000 shares
     authorized; no shares  issued or outstanding                   -              -
   Common stock, no par value, 40,000,000 shares
     authorized; issued and outstanding shares:
          1998 - 12,163,616; 1997 - 10,632,133                   73,768         54,976
   Shareholder notes receivable                                    (288)          (386)
   Deferred compensation                                           (541)          (104)
   Accumulated deficit                                          (51,279)       (35,827)
                                                               --------       --------
     Total shareholders' equity                                  21,660         18,659
                                                               --------       --------
     Total liabilities and shareholders' equity                $ 44,949       $ 30,294
                                                               ========       ========
</TABLE>

See accompanying notes

                                                                         Page 35
<PAGE>   36
                               ARADIGM CORPORATION

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



<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                             --------------------------------------
                                               1998           1997           1996
                                             --------       --------       --------
<S>                                          <C>            <C>            <C>     
Contract and license revenues primarily      $ 17,515       $  3,685       $    730
    from related parties


Expenses:
    Research and development                   25,549         13,452          7,981
    General and administrative                  8,661          6,012          2,958
                                             --------       --------       --------
    Total expenses                             34,210         19,464         10,939
                                             --------       --------       --------

Loss from operations                          (16,695)       (15,779)       (10,209)

Interest income                                 1,754          1,329          1,179
Interest expense                                 (513)          (234)           (52)
                                             --------       --------       --------
Net loss                                     $(15,454)      $(14,684)      $ (9,082)
                                             ========       ========       ========

Basic and diluted  net loss per share        $  (1.32)      $  (1.43)      $  (1.49)
                                             ========       ========       ========

Shares used in computing  basic and
    diluted net loss per share                 11,682         10,280          6,098
                                             ========       ========       ========
</TABLE>

See accompanying notes

                                                                         Page 36
<PAGE>   37
                               ARADIGM CORPORATION
                        STATEMENT OF SHAREHOLDERS' EQUITY
                       (IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
                                                Preferred Stock           Common Stock
                                             ----------------------   --------------------
                                               Shares       Amount      Shares      Amount
                                             ----------    --------   ----------   --------
<S>                                          <C>           <C>        <C>          <C>
Balances at December 31, 1995                 5,611,910    $ 24,119    1,327,025   $    267  
  Issuance of common stock                            -                  662,629        350  
  Repurchase of common stock                          -                    (2,766)        (1) 
  Issuance of common stock upon                                                              
    conversion of preferred stock and                                                        
    warrants, net                            (5,611,910)    (24,119)   5,727,166     24,119  
  Issuance of common stock                            -           -    2,500,000     24,591  
  Deferred compensation                               -           -            -        495  
  Amortization of deferred compensation               -           -            -          -   
  Comprehensive Income                                                                    -  
    Net Loss                                          -           -            -          -  
    Other Comprehensive Income                                                               
      Net Change in unrealized gain (loss)                                                   
      on available-for-sale investments               -           -            -          -

  Total Comprehensive income                                                                 
                                             ----------    --------   ----------   --------  
Balances at December 31, 1996                         -           -   10,214,054     49,821  
  Issuance of common stock                            -           -      432,513      5,164  
  Repurchase of common stock                          -           -      (14,434)        (9) 
  Repayment of Shareholders' notes                    -           -            -          -
  Amortization of deferred compensation                                                       
  Comprehensive Income                                                                       
    Net Loss                                          -           -            -          -
    Other Comprehensive Income                                                               
      Net Change in unrealized gain (loss)                                                   
      on available-for-sale investments                                                      

  Total Comprehensive income                          -           -            -          -  
                                             ----------    --------   ----------   --------  
Balances at December 31, 1997                         -           -   10,632,133     54,976  
  Issuance of common stock                                             1,566,638     17,837  
  Repurchase of common stock                                             (35,155)       (17) 
  Issuance of warrant for services                                                      268  
  Repayment of Shareholders' notes                                                           
  Deferred compensation                                                                 704  
  Amortization of deferred compensation                                                       
  Comprehensive Income                                                                       
    Net Loss                                                                                 
    Other Comprehensive Income                                                               
      Net Change in unrealized gain (loss)                                                   
      on available-for-sale investments                                                      

  Total Comprehensive income                          -           -            -          -  
                                             ----------    --------   ----------   --------  
Balances at December 31, 1998                         -    $      -   12,163,616   $ 73,768  
                                             ==========    ========   ==========   ========  
</TABLE>

<TABLE>
<CAPTION>
                                                                                                                     Total
                                                  Shareholder             Deferred            Accumulated            Equity
                                               Notes Receivable         Compensation            Deficit            Shareholders'
                                               ----------------         ------------          -----------          -------------
<S>                                            <C>                      <C>                   <C>                  <C>     
Balances at December 31, 1995                    $    (196)              $      -              $ (12,069)            $ 12,121
  Issuance of common stock                            (288)                     -                      -                   62
  Repurchase of common stock                             1                      -                      -                    -
  Issuance of common stock upon                                                                                             -
    conversion of preferred stock and                                                                                       -
    warrants, net                                        -                      -                      -                    -
  Issuance of common stock                               -                      -                      -               24,591
  Deferred compensation                                  -                   (495)                     -                    -
  Amortization of deferred compensation                  -                    187                      -                  187
  Comprehensive Income                                                                                                      -
    Net Loss                                             -                      -                 (9,082)              (9,082)
    Other Comprehensive Income                                                                                              -
      Net Change in unrealized gain (loss)                                                                                  -
      on available-for-sale investments                                                                7                    7
                                                                                               ---------             --------
  Total Comprehensive income                             -                      -                 (9,075)              (9,075)
                                                 ---------               --------              ---------             --------
Balances at December 31, 1996                         (483)                  (308)               (21,144)              27,886
  Issuance of common stock                                                                                              5,164
  Repurchase of common stock                             9                                                                  -
  Repayment of Shareholders' notes                      88                                                                 88
  Amortization of deferred compensation                  -                    204                                         204
  Comprehensive Income                                                                                                      -
    Net Loss                                             -                      -                (14,684)             (14,684)
    Other Comprehensive Income                                                                                              -
      Net Change in unrealized gain (loss)                                                                                  -
      on available-for-sale investments                                                                1                    1
                                                                                               ---------             --------
  Total Comprehensive income                             -                      -                (14,683)             (14,683)
                                                 ---------               --------              ---------             --------
Balances at December 31, 1997                         (386)                  (104)               (35,827)              18,659
  Issuance of common stock                                                                                             17,837
  Repurchase of common stock                            17                      -                      -                    -
  Issuance of warrant for services                                                                                        268
  Repayment of Shareholders' notes                      81                      -                      -                   81
  Deferred compensation                                  -                   (704)                     -                    -
  Amortization of deferred compensation                  -                    267                      -                  267
  Comprehensive Income                                   -                      -                      -                    -
    Net Loss                                             -                      -                (15,454)             (15,454)
    Other Comprehensive Income                                                                                              -
      Net Change in unrealized gain (loss)                                                                                  -
      on available-for-sale investments                                                                2                    2
                                                                                               ---------             --------
  Total Comprehensive income                             -                      -                (15,452)             (15,452)
                                                 ---------               --------              ---------             --------
Balances at December 31, 1998                    $    (288)              $   (541)             $ (51,279)            $ 21,660
                                                 =========               ========              =========             ========
</TABLE>

See accompanying notes
                                                                         Page 37
<PAGE>   38
                               ARADIGM CORPORATION

                            STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)



<TABLE>
<CAPTION>
                                                                   YEARS ENDED DECEMBER 31,
                                                          -----------------------------------------
                                                            1998            1997            1996
                                                          ---------       ---------       ---------
<S>                                                       <C>             <C>             <C>       

CASH FLOWS FROM OPERATING ACTIVITIES
Net loss                                                  $ (15,454)      $ (14,684)      $  (9,082)
Adjustments to reconcile net loss to net cash used
   in operating activities:
   Depreciation and amortization                              1,773             691             389
   Issuance of warrant for services                             268              --              --
   Amortization of deferred compensation                        267             204             187
   Changes in operating assets and liabilities:
     Receivables                                               (513)           (261)            260
     Other current assets and inventories                       200            (478)           (376)
     Other assets                                                --              (4)             (8)
     Accounts payable                                           474             904             426
     Accrued liabilities                                      1,715            (388)          1,172
     Deferred revenue                                         6,334           6,170             (61)
                                                          ---------       ---------       ---------
Cash used in operating activities                            (4,936)         (7,846)         (7,093)
                                                          ---------       ---------       ---------

CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures                                        ( 9,552)         (2,756)           (811)
Purchases of available-for-sale investments                 (34,940)        (27,278)       (191,767)
Proceeds from maturities of available-for-sale            
   investments                                               23,459          29,571         180,694
                                                          ---------       ---------       ---------
Cash used in investing activities                           (21,033)           (463)        (11,884)
                                                          ---------       ---------       ---------

CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of common stock, net                  17,837           5,164          24,653
Proceeds from repayments of shareholder notes                    81              88            --
Notes receivable from officers                                  168             (83)            (69)
Proceeds from equipment loans                                 4.176           1,437            --
Payments on capital lease obligations and equipment       
   loans                                                     (1,045)           (234)           (270)
                                                          ---------       ---------       ---------
Cash provided by financing activities                        21,217           6,372          24,314
                                                          ---------       ---------       ---------


Net (decrease) increase in cash and cash equivalents         (4,752)         (1,937)          5,337
Cash and cash equivalents at beginning of year               15,517          17,454          12,117
                                                          ---------       ---------       ---------
Cash and cash equivalents at end of year                  $  10,765       $  15,517       $  17,454
                                                          =========       =========       =========

SUPPLEMENTAL DISCLOSURE REGARDING NON-CASH INVESTING
   AND FINANCING ACTIVITIES
Common stock issued in exchange for notes receivable      $       -       $       -       $     288
                                                          =========       =========       =========
Common stock repurchased upon cancellation of
   shareholder notes                                      $      17       $       9       $       1
                                                          =========       =========       =========
Acquisition of equipment under capital leases             $       -       $     899       $     395
                                                          =========       =========       =========

Cash paid for interest                                    $     513       $     235       $      52
                                                          =========       =========       =========
</TABLE>


See accompanying notes

                                                                         Page 38

<PAGE>   39


                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Basis of Presentation

Aradigm Corporation (the "Company") was incorporated in California. Through June
1997, prior to the signing of the Company's collaborative agreement with
SmithKline Beecham (see Note 7), the Company was in the development stage. Since
inception, Aradigm has been engaged in the development and commercialization of
non-invasive pulmonary drug delivery systems. The Company does not anticipate
receiving significant revenue from the sale of products in the upcoming year.
Principal activities to date have included conducting research and development,
obtaining financing, recruiting management and technical personnel, securing
operating facilities, and expanding commercial production capabilities. These
factors indicate that the Company's ability to continue its research,
development and commercialization activities is dependent upon the ability of
management to obtain additional financing as required.

Use of Estimates

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

Depreciation and Amortization

The Company records property and equipment at cost and calculates depreciation
using the straight-line method over the estimated useful lives of the respective
assets, generally three to seven years. Machinery and equipment acquired under
capital leases is amortized over the useful lives of the assets. Leasehold
improvements are amortized over the shorter of the term of the lease or useful
life of the improvement.

Revenue Recognition

Contract revenues consist of revenue from collaboration agreements and
feasibility studies. The Company recognizes revenue under the agreements as
costs are incurred. Deferred revenue represents the portion of research payments
received that has not been earned. In accordance with contract terms, up-front
and milestone payments from collaborative research agreements are considered
reimbursements for costs incurred under the agreements and, accordingly, are
generally deferred when received and recognized as revenue based on actual
efforts expended over the remaining terms of the agreements. Non-refundable
signing or license fee payments that are not dependent on future performance
under collaborative agreements are recognized as revenue when received. Costs of
contract revenue approximate such revenue and are included in research and
development expenses.

Net Loss Per Share

Basic net loss per common share and diluted net loss per share are presented in
accordance with SFAS No. 128, "Earning per share" ("SFAS 128"), for all the
periods presented. Basic net loss per share has been computed using the weighted
average number of shares of common stock outstanding during the period.

For the years ended December 31, 1998 and 1997, outstanding stock options and
other stock equivalents are not included as their effect would be anti-dilutive.

The following pro forma per share data, as adjusted, is provided to show the net
loss per share calculation on a consistent basis for the year ended December 31,
1996. It has been computed as described above, but includes the retroactive
effect from the date of issuance of the conversion of 



                                                                         Page 39
<PAGE>   40

                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998

convertible preferred stock to common shares upon the closing of the Company's
initial public offering in June 1996.

A reconciliation of shares used in the calculation of historical and pro forma,
as adjusted, basic and diluted net loss per share follows:

<TABLE>
<S>                                                                <C>        
Net loss                                                             $   (9,082)
                                                                     ===========
Basic and Diluted
Weighted average common shares outstanding used in
   computing basic and diluted net loss per share
                                                                      6,098,038
                                                                     ===========
Basic and diluted net loss per share                                 $    (1.49)
                                                                     ===========
Pro Forma Basic and Diluted, as adjusted
Shares used in computing basic and diluted net
   loss per share                                                     6,098,038
Adjusted to reflect the effect of the assumed
   conversion of preferred stock                                      2,529,456
                                                                     -----------
Shares used in computing pro forma basic and
   diluted net loss per share, as adjusted                            8,627,494
                                                                     ===========
Pro forma basic and diluted net loss per share, as adjusted          $    (1.05)
                                                                     ===========

</TABLE>

Had the Company been in a net income position, diluted earnings per share would
have included the weighted average effect of outstanding options and warrants.
(As Determined Using the Treasury Stock Method)

Employee Benefit Plans

The Company has a 401(k) Plan which stipulates that all full-time employees with
at least three months of employment can elect to contribute to the 401(k) Plan,
subject to certain limitations, up to 20% of salary on a pretax basis. The
Company has the option to provide matching contributions but has not done so to
date.

Recent Accounting Pronouncements

Effective January 1, 1998, the Company adopted SFAS 130, "Reporting
Comprehensive Income," which establishes new rules for the reporting and display
of comprehensive income (loss) and its components. Statement 130 requires
unrealized gains or losses on the Company's available for sale securities, which
prior to adoption were reported separately in shareholders' equity to be
included in other comprehensive income (loss). Prior year financial statements
have been reclassified to conform to the requirements of Statement 130. The
adoption of this Statement had no impact on the company's results of operations
or financial position.

For the years ended December 31, 1998, 1997 and 1996, realized and unrealized
gains or losses on the Company's available-for-sale securities are not material.
The accumulated unrealized gains or losses (reflecting accumulated other
comprehensive income) were $10,000, $8,000 and $7,000 at December 31, 1998, 1997
and 1996 respectively.



                                                                         Page 40
<PAGE>   41

                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998

Effective January 1998, the Company adopted SFAS 131, "Disclosures about
segments of an Enterprise and Related Information," which established revised
standards for the reporting of financial and descriptive information about
operating segments in financial statements. The Company has determined that it
operates in only one segment, which is non-invasive pulmonary drug delivery
systems. Accordingly, the adoption of this Statement had no impact on the
Company's operations or financial position.

In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 (SFAS 133), "Accounting for Derivative
Financial Instruments and for Hedging Activities" which provides a comprehensive
and consistent standard for the recognition and measurement of derivatives and
hedging activities. SFAS 133 is effective for years beginning after June 15,
1999 and is not anticipated to have an impact on the Company's results of
operations or financial condition when adopted.

Reclassifications

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

2. FINANCIAL INSTRUMENTS

Cash Equivalents and Investments

The Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents. The Company places its
cash and cash equivalents in money market funds, commercial paper and corporate
master notes. The Company's short-term investments consist of commercial paper,
corporate notes and market auction preferred securities with maturities ranging
from 3 to 12 months.

The Company classifies its investments as available-for-sale. Available-for-sale
investments are recorded at fair value with unrealized gains and losses reported
in other comprehensive income. Fair values of investments are based on quoted
market prices, where available. Realized gains and losses, which have been
immaterial to date, are included in interest and other income and are derived
using the specific identification method for determining the cost of investments
sold. Dividend and interest income is recognized when earned.


The following summarizes the Company's fair value of cash equivalents and
investments:


<TABLE>
<CAPTION>
                                                       December 31,
                                              ----------------------------
                                                 1998             1997
                                              -----------      -----------
<S>                                           <C>              <C>        
Cash equivalents:
     Money market fund                        $    16,000      $     6,000
     Commercial paper                           9,164,000       14,331,000
                                              -----------      -----------
Short-term Investments:                       $ 9,180,000      $14,337,000
                                              ===========      ===========
</TABLE>

                                                                         Page 41
<PAGE>   42

                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998


<TABLE>
<S>                                           <C>              <C>        
     Commercial paper                         $ 2,613,000      $ 3,272,000
     Corporate notes                           16,758,000        3,216,000
     Market auction preferred securities          900,000        2,300,000
                                              -----------      -----------
                                              $20,271,000      $ 8,788,000
                                              ===========      ===========
</TABLE>

As of December 31, 1998 and 1997, the difference between the fair value and the
amortized cost of available-for-sale securities was immaterial. As of December
31, 1998, the average portfolio duration was approximately three months, and the
contractual maturity of any single investment did not exceed seven months from
the balance sheet date.



                                                                         Page 42
<PAGE>   43

                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998

3. PROPERTY AND EQUIPMENT

Property and equipment consist of the following:

<TABLE>
<CAPTION>
                                                             December 31,
                                                    -------------------------------
                                                        1998               1997
                                                    ------------       ------------
<S>                                                 <C>                <C>         
Machinery and equipment                             $ 10,807,000       $  3,294,000
Furniture and fixtures                                   810,000            434,000
Lab equipment                                          1,610,000          1,048,000
Computer equipment and software                        1,264,000            755,000
Leasehold improvements                                   880,000            288,000
                                                    ------------       ------------
                                                      15,371,000          5,819,000
Less accumulated depreciation and amortization        (3,175,000)        (1,402,000)
                                                    ------------       ------------
                                                    $ 12,196,000       $  4,417,000
                                                    ============       ============
</TABLE>

Property and equipment at December 31, 1998 includes assets under capitalized
leases of approximately $7,512,000 ($3,322,000 in 1997). Accumulated
amortization related to leased assets was approximately $2,115,000 at December
31, 1998 ($392,000 in 1997).

4. LEASES AND COMMITMENTS

In December 1998, the Company obtained a new $3.0 million equipment lease line
of credit of which approximately $1.7 million remains available at December 31,
1998 for acquisition through September 1999. Amounts borrowed under the
Company's equipment lease lines of credit bear interest at rates from 10% to 15%
and are collateralized by the equipment acquired. Under the terms of the lease
agreements, the Company has the option to purchase the leased equipment at a
negotiated price at the end of each lease term. The Company leases its office
and laboratory facilities under several operating leases that expire through the
year 2016.

Future minimum lease payments under noncancelable operating and capital leases
at December 31, 1998 are as follows:

<TABLE>
<CAPTION>
                                                                                  Operating          Capital
                                                                                    Leases            Leases
                                                                                 -----------        ----------
<S>                                                                              <C>                <C>
Years ending December 31:
   1999                                                                           $1,687,000        $1,986,000
   2000                                                                            1,809,000         1,927,000
   2001                                                                            2,135,000         1,888,000
   2002                                                                            2,362,000         1,760,000
   2003 and thereafter                                                            39,062,000                 -
                                                                                 -----------        ----------
Total minimum lease payments                                                     $47,055,000         7,561,000
                                                                                 ===========
Less amount representing interest                                                                   (1,709,000)
                                                                                                    ----------
Present value of future lease payments                                                               5,852,000
Current portion of capital lease obligations                                                        (1,282,000)
                                                                                                    ==========
Noncurrent portion of capital lease obligations                                                     $4,570,000
                                                                                                    ==========
Rent expense under these operating leases totaled $1,157,000, $420,000 and
197,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
</TABLE>

5. CONTINGENCIES

                                                                         Page 43
<PAGE>   44

                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998


In June of 1998, Eli Lilly and Company ("Lilly") filed a complaint against the
Company in the United States District Court for the Southern District of
Indiana. The complaint made various allegations against the Company, arising
from the Company's decision to enter into an exclusive collaboration with Novo
Nordisk A/S ("Novo Nordisk"), addressing the development and commercialization
of a pulmonary delivery system for insulin and insulin analogs. The complaint
seeks a declaration that Lilly scientists are co-inventors of a patent
application filed by the Company relating to pulmonary delivery of an insulin
analog or, in the alternative, enforcement of an alleged agreement to grant
Lilly an nonexclusive license under such patent application. The complaint also
contains certain other allegations and seeks unspecified damages and injunctive
relief. Management believes that Lilly's claims are without merit and that this
litigation will not have a material adverse effect on the Company's results of
operations, cash flows or financial position. The Company has filed an answer
denying all material allegations of the complaint.

6. SHAREHOLDERS' EQUITY

Capital Stock

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

In June 1996, the Company completed the initial public offering of its common
stock. The Company issued 2,500,000 shares for net proceeds of $24.6 million.
Concurrent with the closing of the initial public offering, previously
outstanding shares of Series A, B, C, D and E preferred stock were converted
into 5,611,911 shares of common stock. All share and per share data in the
accompanying financial statements has been adjusted retroactively to give effect
to the stock split.

Stock Warrants

In December 1998, the Company issued a warrant in connection with an operating
lease agreement that entitles the holder to purchase 50,000 shares of common
stock at an exercise price of $10.94 per share. This warrant is exercisable
through December 2005. In April 1998, the Company issued warrants to the
underwriters 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. These warrants are exercisable through June 2003.

In September 1997, in connection with a consulting agreement, the Company issued
a warrant that entitles the holder to purchase 170,000 shares of common stock at
an exercise price of $8.96 per share. This warrant is exercisable through August
2003. At December 31, 1998, the Company has reserved 386,665 shares of its
common stock for issuance upon exercise of these common stock warrants.

1996 Equity Incentive Plan

In April 1996, the Company's Board of Directors adopted and the Company's
shareholders approved the 1996 Equity Incentive Plan (the "Plan"), which amended
and restated the 1992 Stock Option Plan. Options granted under the Plan may be
either incentive or non-statutory stock options. At December 31, 1998, the
Company had authorized 2,980,000 shares of common stock for issuance under the
Plan. Options granted under the Plan expire no later than ten years from the
date of grant. For incentive and 



                                                                         Page 44
<PAGE>   45

                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998

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.

Options granted under the 1996 Equity Incentive Plan are immediately exercisable
and the shares acquired are generally vested over a period of four years from
the date of grant. Under the Plan, employees may exercise options in exchange
for a note payable to the Company. As of December 31, 1998 and 1997, notes
receivable from shareholders of $288,000 and $386,000, respectively, were
outstanding. These notes generally bear interest at 6% and are due and payable
in regular installments over a five year period. Any unvested stock issued is
subject to repurchase agreements whereby the Company has the option to
repurchase unvested shares upon termination of employment at the original issue
price. The common stock has voting rights but does not have resale rights prior
to vesting. The Company has repurchased a total of 38,291 shares in accordance
with these agreements. During 1998, the Company granted options to purchase
975,300 shares of common stock, none of which were exercised subject to
repurchase agreements. As of December 31, 1998, 96,007 shares of the Company's
common stock remained subject to repurchase and 1,970,412 shares were reserved
for issuance upon exercise of options.

The following is a summary of activity under the Plan:

<TABLE>
<CAPTION>
                                                              Options Outstanding
                                                    ------------------------------------------
                                   Shares                                             Weighted
                                  Available                                           Average
                                 for Grant of        Number           Price Per       Exercise
                                   Options          of Shares           Share          Price
                                -------------       ----------       ------------    --------
<S>                             <C>                 <C>             <C>              <C>   
Balance at December 31, 1995         171,882          452,242        $0.10-$0.43      $ 0.30
   Options authorized              1,005,000               --        $        --      $   --
   Options granted                  (523,520)         523,520        $0.57-$9.88      $ 3.66
   Options exercised                      --         (662,629)       $0.10-$5.33      $ 0.53
                                ------------        ---------
Balance at December 31, 1996         653,362          313,133        $0.10-$9.88      $ 5.45
   Options granted                  (550,600)         550,600       $6.88-$12.88      $ 8.75
   Options exercised                      --           (5,625)      $       5.33      $ 5.33
   Shares repurchased                 24,229               --       $0.37-$ 0.57      $ 0.49
   Options cancelled                  26,825          (26,825)       $5.33-$9.88      $ 6.03
                                ------------        ---------
Balance at December 31, 1997         153,816          831,283       $0.10-$12.88      $ 7.62
   Options authorized              1,000,000               --       $         --      $   --
   Options granted                  (975,300)         975,300       $9.13-$14.63      $11.51
   Options exercised                      --          (28,749)      $6.88-$12.25      $ 8.99
   Shares repurchased                 14,062               --       $0.43-$ 4.00      $ 0.58
   Options cancelled                  53,963          (53,963)      $5.33-$12.25      $ 8.48
                                ------------        ---------
Balance at December 31, 1998         246,541        1,723,871       $0.10-$14.63      $ 9.77
                                ============        =========
</TABLE>


                                                                         Page 45
<PAGE>   46

                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998

<TABLE>
<CAPTION>
                                                         Options Outstanding and Exercisable
                                            -------------------------------------------------------------
                                                                                      Weighted Average
                                                                 Weighted           Remaining Contractual
                                                                 Average                    Life
         Exercise Price Range                    Number       Exercise Price             (in years)
      ----------------------------          --------------   ----------------       ---------------------
<S>                                         <C>              <C>                    <C>
              $0.10-$2.00                          69,033         $0.46                      5.6
              $4.00-$5.67                         133,500         $5.21                      7.4
              $6.88-$9.94                         716,138         $8.64                      8.8
             $10.63-$14.63                        805,200        $12.32                      9.3
                                            =============
             $0.10-$14.63                       1,723,871         $9.77                      8.8
                                            =============
</TABLE>

The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25"), and the related
Interpretations in accounting for its employee and non-employee director stock
options because, as discussed below, the alternative fair value accounting
provided for under Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123"), requires use of option
pricing valuation models that were not developed for use in valuing employee
stock options. Under APB 25, the Company has generally recognized no
compensation expense with respect to such awards.

The Company recorded deferred compensation of approximately $495,000 for the
difference between the grant price and the fair value of certain of the
Company's common stock options granted in 1996. This amount was amortized
over the vesting period of the individual options. Deferred compensation expense
relating to this $495,000 recognized in the years ended December 31, 1998, 1997
and 1996 was approximately $104,000, $204,000 and $187,000, respectively. The
Company also recorded additional deferred compensation of approximately $649,000
for the difference between grant price and the fair value of certain of the
Company's common stock options granted in 1998, $108,000 of which was recognized
in 1998. The weighted average fair value of options granted during 1996 with an
exercise price below the deemed fair value of the Company's common stock on the
date of grant was $2.15. There were no such grants in 1997. The weighted average
fair value of options granted in 1998 with an exercise price below the deemed
fair value of the Company's common stock on the date of grant was $12.13. The
weighted average fair value of options granted during 1998, 1997 and 1996 with
an exercise price equal to the fair value of the Company's common stock on the
date of grant was $6.09, $3.35 and $5.60, 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 ranging from 5.2%-5.6%,
5.7%-6.4% and 5.1%-5.8% for the years ended December 31, 1998, 1997 and 1996,
respectively; a dividend yield of 0.0%; the annual volatility factor of the
expected market price of the Company's common stock for 1998, 1997 and 1996 are
0.63, 0.70 and 0.70, respectively; and a weighted average expected option life
of four years. Options granted prior to the Company's initial public offering in
June 1996 have a volatility factor of 0.0.



                                                                         Page 46
<PAGE>   47

                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998


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

<TABLE>
<CAPTION>
                                                                             Years ended December 31,
                                                               ----------------------------------------------------
                                                                   1998                1997               1996
                                                               ------------        ------------        ----------- 
<S>                                                            <C>                 <C>                 <C>         
Pro forma net loss                                             $(16,529,000)       $(14,960,000)       $(9,117,000)
Net loss - as reported                                         $(15,454,000)       $(14,684,000)       $(9,082,000)

Pro forma basic and diluted net loss per share                       $(1.41)             $(1.46)            $(1.50)
Basic and diluted net loss per share - as reported                   $(1.32)             $(1.43)            $(1.49)
</TABLE>

The effects of applying SFAS 123 for pro forma disclosures are not likely to be
representative of the effects on reported net loss for future years. Pro forma
net loss for the year ended December 31, 1998 reflects compensation expense for
four years' vesting, while the year ending December 31, 1999 will reflect
compensation expense for five years' vesting of outstanding stock options.

Employee Stock Purchase Plan

Under the two-year Employee Stock Purchase Plan (the "Purchase Plan"), 300,000
shares of common stock have been authorized for issuance. Shares may be
purchased under the Purchase Plan at 85% of the lesser of the fair market value
of the common stock on the grant date or purchase date. As of December 31, 1998,
109,711 shares have been issued under the Purchase Plan.

1996 Non-Employee Directors' Stock Option Plan

The 1996 Non-Employee Directors' Stock Option Plan (the "Directors' Plan")
authorizes the grant of 225,000 options for the Company's common stock. As of
December 31, 1998, 82,500 options have been granted under the Directors' Plan.

7. COLLABORATIVE AGREEMENTS

In June 1998, the Company executed a development and commercialization agreement
with Novo Nordisk to jointly develop a pulmonary delivery system for
administering insulin by inhalation. In addition, the agreement provides Novo
Nordisk with an option to develop the technology for delivery of other compounds
in two undisclosed therapeutic areas outside diabetes. Under the terms of the
agreement, Novo Nordisk has been granted exclusive rights to worldwide marketing
of any products resulting from the development programs.

Pursuant to the Novo Nordisk agreement, Aradigm could receive up to $75 million
in milestone payments and equity investments, of which $9 million, including the
purchase of $5 million newly issued Aradigm stock, occurred upfront. In
addition, Novo Nordisk will fund all product development costs incurred by
Aradigm, while the partners will co-fund final development of the AERx device to
be used in the system. Aradigm will be the initial manufacturer of all the
products covered by the agreements, and will receive a share of the overall
gross profits resulting from Novo Nordisk's sales of the systems. As part of the
transaction, Novo Nordisk agreed to purchase $10 million of newly issued Aradigm
common stock, in two $5 million tranches, the first of which was at a 25%
premium to the market price. Through December 31, 1998, the Company has
recognized total contract revenue of $5.3 million (the entire amount was
received in 1998).



                                                                         Page 47
<PAGE>   48

                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998

In September 1997, the Company executed a development and commercialization
agreement with SmithKline Beecham covering use of the AERx Pain Management
System for the delivery of narcotic analgesics. The Company and SmithKline
Beecham will collaborate on the development of the products within this field.
Under the terms of the agreement, SmithKline Beecham has been granted exclusive
worldwide sales and marketing rights to the AERx Pain Management System for use
with such analgesics, and Aradigm retains all manufacturing rights. If this
system receives regulatory approval, Aradigm intends to sell devices and drug
packets to SmithKline Beecham and will receive royalties on sales of developed
product by SmithKline Beecham.

Pursuant to the SmithKline Beecham agreement, Aradigm could receive up to
approximately $30 million in milestone and product development payments, and $10
million in equity investments if and when the first product from the
collaboration is commercialized. In October 1997, the Company received $14
million from SmithKline Beecham under the agreement, of which $5 million
resulted from the sale of shares of Aradigm Common Stock at the then market
price. Additional milestone and product development payments will be paid if
Aradigm and SmithKline Beecham decide to jointly develop additional AERx
products which incorporate other opiates or opioids. Through December 31, 1998,
the Company has recognized total contract revenue of $13.7 million ($11 million
and $2.7 million in 1998 and 1997, respectively).




                                                                         Page 48
<PAGE>   49

                               Aradigm Corporation
                          Notes to Financial Statements
                                December 31, 1998



8. INCOME TAXES

The Company uses the liability method to account for income taxes as required by
Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes". Under this method, deferred tax assets and liabilities are determined
based on differences between financial reporting and tax bases of assets and
liabilities and are measured using enacted tax rules and laws that are expected
to be in effect when the differences are expected to reverse.

Significant components of the Company's deferred tax assets are as follows:

<TABLE>
<CAPTION>
                                                            December 31,
                                                  -------------------------------
                                                      1998               1997
                                                  ------------       ------------
<S>                                               <C>                <C>         
Net operating loss carryforward                   $ 15,613,000       $ 13,735,000
Deferred Revenue                                     2,880,000                 --
Research and development credit carryforward         1,769,000          1,769,000
Other                                                  457,000             36,000

                                                  ------------       ------------
Gross deferred tax assets                           20,719,000         15,540,000
Valuation allowance                                (20,719,000)       (15,540,000)
                                                  ------------       ------------
Net deferred tax assets                           $         --       $         --
                                                  ============       ============
</TABLE>

The valuation allowance increased by $5,179,000 and $6,742,000 in 1998 and 1997,
respectively.

At December 31, 1998, the Company has net operating loss carryforwards of
approximately $41,000,000 which expires in the tax years 2006 through 2018 and
net operating losses for state income tax purposes of $28,000,000 expiring in
the years 1999 through 2003. At December 31, 1998, the Company had research and
development credit carryforwards for federal income tax purposes of
approximately $1,161,000, which expire in the years 2006 through 2012.

Because of the "change in ownership" provisions of the Tax Reform Act of 1986,
utilization of the Company's tax net operating loss carryforwards and tax credit
carryforwards may be subject to an annual limitation in future periods. As a
result of the annual limitation, a portion of these carryforwards may expire
before ultimately becoming available to reduce future income tax liabilities.

9. SUBSEQUENT EVENT

On January 27, 1999, the Company entered into a binding, non-cancelable
agreement with various investors to sell 2,428,338 shares of its Common Stock
subject to meeting certain closing conditions, including the effectiveness of a
registration statement. The gross proceeds to the Company are expected to be
approximately $25.5 million, upon closing.


                                                                         Page 49
<PAGE>   50



ITEM 10.   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, 1998, 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 the Company's
executive officers is set forth in Part I of this Report.

SECTION 16(a) COMPLIANCE

           The information regarding compliance with Section 16(a) of the
Securities Exchange Act of 1934, as amended, required by this Item is
incorporated by reference from the Proxy Statement.

ITEM 11.   EXECUTIVE COMPENSATION

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

ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

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

ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

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



                                                                         Page 50
<PAGE>   51



                                    PART IV


ITEM 14.   EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K

(a)  (1)   Financial Statements.

<TABLE>
<CAPTION>
           Included in Part II of this Report:                                                       Page in
                                                                                                     Form 10-K
<S>                                                                                                  <C>

                Report of Ernst & Young LLP, Independent Auditors                                         34

                Balance Sheets --- December 31, 1998 and 1997                                             35

                Statements of Operations --- Years ended December 31, 1998, 1997 and 1996
                                                                                                          36

                Statements of Shareholders' Equity --- Years ended December 31, 1998, 1997 and 1996       37

                Statements of Cash Flows --- Years ended December 31, 1998, 1997 and 1996                 38

                Notes to Financial Statements                                                             39
</TABLE>

     (2)   Financial Statement Schedules.

           None.

<TABLE>
<CAPTION>
     (3)   Exhibits.

<S>                        <C>                                                                       
           3.1 (1)         Amended and Restated Articles of Incorporation of the Company.

           3.2 (1)         Bylaws of the Company

           4.1             Reference is made to Exhibits 3.1 and 3.2

           4.2 (1)         Specimen stock certificate

           4.3 (1)         Amended and Restated Investor Rights Agreement, dated December 22, 1995, among the
                           Company and certain of its shareholders

           10.1 (1) (2)    Form of Indemnity Agreement between the Registrant and each of its directors and
                           officers

           10.2 (1) (2)    The Company's Equity Incentive Plan, as amended (the "Equity Incentive Plan")

           10.3 (1) (2)    Form of the Company's Incentive Stock Option Agreement under the Equity Incentive Plan

           10.4 (1) (2)    Form of the Company's Non-statutory Stock Option Agreement under the Equity Incentive
                           Plan

           10.5 (1) (2)    Form of the Company's Non-Employee Directors' Stock Option Plan

           10.6 (1) (2)    Form of the Company's Non-statutory Stock Option Agreement under the Non-Employee
                           Directors' Stock Option Plan

           10.7 (1) (2)    Form of the Company's Employee Stock Purchase Plan

           10.8 (1) (2)    Form of the Company's Employee Stock Purchase Plan Offering Document

           10.9 (1)        Lease Agreement for the property located at 26219 Eden Landing Road, Hayward,
                           California, dated November 1992 and amended November 29, 1994, between the Company
                           and Hayward Point Eden I Limited Partnership

           10.9a(3)        Second Amendment to Lease, dated December 22, 1997, between the Company and Hayward
                           Point Eden I Limited Partnership

           10.9b(3)        Third Amendment to Lease, dated January 28, 1998, between the Company and Hayward
                           Point Eden I Limited Partnership
</TABLE>



                                                                         Page 51
<PAGE>   52
<TABLE>
<S>                        <C>                                                                       
           10.10(3)        Lease Agreement for the property located at 26224 Executive Place, Hayward, California, 
                           dated January 28, 1998, between the Company and Hayward Point Eden I Limited Partnership

           10.11 (1)       Lease Agreement for the property located at 3930 Point Eden Way, Hayward, California,
                           dated February 21, 1996, between the Company and Hayward Point Eden I Limited
                           Partnership

           10.11a(3)       First Amendment to Lease, dated June 10, 1996, between the Company and Hayward Point
                           Eden I Limited Partnership

           10.11b(3)       Second Amendment to Lease, dated December 22, 1997, between the Company and Hayward
                           Point Eden I Limited Partnership

           10.11c(3)       Third Amendment to Lease, dated January 28, 1998, between the Company and Hayward
                           Point Eden I Limited Partnership

           10.12 (1) (2)   Stock Purchase Agreement and related agreements, including Promissory Note, dated May
                           19, 1994, between the Company and Richard P. Thompson

           10.13 (1) (2)   Stock Purchase Agreement and related agreements, including Promissory Note, dated May
                           23, 1995, between the Company and R. Ray Cummings

           10.14 (1) (2)   Note Agreement and Promissory Note Secured by Deed of Trust, dated May 1, 1995,
                           between the Company and R. Ray Cummings

           10.15 (1) (2)   Promissory Note, dated October 26, 1995, between the Company and Igor Gonda

           10.16 (1) (2)   Promissory Note, dated December 27, 1995, between the Company and Igor Gonda

           10.17 (1)       Master Lease Agreement and Warrant, between the Company and Comdisco, Inc., dated June
                           9, 1995

           10.18 (4)(5)    Product Development and Commercialization Agreement between the Company and SmithKline
                           Beecham PLC

           10.19 (4)(5)    Stock Purchase Agreement between the Company and SmithKline Beecham PLC 

           10.20(3)        Lease Agreement for the property located at 3911 Trust Way, Hayward, California, dated
                           March 17, 1997, between the Company and Hayward Point Eden I Limited Partnership 


           10.20a(3)       First Amendment to Lease, dated December 22, 1997, between the Company and Hayward
                           Point Eden I Limited Partnership

           10.20b(3)       Second Amendment to Lease, dated January 28, 1998, between the Company and Hayward
                           Point Eden I Limited Partnership

           10.21(3)        Lease Agreement for the property located in Phase V
                           of the Britannia Point Eden Business Park in Hayward,
                           California, dated January 28, 1998, between the
                           Company and Britannia Point Eden, LLC 

           10.22(6)        Common Stock Purchase Agreement, dated April 3, 1998,
                           between the Company and certain purchasers of Common
                           Stock.
       
           10.23           Common Stock Purchase Agreement dated January 27, 
                           1998, between the Company and certain purchasers of Common Stock.

           23.1            Consent of Ernst & Young L.L.P., Independent Auditors.  Reference is made to page 55

           24.1            Power of Attorney.  Reference is made to page 53.

           27.1            Financial Data Schedule.
</TABLE>

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

(1) Incorporated by reference to the indicated exhibit in the Company's
    Registration Statement on Form S-1 (No. 333-4236), as amended.

(2) Represents a management contract or compensatory plan or arrangement.

(3) Incorporated by reference to the indicated exhibit in the Company's Annual
    Report on Form 10-K for the year ended December 31, 1997, as amended..

(4) Incorporated by reference to the Company's Form 8-K filed on November 11,
    1997

(5) Confidential treatment requested.

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


(b)        Reports on Form 8-K.

           None.

(c)        Index to Exhibits.

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




                                                                         Page 52
<PAGE>   53
(d)        Financial Statement Schedules.


                                   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 5th day of March, 1999.


                               ARADIGM CORPORATION

                               By /s/   Richard P. Thompson 
                                  ---------------------------------------
                               Richard P. Thompson
                               President and Chief Executive Officer


                                POWER OF ATTORNEY

     KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints, jointly and severally, Richard P.
Thompson and Reid M. Rubsamen, M.D., and each one of them, attorneys-in-fact for
the undersigned, each with the 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 an Exchange Commission, hereby ratifying and
confirming all that each of said attorneys-in-fact, or his substitutes, may do
or cause to be done by virtue hereof.

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

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

<TABLE>
<CAPTION>
     SIGNATURE                                      TITLE                                     DATE
<S>                                     <C>                                              <C>


/s/  Richard P. Thompson                President, Chief Executive Officer               March 5, 1998
-------------------------------
Richard P. Thompson                     and Director (Principal Executive Officer)


/s/  Mark A. Olbert                     Vice President, Finance and Administration       March 5, 1998
-------------------------------
Mark A. Olbert                          and Chief Financial Officer
                                       (Principal Financial and Accounting Officer)


/s/  Reid M. Rubsamen, M.D              Vice President, Medical Affairs, Secretary       March 5, 1998
-------------------------------
Reid M. Rubsamen, M.D                   and Director



/s/  Burton J. McMurtry, Ph.D           Director                                         March 5, 1998
-------------------------------
Burton J. McMurtry, Ph.D.


/s/ Gordon W. Russell                   Director                                         March 5, 1998
-------------------------------
Gordon W. Russell
</TABLE>


                                                                         Page 53
<PAGE>   54

<TABLE>
<S>                                     <C>                                              <C>
                                        Director                                         March 5, 1998
-------------------------------
Fred E. Silverstein, M.D.


/s/  Virgil D. Thompson                 Director                                         March 5, 1998
-------------------------------
Virgil D. Thompson

</TABLE>



                                                                         Page 54
<PAGE>   55
                                 EXHIBIT INDEX
<TABLE>
<CAPTION>
         Exhibit
           No.                               Document
          ----                               --------
<S>                        <C>                                                                       
           3.1 (1)         Amended and Restated Articles of Incorporation of the Company.

           3.2 (1)         Bylaws of the Company

           4.1             Reference is made to Exhibits 3.1 and 3.2

           4.2 (1)         Specimen stock certificate

           4.3 (1)         Amended and Restated Investor Rights Agreement, dated December 22, 1995, among the
                           Company and certain of its shareholders

           10.1 (1) (2)    Form of Indemnity Agreement between the Registrant and each of its directors and
                           officers

           10.2 (1) (2)    The Company's Equity Incentive Plan, as amended (the "Equity Incentive Plan")

           10.3 (1) (2)    Form of the Company's Incentive Stock Option Agreement under the Equity Incentive Plan

           10.4 (1) (2)    Form of the Company's Non-statutory Stock Option Agreement under the Equity Incentive
                           Plan

           10.5 (1) (2)    Form of the Company's Non-Employee Directors' Stock Option Plan

           10.6 (1) (2)    Form of the Company's Non-statutory Stock Option Agreement under the Non-Employee
                           Directors' Stock Option Plan

           10.7 (1) (2)    Form of the Company's Employee Stock Purchase Plan

           10.8 (1) (2)    Form of the Company's Employee Stock Purchase Plan Offering Document

           10.9 (1)        Lease Agreement for the property located at 26219 Eden Landing Road, Hayward,
                           California, dated November 1992 and amended November 29, 1994, between the Company
                           and Hayward Point Eden I Limited Partnership

           10.9a(3)        Second Amendment to Lease, dated December 22, 1997, between the Company and Hayward
                           Point Eden I Limited Partnership

           10.9b(3)        Third Amendment to Lease, dated January 28, 1998, between the Company and Hayward
                           Point Eden I Limited Partnership
           10.10(3)        Lease Agreement for the property located at 26224 Executive Place, Hayward, California, 
                           dated January 28, 1998, between the Company and Hayward Point Eden I Limited Partnership

           10.11 (1)       Lease Agreement for the property located at 3930 Point Eden Way, Hayward, California,
                           dated February 21, 1996, between the Company and Hayward Point Eden I Limited
                           Partnership

           10.11a(3)       First Amendment to Lease, dated June 10, 1996, between the Company and Hayward Point
                           Eden I Limited Partnership

           10.11b(3)       Second Amendment to Lease, dated December 22, 1997, between the Company and Hayward
                           Point Eden I Limited Partnership

           10.11c(3)       Third Amendment to Lease, dated January 28, 1998, between the Company and Hayward
                           Point Eden I Limited Partnership

           10.12 (1) (2)   Stock Purchase Agreement and related agreements, including Promissory Note, dated May
                           19, 1994, between the Company and Richard P. Thompson

           10.13 (1) (2)   Stock Purchase Agreement and related agreements, including Promissory Note, dated May
                           23, 1995, between the Company and R. Ray Cummings

           10.14 (1) (2)   Note Agreement and Promissory Note Secured by Deed of Trust, dated May 1, 1995,
                           between the Company and R. Ray Cummings

           10.15 (1) (2)   Promissory Note, dated October 26, 1995, between the Company and Igor Gonda

           10.16 (1) (2)   Promissory Note, dated December 27, 1995, between the Company and Igor Gonda

           10.17 (1)       Master Lease Agreement and Warrant, between the Company and Comdisco, Inc., dated June
                           9, 1995

           10.18 (4)(5)    Product Development and Commercialization Agreement between the Company and SmithKline
                           Beecham PLC

           10.19 (4)(5)    Stock Purchase Agreement between the Company and SmithKline Beecham PLC 

           10.20(3)        Lease Agreement for the property located at 3911 Trust Way, Hayward, California, dated
                           March 17, 1997, between the Company and Hayward Point Eden I Limited Partnership 


           10.20a(3)       First Amendment to Lease, dated December 22, 1997, between the Company and Hayward
                           Point Eden I Limited Partnership

           10.20b(3)       Second Amendment to Lease, dated January 28, 1998, between the Company and Hayward
                           Point Eden I Limited Partnership

           10.21(3)        Lease Agreement for the property located in Phase V of the Britannia Point Eden Business
                           Park in Hayward, California, dated January 28, 1998, between the Company and Britannia 
                           Point Eden, LLC

           10.22(6)        Common Stock Purchase Agreement, dated April 3, 1998,
                           between the Company and certain purchasers of Common
                           Stock.
       
           10.23           Common Stock Purchase Agreement dated January 27, 
                           1998, between the Company and certain purchasers of Common Stock.

           23.1            Consent of Ernst & Young L.L.P., Independent Auditors.  Reference is made to page 55

           24.1            Power of Attorney.  Reference is made to page 53.

           27.1            Financial Data Schedule.
</TABLE>

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

(1) Incorporated by reference to the indicated exhibit in the Company's
    Registration Statement on Form S-1 (No. 333-4236), as amended.

(2) Represents a management contract or compensatory plan or arrangement.

(3) Incorporated by reference to the indicated exhibit in the Company's Annual
    Report on Form 10-K for the year ended December 31, 1997, as amended..

(4) Incorporated by reference to the Company's Form 8-K filed on November 11,
    1997

(5) Confidential treatment requested.