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

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

                                   FORM 10-K

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

(MARK ONE)

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

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999

                                       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

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

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

                     3929 POINT EDEN WAY, HAYWARD, CA 94545
                    (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

      REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:  (510) 265-9000

       SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:  NONE
 SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:  COMMON STOCK, NO
                                   PAR VALUE

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

                               Yes [X]     No [ ]

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

     As of February 29, 2000, there were 14,891,088 shares of common stock
outstanding. The aggregate market value of voting stock held by non-affiliates
of the Registrant was approximately $430,320,000 based upon the closing price of
the common stock on February 29, 2000 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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                                     PART I

ITEM 1. BUSINESS

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

OVERVIEW

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

     According to IMS Health Incorporated, the total United States market for
injectable drugs was approximately $20 billion in 1999. Of this market, we
believe that drugs with aggregate sales in excess of $7 billion could
potentially be delivered using the AERx platform. In addition, most biotech
compounds currently under development rely on injection as their primary means
of delivery.

     We have tested 11 compounds in human clinical trials, four of which are
currently in Phase II development, which we believe are more than any other
company in the advanced pulmonary drug delivery market. We have attracted the
attention of some of the world's leading pharmaceutical and biotechnology
companies, who have contributed over $55 million for the advancement of our AERx
technology. Our most advanced programs include development partnerships with:

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

     - SmithKline Beecham, plc, for the rapid, needle-free delivery of morphine
       to treat severe pain; and

     - Genentech, Inc., for the rapid delivery of the protein dornase alfa, the
       active ingredient in Pulmozyme, used in the treatment of cystic fibrosis.

We believe that our technology platform will provide the basis for the next
generation in pulmonary drug delivery systems. Our AERx platform is based on a
set of proprietary technologies, protected to date by 57 issued United States
patents, that control the physical factors critical for rapid, reproducible
pulmonary drug delivery. These proprietary technologies allow us to:

     - utilize existing liquid formulation technology instead of complex dry
       powder processing;

     - consistently create the high-quality aerosol required to reach the deep
       lung;

     - guide patients to inhale in the most effective manner for deep lung
       delivery; and

     - automatically monitor and control patient drug usage, allowing for better
       disease management.

BACKGROUND -- PULMONARY DRUG DELIVERY

     Today an increasing number of drugs, including nearly all biotech drugs,
are delivered by injection. While injections are quick and efficient, they have
inherent limitations, including inconvenience, discomfort and risk of infection.
These limitations have prompted drug manufacturers to explore alternatives such
as improved

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

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

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

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

THE ARADIGM SOLUTION

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

  Ease of Drug Formulation

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

  Efficient, Precise Aerosol Generation

     Our proprietary technology produces the low-velocity, small-particle
aerosols necessary for efficient deposition of drug in the deep lung. Liquid
drug formulations are aerosolized from pre-packaged, single-use, disposable
packets using the hand-held AERx device. Each disposable packet is comprised of
a small blister
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package of drug adjacent to an aerosolization nozzle. The AERx device compresses
the packet to push the drug through the nozzle and thereby creates the aerosol.
No propellants are required since mechanical pressure is used to generate the
aerosol. Each packet is used only once to avoid plugging or wear that would
degenerate aerosol quality if reused. Through this technology, we believe we can
achieve highly efficient and reproducible aerosols.

  Automated Breath-Controlled Delivery

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

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

STRATEGY

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

  Establish Broad Applicability of the AERx Platform

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

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

  Focus on Quicker-to-Market Opportunities

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

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  Expand Existing and Develop New Collaborative Relationships

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

  Create a Large and Loyal Customer Base

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

  Enhance Our Strong Proprietary Position

     We believe that establishing a strong proprietary position in pulmonary
drug delivery could provide an important competitive advantage in our target
markets. We have aggressively pursued comprehensive patent protection of our
technology and, as of February 15, 2000, had 57 issued United States patents
with a number of additional United States patent applications pending. When
appropriate, we also seek foreign patent protection and, as of February 15,
2000, had 23 issued foreign patents. While there can be no assurance that any of
our patents will provide a significant commercial advantage, these patents are
intended to provide protection for important aspects of our technology,
including aerosol generation, breath control, compliance monitoring and
unit-dose formulation. In addition, we are maintaining as trade secrets key
elements of our manufacturing technologies, particularly those associated with
production of disposable unit-dose packets for the AERx systems.

  Maintain Technological Leadership

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

ARADIGM PRODUCT APPLICATIONS

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

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  AERx Diabetes Management System

     We are developing the AERx Diabetes Management System to permit patients
with diabetes to non-invasively self-administer insulin. We believe that
patients, when provided with a non-invasive delivery alternative to injection,
will be more likely to self-administer insulin as often as needed to keep tight
control of their blood glucose levels. We are developing and plan to
commercialize this product in collaboration with Novo Nordisk. Phase IIa
clinical trials commenced in October 1998 and are currently ongoing. There can
be no assurance that this development program will be successful.

     The Market

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

     We believe that approximately 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 1998, approximately eight to nine million Americans
have been diagnosed with Type 2 diabetes. These Type 2 patients consume the
majority of insulin used in the United States due to their larger numbers.
However, given their less severe impairment, many of these patients are
reluctant to use injection-based therapy. We believe that this failure to comply
with recommended therapies contributes to the $45 billion in annual direct costs
associated with the treatment of diabetes. Through our convenient, non-invasive
AERx system, we believe we can address this patient reluctance, reduce overall
treatment costs and grow the total world-wide insulin market beyond 1998 levels
of $2.4 billion. The leading supplier of insulin is Novo Nordisk, followed by
Eli Lilly, and these two companies together account for more than 90% of the
world-wide insulin market.

     The Product

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

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

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

     Clinical Development

     In 1999, we presented data at the American Diabetes Association meeting on
a study of 20 patients with Type 1 diabetes. These patients were given inhaled
insulin immediately before a standard meal or injected insulin thirty minutes
before the meal. Each patient in the study received insulin by each method twice
for a total of four dosing days. There was no significant difference between the
blood glucose profiles seen following the meal after AERx insulin or injected
insulin dosing. The study concluded that AERx insulin given with a meal to these
patients with Type 1 diabetes controlled blood sugar as effectively as insulin
given 30 minutes before the meal by injection. This is consistent with our goal
of providing a convenient means for dosing insulin without using needles at the
time of each meal. By giving patients an alternative to injection and by
allowing them to dose insulin with the meal instead of a half-hour before, we
believe that people with diabetes will find it easier to comply with recommended
insulin therapy. The next phase of clinical testing will be pivotal trials
involving patients with Type 1 and Type 2 diabetes using AERx insulin daily for
the management of their diabetes. Some of the patients with Type 2 diabetes are
expected to use AERx insulin as their sole source of insulin. Through our
development partnership with Novo Nordisk, we have continued to conduct multiple
Phase IIa studies in the United States and Europe throughout 1999 and 2000.

     The Collaboration

     In June 1998, we entered into a product development and commercialization
agreement with Novo Nordisk, the world leader in insulin therapy, covering the
use of the AERx Diabetes Management System for the delivery of blood glucose
regulating medicines. While the collaboration is initially focused on the
delivery of insulin, Novo Nordisk is also obligated to consider with us the
development, under certain conditions, of at least one additional compound in
the field of blood glucose regulation. Novo Nordisk has been granted worldwide
sales and marketing rights to any products developed under the terms of the
agreement, and we retain all manufacturing rights. For any system developed
under the collaboration which receives regulatory approval, we expect to receive
a share of gross profit on the sales of such products by Novo Nordisk.

     Pursuant to the Novo Nordisk agreement, we could also receive approximately
$38 million in milestone payments in addition to reimbursement for product
development expenses and $10 million in equity investments by the time the first
product from the collaboration is commercialized. As of December 1999, we had
received $22.4 million in milestone and product development payments and $5
million from the purchase of our common stock by Novo Nordisk at a 25% premium
to market price. Under certain conditions, a second $5 million equity investment
may be made at our option at the market price at the time of exercise.
Additional milestone payments and product development payments will be paid if
we and Novo Nordisk decide to jointly develop additional AERx products under the
terms of the agreement.

  AERx Pain Management System

     We are developing the hand-held AERx Pain Management System as a
non-invasive, patient-controlled pulmonary drug delivery product for treatment
of severe pain. We are developing and plan to commercialize this product in
collaboration with SmithKline Beecham. We have completed Phase IIa clinical
trials of the AERx Pain Management System and we expect Phase IIb trials will
begin in 2000. There can be no assurance that these clinical trials will be
successful.

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     The Market

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

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

     The Product

     We believe that a patient-controlled, non-invasive drug delivery system
that enables rapid uptake of medication could significantly expand the market
for pain management in the outpatient setting and improve the management of pain
in the hospital. The AERx Pain Management System is expected to have features
similar to current intravenous patient-controlled analgesia systems, but without
the need for intravenous access and the resulting impairment of patient
ambulation and risk of infection. The AERx system is being designed to be
programmed to allow for patient-activated delivery in accordance with a
physician-directed dosing program. Lock-out mechanisms being designed for the
product should eliminate the risk of inappropriate dosing, and a patented
electronic patient identification feature should prevent unauthorized use of the
device. An automatically maintained dosing event diary kept by the AERx system
is designed to allow a physician to closely monitor patient use. We believe that
these features of the AERx Pain Management System, combined with the inherent
speed of onset of pulmonary delivery, should provide a significant advance in
pain management with important applications in both the home and hospital
settings.

     Clinical Development

     In 1999, we reported the results of a study comparing the blood profile of
morphine delivered via AERx to the blood profile of morphine following
intravenous administration at the Ninth World Congress on Pain. During this
study of ten healthy subjects, each participant received 4 mg of intravenous
morphine or 8.8 mg of morphine given in four consecutive inhalations via the
AERx system. Seventy-five percent of the morphine loaded into the AERx system
was shown to be bioavailable as measured in the patient's blood. The time to
maximum blood concentration was less than two minutes for both intravenous and
AERx morphine administration. The study concluded that AERx-delivered morphine
produces a blood morphine concentration profile similar to that of intravenous
morphine in terms of speed of onset and consistency of dosing.

     During 1999, the AERx Pain Management System was evaluated in comprehensive
design and field testing to ensure that the system was ready for more extensive
clinical trials. Based on the results of this work, we and SmithKline Beecham
now expect to commence Phase IIb clinical trials during 2000.

     The Collaboration

     In September 1997, we entered into a product development and worldwide
commercialization agreement with SmithKline Beecham covering the use of the AERx
Pain Management System for the delivery of narcotic analgesics. If this system
receives regulatory approval, we expect to sell AERx hand-held devices and drug
packets to, and to receive royalties on sales by, SmithKline Beecham.

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     Pursuant to the SmithKline Beecham agreement, we could also 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 1999, we had received
$19 million in milestone and product development payments and $5 million from
the purchase of our common stock by SmithKline Beecham at a 25% premium to
market price. A second $5 million equity investment may be made, at our option,
at the market price at the time of exercise. Additional milestone payments and
product development payments will be due if we and SmithKline Beecham decide to
jointly develop additional AERx products that incorporate other narcotic
analgesics.

  AERx Respiratory Management System

     We are developing the hand-held AERx Respiratory Management System for the
rapid delivery of dornase alfa to the lung to treat cystic fibrosis. We are
developing and plan to commercialize this product in collaboration with
Genentech. We commenced Phase IIa clinical trials of the AERx Respiratory
Management System in early 2000. There can be no assurance that these clinical
trials will be successful.

     The Market

     Cystic fibrosis, an inherited disorder, affects approximately 50,000
patients worldwide. A faulty gene in cystic fibrosis patients leads to the
production of thick, viscous secretions which clog the lungs and make breathing
difficult. These thick secretions also encourage and lengthen respiratory tract
infections, which damage lung tissue and ultimately lead to death. People with
cystic fibrosis also have difficulty digesting and absorbing food because of the
viscous secretions lining their gastrointestinal tracts.

     In the early 1950's, children born with cystic fibrosis often died before
age five. Today, progress in treating lung and gastrointestinal disorders has
led to a median survival age of about 31 years. Children or young adults
afflicted with the disease usually die from respiratory failure brought on by
repeated, severe lung infections that permanently damage their lungs.

     Experiments in the 1950s and 1960s revealed that cystic fibrosis sputum
contained extraordinary amounts of DNA. However, the research was abandoned
until scientists at Genentech identified an enzyme that could break up the
thick, DNA-rich secretions characteristic of cystic fibrosis. Dornase alfa is a
naturally occurring enzyme which cuts up DNA, including the DNA in the thick
secretions in the lungs of cystic fibrosis patients. Dornase alfa is the active
ingredient in Pulmozyme, which was developed by Genentech and approved for
marketing by the FDA in 1993. Pulmozyme represented the first new therapy
targeted specifically for cystic fibrosis in 30 years.

     The Product

     Pulmozyme is currently given via nebulizer. Ampoules containing dornase
alfa in solution are inhaled once or twice a day by patients, a process which
can take over an hour. Because the AERx system is much more efficient than a
conventional nebulizer, a dose given in one or two breaths can equal the dose to
the lung following hundreds of breaths of a drug taken via nebulizer. By
reducing treatment time, dornase alfa therapy may be more acceptable to
patients, increasing compliance.

     Clinical Development

     We will be conducting all clinical studies of dornase alfa in the AERx
Respiratory Management System. The clinical development plan consists of three
studies: Phase IIa (feasibility), Phase IIb (dose ranging) and Phase III
(pivotal). The Phase IIa study, currently ongoing, is designed to demonstrate
the feasibility of dornase alfa delivery using the AERx system in patients with
cystic fibrosis.

     The Collaboration

     In May 1999, we signed an agreement with Genentech to develop dornase alfa
for the pulmonary delivery in the AERx system in the United States. Under the
terms of this agreement, we will develop the AERx

                                        9
<PAGE>   10

system and conduct all clinical trials in cooperation with Genentech. If the
product is approved by the FDA, we will manufacture the product and Genentech
will be responsible for marketing and sales.

     Upon signing the agreement, we received an upfront licensing fee from
Genentech. Genentech also agreed to loan us the funds required to conduct all
development activities. We will receive milestone payments at the initiation of
certain clinical events. If the product is approved by the FDA, we will receive
a milestone payment that exceeds the cumulative loan and accrued interest
amounts, from which we will repay the loan. We will also receive a profit on all
product manufactured and delivered to Genentech and a royalty on sales by
Genentech above specified levels.

  Additional Potential AERx Applications

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

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

     We currently have seven externally-funded programs that are developing or
evaluating the use of the AERx delivery technology across a range of drug
therapies. In addition to our three principal collaborations with Genentech,
Novo Nordisk and SmithKline Beecham, these programs include a Stage 2 grant from
the National Institutes of Health to evaluate the use of the AERx platform for
delivery of gene therapies. The remaining three externally-funded programs
address a small molecule for systemic delivery that is in Phase I clinical
trials, a small molecule for local delivery to the lung that is in Phase I
clinical trials and a biotech compound for local delivery that is in Phase II
clinical trials. The following table summarizes the seven programs that we are
currently conducting:

<TABLE>
<S>                        <C>                                   <C>
------------------------------------------------------------------------------------------------------
</TABLE>

<TABLE>
<CAPTION>
                                    LOCAL LUNG DELIVERY                    SYSTEMIC DELIVERY
------------------------------------------------------------------------------------------------------
<S>                        <C>                                   <C>
  Small Molecule           Phase I program-undisclosed           Phase II program-morphine
                           compound                              Phase I program-undisclosed  compound
------------------------------------------------------------------------------------------------------
  Macromolecule            Phase II program-dornase alfa         Phase II program-insulin
                           Phase II program-undisclosed          Phase I program-gene therapy
                            compound
</TABLE>

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

Phase I clinical 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 evaluated in a patient population.

                                       10
<PAGE>   11

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

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

SALES AND MARKETING

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

MANUFACTURING

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

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

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

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

INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS

     Our business and competitive position is dependent upon our ability to
protect our proprietary technology and avoid infringing the proprietary rights
of others. We have conducted original research on a number of aspects relating
to pulmonary drug delivery. This research has led to novel ideas which in turn
have resulted in our being issued 54 United States patents to date, with 29
United States patent applications pending. In addition, we have purchased three
United States patents covering inventions that are relevant to our technologies.
We have 23 issued foreign patents and 90 foreign patent applications pending.

                                       11
<PAGE>   12

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

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

     - United States patent 5,672,581, which contains claims directed to the
       inspiratory flow rate and volume at which an insulin aerosol should be
       released into the patient's inhalation.

     - United States patent 5,884,620, which contains claims directed to the
       role of total inhaled volume for the delivery of aerosolized insulin.

     - United States patent 5,888,477, which contains claims directed to the
       delivery of monomeric insulin by inhalation.

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

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

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

                                       12
<PAGE>   13

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

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

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

COMPETITION

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

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

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

GOVERNMENT REGULATION

     All medical devices and drugs, including our products under development,
are subject to extensive and rigorous regulation by the federal government,
principally the FDA, and by state and local governments. If these products are
marketed abroad, they also are subject to export requirements and to regulation
by foreign

                                       13
<PAGE>   14

governments. The regulatory clearance process is generally lengthy, expensive
and uncertain. The Federal Food, Drug, and Cosmetic Act, and other federal
statutes and regulations, govern or influence the development, testing,
manufacture, labeling, storage, approval, advertising, promotion, sale and
distribution of such products. Failure to comply with applicable FDA and other
regulatory requirements can result in sanctions being imposed on us or the
manufacturers of our products, including warning letters, fines, product recalls
or seizures, injunctions, refusals to permit products to be imported into or
exported out of the United States, refusals of the FDA to grant approval of
drugs or to allow us to enter into government supply contracts, withdrawals of
previously approved marketing applications and criminal prosecutions.

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

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

     Clinical testing involves the administration of the drug to healthy human
volunteers or to patients under the supervision of a qualified principal
investigator, usually a physician, pursuant to FDA reviewed protocol. Each
clinical study is conducted under the auspices of an Institutional Review Board
at each of the institutions at which the study will be conducted. An
Institutional Review Board will consider, among other things, ethical factors,
the safety of human subjects, informed consent requirements and the possible
liability of the institution. Human clinical trials typically are conducted in
three sequential phases, but the phases may overlap. Phase 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.

     A company seeking FDA approval to market a new drug must file a new drug
application with the FDA pursuant to the Federal Food, Drug, and Cosmetic Act.
In addition to reports of the pre-clinical and clinical trials conducted under
an effective Investigational New Drug application, the new drug application
includes information pertaining to the preparation of the drug substance,
analytical methods, drug product formulation, details on the manufacture of
finished products and proposed product packaging and labeling. Submission of a
new drug application does not assure FDA approval for marketing. The application
review process can take a year or more to complete, although reviews of
treatments for cancer and other life-threatening diseases may be accelerated or
expedited. However, the process may take substantially longer if, among other
things, the FDA has questions or concerns about the safety or efficacy of a
product. In general, the FDA requires at least two properly conducted, adequate
and well-controlled clinical studies demonstrating efficacy with sufficient
levels of statistical assurance.

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

                                       14
<PAGE>   15

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

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

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

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

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

                                       15
<PAGE>   16

INTERNATIONAL SCIENTIFIC ADVISORY BOARD

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

<TABLE>
<CAPTION>
                   NAME                              AFFILIATION                 AREA OF EXPERTISE
                   ----                              -----------                 -----------------
<S>                                         <C>                            <C>
Peter Byron, Ph.D.........................  Medical College of Virginia,   Aerosol Science/Pharmaceutics
                                            Virginia Commonwealth
                                            University
Michael Cousins, M.D......................  University of Sydney,          Pain Management
                                            Australia
Peter Creticos, M.D.......................  The Johns Hopkins University   Allergy/Immunology/Asthma
                                            School of Medicine
Stanley S. Davis, Ph.D....................  University of Nottingham       Drug Delivery
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                      Development
</TABLE>

EMPLOYEES

     As of February 19, 2000, we had 208 employees, of whom 164 were in research
and development and product development and 44 were in business development,
finance and administration. Of these employees 58 have advanced graduate
degrees. We believe that our future success is dependent on attracting and
retaining highly skilled scientific, sales and marketing and senior management
personnel. Competition for such skills is intense, and there is no assurance
that we will continue to be able to attract and retain high-quality employees.
Our employees are not represented by any collective bargaining agreement. We
consider our relations with our employees to be good.

LEGAL PROCEEDINGS

     In June 1998, Eli Lilly and Company filed a complaint against us in the
United States District Court for the Southern District of Indiana. The complaint
made various allegations against us, arising from our decision to enter into an
exclusive collaboration with Novo Nordisk with respect to the development and
commercialization of a pulmonary delivery system for insulin and insulin
analogs. We have sponsored various studies of the pulmonary delivery of insulin
and insulin analogs using materials supplied by Eli Lilly under a series of
agreements dating from January 1996. We had also conducted negotiations with Eli
Lilly concerning a long-term supply agreement under which Eli Lilly would supply
bulk insulin to us for commercialization in our AERx Diabetes Management System,
and a separate agreement under which we would license certain intellectual
property to Eli Lilly. These negotiations were terminated after we proceeded
with our agreement with Novo Nordisk. The complaint seeks a declaration that Eli
Lilly scientists are co-inventors of a patent application filed by us relating
to pulmonary delivery of an insulin analog or, in the alternative, enforcement
of an alleged agreement to grant Eli Lilly a nonexclusive license under such
patent application. The complaint also contains allegations of misappropriation
of trade secrets, breach of fiduciary duty, conversion and unjust enrichment and
seeks unspecified damages and injunctive relief. We believe that we have
meritorious defenses against each of Eli Lilly's claims. However, there can be
no assurance that we will prevail in this case. We have filed an answer denying
all material allegations of the complaint and a motion for summary judgment
directed against all claims in Eli Lilly's complaint.

                                       16
<PAGE>   17

                                   MANAGEMENT

DIRECTORS AND EXECUTIVE OFFICERS

     The directors and executive officers of the Company and their ages as of
February 29, 2000 are as follows:

<TABLE>
<CAPTION>
                   NAME                     AGE                       POSITION
                   ----                     ---                       --------
<S>                                         <C>   <C>
Richard P. Thompson.......................   48   President, Chief Executive Officer and Director
Reid M. Rubsamen, M.D.....................   43   Vice President, Medical Affairs, Secretary and
                                                  Director
R. Jerald Beers...........................   51   Executive Vice President, Business Development
                                                  and Marketing
Bikash K. Chatterjee......................   41   Vice President, Operations
Steven J. Farr, Ph.D......................   40   Vice President, Pharmaceutical Sciences
Maximillian D. Fiore......................   45   Vice President, Engineering
Igor Gonda, Ph.D..........................   52   Vice President, Research & Development
Norman Halleen............................   46   Vice President, Finance & Administration and
                                                  Chief Financial Officer
Norma L. Milligin.........................   61   Vice President, Human Resources
Babatunde A. Otulana, M.D.................   42   Vice President, Clinical & Regulatory Affairs
Frank H. Barker(1)(2).....................   69   Director
Wayne I. Roe(1)(2)........................   49   Director
Virgil D. Thompson(1)(2)..................   60   Director
</TABLE>

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

(2) Member of the Compensation Committee.

     Richard P. Thompson has been a director and has served as our President and
Chief Executive Officer since 1994 and was Chief Financial Officer from April
1996 until December 1996. From 1991 to 1994, he was President of LifeScan, Inc.,
a Johnson & Johnson Company, a diversified health care company. In 1981, Mr.
Thompson founded LifeScan, which was sold to Johnson & Johnson in 1986. Mr.
Thompson holds a B.S. in biological sciences from the University of California
at Irvine and an MBA from California Lutheran College.

     Reid M. Rubsamen, M.D., our founder, has been a director and has served as
our 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 Aradigm. 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.

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

     Bikash K. Chatterjee has served as our Vice President, Pharmaceutical
Operations since March 1998. From September 1997 until March 1998, Mr.
Chatterjee was our Director of Pharmaceutical Operations. From January 1992 to
August 1997, Mr. Chatterjee was the plant manager for manufacturing Boehringer-

                                       17
<PAGE>   18

Mannheim's disposable coagulation testing system. From 1988 to 1992, he held a
number of senior manufacturing positions at various pharmaceutical companies,
including Syntex Corporation. Mr. Chatterjee holds a B.A. in Biochemistry and a
B.S. in chemical engineering from the University of California at San Diego.

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

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

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

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

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

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

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

                                       18
<PAGE>   19

     Wayne I. Roe has been a director since May 1999. He has been the Chairman
of Covance Health Economics and Outcomes Services, Inc., a contract research and
developmental services company to the medical technology marketplace, since
March 1996. From June 1988 to March 1996, Mr. Roe was the President of Health
Technology Associates, a pharmaceutical industry consulting firm. Mr. Roe
received a B.A. from Union College, an M.A. from the State University of New
York at Albany and an M.A. from the University of Maryland.

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

ITEM 2. PROPERTIES

     At December 31, 1999, we leased approximately 146,000 square feet of office
space in six buildings in an office park at 3929 Point Eden Way, Hayward,
California. Our leases for such office space expire at various times through the
year 2016. Minimum annual payments under these leases will be approximately $3.5
million in 2000 and $3.3 million in 2001, respectively. We use this space for
general administrative, product development, clinical, manufacturing and
research and development purposes. We believe that our existing facilities are
adequate to meet our requirements for the near term and that additional space
will be available on commercially reasonable terms if needed.

ITEM 3. LEGAL PROCEEDINGS

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

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

     No matters were submitted to a vote of our security holders during the
quarter ended December 31, 1999.

                                       19
<PAGE>   20

                                    PART II

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

MARKET INFORMATION

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

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

1999
  First Quarter.............................................  $14.13   $ 7.63
  Second Quarter............................................    9.56     5.63
  Third Quarter.............................................   12.88     8.00
  Fourth Quarter............................................   10.50     6.38

2000
  First Quarter (through February 28, 2000).................  $34.75   $ 9.50
</TABLE>

     On February 28, 2000, there were 153 holders of record of our common stock.
On February 28, 2000, the last sale price reported on the Nasdaq National Market
for the common stock was $30.25 per share.

DIVIDEND POLICY

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

                                       20
<PAGE>   21

ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                            YEARS ENDED DECEMBER 31,
                                              ----------------------------------------------------
                                                1999       1998       1997       1996       1995
                                              --------   --------   --------   --------   --------
                                                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                           <C>        <C>        <C>        <C>        <C>
STATEMENTS OF OPERATIONS DATA:
Contract and license revenues...............  $ 16,812   $ 17,515   $  3,685   $    730   $    155
Operating expenses:
  Research and development..................    33,625     25,549     13,452      7,981      3,440
  General and administrative................     7,849      8,661      6,012      2,958      2,334
                                              --------   --------   --------   --------   --------
          Total expenses....................    41,474     34,210     19,464     10,939      5,774
                                              --------   --------   --------   --------   --------
Loss from operations........................   (24,662)   (16,695)   (15,779)   (10,209)    (5,619)
Interest income.............................     1,947      1,754      1,329      1,179        206
Interest expense and other..................      (888)      (513)      (234)       (52)       (20)
                                              --------   --------   --------   --------   --------
Net loss....................................  $(23,603)  $(15,454)  $(14,684)  $ (9,082)  $ (5,433)
                                              ========   ========   ========   ========   ========
Basic and diluted net loss per share(1).....  $  (1.66)  $  (1.32)  $  (1.43)  $  (1.49)  $  (5.41)
Shares used in computing basic and diluted
  net loss per share(1).....................    14,216     11,682     10,280      6,098      1,004
BALANCE SHEET DATA:
Cash, cash equivalents and investments......  $ 31,259   $ 31,036   $ 24,305   $ 28,534   $ 12,117
Working capital.............................    22,971     16,620     15,999     23,486     11,594
Total assets................................    50,790     44,949     30,294     30,733     13,306
Noncurrent portion of notes payable and
  capital lease obligation..................     9,609      4,570      2,139        350        490
Accumulated deficit.........................   (74,904)   (51,279)   (35,827)   (21,144)   (12,069)
Total shareholders' equity..................    24,157     21,660     18,659     27,886     12,121
</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.

                                       21
<PAGE>   22

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

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

OVERVIEW

     Since our inception in 1991, we have been engaged in the development of
pulmonary drug delivery systems. As of December 31, 1999, we had an accumulated
deficit of $74.9 million. We have not been profitable since inception and expect
to incur additional operating losses over the next several years as our research
and development efforts, preclinical and clinical testing activities and
manufacturing scale-up efforts expand and as we plan and build our late-stage
clinical and early commercial production capabilities. To date, we have not had
any material product sales and do not anticipate receiving significant revenue
from product sales in 2000. The sources of working capital have been equity
financings, equipment lease financings, contract research funding and interest
earned on investments.

     We have performed initial feasibility work on a number of compounds and
have been compensated for expenses incurred by us in performing this work in
several cases pursuant to feasibility study agreements with third parties. Once
feasibility is demonstrated with respect to a potential product, we seek to
enter into development contracts with pharmaceutical corporate partners. We
currently have such agreements pursuant to which we are developing pulmonary
delivery systems with Genentech, to manage cystic fibrosis with dornase alfa,
the active ingredient in Pulmozyme, with Novo Nordisk, to manage diabetes using
insulin and other blood glucose regulating compounds and with SmithKline
Beecham, to manage acute and breakthrough pain using opioid analgesics.

     Our collaborative agreements with Novo Nordisk and SmithKline Beecham
provide for reimbursement of research and development expenses as well as
additional payments to us as we achieve certain significant milestones. We also
expect to receive royalties from these development partners based on revenues
from partner sales of product and to receive revenue from the manufacturing of
unit dose packets and hand-held devices. We recognize revenues under the terms
of our collaborative agreements as the research and development expenses are
incurred, to the extent they are reimbursable.

RESULTS OF OPERATIONS

  Years Ended December 31, 1999, 1998 and 1997

     Contract Revenues.  We reported revenues from collaborative contracts of
$16.8 million in 1999, compared to $17.5 million in 1998 and $3.7 million in
1997. Revenue decreases in 1999 resulted from the completion of certain
reimbursable Phase II activities associated with the SmithKline Beecham program.
Revenue increases in 1998 resulted from expansion of our partner-funded project
development program, primarily the Novo Nordisk agreement signed in June 1998.
Costs associated with contract research revenue are included in research and
development expenses.

     Our collaborative development agreement with Genentech, entered into as of
May 21, 1999, provides that certain expense reimbursements received from
Genentech under this agreement are subject to repayment if the product does not
receive approval from the FDA. Development expenses incurred are reimbursed by
Genentech in the form of loans supported by promissory notes bearing interest at
2% over the prime rate. Upon receipt of FDA approval, we will receive a
milestone payment that is larger than the loan principal and accrued interest,
allowing the loan to be fully repaid at that time. We will also receive certain
milestone payments at various points of product development.

     Research and Development Expenses.  Research and development expenses have
increased each year since our inception. These expenses were $33.6 million in
1999, compared to $25.5 million in 1998 and $13.4 million in 1997. Research and
development expenses as a percentage of total expenses was 81% in 1999,

                                       22
<PAGE>   23

75% in 1998 and 69% in 1997. Research and development expenses in 1999 increased
by 32% over 1998, attributable to the expansion of research and development
efforts to support the ongoing programs with Novo Nordisk and SmithKline Beecham
and the addition of the Genentech program. Research and development expenses in
1998 increased by $12.1 million over 1997, similarly attributable to the hiring
of additional scientific personnel and increased costs associated with the
expansion of research and development efforts and the addition of the Novo
Nordisk program.

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

     General and Administrative Expenses.  General and administrative expenses
were $7.8 million in 1999 compared to $8.7 million in 1998 and $6.0 million in
1997. General and administrative expenses decreased by 9% in 1999 compared to
1998, as a result of the termination of our program to market and sell a
discontinued product. General and administrative expenses increased by 44% in
1998 as compared to 1997, resulting from additional leased facilities to support
our expansion of research, development and manufacturing activities, and
increased efforts to develop collaborative relationships with corporate
partners.

     Interest Income.  Interest income increased to $1.9 million in 1999 from
$1.8 million in 1998 and $1.3 million in 1997. These increases were due to our
maintaining larger cash and investment balances, which resulted from our receipt
of research funding and milestone payments from collaborative partners and the
completion of private placements of our common stock in April 1998 and March
1999.

     Interest Expense and Other.  Interest expense was $0.9 million in 1999
compared to $0.5 million in 1998 and $0.2 million in 1997. The increases
resulted primarily from higher outstanding capital lease and equipment loan
balances under our equipment and lease lines of credit.

LIQUIDITY AND CAPITAL RESOURCES

     We have financed our operations since inception primarily through private
placements and a public offering of our capital stock, proceeds from equipment
lease financings, contract research funding and interest earned on investments.
As of December 31, 1999, we had received approximately $99.6 million in net
proceeds from sales of our capital stock. In April 1999, we obtained an
additional $3.0 million equipment line of credit, of which $1.6 million was
funded as of December 31, 1999. As of December 31, 1999, we had cash, cash
equivalents and short-term investments of approximately $31.3 million.

     Net cash used in operating activities in 1999 was $27.0 million, compared
to $4.9 million in 1998 and $7.8 million in 1997. The increase in cash used
during 1999 resulted primarily from increases in operating losses and
receivables, as well as decreases in accrued liabilities and deferred revenue.
The decrease in cash used during 1998 compared to 1997 resulted primarily from
increases in deferred revenue, accrued liabilities and depreciation, offset
partially by an increase in the net loss.

     Net cash used in investing activities in 1999 was $6.0 million, compared to
net cash used of $21.0 million in 1998 and $0.5 million in 1997. The decrease in
cash used in 1999 resulted primarily from less capital spending and a decrease
in the purchase of short-term investments. The increase in cash used in 1998
compared to 1997 resulted primarily from increased net purchases of short-term
investments and increased expenditures made for capital equipment.

     Net cash provided by financing activities in 1999 was $31.6 million,
consisting primarily of proceeds from the completion of a private placement of
common stock in March 1999 which raised net proceeds of approximately $25.5
million, notes payable supporting loans received under a collaborative
development agreement with Genentech and proceeds from equipment loans. Net cash
provided by financing activities in
                                       23
<PAGE>   24

1998 was $21.2 million, primarily from the completion of a private placement of
common stock in April 1998 which raised net proceeds of $12.0 million, a $5.0
million equity investment by Novo Nordisk in June 1998, and the receipt of
proceeds from equipment loans. Net cash provided by financing activities in 1997
was $6.4 million, consisting primarily of proceeds from issuances of common
stock, of which $5.0 million was an equity investment by SmithKline Beecham, and
proceeds from equipment loans.

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

     We believe that the committed funding from our existing corporate
development partnerships with Genentech, Novo Nordisk and SmithKline Beecham,
plus existing capital resources and projected interest income will enable us to
maintain current and planned operations, including anticipated capital spending
requirements, through the end of 2000. We expect that our cash requirements will
increase in future periods and that we will need to raise additional capital
before we become profitable. Given our projected cash requirements, we believe
that our existing capital resources and committed funding from our collaborative
partners, together with the proceeds of this offering and projected interest
income will enable us to maintain current and planned operations, including
anticipated capital spending requirements of approximately $50 million, through
the end of 2001. However, there can be no assurance that we will not need to
raise substantial additional capital to fund our operations and capital spending
within this period. We may seek additional funding through collaborations or
through public or private equity or debt financing. 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, we may be required
to delay, to reduce the scope of, or to eliminate one or more of our research
and development programs, or to obtain funds through arrangements with
collaborative partners or other sources that may require us to relinquish rights
to certain of our technologies or products that we would not otherwise
relinquish.

                                       24
<PAGE>   25

                                  RISK FACTORS

     Except for historical information contained herein, the discussion in this
section contains forward-looking statements, including, without limitation,
statements regarding timing and results of clinical trials, the establishment of
corporate partnering arrangements, the anticipated commercial introduction of
our products and the timing of our cash requirements. These forward-looking
statements involve certain risks and uncertainties that could cause actual
results to differ materially from those in such forward-looking statements.

WE ARE AN EARLY STAGE COMPANY.

     You must evaluate us in light of the uncertainties and complexities present
in an early stage company. Virtually all of our potential products are in an
early stage of research or development. We cannot assure you that:

     - our research and development efforts will be successful;

     - any potential products will be proven safe and effective;

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

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

WE HAVE A HISTORY OF LOSSES AND ANTICIPATE FUTURE LOSSES.

     We have never been profitable, and through December 31, 1999, we have
incurred a cumulative deficit of approximately $74.9 million. We expect to
continue to incur substantial losses over at least the next several years as we:

     - expand our research and development efforts;

     - expand our preclinical and clinical testing activities;

     - expand our manufacturing efforts; and

     - plan and build our commercial production capabilities.

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

WE MAY NOT BE ABLE TO DEVELOP PRODUCTS SUCCESSFULLY.

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

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

     - are safe and effective;

     - will not be subject to physical or chemical instability over time and
       under differing storage conditions; and

     - do not suffer from other problems that would affect commercial viability.

                                       25
<PAGE>   26

     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.

WE MAY NOT BE ABLE TO COMMERCIALIZE PRODUCTS SUCCESSFULLY.

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

     - safety;

     - efficacy;

     - ease of use; and

     - price.

     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 Respiratory Management System
depends on our development partnership with Genentech, our ability to
successfully develop and commercialize the AERx Diabetes Management System
depends on our development partnership with Novo Nordisk and our ability to
successfully develop and commercialize the AERx Pain Management System depends
on our development partnership with SmithKline Beecham. Novo Nordisk and
SmithKline Beecham 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.

Genentech has agreed to:

     - undertake certain collaborative activity with us;

     - lend us money to pay our research and development costs;

     - pay us fees upon achievement of certain milestones; and

     - purchase product from us at a defined premium if and when we
       commercialize a product.

     The development and commercialization of these systems will be delayed if
Genentech, Novo Nordisk or SmithKline Beecham fail to conduct these
collaborative activities in a timely manner or at all. In addition, our
development partners 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 any of our development partners breach or terminate their agreement, our
business will be impaired. In addition, if Genentech terminates its agreement
with us due to a technical failure of our development program for dornase alfa,
we may be required to repay the loans Genentech makes to us to fund our work.

                                       26
<PAGE>   27

     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, which may not
be resolved in our favor. If any of our corporate partners or collaborators do
not develop or commercialize any product to which it has obtained rights from
us, our business could be impaired.

WE HAVE LIMITED MANUFACTURING EXPERIENCE.

     We have only limited manufacturing experience. We have validated only a
single clinical manufacturing facility for disposable packets for our various
AERx systems. We anticipate spending significant amounts to attempt to provide
for the high-volume manufacturing required for multiple AERx products, and some
of this spending will occur before our products are approved. We cannot assure
investors that:

     - the design requirements of the AERx system will make it feasible for us
       to develop it beyond the current prototype;

     - manufacturing and quality control problems will not arise as we attempt
       to scale-up; or

     - any scale-up can be achieved in a timely manner or at a commercially
       reasonable cost.

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

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

     We intend to use contract manufacturers to produce key components,
assemblies and subassemblies in the clinical and commercial manufacturing of our
AERx devices. 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;

                                       27
<PAGE>   28

     - 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 public and
private equity financings, equipment lease financings, contract research funding
and interest earned on investments.

     We anticipate that we will be able to maintain our current and planned
operations through the end of 2001 with the proceeds from this offering, 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 partners or others. Such arrangements
might require us to relinquish rights to certain of our technologies or products
that we would not otherwise relinquish.

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

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

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

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

     Our policy is to require our officers, employees, consultants and advisors
to execute proprietary information and invention and assignment agreements upon
commencement of their relationships with us.

                                       28
<PAGE>   29

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

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

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

WE MAY NOT OBTAIN REGULATORY APPROVAL FOR OUR PRODUCTS ON A TIMELY BASIS, OR AT
ALL.

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

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

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

     - warning letters;

     - fines;

     - product recalls or seizures;

     - injunctions;

     - refusals to permit products to be imported into or exported out of the
       United States;

     - withdrawals of previously approved marketing applications; and

     - criminal prosecutions.

     Manufacturers of drugs also are required to comply with the applicable Good
Manufacturing Practices, or GMP, requirements, which relate to product testing,
quality assurance and maintaining records and documentation. We cannot assure
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 from foreign regulatory
agencies and comply with extensive regulations regarding safety
                                       29
<PAGE>   30

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

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

THE RESULTS OF PRECLINICAL AND CLINICAL TESTING ARE UNCERTAIN.

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

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

     Although we believe the limited data we have regarding our potential
products is encouraging, the results of initial preclinical and clinical testing
do not necessarily predict the results that we will get from subsequent or more
extensive preclinical and clinical testing. Furthermore, we cannot assure
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.

     We are also developing applications of our AERx platform 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.

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

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

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

                                       30
<PAGE>   31

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

WE DEPEND ON KEY PERSONNEL AND MUST CONTINUE TO ATTRACT AND RETAIN KEY
EMPLOYEES.

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

WE MAY BE EXPOSED TO PRODUCT LIABILITY.

     Researching, developing and commercializing medical devices and therapeutic
products 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.

     In both domestic and foreign markets, sales of our potential products
depend in part on the availability of reimbursement from third-party payors such
as government health administration authorities, private health insurers and
other organizations. Third-party payors often challenge the price and
cost-effectiveness of medical products and services. Significant uncertainty
exists as to the reimbursement status of newly approved health care products. We
cannot assure 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 use of hazardous and toxic materials, chemicals and
various radioactive compounds and generate hazardous, toxic and radioactive
wastes. Although we believe that our safety procedures for handling and
disposing of such materials comply with all state and federal regulations and
standards, the risk of accidental contamination or injury from these materials
cannot be completely eliminated. In the event of such an accident, we could be
held liable for any damages that result and such liability could exceed the
resources of our business.

NEW INVESTORS IN OUR COMMON STOCK WILL EXPERIENCE IMMEDIATE AND SUBSTANTIAL
DILUTION.

     The offering price is substantially higher than the book value per share of
our common stock. Investors purchasing common stock in this offering will,
therefore, incur immediate dilution of $24.76 in net tangible book value per
share of common stock, based on an assumed offering price of $30.25 per share.
In addition, investors will incur additional dilution upon the exercise of
outstanding stock options and warrants.

OUR STOCK PRICE IS LIKELY TO REMAIN VOLATILE AND YOU MAY LOSE ALL OR A PART OF
YOUR INVESTMENT.

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

                                       31
<PAGE>   32

volume fluctuations unrelated to the operating performance of particular
companies. As a result, you may be unable to sell your shares of common stock at
or above the offering price. Prices for our common stock may be influenced by
many factors, including:

     - investor perception of us;

     - analyst recommendations;

     - fluctuations in our operating results;

     - market conditions relating to the drug delivery industry;

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

     - publicity regarding actual or potential developments relating to products
       under development by us or our competitors;

     - failure to establish new collaborative relationships;

     - developments or disputes concerning patent or proprietary rights;

     - delays in the development or approval of our product candidates;

     - regulatory developments in both the United States and foreign countries;

     - public concern as to the safety of drug delivery technologies;

     - period-to-period fluctuations in financial results;

     - future sales of substantial amounts of common stock by shareholders; or

     - economic and other external factors.

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

YEAR 2000 RISKS COULD HARM OUR BUSINESS.

     A "Year 2000" issue exists because many existing application software
programs, operating systems and manufacturing equipment containing
computer-related components 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 such 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.

     We have reviewed our key internal financial, information and operational
systems, including manufacturing control systems, and remedied those systems
that are not Year 2000 compliant. In addition, we have communicated with our
critical third-party suppliers to determine the extent to which we may be
vulnerable to those third parties' failure to remedy their own Year 2000 issues.
We have a contingency plan for handling Year 2000 problems that were not
detected and corrected prior to their occurrence, and we are continuing to
assess any exposure areas in order to determine what additional steps are
advisable. We are prepared to use backup systems and have developed other
alternative contingency plans for other critical functions where computer
systems are essential. To date, we have not experienced any material Year 2000
problems. However, if all of our potential Year 2000 problems were not properly
identified or if adequate assessment and remediation are not timely effected
with respect to any Year 2000 problems, our business could be harmed. In
addition, any Year 2000 compliance problems facing our suppliers could also harm
our business.

                                       32
<PAGE>   33

WE HAVE IMPLEMENTED CERTAIN ANTI-TAKEOVER PROVISIONS.

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

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Market Risk Disclosure

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

     As of December 31, 1999, we had cash equivalents and short-term investments
of $31.3 million consisting of cash and highly liquid, short-term investments.
Our short-term investments will decline by an immaterial amount if market
interest rates increase, and therefore, our exposure to interest rate changes
has been immaterial. Declines of interest rates over time will, however, reduce
our interest income from our short-term investments. Our outstanding bank loan
and capital lease obligations are all at fixed interest rates and, therefore,
have minimal exposure to changes in interest rates.

                                       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, 1999 and 1998, and the related statements of operations,
shareholders' equity, and cash flows for each of the three years in the period
ended December 31, 1999. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

     In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Aradigm Corporation at
December 31, 1999 and 1998, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1999, in conformity
with accounting principles generally accepted in the United States.

                                                          /S/  ERNST & YOUNG LLP

Palo Alto, California
February 18, 2000

                                       34
<PAGE>   35

                              ARADIGM CORPORATION

                                 BALANCE SHEETS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                              --------------------
                                                                1999        1998
                                                              --------    --------
<S>                                                           <C>         <C>
ASSETS
Current assets:
  Cash and cash equivalents.................................  $  9,347    $ 10,765
  Short-term investments....................................    21,912      20,271
  Receivables
     Billed.................................................     1,836         774
     Unbilled...............................................     2,050          --
  Other current assets......................................     1,187         729
                                                              --------    --------
     Total current assets...................................    36,332      32,539
Property and equipment, net.................................    14,160      12,196
Notes receivable from officers..............................       130         135
Other assets................................................       168          79
                                                              --------    --------
     Total assets...........................................  $ 50,790    $ 44,949
                                                              ========    ========
LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
  Accounts payable..........................................  $  2,506    $  1,979
  Accrued clinical and cost of other studies................        95         633
  Accrued compensation......................................     1,275       1,261
  Deferred revenue..........................................     7,361       9,873
  Other accrued liabilities.................................       261         891
  Current portion of capital lease obligations..............     1,863       1,282
                                                              --------    --------
     Total current liabilities..............................    13,361      15,919

Notes payable...............................................     3,956          --
Noncurrent portion of deferred revenue......................     3,663       2,800
Capital lease obligations, less current portion.............     5,653       4,570

Commitments
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: 1999 -- 14,749,777;
     1998 -- 12,163,616.....................................    99,603      73,768
  Shareholder notes receivable..............................      (163)       (288)
  Deferred compensation.....................................      (379)       (541)
  Accumulated deficit.......................................   (74,904)    (51,279)
                                                              --------    --------
     Total shareholders' equity.............................    24,157      21,660
                                                              --------    --------
     Total liabilities and shareholders' equity.............  $ 50,790    $ 44,949
                                                              ========    ========
</TABLE>

                            See accompanying notes.

                                       35
<PAGE>   36

                              ARADIGM CORPORATION

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

<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                             --------------------------------
                                                               1999        1998        1997
                                                             --------    --------    --------
<S>                                                          <C>         <C>         <C>
Contract and license revenues..............................  $ 16,812    $ 17,515    $  3,685
Expenses:
  Research and development.................................    33,625      25,549      13,452
  General and administrative...............................     7,849       8,661       6,012
                                                             --------    --------    --------
          Total expenses...................................    41,474      34,210      19,464
                                                             --------    --------    --------
Loss from operations.......................................   (24,662)    (16,695)    (15,779)
Interest income............................................     1,947       1,754       1,329
Interest expense and other.................................      (888)       (513)       (234)
                                                             --------    --------    --------
Net loss...................................................  $(23,603)   $(15,454)   $(14,684)
                                                             ========    ========    ========
Basic and diluted net loss per share.......................  $  (1.66)   $  (1.32)   $  (1.43)
                                                             ========    ========    ========
Shares used in computing basic and diluted net loss per
  share....................................................    14,216      11,682      10,280
                                                             ========    ========    ========
</TABLE>

                            See accompanying notes.

                                       36
<PAGE>   37

                              ARADIGM CORPORATION

                       STATEMENTS OF SHAREHOLDERS' EQUITY
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                               COMMON STOCK       SHAREHOLDER                                    TOTAL
                                           --------------------      NOTES        DEFERRED     ACCUMULATED   SHAREHOLDERS'
                                             SHARES     AMOUNT    RECEIVABLE    COMPENSATION     DEFICIT        EQUITY
                                           ----------   -------   -----------   ------------   -----------   -------------
<S>                                        <C>          <C>       <C>           <C>            <C>           <C>
Balances at December 31, 1996............  10,214,054   $49,821      $(483)        $(308)       $(21,144)      $ 27,886
  Issuance of common stock for cash,
    net..................................     405,064     5,000         --            --              --          5,000
  Issuance of common stock under the
    employee stock purchase plan.........      21,824       134         --            --              --            134
  Issuance of common stock upon exercise
    of stock options.....................       5,625        30         --            --              --             30
  Repurchase of common stock.............     (14,434)       (9)         9            --              --             --
  Repayment of shareholders' notes.......          --        --         88            --              --             88
  Amortization of deferred
    compensation.........................          --        --         --           204              --            204
  Comprehensive loss
    Net loss.............................          --        --         --            --         (14,684)       (14,684)
    Other comprehensive income (loss)
      Net change in unrealized gain on
         available-for-sale
         investments.....................          --        --         --            --               1              1
                                           ----------   -------      -----         -----        --------       --------
         Total comprehensive loss........          --        --         --            --         (14,683)       (14,683)
                                           ----------   -------      -----         -----        --------       --------
Balances at December 31, 1997............  10,632,133    54,976       (386)         (104)        (35,827)        18,659
  Issuance of common stock for cash,
    net..................................   1,450,002    16,988         --            --              --         16,988
  Issuance of common stock under the
    employee stock purchase plan.........      87,887       590         --            --              --            590
  Issuance of common stock upon exercise
    of stock options.....................      28,749       259         --            --              --            259
  Repurchase of common stock.............     (35,155)      (17)        17            --              --             --
  Issuance of warrants for services......          --       268         --            --              --            268
  Repayment of shareholders' notes.......          --        --         81            --              --             81
  Deferred and other compensation........          --       704         --          (704)             --             --
  Amortization of deferred
    compensation.........................          --        --         --           267              --            267
  Comprehensive loss
    Net loss.............................          --        --         --            --         (15,454)       (15,454)
    Other comprehensive income (loss)
      Net change in unrealized gain on
         available-for-sale
         investments.....................          --        --         --            --               2              2
                                           ----------   -------      -----         -----        --------       --------
         Total comprehensive loss........          --        --         --            --         (15,452)       (15,452)
                                           ----------   -------      -----         -----        --------       --------
Balances at December 31, 1998............  12,163,616    73,768       (288)         (541)        (51,279)        21,660
  Issuance of common stock for cash,
    net..................................   2,428,338    24,798         --            --              --         24,798
  Issuance of common stock under the
    employee stock purchase plan.........      98,860       713         --            --              --            713
  Issuance of common stock upon exercise
    of stock options.....................      58,963       324         --            --              --            324
  Repayment of shareholders' notes.......          --        --        125            --              --            125
  Amortization of deferred
    compensation.........................          --        --         --           162              --            162
  Comprehensive loss
    Net loss.............................          --        --         --            --         (23,603)       (23,603)
    Other comprehensive income (loss)
      Net change in unrealized loss on
         available-for-sale
         investments.....................          --        --         --            --             (22)           (22)
                                           ----------   -------      -----         -----        --------       --------
         Total Comprehensive loss........          --        --         --            --         (23,625)       (23,625)
                                           ----------   -------      -----         -----        --------       --------
Balances at December 31, 1999............  14,749,777   $99,603      $(163)        $(379)       $(74,904)      $ 24,157
                                           ==========   =======      =====         =====        ========       ========
</TABLE>

                            See accompanying notes.
                                       37
<PAGE>   38

                              ARADIGM CORPORATION

                            STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                             --------------------------------
                                                               1999        1998        1997
                                                             --------    --------    --------
<S>                                                          <C>         <C>         <C>
Cash flows from operating activities:
Net loss...................................................  $(23,603)   $(15,454)   $(14,684)
Adjustments to reconcile net loss to net cash used in
  operating activities:
  Depreciation and amortization............................     2,356       1,773         691
  Loss on sale of equipment................................        15          --          --
  Issuance of warrants for services........................        --         268          --
  Amortization of deferred compensation....................       162         267         204
  Changes in operating assets and liabilities:
     Receivables...........................................    (3,112)       (513)       (261)
     Other current assets..................................      (458)        200        (478)
     Other assets..........................................       (89)         --          (4)
     Accounts payable......................................       527         474         904
     Accrued liabilities...................................    (1,154)      1,715        (388)
     Deferred revenue......................................    (1,649)      6,334       6,170
                                                             --------    --------    --------
Net cash used in operating activities......................   (27,005)     (4,936)     (7,846)
                                                             --------    --------    --------
Cash flows from investing activities:
Capital expenditures.......................................    (4,349)     (9,552)     (2,756)
Proceeds for sale of equipment.............................        14          --          --
Purchases of available-for-sale investments................   (30,841)    (34,940)    (27,278)
Proceeds from maturities of available-for-sale
  investments..............................................    29,178      23,459      29,571
                                                             --------    --------    --------
Net cash used in investing activities......................    (5,998)    (21,033)       (463)
                                                             --------    --------    --------
Cash flows from financing activities:
Proceeds from issuance of common stock, net................    25,835      17,837       5,164
Notes payable..............................................     3,956          --          --
Proceeds from repayments of shareholder notes..............       125          81          88
Notes receivable from officers.............................         5         168         (83)
Proceeds from equipment loans..............................     3,294       4,176       1,437
Payments on capital lease obligations and equipment
  loans....................................................    (1,630)     (1,045)       (234)
                                                             --------    --------    --------
Net cash provided by financing activities..................    31,585      21,217       6,372
                                                             --------    --------    --------
Net decrease in cash and cash equivalents..................    (1,418)     (4,752)     (1,937)
Cash and cash equivalents at beginning of year.............    10,765      15,517      17,454
                                                             --------    --------    --------
Cash and cash equivalents at end of year...................  $  9,347    $ 10,765    $ 15,517
                                                             ========    ========    ========
Supplemental disclosure of cash flow information:
  Cash paid for interest...................................  $    820    $    513    $    235
                                                             ========    ========    ========

Non-cash investing and financing activities:

  Common stock repurchased upon cancellation of shareholder
     notes.................................................  $     --    $     17    $      9
                                                             ========    ========    ========
  Issuance of warrants for services........................  $     --    $    268    $     --
                                                             ========    ========    ========
  Acquisition of equipment under capital leases............  $     --    $     --    $    899
                                                             ========    ========    ========
</TABLE>

                            See accompanying notes.
                                       38
<PAGE>   39

                              ARADIGM CORPORATION

                         NOTES TO FINANCIAL STATEMENTS

 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Basis of Presentation

     Aradigm Corporation (the "Company") is a California corporation. 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 obtaining financing, recruiting
management and technical personnel, securing operating facilities, conducting
research and development, and expanding commercial production capabilities.
These factors indicate that the Company's ability to continue its research,
development and commercialization activities 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, 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. Costs of contract revenue approximate
such revenue and are included in research and development expenses. Refundable
development and license fee payments are deferred until the specified
performance criteria are achieved.

Net Loss Per Share

     Historical net loss per share has been calculated under Statement of
Financial Accounting Standards No. 128, "Earnings Per Share." Basic net loss per
share on a historical basis is computed using the weighted average number of
shares of common stock outstanding less the weighted average number of shares
subject to repurchase. In the years ended December 31, 1999, 1998 and 1997, the
weighted average number of shares subject to repurchase were 48,000, 158,000 and
315,000, respectively. No diluted loss per share information has been presented
in the accompanying statements of operations since potential common shares from
stock options and warrants are antidilutive. The total number of shares excluded
from diluted loss per share relating to these securities was 899,319, 1,234,298
and 695,799 shares for the years ended December 31, 1999, 1998 and 1997,
respectively.

                                       39
<PAGE>   40
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
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

     In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Financial
Instruments and for Hedging Activities" ("SFAS 133") 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, 2000 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 notes. The Company's short-term investments consist of commercial
paper and corporate notes with maturities ranging from three to twelve months.

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

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

<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                           ------------------
                                                            1999       1998
                                                           -------    -------
<S>                                                        <C>        <C>
Cash equivalents:
  Money market fund......................................  $    52    $    16
  Commercial paper.......................................    8,318      9,164
                                                           -------    -------
                                                           $ 8,370    $ 9,180
                                                           =======    =======
Short-term investments:
  Commercial paper.......................................  $ 9,304    $ 2,613
  Corporate notes........................................   12,608     16,758
  Market auction preferred securities....................       --        900
                                                           -------    -------
                                                           $21,912    $20,271
                                                           =======    =======
</TABLE>

     As of December 31, 1999 and 1998, the difference between the fair value and
the amortized cost of available-for-sale securities was immaterial. As of
December 31, 1999, the average portfolio duration was approximately three
months, and the contractual maturity of any single investment did not exceed six
months from the balance sheet date.

                                       40
<PAGE>   41
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 3. PROPERTY AND EQUIPMENT

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

<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                           ------------------
                                                            1999       1998
                                                           -------    -------
<S>                                                        <C>        <C>
Machinery and equipment..................................  $13,681    $10,807
Furniture and fixtures...................................    1,181        810
Lab equipment............................................    2,006      1,610
Computer equipment and software..........................    1,828      1,264
Leasehold improvements...................................      937        880
                                                           -------    -------
                                                            19,633     15,371
Less accumulated depreciation and amortization...........   (5,473)    (3,175)
                                                           -------    -------
                                                           $14,160    $12,196
                                                           =======    =======
</TABLE>

     Property and equipment at December 31, 1999 include assets under
capitalized leases of approximately $9,890,000 ($7,512,000 in 1998). Accumulated
depreciation related to leased assets was approximately $3,667,000 at December
31, 1999 ($2,115,000 in 1998).

 4. LEASES AND COMMITMENTS

     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. In July 1999, the Company leased a new facility for clinical manufacturing
and moved into a new leased administrative and laboratory facility. The Company
leases its office, laboratory and manufacturing facilities under several
operating leases expiring through the year 2016.

     Future minimum lease payments under noncancelable operating and capital
leases at December 31, 1999 are as follows (amounts in thousands):

<TABLE>
<CAPTION>
                                                           OPERATING    CAPITAL
                                                            LEASES      LEASES
                                                           ---------    -------
<S>                                                        <C>          <C>
Years ending December 31:
  2000...................................................   $ 3,477     $ 2,601
  2001...................................................     3,289       2,802
  2002...................................................     3,373       2,834
  2003...................................................     3,463         871
  2004 and thereafter....................................    41,729          --
                                                            -------     -------
Total minimum lease payments.............................   $55,331       9,108
                                                            =======
Less amount representing interest........................                (1,592)
                                                                        -------
Present value of future lease payments...................                 7,516
Current portion of capital lease obligations.............                (1,863)
                                                                        -------
Noncurrent portion of capital lease obligations..........               $ 5,653
                                                                        =======
</TABLE>

     Rent expense under operating leases totaled $2,449,000, $1,157,000 and
$420,000 for the years ended December 31, 1999, 1998 and 1997, respectively.

                                       41
<PAGE>   42
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 5. CONTINGENCIES

     In June 1998, Eli Lilly and Company ("Lilly") filed a complaint against the
Company in the United States District Court for the Southern District of
Indiana. The complaint made various allegations against the Company, arising
from the Company's decision to enter into an exclusive collaboration with Novo
Nordisk 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 it has meritorious defenses against each of Eli
Lilly's claims and that this litigation will not have a material adverse effect
on the Company's results of operations, cash flows or financial position.
However, there can be no assurance that the Company will prevail in this case.
The Company recently filed an answer denying all material allegations of the
complaint and a motion for summary judgment directed against all claims in Eli
Lilly's complaint.

 6. SHAREHOLDERS' EQUITY

Capital Stock

     In March 1999, the Company completed a private placement of 2,428,338
shares of its common stock, raising approximately $24.8 million in net proceeds.
In June 1998, the company raised approximately $5.0 million through a private
sale of 312,396 shares of its common stock to a development partner at a 25%
premium to the market price. In April 1998, the Company raised approximately
$12.0 million through a private sale of 1,111,100 shares of its common stock to
a group of institutional investors.

     At December 31, 1999, the Company has reserved 326,665 shares of its common
stock for issuance upon exercise of common stock warrants and 3,753,947 shares
were reserved for issuance upon exercise of options.

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. Management valued the warrant using the
Black-Scholes option pricing model and is amortizing the warrant over the term
of the operating lease agreement, which is 17 years.

     In April 1998, the Company issued warrants to the placement agents of the
private placement of common stock that entitles the holders to purchase 166,665
shares of common stock at an exercise price of $12.42 per share. Management
valued the warrants using the Black-Scholes option pricing model and recorded
approximately $765,000 as issuance costs related to the private placement. These
warrants are exercisable through June 2003.

     In September 1997, in connection with a consulting agreement, the Company
issued a warrant that entitled the holder to purchase 170,000 shares of common
stock at an exercise price of $8.96 per share. In June 1998, the Company and the
holder mutually agreed to cancel 60,000 unvested shares of the original 170,000
shares, leaving an outstanding balance of 110,000 shares. This warrant is
exercisable through August 2003. 26,000 shares vested immediately upon issuance
of the warrant. Another 24,000 shares vested ratably over the first twelve
months after issuance. Management valued these warrants using the Black-Scholes
option

                                       42
<PAGE>   43
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 6. SHAREHOLDERS' EQUITY (CONTINUED)

Stock Warrants (continued)
pricing model. 60,000 shares of the 110,000 vested upon certain contingent
events that occurred in 1998. Management valued these shares using the
Black-Scholes option pricing model, resulting in a value of $268,000 which was
fully expensed in 1998.

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, 1999, the
Company had authorized 4,800,000 shares of common stock for issuance under the
Plan. Options granted under the Plan expire no later than ten years from the
date of grant. For incentive and non-statutory stock option grants, the option
price shall be at least 100% and 85%, respectively, of the fair value on the
date of grant, as determined by the Board of Directors. If at any time the
Company grants an option, and the optionee directly or by attribution owns stock
possessing more than 10% of the total combined voting power of all classes of
stock of the Company, the option price shall be at least 110% of the fair value
and shall not be exercisable more than five years after the date of grant.

     Options granted under the 1996 Equity Incentive Plan are immediately
exercisable subject to repurchase provisions, and the shares acquired generally
vest over a period of four years from the date of grant. The Plan also provides
for a transition from employee to consultant status without termination of the
vesting period as a result of such transition. Under the Plan, employees may
exercise options in exchange for a note payable to the Company. As of December
31, 1999 and 1998, full recourse notes receivable from shareholders of $163,000
and $288,000, 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 38,294 shares in accordance with these agreements. During 1999, the
Company granted options to purchase 475,347 shares of common stock, none of
which were exercised subject to repurchase agreements.

                                       43
<PAGE>   44
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 6. SHAREHOLDERS' EQUITY (CONTINUED)

1996 Equity Incentive Plan (continued)
     The following is a summary of activity under the Plan:

<TABLE>
<CAPTION>
                                       SHARES                                      WEIGHTED
                                    AVAILABLE FOR                                  AVERAGE
                                      GRANT OF       NUMBER OF      PRICE PER      EXERCISE
                                       OPTIONS        SHARES          SHARE         PRICE
                                    -------------    ---------    -------------    --------
<S>                                 <C>              <C>          <C>              <C>
Balance at December 31, 1996......      653,357        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..............       24,232             --    $0.37 - $ 0.57    $ 0.49
  Options cancelled...............       26,975        (26,975)   $5.33 - $ 9.88    $ 6.03
                                      ---------      ---------
Balance at December 31, 1997......      153,964        831,133    $0.10 - $12.88    $ 7.62
  Options authorized..............    1,000,000             --         --               --
  Options granted.................     (975,300)       975,300    $9.13 - $14.63    $11.50
  Options exercised...............           --        (28,749)   $6.88 - $12.25    $ 8.99
  Shares repurchased..............       14,062             --    $0.43 - $ 4.00    $ 0.58
  Options cancelled...............       58,313        (58,313)   $6.88 - $12.88    $ 8.62
                                      ---------      ---------
Balance at December 31, 1998......      251,039      1,719,371    $0.10 - $14.63    $ 9.77
  Options authorized..............    1,820,000             --         --               --
  Options granted.................     (475,347)       475,347    $6.19 - $12.00    $ 9.42
  Options exercised...............           --        (36,463)   $0.37 - $12.25    $ 5.19
  Options cancelled...............       60,349        (60,349)   $5.33 - $14.63    $11.03
                                      ---------      ---------
Balance at December 31, 1999......    1,656,041      2,097,906    $0.10 - $14.63    $ 9.72
                                      =========      =========
</TABLE>

<TABLE>
<CAPTION>
                                 OPTIONS OUTSTANDING AND EXERCISABLE
                      ---------------------------------------------------------
                                                     WEIGHTED AVERAGE REMAINING
                                  WEIGHTED AVERAGE        CONTRACTUAL LIFE
EXERCISE PRICE RANGE   NUMBER      EXERCISE PRICE            (IN YEARS)
--------------------  ---------   ----------------   --------------------------
<S>                   <C>         <C>                <C>
       $ 0.10             3,000        $ 0.10                   2.4
  $ 0.33 - $ 0.43        44,025        $ 0.37                   4.4
       $ 0.57             6,558        $ 0.57                   6.1
       $ 2.00             3,450        $ 2.00                   6.2
  $ 4.00 - $ 5.67       122,250        $ 5.24                   6.4
  $ 6.19 - $ 9.25       770,112        $ 8.02                   8.3
  $ 9.31 - $13.38     1,069,761        $11.62                   8.4
  $14.00 - $14.63        78,750        $14.32                   8.3
                      ---------
  $ 0.10 - $14.63     2,097,906        $ 9.72                   8.1
                      =========
</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.

                                       44
<PAGE>   45
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 6. SHAREHOLDERS' EQUITY (CONTINUED)

1996 Equity Incentive Plan (continued)
     The Company recorded deferred compensation of approximately $704,000 for
the difference between the grant price and the fair value of certain of the
Company's common stock options granted in 1998. This amount is being amortized
over the vesting period of the individual options. There were no such grants in
1999 or in 1997. Amortization of deferred compensation recognized in the years
ended December 31, 1999, 1998 and 1997 was approximately $162,000, $267,000 and
$204,000, respectively. The weighted average fair value of options granted in
1998 with an exercise price below the deemed fair value of the Company's common
stock on the date of grant was $12.13. The weighted average fair value of
options granted during 1999, 1998 and 1997 with an exercise price equal to the
fair value of the Company's common stock on the date of grant was $4.98, $6.09
and $3.35, respectively.

     Pro forma information regarding net loss and basic and diluted net loss per
share is required by SFAS 123, which also requires that the information be
determined as if the Company had accounted for its employee and non-employee
director stock options granted subsequent to December 31, 1994 under the fair
value method prescribed by this statement. The fair value of options was
estimated at the date of grant using the Black-Scholes option pricing model with
the following assumptions: a risk-free interest rate of 5.2%, 5.2% and
5.7% - 6.4% for the years ended December 31, 1999, 1998 and 1997, respectively;
a dividend yield of 0.0%; the annual volatility factor of the expected market
price of the Company's common stock for 1999, 1998 and 1997 are 0.64, 0.63 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.

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

<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                             --------------------------------
                                                               1999        1998        1997
                                                             --------    --------    --------
<S>                                                          <C>         <C>         <C>
Net loss -- as reported....................................  $(23,603)   $(15,454)   $(14,684)
Pro forma net loss.........................................  $(26,087)   $(17,254)   $(15,232)
Basic and diluted net loss per share -- as reported........  $  (1.66)   $  (1.32)   $  (1.43)
Pro forma basic and diluted net loss per share.............  $  (1.85)   $  (1.41)   $  (1.46)
</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
reflects compensation expense for five years' vesting of outstanding stock
options.

Employee Stock Purchase Plan

     Under the Employee Stock Purchase Plan (the "Purchase Plan"), 380,000
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, 1999,
209,059 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, 1999, 104,068 options have been granted under the Directors' Plan.
During the year ended December 31, 1999, 21,568 shares were granted

                                       45
<PAGE>   46
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 6. SHAREHOLDERS' EQUITY (CONTINUED)

1996 Non-Employee Directors' Stock Option Plan (continued)
under the plan and 22,500 shares subject to option were exercised. At December
31, 1999, options to purchase 59,068 shares were outstanding under the plan.

 7. COLLABORATIVE AGREEMENTS

     In May 1999, Aradigm signed an agreement with Genentech to develop the drug
dornase alfa in the AERx system. Dornase alfa is the active ingredient in the
currently marketed Genentech product, Pulmozyme. The agreement provides that
development expenses incurred by Aradigm will be reimbursed by Genentech in the
form of loans supported by promissory notes bearing interest at two percent over
the prime rate which was 10.5% at December 31, 1999. Principal and unpaid
accrued interest is due at the earlier of 15 days after FDA approval or seven
years after the effective date of the collaborative agreement or May 21, 2006.
Upon receipt of FDA approval, Aradigm will receive a milestone payment that is
larger than the loan principal and accrued interest, allowing the loan to be
repaid in full. The Company will also receive certain milestone payments at
various points of product development.

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

     In 1999, pursuant to the Novo Nordisk agreement, Aradigm had received
approximately $13.9 million milestone and product development payments and could
receive up to $34 million in additional milestone payments and a $5.0 million
equity investment. In 1998, Aradigm received approximately $13.5 million,
including the purchase of $5.0 million of newly issued Aradigm common stock at a
25% premium to the market price. In addition, Novo Nordisk will fund all product
development costs incurred by Aradigm, while the development partners will
co-fund final development of the AERx device. Aradigm will be the initial
manufacturer of all the products covered by the agreement and will receive a
share of the overall gross profits resulting from Novo Nordisk's sales of the
products. Through December 31, 1999, the Company has recognized total contract
revenue of $14.0 million ($8.7 million and $5.3 million in 1999 and 1998,
respectively).

     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 developed product
sold by SmithKline Beecham.

     At December 31, 1999, the Company had received from SmithKline Beecham
approximately $19 million in milestone and product development payments and $5
million from the purchase of shares of Aradigm common stock at a 25% premium to
the market price. As of December 31, 1999, pursuant to the agreement, Aradigm is
entitled to approximately $4.4 million in additional product development
payments, and could receive $14 million in additional milestone payments and
additional future product development payments, if and when the first product
from the collaboration is commercialized. The Company also has the rights to
receive an additional $5 million equity investment from SmithKline Beecham.
Additional milestone and product development payments will be paid if Aradigm
and SmithKline Beecham decide to jointly develop
                                       46
<PAGE>   47
                              ARADIGM CORPORATION

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)

 7. COLLABORATIVE AGREEMENTS (CONTINUED)
additional AERx systems which incorporate other opiates or opioids. Through
December 31, 1999, the Company has recognized total contract revenue of $18.8
million ($5.2 million, $11.0 million and $2.6 million in 1999, 1998 and 1997,
respectively).

 8. INCOME TAXES

     The Company uses the liability method to account for income taxes as
required by Statement of Financial Accounting Standards No. 109, "Accounting for
Income Taxes". Under this method, deferred 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
(amounts in thousands):

<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                         --------------------
                                                           1999        1998
                                                         --------    --------
<S>                                                      <C>         <C>
Net operating loss carryforward........................  $ 21,340    $ 15,613
Deferred revenue.......................................     4,410       2,880
Research and development credit carryforward...........     2,575       1,769
Other..................................................     1,303         457
                                                         --------    --------
Gross deferred tax assets..............................    29,628      20,719
Valuation allowance....................................   (29,628)    (20,719)
                                                         --------    --------
Net deferred tax assets................................  $     --    $     --
                                                         ========    ========
</TABLE>

     The valuation allowance increased by $8,909,000 and $5,179,000 in 1999 and
1998, respectively.

     As of December 31, 1999, the Company had net operating loss carryforwards
of approximately $57,000,000 which expire in the tax years 2006 through 2019 and
net operating losses for state income tax purposes of $32,500,000 expiring in
the years 2000 through 2004. At December 31, 1999, the Company had research and
development credit carryforwards for federal income tax purposes of
approximately $1,909,000, which expire in the years 2006 through 2013.

     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

PROPOSED PUBLIC OFFERING OF COMMON STOCK

     In February 2000, the Board of Directors authorized the Company to proceed
with a public offering of its common stock. If the offering is consummated as
presently anticipated, the Company will issue 2.5 million shares of common
stock.

                                       47
<PAGE>   48

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

     None.

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

IDENTIFICATION OF DIRECTORS

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

IDENTIFICATION OF EXECUTIVE OFFICERS

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

SECTION 16(a) COMPLIANCE

     Section 16(a) of the Securities Exchange Act requires our directors and
executive officers, and persons who own more than ten percent of a registered
class of our equity securities, to file with the Securities and Exchange
Commission initial reports of ownership and reports of changes in ownership of
our common stock and other equity securities. Officers, directors and greater
than ten percent shareholders are required by Securities and Exchange Commission
regulations to furnish us with copies of all Section 16(a) forms they file. To
our knowledge, based solely on a review of the copies of such reports furnished
to us and written representations that no other reports were required, during
the fiscal year ended December 31, 1999, all Section 16(a) filing requirements
applicable to our officers, directors and greater than ten percent beneficial
owners were complied with, except that one report covering two transactions was
filed late by Bikash Chatterjee, our Vice President, Operations and one report
covering one transaction was filed late by three of our directors, Frank H.
Barker, Wayne I. Roe and Virgil D. Thompson.

ITEM 11. EXECUTIVE COMPENSATION

COMPENSATION OF DIRECTORS

     Our directors do not currently receive any cash compensation from us for
their service as a member of the board of directors, although they are
reimbursed for certain expenses incurred in connection with their attendance at
board of directors and committee meetings in accordance with our policy.

     Each non-employee director also receives stock option grants under our
Non-employee Directors' Stock Option Plan, or the Directors' Plan. Only
non-employee directors are eligible to receive options under the Directors'
Plan. Options granted under the Directors' Plan are intended not to qualify as
incentive stock options under the Internal Revenue Code, or the Code. Options
granted under the Directors' Plan are non-discretionary. On June 19 of each
year, or the next business day, each non-employee director is automatically
granted under the Directors' Plan an option to purchase 7,500 shares of common
stock, or such pro-rated amount for non-employee directors with less than a full
year's tenure. Options under the Directors' Plan vest in four equal, quarterly
installments, commencing on the date of grant of the option. The exercise price
of the options granted under the Directors' Plan is the fair market value of the
common stock on the date of grant. No option granted under the Directors' Plan
may be exercised after the expiration of 10 years from the date it was granted.
Options granted under the Directors' Plan are generally non-transferable except
pursuant to a qualified domestic relations order. The Directors' Plan will
terminate at the discretion of the Board. In the event of certain changes of
control, options outstanding under the Directors' Plan will automatically become
fully vested and will terminate if not exercised prior to such change of
control.

     During 1999, we granted 10,000 shares to two directors at an exercise price
of $8.25 and 11,568 shares to three directors at an exercise price of $8.75. As
of December 31, 1999, 36,568 options to purchase common stock granted under the
Directors' Plan were outstanding. In February 2000, the board of directors
terminated

                                       48
<PAGE>   49

the Director's Plan and amended the 1996 Equity Incentive Plan to allow for
options grants under that plan to non-employee directors.

COMPENSATION OF EXECUTIVE OFFICERS

     The following table presents the compensation earned by our chief executive
officer and our other four most highly compensated executive officers whose
salary and bonus for the year ended December 31, 1999 were in excess of
$100,000, referred to as the named executive officers. In accordance with the
rules of the Securities and Exchange Commission, the compensation described in
this table does not include medical, group life insurance or other benefits
received by the named executive officers that are available generally to all our
salaried employees and certain perquisites and other personal benefits received
by the named executive officers, which do not exceed the lesser of $50,000 or
10% of any such officer's salary and bonus contained in the table.

                           SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                                                           LONG-TERM AND
                                                ANNUAL COMPENSATION     OTHER COMPENSATION
                                                --------------------   ---------------------
                                       FISCAL                          SECURITIES UNDERLYING      ALL OTHER
     NAME AND PRINCIPAL POSITION        YEAR    SALARY($)   BONUS($)        OPTIONS(#)         COMPENSATION($)
     ---------------------------       ------   ---------   --------   ---------------------   ---------------
<S>                                    <C>      <C>         <C>        <C>                     <C>
Richard P. Thompson..................   1999     276,000     75,000            30,000                  --
  President, Chief Executive Officer
  and                                   1998     260,000     79,000           100,000                  --
  Director                              1997     225,000     56,000            40,000                  --
R. Jerald Beers......................   1999     208,000     45,000            20,000                  --
  Executive Vice President Marketing
  and                                   1998     208,000     49,000           120,000                  --
  Business Development                  1997      92,000         --                --                  --
Reid M. Rubsamen, M.D. ..............   1999     188,000     41,000            30,000                  --
  Vice President, Medical Affairs,
  Secretary                             1998     180,000     44,000            55,000                  --
  and Director                          1997     160,000     32,000            20,000                  --
Igor Gonda, Ph.D. ...................   1999     188,000     41,000            30,000                  --
  Vice President Research and
     Development                        1998     180,000     32,000            35,000                  --
                                        1997     160,000     39,000            20,000                  --
John Parker, Ph.D.(1)................   1999     190,000     41,000                --                  --
  Vice President Quality                1998      45,000         --           100,000              15,000(2)
                                        1997          --         --                --                  --
Babatunde A. Otulana, M.D.(3)........   1999     170,000     37,000            30,000              39,000(4)
  Vice President Clinical and
     Regulatory                         1998     153,000     37,000            10,000              17,000(5)
  Affairs                               1997      30,000      6,000            55,000                  --
</TABLE>

---------------
(1) Mr. Parker commenced his employment with us in October 1998. As of January
    1, 2000, Mr. Parker terminated his employment with us as Vice President,
    Quality.

(2) In 1998, Mr. Parker was reimbursed by us for moving expenses in the amount
    of $15,000.

(3) Mr. Otulana commenced his employment with us in October 1997.

(4) In 1999, Mr. Otulana was reimbursed by us for moving expenses in the amount
    of $39,000.

(5) In 1998, Mr. Otulana was reimbursed by us for moving expenses in the amount
    of $17,000.

OPTION GRANTS IN YEAR 1999

     The following table presents each grant of stock options made to each of
the named executive officers during the year ended December 31, 1999. We grant
options to our executive officers under our 1996 Equity Incentive Plan, or the
Incentive Plan. These options vest quarterly over a four-year period. The
options will fully vest upon a change of control, as defined in the Incentive
Plan, unless the acquiring company assumes the

                                       49
<PAGE>   50

options or substitutes similar options. The board of directors may reprice
options under the terms of the Incentive Plan. In the year ended December 31,
1999, we granted to our employees options to purchase a total of 475,347 shares
of our common stock.

     Potential realizable value is calculated assuming that the stock price on
the date of grant appreciates at the indicated rate compounded annually until
the option is exercised and sold on the last day of its term for the appreciated
stock price. The 5% and 10% assumed rates of appreciation are required by the
rules of the Securities and Exchange Commission and do not represent our
estimate or projection of the future common stock price.

<TABLE>
<CAPTION>
                                                                                         POTENTIAL REALIZABLE
                                                                                           VALUE AT ASSUMED
                                     NUMBER OF     % OF TOTAL                            ANNUAL RATES OF STOCK
                                     SECURITIES     OPTIONS      EXERCISE                 PRICE APPRECIATION
                                     UNDERLYING    GRANTED TO    OR BASE                    FOR OPTION TERM
                                      OPTIONS     EMPLOYEES IN    PRICE     EXPIRATION   ---------------------
               NAME                   GRANTED     FISCAL YEAR     ($/SH)       DATE         5%          10%
               ----                  ----------   ------------   --------   ----------   ---------   ---------
<S>                                  <C>          <C>            <C>        <C>          <C>         <C>
Richard P. Thompson................    15,000           3.16      12.00       2/1/09      113,000     287,000
                                       15,000           3.16       7.00      5/20/09       66,000     167,000
R. Jerald Beers....................    10,000           2.10      12.00       2/1/09       75,000     191,000
                                       10,000           2.10       7.00      5/20/09       44,000     112,000
Reid M. Rubsamen, M.D..............    15,000           3.16      12.00       2/1/09      113,000     287,000
                                       15,000           3.16       7.00      5/20/09       66,000     167,000
Igor Gonda, Ph.D...................    15,000           3.16      12.00       2/1/09      113,000     287,000
                                       15,000           3.16       7.00      5/20/09       66,000     167,000
John Parker, Ph.D..................        --             --         --           --           --          --

Babatunde A. Otulana, M.D..........    15,000           3.16      12.00       2/1/09      113,000     287,000
                                       15,000           3.16       7.00      5/20/09       66,000     167,000
</TABLE>

OPTION EXERCISES AND YEAR END OPTION VALUES

     No named executive officers exercised any options during 1999. Options
granted under the Incentive Plan are immediately exercisable, but are subject to
our right to repurchase unvested shares at the original exercise price paid per
share upon termination of employment. The value of in-the-money options is based
on the fair market value of our common stock at December 31, 1999 ($9.50) minus
the exercise price payable of the options.

    AGGREGATED OPTION EXERCISES IN FISCAL YEAR 1999 AND FY-END OPTION VALUES

<TABLE>
<CAPTION>
                                                      NUMBER OF SECURITIES          VALUE OF UNEXERCISED
                                                     UNDERLYING UNEXERCISED         IN-THE-MONEY OPTIONS
                                                      OPTIONS AT FY-END (#)             AT FY-END ($)
                                                   ---------------------------   ---------------------------
                      NAME                         EXERCISABLE   UNEXERCISABLE   EXERCISABLE   UNEXERCISABLE
                      ----                         -----------   -------------   -----------   -------------
<S>                                                <C>           <C>             <C>           <C>
Richard P. Thompson..............................    170,000          --            68,000          --
R. Jerald Beers..................................    140,000          --           325,000          --
Reid M. Rubsamen, M.D............................    105,000          --            53,000          --
Igor Gonda, Ph.D.................................     85,000          --            53,000          --
John Parker, Ph.D................................    100,000          --            37,000          --
Babatunde A. Otulana, M.D........................     95,000          --            38,000          --
</TABLE>

                                       50
<PAGE>   51

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The following table sets forth certain information known to us with respect
to the beneficial ownership of our common stock as of February 29, 2000 by: (i)
each shareholder who is known by us own beneficially more than 5% of our common
stock; (ii) our chief executive officer and each of our four other most highly
compensated executive officers at December 31, 1999; (iii) each of our
directors; and (iv) all of our directors and executive officers as a group.

<TABLE>
<CAPTION>
                                                                           PERCENTAGE
                                                              SHARES (1)     OWNED
                                                              ----------   ----------
<S>                                                           <C>          <C>
Zesiger Capital Group LLC...................................  1,041,000        7.0%
  320 Park Avenue, 30th Floor
  New York, NY 10022(2)
Richard P. Thompson(3)......................................    535,001        3.5%
Reid M. Rubsamen, M.D.(4)...................................    352,841        2.3%
Igor Gonda, Ph.D.(5)........................................    242,776        1.6%
R. Jerald Beers(6)..........................................    163,390        1.1%
Babatunde A. Otulana, M.D.(7)...............................    136,634          *
John H. Parker, Ph.D.(8)....................................     33,218          *
Virgil D. Thompson(9).......................................     50,000          *
Wayne I. Roe(10)............................................     23,712          *
Frank H. Barker(10).........................................     22,712          *
All directors and executive officers as a group (14           3,172,730       19.6%
  persons)(11)..............................................
</TABLE>

---------------
  *  Represents beneficial ownership of less than 1%.

 (1) This table is based upon information supplied by officers, directors and
     principal shareholders and Schedules 13D and 13G filed with the Securities
     and Exchange Commission. Unless otherwise indicated in the footnotes to
     this table and subject to community property laws where applicable, we
     believe that each of the shareholders named in this table has sole voting
     and investment power with respect to the shares indicated as beneficially
     owned. Applicable percentages are based on 14,891,088 shares outstanding on
     February 29, 2000, adjusted as required by rules promulgated by the
     Securities and Exchange Commission.

 (2) Represents 1,041,000 shares held by Zesiger Capital Group LLC solely for
     investment purposes on behalf of client discretionary investment advisory
     accounts.

 (3) Represents 245,874 shares held by Mr. Thompson, 100 shares held by a member
     of Mr. Thompson's immediate family, 54,037 shares held by the Thompson
     Family Trust and 15,000 shares held by Thompson Family Partners. Mr.
     Thompson is a Trustee of the Thompson Family Trust and a General Partner of
     Thompson Family Partners and, as such, may be deemed to share voting and
     investment power with respect to the shares held by the Thompson Family
     Trust and Thompson Family Partners. Mr. Thompson disclaims beneficial
     ownership of the shares held by his family members, the Thompson Family
     Trust and Thompson Family Partnership except to the extent of his pecuniary
     and proportionate partnership interest arising from his interest therein.
     Includes 220,000 shares subject to options exercisable within 60 days of
     February 29, 1999, subject to repurchase of unvested shares.

 (4) Includes 135,000 shares subject to options exercisable within 60 days of
     February 29, 2000, subject to repurchase of unvested shares.

 (5) Represents 126,976 shares held by Dr. Gonda and 800 shares held by members
     of Dr. Gonda's immediate family. Dr. Gonda disclaims beneficial ownership
     of such shares. Includes 115,000 shares subject to options exercisable
     within 60 days of February 29, 2000, subject to repurchase of unvested
     shares.

 (6) Includes 160,000 shares subject to options exercisable within 60 days of
     February 29, 2000, subject to repurchase of unvested shares.

                                       51
<PAGE>   52

 (7) Includes 135,000 shares subject to options exercisable within 60 days of
     February 29, 2000, subject to repurchase of unvested shares.

 (8) Includes 33,218 shares subject to options exercisable within 60 days of
     February 29, 2000, subject to repurchase of unvested shares. Dr. Parker is
     a former executive officer, who continues to serve as a consultant to us.

 (9) Includes 30,500 shares subject to options exercisable within 60 days of
     February 29, 2000, subject to repurchase of unvested shares.

(10) Includes 22,712 shares subject to options exercisable within 60 days of
     February 29, 2000, subject to repurchase of unvested shares.

(11) See footnotes (1) through (10) above, as applicable.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     In May 1994, we issued and sold to Mr. Thompson, President, Chief Executive
Officer and director, an aggregate of 225,000 shares of common stock for an
aggregate purchase price of $82,500, payable pursuant to a secured promissory
note bearing interest at the rate of 7.0% per annum, with accrued but unpaid
interest due and payable annually and the principal and remaining interest due
and payable on July 1, 1999. In February 1996, we issued and sold to Mr.
Thompson an aggregate of 106,596 shares of common stock for an aggregate
purchase price of $60,404, $54,364 of which was paid pursuant to a secured
promissory note bearing interest at the rate of 5.45% per annum, with the
principal and accrued but unpaid interest due and payable on February 28, 2001.
The largest aggregate amount of Mr. Thompson's indebtedness to us during fiscal
1999 was $129,058. The outstanding balance of the loans to Mr. Thompson was
$34,656 as of February 29, 2000.

     In December 1995, we issued and sold to Dr. Gonda, Vice President of
Research and Development, 150,000 shares of common stock for an aggregate
purchase price of $65,000, $58,000 of which was paid pursuant to a secured
promissory note bearing interest at the rate of 5.91% per annum, with the
principal and accrued but unpaid interest due and payable in October 2000. The
largest aggregate amount of Dr. Gonda's indebtedness to us during fiscal 1999
was $46,850. The aggregate outstanding balance of the loans to Dr. Gonda was
$46,850 as of February 29, 2000.

     We have entered into indemnity agreements with certain officers and
directors which provided, among other things, that we will indemnify such
officer or director, under the circumstances and to the extent provided for
therein, for expenses, damages, judgments, fines and settlements he may be
required to pay in actions or proceedings which he is or may be made a party by
reason of his position as a director, officer or other agent of us, and
otherwise to the full extent permitted under California law and our bylaws.

     We believe that the foregoing transactions were in our best interests. As a
matter of policy these transactions were, and all future transactions between us
and any of our officers, directors or principal shareholders will be, approved
by a majority of the independent and disinterested members of the board of
directors, will be on terms no less favorable to us than could be obtained from
unaffiliated third parties and will be in connection with our bona fide business
purposes.

                                       52
<PAGE>   53

                                    PART IV

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

(A) (1) FINANCIAL STATEMENTS.

     Included in Part II of this Report:

<TABLE>
<CAPTION>
                                                               PAGE IN
                                                              FORM 10-K
                                                              ---------
<S>                                                           <C>
Report of Ernst & Young LLP, Independent Auditors...........     35
Balance Sheets -- December 31, 1999 and 1998................     36
Statements of Operations -- Years ended December 31, 1999,
  1998 and 1997.............................................     37
Statements of Shareholders' Equity -- Years ended December
  31, 1999, 1998 and 1997...................................     38
Statements of Cash Flows -- Years ended December 31, 1999,
  1998 and 1997.............................................     39
Notes to Financial Statements...............................     40
</TABLE>

(2) FINANCIAL STATEMENT SCHEDULES.

     None.

(3) EXHIBITS.

<TABLE>
    <S>           <C>
     3.1(1)       Amended and Restated Articles of Incorporation of the
                  Company.
     3.2(1)       Bylaws of the Company
     4.1          Reference is made to Exhibits 3.1 and 3.2
     4.2(1)       Specimen stock certificate
     4.3(1)       Amended and Restated Investor Rights Agreement, dated
                  December 22, 1995, among the Company and certain of its
                  shareholders
    10.1(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>

                                       53
<PAGE>   54
<TABLE>
    <S>           <C>
    10.10(3)      Lease Agreement for the property located at 26224 Executive
                  Place, Hayward, California, dated January 28, 1998, between
                  the Company and Hayward Point Eden I Limited Partnership
    10.11(1)      Lease Agreement for the property located at 3930 Point Eden
                  Way, Hayward, California, dated February 21, 1996, between
                  the Company and Hayward Point Eden I Limited Partnership
    10.11a(3)     First Amendment to Lease, dated June 10, 1996, between the
                  Company and Hayward Point Eden I Limited Partnership
    10.11b(3)     Second Amendment to Lease, dated December 22, 1997, between
                  the Company and Hayward Point Eden I Limited Partnership
    10.11c(3)     Third Amendment to Lease, dated January 28, 1998, between
                  the Company and Hayward Point Eden I Limited Partnership
    10.12(1)(2)   Stock Purchase Agreement and related agreements, including
                  Promissory Note, dated May 19, 1994, between the Company and
                  Richard P. Thompson
    10.13(1)(2)   Stock Purchase Agreement and related agreements, including
                  Promissory Note, dated May 23, 1995, between the Company and
                  R. Ray Cummings
    10.14(1)(2)   Note Agreement and Promissory Note Secured by Deed of Trust,
                  dated May 1, 1995, between the Company and R. Ray Cummings
    10.15(1)(2)   Promissory Note, dated October 26, 1995, between the Company
                  and Igor Gonda
    10.16(1)(2)   Promissory Note, dated December 27, 1995, between the
                  Company and Igor Gonda
    10.17(1)      Master Lease Agreement and Warrant, between the Company and
                  Comdisco, Inc., dated June 9, 1995
    10.18(4)(5)   Product Development and Commercialization Agreement between
                  the Company and SmithKline Beecham PLC
    10.19(4)(5)   Stock Purchase Agreement between the Company and SmithKline
                  Beecham PLC
    10.20(3)      Lease Agreement for the property located at 3911 Trust Way,
                  Hayward, California, dated March 17, 1997, between the
                  Company and Hayward Point Eden I Limited Partnership
    10.20a(3)     First Amendment to Lease, dated December 22, 1997, between
                  the Company and Hayward Point Eden I Limited Partnership
    10.20b(3)     Second Amendment to Lease, dated January 28, 1998, between
                  the Company and Hayward Point Eden I Limited Partnership
    10.21(3)      Lease Agreement for the property located in Phase V of the
                  Britannia Point Eden Business Park in Hayward, California,
                  dated January 28, 1998, between the Company and Britannia
                  Point Eden, LLC
    10.22(6)      Common Stock Purchase Agreement, dated April 3, 1998,
                  between the Company and the purchasers named therein.
    10.23(6)      Development and License Agreement, dated June 2, 1998,
                  between the Company and Novo Nordisk A/S
    10.24(7)      Rights Agreement, dated as of August 31, 1998, between the
                  Company and Bank Boston, N.A.
    10.25(8)      Common Stock Purchase Agreement, dated January 27, 1999,
                  between the Company and the purchasers named therein.
</TABLE>

                                       54
<PAGE>   55
<TABLE>
    <S>           <C>
    23.1          Consent of Ernst & Young LLP, Independent Auditors.
    24.1          Power of Attorney. Reference is made to page 57.
    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.

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

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

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

(B) REPORTS ON FORM 8-K.

     None.

(C) INDEX TO EXHIBITS.

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

(D) FINANCIAL STATEMENT SCHEDULES.

                                       55
<PAGE>   56

                                   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 25th day of February, 2000.

                                          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    February 25, 2000
-----------------------------------------------------      Officer and Director
                 Richard P. Thompson                            (Principal
                                                            Executive Officer)

                 /s/ NORMAN HALLEEN                     Vice President, Finance and   February 25, 2000
-----------------------------------------------------    Administration and Chief
                   Norman Halleen                      Financial Officer (Principal
                                                         Financial and Accounting
                                                                 Officer)

             /s/ REID M. RUBSAMEN, M.D.                   Vice President, Medical     February 25, 2000
-----------------------------------------------------            Affairs,
               Reid M. Rubsamen, M.D.                     Secretary and Director

                 /s/ FRANK H. BARKER                             Director             February 25, 2000
-----------------------------------------------------
                   Frank H. Barker

                  /s/ WAYNE I. ROE                               Director             February 25, 2000
-----------------------------------------------------
                    Wayne I. Roe

               /s/ VIRGIL D. THOMPSON                            Director             February 25, 2000
-----------------------------------------------------
                 Virgil D. Thompson
</TABLE>

                                       56
<PAGE>   57

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
 EXHIBIT
  NUMBER                              DESCRIPTION
 -------                              -----------
<S>           <C>
 3.1(1)       Amended and Restated Articles of Incorporation of the
              Company.
 3.2(1)       Bylaws of the Company
 4.1          Reference is made to Exhibits 3.1 and 3.2
 4.2(1)       Specimen stock certificate
 4.3(1)       Amended and Restated Investor Rights Agreement, dated
              December 22, 1995, among the Company and certain of its
              shareholders
10.1(1)(2)    Form of Indemnity Agreement between the Registrant and each
              of its directors and officers
10.2(1)(2)    The Company's Equity Incentive Plan, as amended (the "Equity
              Incentive Plan")
10.3(1)(2)    Form of the Company's Incentive Stock Option Agreement under
              the Equity Incentive Plan
10.4(1)(2)    Form of the Company's Non-statutory Stock Option Agreement
              under the Equity Incentive Plan
10.5(1)(2)    Form of the Company's Non-Employee Directors' Stock Option
              Plan
10.6(1)(2)    Form of the Company's Non-statutory Stock Option Agreement
              under the Non-Employee Directors' Stock Option Plan
10.7(1)(2)    Form of the Company's Employee Stock Purchase Plan
10.8(1)(2)    Form of the Company's Employee Stock Purchase Plan Offering
              Document
10.9(1)       Lease Agreement for the property located at 26219 Eden
              Landing Road, Hayward, California, dated November 1992 and
              amended November 29, 1994, between the Company and Hayward
              Point Eden I Limited Partnership
10.9a(3)      Second Amendment to Lease, dated December 22, 1997, between
              the Company and Hayward Point Eden I Limited Partnership
10.9b(3)      Third Amendment to Lease, dated January 28, 1998, between
              the Company and Hayward Point Eden I Limited Partnership
10.10(3)      Lease Agreement for the property located at 26224 Executive
              Place, Hayward, California, dated January 28, 1998, between
              the Company and Hayward Point Eden I Limited Partnership
10.11(1)      Lease Agreement for the property located at 3930 Point Eden
              Way, Hayward, California, dated February 21, 1996, between
              the Company and Hayward Point Eden I Limited Partnership
10.11a(3)     First Amendment to Lease, dated June 10, 1996, between the
              Company and Hayward Point Eden I Limited Partnership
10.11b(3)     Second Amendment to Lease, dated December 22, 1997, between
              the Company and Hayward Point Eden I Limited Partnership
10.11c(3)     Third Amendment to Lease, dated January 28, 1998, between
              the Company and Hayward Point Eden I Limited Partnership
10.12(1)(2)   Stock Purchase Agreement and related agreements, including
              Promissory Note, dated May 19, 1994, between the Company and
              Richard P. Thompson
10.13(1)(2)   Stock Purchase Agreement and related agreements, including
              Promissory Note, dated May 23, 1995, between the Company and
              R. Ray Cummings
10.14(1)(2)   Note Agreement and Promissory Note Secured by Deed of Trust,
              dated May 1, 1995, between the Company and R. Ray Cummings
</TABLE>

                                       57
<PAGE>   58

<TABLE>
<CAPTION>
 EXHIBIT
  NUMBER                              DESCRIPTION
 -------                              -----------
<S>           <C>
10.15(1)(2)   Promissory Note, dated October 26, 1995, between the Company
              and Igor Gonda
10.16(1)(2)   Promissory Note, dated December 27, 1995, between the
              Company and Igor Gonda
10.17(1)      Master Lease Agreement and Warrant, between the Company and
              Comdisco, Inc., dated June 9, 1995
10.18(4)(5)   Product Development and Commercialization Agreement between
              the Company and SmithKline Beecham PLC
10.19(4)(5)   Stock Purchase Agreement between the Company and SmithKline
              Beecham PLC
10.20(3)      Lease Agreement for the property located at 3911 Trust Way,
              Hayward, California, dated March 17, 1997, between the
              Company and Hayward Point Eden I Limited Partnership
10.20a(3)     First Amendment to Lease, dated December 22, 1997, between
              the Company and Hayward Point Eden I Limited Partnership
10.20b(3)     Second Amendment to Lease, dated January 28, 1998, between
              the Company and Hayward Point Eden I Limited Partnership
10.21(3)      Lease Agreement for the property located in Phase V of the
              Britannia Point Eden Business Park in Hayward, California,
              dated January 28, 1998, between the Company and Britannia
              Point Eden, LLC
10.22(6)      Common Stock Purchase Agreement, dated April 3, 1998,
              between the Company and the purchasers named therein.
10.23(6)      Development and License Agreement, dated June 2, 1998,
              between the Company and Novo Nordisk A/S
10.24(7)      Rights Agreement, dated as of August 31, 1998, between the
              Company and Bank Boston, N.A.
10.25(8)      Common Stock Purchase Agreement, dated January 27, 1999,
              between the Company and the purchasers named therein.
23.1          Consent of Ernst & Young LLP, Independent Auditors.
24.1          Power of Attorney. Reference is made to page 57.
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.

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

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

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

                                       58