##### Table of Contents











UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington D.C. 20549




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Form 10-K



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|           |  |                                                                                                 
|---------- |  | ------------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                                 
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|           |  | For the fiscal year ended December 31,
    2003                                                 
|          
|or        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|          
|           |  | For the transition period
    from           to           .                                     

Commission file number: 0-28402



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Aradigm Corporation

(Exact Name of Registrant as Specified in Its
Charter)


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

3929 Point Eden Way, Hayward, CA
94545

(Address of Principal Executive
Offices)


Registrants telephone number, including
area code:

(510) 265-9000


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

None


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

Common Stock, no par value




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

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

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Act)     Yes o          No þ

Aggregate market value of registrants
common stock held by non-affiliates of the registrant, based
upon the closing price of a share of the registrants
common stock on June 30, 2003: $72,591,000.

Number of shares of the registrants common
stock outstanding as of February 27, 2004: 63,036,004.

DOCUMENTS INCORPORATED BY REFERENCE

(1) Items 10,
11, 12, 13 and 14 of Part III incorporate information by
reference from the Registrants definitive proxy statement
for the Annual Meeting of Shareholders to be held on
May 20, 2004.



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TABLE OF CONTENTS

|                 |  |                                                                                                        |    |      |    | 
|---------------- |  | ------------------------------------------------------------------------------------------------------ | -- | ---- | -- | 
|                 |  |                                                                                                        |    | Page
|                 |  |                                                                                                        |    |     
|PART I          
|Item 1.          |  | Business                                                                                               |    |      | 1  | 
|Item 2.          |  | Properties                                                                                             |    |      | 17 | 
|Item 3           |  | Legal Proceedings                                                                                      |    |      | 17 | 
|Item 4.          |  | Submission of Matters to a
    Vote of Security Holders                                                |    |      | 18 | 
|PART II         
|Item 5.          |  | Market for the
    Registrants Common Stock and Related Stockholder
    Matters                       |    |      | 18 | 
|Item 6.          |  | Selected Financial Data                                                                                |    |      | 19 | 
|Item 7.          |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations              |    |      | 20 | 
|RISK
    FACTORS
|Item 7A.         |  | Quantitative and Qualitative
    Disclosure About Market Risk                                          |    |      | 35 | 
|Item 8.          |  | Financial Statements and
    Supplementary Data                                                        |    |      | 36 | 
|Item 9.          |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure               |    |      | 62 | 
|Item 9A.         |  | Controls and Procedures                                                                                |    |      | 62 | 
|PART III        
|Item 10.         |  | Directors and Executive
    Officers of the Registrant                                                 |    |      | 62 | 
|Item 11.         |  | Executive Compensation                                                                                 |    |      | 62 | 
|Item 12.         |  | Security Ownership of
    Certain Beneficial Owners and Management and Related Stockholder
    Matters |    |      | 63 | 
|Item 13.         |  | Certain Relationships and
    Related Transactions                                                     |    |      | 63 | 
|Item 14.         |  | Principal Accountant Fees
    and Services                                                             |    |      | 63 | 
|PART IV         
|Item 15.         |  | Exhibits, Financial
    Statements Schedules, and Reports on Form 8-K                                  |    |      | 63 | 
|SIGNATURES       |  |                                                                                                        | 67 |     
|EXHIBIT INDEX    |  |                                                                                                        | 69 |     
|EXHIBIT 23.1    
|EXHIBIT 31.1    
|EXHIBIT 31.2    
|EXHIBIT 32.1    





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This Annual 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.




PART I






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

Overview

Aradigm Corporation is a leading developer of
advanced needle-free drug delivery systems for the treatment of
lung and systemic diseases. We are developing two technologies
designed to deliver drugs and biologics either via the pulmonary
or subcutaneous route. Our hand-held AERx platform is being
designed for the rapid and reproducible delivery of a wide range
of pharmaceutical drugs and biotech compounds via pulmonary
delivery or through the lung. Our pen-sized, needle-free
subcutaneous Intraject system is designed to comfortably and
rapidly deliver drugs to the subcutaneous region of the skin,
where it can gain access to the bloodstream. We believe that our
non-invasive AERx and Intraject systems, which have been shown
in clinical studies to achieve performance equivalent to
injection, will be welcome alternatives to injection-based drug
delivery. In addition, both of 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 Frost and Sullivan, recognized as a
global leader in growth consulting, the total United States
market for biopharmaceuticals is estimated to grow to
$40 billion by 2005 with the majority of biopharmaceutical
therapies requiring parenteral administration (injection). We
believe that many of these molecules could potentially be
delivered using the AERx and Intraject platforms.

Since our founding in 1991, we have been
successful in attracting the attention of some of the
worlds leading pharmaceutical and biotechnology companies.
Together, our partners have contributed cumulatively over
$151 million in contract and license revenues for the
advancement of our AERx technology. Our most advanced program
using our AERx technology is based on a development partnership
with Novo Nordisk A/S, the world leader in insulin products, for
the pulmonary delivery of insulin for diabetes. Our AERx
platform is based on a set of proprietary technologies,
protected to date by 177 issued and allowed United States and
foreign patents that control the physical factors critical for
rapid, reproducible pulmonary drug delivery. These proprietary
technologies allow us to:



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

In May 2003, our company expanded its technology
base with the acquisition of the Intraject technology from
Weston Medical Group, plc (Weston Medical) of
Cambridge, United Kingdom. The Intraject technology is in
late-stage development and its proprietary technologies are
covered by an estate of over 85 issued and allowed United States
and foreign patents. These proprietary technologies allow us to:



| |   |                                                                                   
| | - | ----------------------------------------------------------------------------------
| |  | utilize a glass capsule in a pre-filled sterile
    needle-free system;           
|
| |  | activate the systems power source upon
    sensing pressure against the skin; and
|
| |  | manufacture a pressurized glass capsule.                                          

1



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Background  Needle Free Drug
Delivery

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



| |                   
| | ------------------
| | Pulmonary Delivery

Due to the natural ability of the lung to
transfer molecules into the bloodstream, pulmonary drug delivery
systems are now being pursued as an alternative to injection.
Pulmonary delivery systems were originally developed to treat
lung diseases by depositing aerosolized, or fine particles or
mists of, medication in the large airways of the lung. These
aerosols were created in medical devices, such as nebulizers,
metered-dose inhalers and dry powder inhalers, for inhalation by
the patient. While these systems have been useful in the
treatment of diseases such as asthma, they generate a wide range
of particle sizes, only a portion of which can reach the
targeted lung tissues, and rely heavily on proper patient
breathing technique to effect delivery.

Considerable recent research has been devoted to
developing a means to create well-defined small particle
aerosols suitable for efficient pulmonary delivery of drugs,
either to treat lung diseases or for absorption into the
bloodstream for systemic effect. To deliver pharmaceuticals to
or through the lungs, drugs must be transformed into an aerosol
that can be inhaled by the patient. In order for aerosols to be
delivered to the deep lung, the individual particles must be
small, three microns or less in diameter, and the velocity of
these particles must be low as they pass through the upper
airways and into the deep lung. The particle velocity is largely
determined by how fast the patient is inhaling. Larger or
fast-moving particles typically get deposited in the mouth or
upper airways where they cannot be absorbed and may not be
effective. Recent advances in dry powder formulation technology
have made possible the creation of smaller particle aerosols
suitable for more efficient deep lung delivery and several
companies are developing systems based on this approach.
However, most drugs being considered for pulmonary delivery are
currently marketed in stable liquid formulations. We believe the
extra steps involved in making dry powder formulations of these
drugs will make them more difficult and costly to produce than
liquid-based formulations. In addition, todays dry powder
delivery systems under development continue to rely on
individual patient breathing technique for the actual drug
delivery. It is well documented that the typical patient
frequently strays from proper inhalation technique and may not
be able to maintain a consistent approach over even moderate
periods of time after training. Given the need with many
medications to achieve precise and reproducible dosing,
variability in technique among patients or from dose to dose may
compromise safety or therapeutic efficacy.



| |                      
| | ---------------------
| | Subcutaneous Delivery

While the concept of subcutaneous, needle-free
drug delivery has been around for several decades, early systems
were powered by large, complex and expensive air compressors and
therefore usually reserved for vaccine applications. Only
recently has research and advances in technology produced
smaller, more patient- friendly configurations and made
subcutaneous, needle-free delivery an attractive and viable
option. In order to deliver drugs through the skin and target
the subcutaneous region, we believe that liquid formulations
moving at a specific well-controlled velocity are necessary. We
believe that such an approach could improve patient compliance
with prescribed therapy associated with needle injections.

We believe that the delivery of drugs to the
subcutaneous region of the skin allows for a speed of absorption
into the bloodstream equivalent to subcutaneous needle
injections.

The Aradigm Solution



| |     
| | ----
| | AERx

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

2



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over patient inhalation technique in order to
efficiently and reproducibly deliver the aerosol drug to the
deep lung. We have developed these proprietary technologies
through an integrated approach that combines expertise in
physics, electrical engineering, mechanical engineering, laser
engineering and pharmaceutical sciences. The key features of the
AERx platform include:




| |                         
| | ------------------------
| | Ease of Drug Formulation

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



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

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



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

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

Intraject

In May 2003, we announced the acquisition of
selected assets from Weston Medical relating to Weston
Medicals Intraject needle-free drug delivery system.
Weston Medical developed a proprietary needle-free drug delivery
system, successfully moved it through the early-stage
development process and signed several commercial agreements. In
September 2002, Weston Medical announced that it had encountered
certain performance problems associated with the systems
configuration and that its program would be delayed until those
problems could be resolved. Subsequently, Weston Medical was
unable to secure the financing needed to continue its programs
and was forced into bankruptcy administration in February 2003.
We acquired select assets of Weston Medical, including the
Intraject technology, related manufacturing equipment and
intellectual property for approximately $2 million in
initial purchase price and approximately an additional
$1 million in acquisition and transfer costs.

Intraject is designed to enable patients or
healthcare workers to deliver measured doses of drug precisely
to the subcutaneous layer of the skin. The Intraject system is a
portable, pre-filled, single-use system that is the size of a
pen. This system has two main parts: the glass drug capsule with
a fill volume of 0.5 ml and a compact nitrogen gas power
source called the actuator. Intraject uses the actuator to
create a short-lived

3



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pressure peak in the skin and by activating a
piston creates a fine liquid stream that at a high velocity
penetrates the skin to pass into the subcutaneous layer.


Ease-of-use is a benefit of the Intraject system.
The patient or healthcare worker first snaps the cap off of the
system, flips the safety lever, and prepares the abdomen area by
gathering or pinching the proper amount of skin. The patient or
healthcare worker then applies Intraject directly to the skin,
adding slight pressure and thereby activating the system. The
injection itself is completed in less than 60 milliseconds.

We are developing this system to allow for the
subcutaneous needle-free delivery of a wide range of
biopharmaceuticals. In clinical trials, patients have preferred
Intraject to the standard needle and syringe. We have made
significant progress on the configuration of the device and in
September 2003, we announced positive results from a
configuration trial that showed that the performance of at least
one design of the Intraject system would result in a viable
commercial product. We are now in a position to perform clinical
performance trials and to complete the manufacturing validation
process by the end of 2004, in anticipation of, and preparation
for, bio-equivalence trials.

Key features of the Intraject platform include:



| |   |                                  
| | - | ---------------------------------
| |  | prefilled and ready to use;      
|
| |  | lightweight and pocket-sized; and
|
| |  | easy to operate.                 

In addition, Intrajects clinical and
regulatory development timelines are more abbreviated, as only
bioequivalence need be demonstrated in order to obtain marketing
approval. These studies and trials could be conducted in as
little as a few months. We believe that this is another
attractive feature to potential partners as they address issues
such as patent expiration and life-cycle management relating to
their marketed products. We believe that we are unlikely to
enter into an agreement relating to the commercialization of
Intraject until the clinical verification trials are completed
and presented to potential partners, which we anticipate will
happen in fiscal 2004.

Strategy

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



| |                                                   
| | --------------------------------------------------
| | Establish Broad Applicability of our
    Platforms

We believe that the AERx and Intraject platforms
will be broadly applicable to drugs that are intended for either
local delivery to the lung or systemic delivery. In addition to
our publicly announced late-stage programs with AERx in diabetes
and pain management potential applications for both the AERx and
Intraject platforms include delivery of therapies in the areas
of cardiovascular disease, oncology, endocrine disorders,
infections, neurological diseases, inflammatory conditions and
respiratory diseases.

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
and Intraject platforms.



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

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

4



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whose pipelines contain multiple products whose
value could be enhanced by our AERx and Intraject drug delivery
technologies. 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 and
Intraject devices. These disposable components are expected to
generate most of our revenues and substantially all of our
profits over time. 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 and Intraject devices.



| |                                            
| | -------------------------------------------
| | Enhance Our Strong Proprietary
    Position

We believe that establishing a strong proprietary
position in pulmonary and needle-free drug delivery could
provide important competitive advantages in our target markets.
We have aggressively pursued comprehensive patent protection of
our technology and, as of February 27, 2004, have over 250
issued United States and foreign patents, with a number of
additional United States and foreign patent applications
pending. While there can be no assurance that any of our patents
will provide a significant commercial advantage, these patents
are intended to provide protection for important aspects of our
technologies and maintenance of trade secrets associated with
key elements of our manufacturing technologies.



| |                                      
| | -------------------------------------
| | Maintain Technological
    Leadership

We are making a substantial research and
development investment to establish and maintain technological
leadership in pulmonary and needle-free drug delivery. This
includes research and development programs to design the future
generations of our pulmonary and needle free delivery systems.
The goal of these programs is to access a wider range of
markets, broaden our technology base, achieve manufacturing
efficiencies and develop next-generation delivery devices. We
have invested in efforts to speed up development on the
Intraject program by creating an in vitro in vivo
correlation model to predict the clinical performance of
compounds that we are testing. We are supported by the
International Scientific Advisory Board whose members are global
leaders in drug delivery and clinical specialties of key
interest to Aradigm.

Aradigm Product Applications

Our two platforms are positioned to address
multiple therapeutic disease areas. We are developing the
hand-held AERx platform based on a comprehensive approach to
pulmonary drug delivery that includes drug formulation, aerosol
generation, patient breath control and compliance monitoring
technologies. We are currently developing AERx products for pain
and diabetes management. In addition, we are planning to develop
AERx systems for the non-invasive delivery of certain other
drugs, including proteins, peptides, gene vectors and small
molecules. Our Intraject platform is well under development. We
are now in a position to perform clinical performance validation
trials and to complete the manufacturing validation process by
the end of 2004 in anticipation of, and preparation for,
bio-equivalence trials. The platform employs drug formulation,
liquid jet generation, and a compact self-contained power source
to deliver a variety of therapeutics including monoclonal
antibodies.



| |                                            
| | -------------------------------------------
| | AERx insulin Diabetes Management
    System

Our most advanced product is the AERx insulin
Diabetes Management System to permit patients with diabetes to
non-invasively self-administer insulin. We believe that
patients, when provided with a non-invasive delivery alternative
to injection, will be more likely to self-administer insulin as
often as needed to keep tight control of their blood glucose
levels. We are developing and planning to commercialize this
product in collaboration with Novo Nordisk A/S, a leader in the
field of diabetes care. During the third quarter of 2002,

5



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we initiated the first study in our Phase 3
clinical program. This study is ongoing. There can be no
assurance that this development program will be successful.




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

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

According to 2002 statistics from the American
Diabetes Association, approximately 18.2 million Americans
suffer from either Type 1 or Type 2 diabetes. All of
these patients either self-inject insulin multiple times a day
or use external insulin pumps. Approximately 90-95% of these
Americans have Type 2 diabetes, and the prevalence of
Type 2 diabetes has increased dramatically over the past
decade due to lifestyle factors such as obesity and inactivity.
Type 2 patients consume the majority of insulin used in the
United States due to their larger numbers. However, given their
less severe impairment, many of these patients are reluctant to
use injection-based therapy despite the medical benefits.
Through our convenient, non-invasive AERx insulin Diabetes
Management System, we believe we can address this patient
reluctance, reduce overall treatment costs and grow the total
worldwide insulin market beyond its currently accepted level.
The leading suppliers of insulin worldwide are Novo Nordisk A/S
and Eli Lilly.



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

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

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

6



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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 November 2001, we successfully completed
Phase 2b clinical trials for our AERx insulin Diabetes
Management System, which showed that the product might be
successfully used to treat Type 2 diabetes patients with
insulin delivered via the pulmonary route. The Phase 2
trial was designed to investigate the safety and efficacy of
pulmonary insulin via the AERx insulin Diabetes Management
System compared to intensified treatment with insulin injections
in patients with Type 2 diabetes. Approximately
100 patients were included for a 12-week period in the
study. The results of the study, announced in June 2002 at the
Annual Meeting of the American Diabetes Association in
San Francisco, California, showed the safety and efficacy
of the AERx insulin Diabetes Management System to be comparable
to an intensive subcutaneous injection regimen of insulin.

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



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

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

From the inception of our collaboration in June
1998 through December 31, 2003, we have received from Novo
Nordisk A/S approximately $115.7 million in product
development payments, approximately $13.0 million in
milestone payments and $35.0 million from the purchase of
our common stock by Novo Nordisk A/S and its affiliates. During
the same period, of the payments received, approximately
$109.3 million of the product development payments and
$6.5 million of milestone payments have been recognized as
contract revenue and $12.9 million has yet to be recognized
over the life of the project. Pursuant to the Novo Nordisk A/S
agreement, we could receive approximately $38.0 million in
milestone payments as well as further reimbursement for product
development expenses in connection with the insulin program.
Additional milestone payments and product development payments
would be paid by Novo Nordisk A/S if the parties decide to
jointly develop additional AERx products under the agreement.

In June 1998, we and Novo Nordisk A/S entered
into a common stock purchase agreement whereby Novo Nordisk A/S
made an initial equity investment in our common stock of
$5 million. In June 2001, Novo Nordisk A/S purchased an
additional $5 million of our common stock pursuant to the
June 1998 purchase agreement. In October 2001, we entered into
another common stock purchase agreement with Novo Nordisk
Pharmaceuticals, an affiliate of Novo Nordisk A/S, pursuant to
which Novo Nordisk Pharmaceuticals purchased $20.0 million
of our common stock at the fair market value. We also received
the option under the agreement to sell an aggregate of up to
$25.0 million of additional shares of our common stock to
Novo Nordisk Pharmaceuticals, in amounts per sale of between
$5 million and $10 million every three months, by
delivering written notice to Novo Nordisk Pharmaceuticals of our
election to sell additional shares. Under the terms of the
agreement the number of additional shares to be sold is
calculated by dividing the aggregate amount of the put by the
average closing price of the Companys common stock on the
Nasdaq for the 30 trading days immediately prior to the
date of the notice.

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In addition, the sale of shares of common stock
to Novo Nordisk Pharmaceuticals is subject to certain
conditions, including, if applicable, that we must have obtained
any requisite shareholder approval and that the development
program with Novo Nordisk A/S must be making good progress.
In July 2002, we issued an additional $5 million of common
stock to Novo Nordisk Pharmaceuticals under the October 2001
purchase agreement. In May 2003, we obtained shareholder
approval for future sales of common stock to Novo
Nordisk A/S and its affiliates. Novo Nordisk A/S,
together with its affiliates, owned approximately 11% of our
total outstanding common stock on an as-converted basis as of
December 31, 2003, and is considered a related party.

In a separate agreement, we and Novo Nordisk A/S
agreed to share manufacturing responsibilities for the AERx
insulin Diabetes Management System. Novo Nordisk A/S now has
responsibility for all commercial production beyond the capacity
of our first factory and will bear potentially significant
future capital investments in connection with establishing this
additional manufacturing capacity.



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

We are developing the hand-held AERx Pain
Management System as a non-invasive, patient-controlled
pulmonary drug delivery product for treatment of severe pain. In
December 2001, we successfully completed Phase 2b clinical
trials of the AERx Pain Management System incorporating morphine
sulfate for the treatment of cancer and post-operative pain. We
have also evaluated in a Phase 1 clinical trial the AERx
Pain Management System incorporating fentanyl. Only if we enter
into a development agreement with a partner will we continue to
pursue this program. There can be no assurance that this
development program will be successful.



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

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

Most pain medication taken by patients at home is
delivered orally or by transdermal patch. These methods are
typically slow to act and difficult to adjust to match the level
of pain. Intravenous patient-controlled analgesia products,
which are used primarily in hospitals, allow patients to
self-administer pain medication on demand from a
microprocessor-controlled infusion pump. Although effective for
treating severe pain, widespread adoption of patient-controlled
analgesia outside the hospital has been limited by the regular
and expensive maintenance required by its use.



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

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



| |                                                           
| | ----------------------------------------------------------
| | Additional Potential
    Applications  AERx and Intraject

We believe that the AERx and Intraject systems
have applicability for a range of compounds developed by
pharmaceutical and biotechnology companies, including many
compounds that cannot be delivered orally.

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Due to their large size and poor oral
bioavailability, large molecules developed by the biotechnology
industry are typically developed in liquid formulations and
delivered by injection. We believe that the AERx platform can
provide for improved delivery and increased utilization of these
therapies. In addition we believe that our Intraject platform
offers the opportunity to deliver small molecules as well as
monoclonal antibodies.


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

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

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

While we are assessing the feasibility of the
AERx system with these compounds, Aradigm does not typically
disclose information surrounding the specifics of these studies
(including the drug or partner involved) until the program moves
into a later stage of development or at an earlier time that it
is mutually agreed upon by Aradigm and the partner.

Sales and Marketing

We plan to establish additional collaborative
relationships to develop and commercialize our AERx and
Intraject products. Through these collaborations, we intend to
access resources and expertise to conduct late-stage clinical
development and to market and sell AERx and Intraject 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 drug
delivery technologies.

Manufacturing

Our clinical strip manufacturing facility was
completed and validated in July 1998. This facility enables us
to produce the disposable nozzles, assemble the disposable
unit-dose strips and fill the drug into the unit-dose strips. We
believe that it is capable of producing the AERx unit-dose
strips in volumes adequate to support all of our current and
anticipated clinical trials for our products under development
and limited commercial requirements. Current capacity of this
facility exceeds 20 million disposable packets per year.

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

We completed the construction of a new facility
for commercial scale production in 2001. We have designed and
built equipment that will ultimately be installed in the
facility at which time we will validate the process.

In August 2003, we announced the discovery of a
blemish on a small number of AERx strips that appeared during
the manufacturing process. Pending results from an
investigation, our partner Novo Nordisk announced that
additional Phase 3 trials of the AERx iDMS would be delayed
until the end of 2004. Since then, the source of the blemish has
been thoroughly investigated, the problem identified, and the
issue resolved.

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We will look to contract manufacturers to produce
the main components and subassemblies for the AERx devices. We
will either outsource or perform ourselves final assembly,
calibration, testing and packaging of these devices ourselves.
All of our AERx manufacturing capabilities are being established
at our facilities in Hayward, California.

Our Intraject manufacturing strategy employs a
fully integrated third party supply chain, in which several
outside suppliers are each responsible for key components,
including final assembly. Many of these third parties have
experience working with Intraject. This approach will allow
Aradigm to focus on establishing core competencies in the area
of Quality. In the future, this assembly may be conducted at
Aradigm.

There can be no assurance that we will not
encounter unanticipated delays or expenses in establishing
high-volume production capacity for AERx devices, AERx
disposable drug packets or clinical components related to the
Intraject system. 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 89 United States
patents to date, with 28 United States patent applications
pending. In addition, we have purchased three United States
patents covering inventions that are relevant to our inhalation
technologies. We have 85 issued foreign patents and 108 foreign
patent applications pending. Through the acquisition of the
assets of Weston Medical, we acquired their patent portfolio.
This resulted in 12 additional United States issued patents and
five pending United States cases. We also acquired 73 issued
foreign patents, and 29 pending foreign cases. In total, we have
104 issued United States patents, 33 Pending United States
cases, 158 issued foreign patents, and 137 pending foreign cases.

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

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

The coverage claimed in a patent application can
be significantly reduced before a patent is issued, either in
the United States or abroad. Consequently, we do not know
whether any of our pending or future patent applications will
result in the issuance of patents or, to the extent patents have
been issued or will be issued, whether these patents will be
subjected to further proceedings limiting their scope, will
provide significant proprietary protection or competitive
advantage, or will be circumvented or invalidated.

Furthermore, patents already issued to us or our
pending applications may become subject to dispute, and any
disputes could be resolved against us. For example, Eli Lilly
brought an action against us seeking to have one or more
employees of Eli Lilly named as co-inventors on some of our
patents. In addition, because patent applications in the United
States and 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.

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

We believe our technology and integrated
pulmonary delivery systems approach provides us with important
competitive advantages in the delivery of drugs compared with
currently known alternatives. While we believe that the
capabilities of our AERx and Intraject platforms 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 or
Intraject systems.

Several companies have developed or are
developing products that will compete with our technology
platforms. Some are marketing and developing dry powder and
other devices that could have applications for pulmonary drug
delivery, including Nektar Therapeutics (formerly Inhale
Therapeutic Systems, Inc.) and Alkermes
Pharmaceuticals, Inc. These companies also have
collaborative arrangements with corporate partners for the
development of pulmonary delivery systems for insulin. There are
also several companies that are marketing and developing
needle-free injection systems, including Antares Pharma Inc.,
Bioject Medical Technologies Inc., Biovalve Technologies, Inc.,
Crossject and Penjet Corporation. There can be no assurance that
competitors will not introduce products or processes competitive
with or superior to ours.

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Government Regulation

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

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

The preclinical work necessary to administer
investigational drugs to human subjects is summarized in an
Investigational New Drug application to the FDA. FDA regulations
provide that human clinical trials may begin 30 days
following submission of an Investigational New Drug application,
unless the FDA advises otherwise or requests additional
information. There is no assurance that the submission of an
Investigational New Drug application will eventually allow a
company to commence clinical trials. Once trials have commenced,
the FDA may stop the trials by placing them on clinical
hold because of concerns about, for example, the conduct
of the study or 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. Typically,
Phase 1 trials consist of testing the product in a small
number of normal volunteers, primarily for safety, at one or
more dosage levels, as well as characterization of a drugs
pharmacokinetic and/or pharmacodynamic profile. In Phase 2
clinical trials, in addition to safety, the efficacy of the
product is usually evaluated in the patient population.
Phase 3 trials, the basis for approval, 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 (NDA) 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 NDA
includes Chemistry, Manufacturing and Controls (CMC) information
pertaining to the preparation of the drug substance (active
ingredient), analytical methods, drug product formulation,
details on the manufacture of finished products and proposed
product packaging, labeling and storage. Submission of a new
drug application does not assure FDA approval for marketing.
Based on the Prescription Drug User Fee Act, review of NDAs
should result in an action letter within ten months after
filing. However, the application approval 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. The process may take substantially longer if, among
other things, the FDA has questions or concerns about the
safety, efficacy or CMC 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

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determine that there is insufficient data or
experience with chronic administration of drugs delivered via
the lung for systemic effect to demonstrate that such chronic
administration is safe, and could require further studies. The
FDA also may require additional clinical tests (i.e.,
Phase 4 clinical trials) following new drug application
approval to confirm safety and efficacy.


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

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

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

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



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

The United States Drug Enforcement Agency (DEA),
regulates controlled drug substances, such as morphine and other
narcotics. Establishments handling controlled drug substances
such as morphine must be registered and inspected by the DEA and
may be subject to export, import, security and production quota
requirements. In addition, advertising and promotional materials
are, in certain instances, subject to regulation by the Federal
Trade Commission. There can be no assurance that we will not be
required to incur significant costs to comply with such laws and
regulations in the future or that such laws or regulations will
not have a material adverse effect upon our business.

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

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products under development, and delays in receipt
or failure to receive such clearances or approvals, the loss of
previously received clearances or approvals, or failure to
comply with existing or future regulatory requirements could
have a material adverse effect on our business.


International Scientific Advisory
Board

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

|                        |  |                                                                   |  |                              
|----------------------- |  | ----------------------------------------------------------------- |  | -----------------------------
|Name                    |  | Affiliation                                                       |  | Area of Expertise            
|                        |  |                                                                   |  |                              
|Peter R. Byron, Ph.D.   |  | Medical College of Virginia, Virginia
    Commonwealth University |  | Aerosol Science/Pharmaceutics
|Peter S. Creticos, M.D. |  | The Johns Hopkins University School of Medicine                   |  | Allergy/Immunology/Asthma    
|Igor Gonda, Ph.D.       |  | Acrux Limited                                                     |  | Drug Delivery                
|Henrik Egesborg Hansen  |  | Novo Nordisk A/S                                                  |  | Device Technology            
|Vincent H.L. Lee, Ph.D. |  | University of Southern California                                 |  | Pharmaceutics/Drug Delivery  
|Craig M. Pratt, M.D.    |  | Baylor College of Medicine                                        |  | Clinical Cardiology          
|Robert E. Ratner, M.D.  |  | MedStar Research Institute                                        |  | Endocrinology                

Employees

As of February 27, 2004, we had
242 employees, of whom 203 were in research and development
and product development and 39 were in business development,
finance and administration. We believe that our future success
is dependent on attracting and retaining highly skilled
scientific, sales and marketing and senior management personnel.
Competition for such skills is intense, and there is no
assurance that we will continue to be able to attract and retain
high-quality employees. Our employees are not represented by any
collective bargaining agreement. We consider our relations with
our employees to be good.

Corporate History and Website
Information

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

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MANAGEMENT

Directors and Executive Officers

The directors and executive officers of the
Company and their ages as of February 27, 2004 are as
follows:

|                           |  |     |    |          |  |                                                                        
|-------------------------- |  | --- | -- | -------- |  | -----------------------------------------------------------------------
|Name                       |  | Age |    | Position
|                           |  |     |    |         
|Richard P. Thompson        |  |     | 52 |          |  | Chief Executive Officer and Chairman of the Board                      
|V. Bryan Lawlis, Ph.D.     |  |     | 52 |          |  | President and Chief Operating Officer                                  
|Thomas C. Chesterman       |  |     | 44 |          |  | Senior Vice President and Chief Financial Officer                      
|Klaus D. Kohl, Ph.D.       |  |     | 53 |          |  | Senior Vice President, Quality and Technical
    Director, iDMS program
|Steven J. Farr, Ph.D.      |  |     | 45 |          |  | Senior Vice President, Chief Scientific Officer                        
|Bobba Venkatadri           |  |     | 60 |          |  | Senior Vice President, Operations                                      
|Babatunde A. Otulana, M.D. |  |     | 47 |          |  | Vice President, Clinical & Regulatory
    Affairs                      
|Norma L. Milligin          |  |     | 65 |          |  | Vice President, Human Resources                                        
|Frank H. Barker(1)(3)      |  |     | 73 |          |  | Director                                                               
|Stan M. Benson(2)(3)       |  |     | 53 |          |  | Director                                                               
|Igor Gonda                 |  |     | 56 |          |  | Director                                                               
|John Nehra(1)(3)           |  |     | 55 |          |  | Director                                                               
|Wayne I. Roe(1)            |  |     | 54 |          |  | Director                                                               
|Virgil D. Thompson(2)      |  |     | 64 |          |  | Director                                                               



---



|    |                                                                 
|--- | ----------------------------------------------------------------
|(1) | Member of the Audit Committee.                                  
|   
|(2) | Member of the Compensation Committee.                           
|   
|(3) | Member of the Nominating and Corporate Governance
    Committee.

Richard P.
Thompsonhas been a director and
has served as our Chief Executive Officer since 1994 and was
named Chairman of the Board in 2000. In addition,
Mr. Thomson served as our President from 1994 until June
2003. From 1991 to 1994, Mr. Thompson was President of
LifeScan, Inc., a Johnson & Johnson Company, a
diversified health care company. In 1981, Mr. Thompson
co-founded LifeScan, which was sold to Johnson &
Johnson in 1986. Mr. Thompson holds a B.S. in Biological
Sciences from the University of California at Irvine and an MBA
from California Lutheran College. Mr. Thompson currently
serves on the board of TheraSense, Inc.

V. Bryan
Lawlis, Ph.D., has served as
President and Chief Operating Officer since June 2003 and as our
Chief Operating Officer since 2001. Previously, Dr. Lawlis
founded Covance Biotechnology Services, a contract
biopharmaceutical manufacturing operation, and served as its
President and Chief Executive Officer from 1996 to 1999, and as
Chairman from 1999 to 2001, when it was sold to Diosynth RTP,
Inc., a division of Akzo Nobel. From 1981 to 1996,
Dr. Lawlis was employed at Genencor, Inc., and
Genentech, Inc. His last position at Genentech was Vice
President of Process Sciences. Dr. Lawlis holds a B.A. in
Microbiology from the University of Texas at Austin, and a Ph.D.
in Biochemistry from Washington State University.

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

Klaus D.
Kohl, Ph.D., has served as
our Senior Vice President, Quality and Technical Director, iDMS
program since August 2002. From October 2000 to August 2002,
Dr. Kohl served as Vice President, Quality. From 1998 to
2000, Dr. Kohl was Quality Manager of GE Bayer Silicones, a
joint venture of General Electric

15



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##### Table of Contents



and Bayer Corporation. From 1996 to 1998,
Dr. Kohl was Vice President of Quality Assurance,
Pharmaceutical Division, Bayer Corporation North America.
Dr. Kohl joined Bayer in 1985 and held various positions in
quality assurance/drug product development in the United States
and in Europe. Previously, Dr. Kohl spent more than seven
years in basic research at the Research Center Juelich, Germany,
and the Max Planck Institute in Dortmund, Germany. Dr. Kohl
received his undergraduate degree in Mathematics and Physics
from the University of Marburg, Germany, and his Ph.D. from the
University of Aachen, Germany.


Stephen J.
Farr, Ph.D., has served as
our Senior Vice President, Chief Scientific Officer since April
2003. Since 1995, Dr. Farr served in various positions at
Aradigm including as Director, Pharmaceutical Sciences, Senior
Director and Vice President, Pharmaceutical Sciences, and Vice
President, Research and Development. From September 1985 to
December 1994, Dr. Farr was Lecturer and later Senior
Lecturer in the Welsh School of Pharmacy, Cardiff University,
United Kingdom. Dr. Farr was a founder and director of
Cardiff Scintigraphics Ltd., a contract research organization.
Dr. Farr holds a B.Sc. in Pharmacy from DeMontfort
University, and a Ph.D. in Pharmaceutics from the University of
Wales. Dr. Farr is a Visiting Associate Professor in the
Department of Pharmaceutics, School of Pharmacy, Virginia
Commonwealth University, Richmond, Virginia.

Bobba
Venkatadrihas served as our
Senior Vice President, Operations since June 2003.
Mr. Venkatadri has over 30 years of U.S. and
international senior executive leadership experience in
pharmaceutical and biotechnology manufacturing. Prior to joining
Aradigm, Mr. Venkatadri was Executive Vice President of
Operations for Diosynth RTP, Inc., a division of Akzo Nobel
from January 2001. Mr. Venkatadri served as Chief Executive
Officer of Molecular Biosystems, Inc. from 1995 to 2000,
and Executive Vice President of Centocor from 1992 to 1995.
Prior to this, Mr. Venkatadri held multiple positions with
Warner-Lambert from 1967 to 1992 including, President of
Warner-Lambert Indonesia, Vice President of Warner-Lambert
Puerto Rico, and Vice President, U.S. Operations of
Parke-Davis. Mr. Venkatadri holds a Masters Degree in
Pharmacy from Andhra University, India, and an MBA in
Finance from Fairleigh Dickinson University.

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

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

Frank H.
Barkerhas been a director since
May 1999. From January 1980 to January 1994, Mr. Barker
served as a company group chairman of Johnson & Johnson
Company, a diversified health care company, and was Corporate
Vice President from January 1989 to January 1996.
Mr. Barker holds a B.A. in Business Administration from
Rollins College, Winter Park, Florida. Mr. Barker is a
director of Catalina Marketing Corporation, a direct-to-consumer
marketing company.

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

Igor
Gonda, Ph.D.has been a
director since September 2001. Dr. Gonda is the Chief
Executive Officer and Managing Director of Acrux Limited, a
drug-delivery company in Melbourne, Australia. Dr. Gonda was

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##### Table of Contents



our Chief Scientific Officer until December 2001
and previously held the position of Vice President, Research and
Development, from October 1995 until July 2001. From February
1992 to September 1995, Dr. Gonda was a Senior Scientist
and Group Leader at Genentech, Inc. Prior to that,
Dr. Gonda held academic positions at the University of
Aston in Birmingham, UK, and the University of Sydney,
Australia. Dr. Gonda has a B.Sc. in Chemistry and a Ph.D.
in Physical Chemistry from Leeds University, UK. Dr. Gonda
is the Chairman of our Scientific Advisory Board.


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

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

Virgil D.
Thompsonhas been a director since
June 1995. Since November 2002, Mr. Thompson has been
President and Chief Executive Officer of Angstrom
Pharmaceuticals, a pharmaceutical company. From September 2000
to November 2002, Mr. Thompson was President, Chief
Executive Officer and Director of Chimeric Therapies, Inc.,
a biotechnology company. From May 1999 until September 2000,
Mr. Thompson was the President, Chief Operating Officer and
a Director of Bio-Technology General Corp., a pharmaceutical
company. From January 1996 to April 1999, Mr. Thompson was
the President and Chief Executive Officer and a Director of
Cytel Corporation, a biopharmaceutical company. From 1994 to
1996, Mr. Thompson was President and Chief Executive
Officer of Cibus Pharmaceuticals, Inc., a drug delivery
device company. From 1991 to 1993, Mr. Thompson 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. Mr. Thompson is also a director of Questcor
Pharmaceuticals, Inc. and Savient Pharmaceuticals, Inc.






|        |           
|------- | ----------
|Item 2. | Properties

At December 31, 2003, we leased a total of
approximately 253,898 square feet of office space in two
office parks. We leased approximately 163,658 square feet
in three buildings in an office park at 3929 Point Eden Way,
Hayward, California, and leased 90,240 square feet in one
building in an office park located at 2704 West Winton
Avenue, Hayward, California. The leases for the various office
spaces expire at various times through the year 2016. Minimum
annual payments under these leases will be approximately
$5.3 million in 2004 and $5.5 million in 2005. 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

There are no material pending legal proceedings.

17



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##### Table of Contents








|        |                                                        
|------- | -------------------------------------------------------
|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, 2003.




PART II






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

Market Information

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

|     |                                           |      |   |      |  |  |   |      | 
|---- | ----------------------------------------- | ---- | - | ---- |  |  | - | ---- | 
|     |                                           | High |   | Low 
|     |                                           |      |   |     
|2002 |                                           |      |   |      |  |  |   |     
|     | First Quarter                             |      | $ | 7.29 |  |  | $ | 4.01 | 
|     | Second Quarter                            |      |   | 4.61 |  |  |   | 3.43 | 
|     | Third Quarter                             |      |   | 3.99 |  |  |   | 1.94 | 
|     | Fourth Quarter                            |      |   | 2.81 |  |  |   | 1.30 | 
|2003 |                                           |      |   |      |  |  |   |     
|     | First Quarter                             |      | $ | 1.85 |  |  | $ | 0.66 | 
|     | Second Quarter                            |      |   | 3.51 |  |  |   | 0.84 | 
|     | Third Quarter                             |      |   | 2.25 |  |  |   | 1.07 | 
|     | Fourth Quarter                            |      |   | 2.65 |  |  |   | 1.67 | 
|2004 |                                           |      |   |      |  |  |   |     
|     | First Quarter (through February 27, 2004) |      | $ | 2.80 |  |  | $ | 1.71 | 

On February 27, 2004, there were
333 holders of record of our common stock.

Dividend Policy

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

Sales of Unregistered Securities

In November 2003, the Company issued
7,780,550 shares of common stock in a private placement at
a price of $1.80 per share and warrants to purchase
1,945,133 shares of common stock at $2.50 per share
for an aggregate consideration of approximately
$14.0 million. These securities were not registered when
sold and were issued in reliance upon Regulation D of the
Securities Act of 1933, as amended (the Act). These
securities were subsequently registered under the Act.

18



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##### Table of Contents



The following table summarizes our equity
compensation plan information as of December 31, 2003.
Information is included for both equity compensation plans
approved by our stockholders and equity compensation plans not
approved by our stockholders.

|                                                                   |  |                     |           |                     |  |                      |      |  |  |  |           | 
|------------------------------------------------------------------ |  | ------------------- | --------- | ------------------- |  | -------------------- | ---- |  |  |  | --------- | 
|                                                                   |  |                     |           |                     |  | Common Stock        
|                                                                   |  |                     |           |                     |  | Available for Future
|                                                                   |  | Common Stock to     |           |                     |  | Issuance Under      
|                                                                   |  | Be Issued Upon      |           | Weighted-average    |  | Equity Compensation 
|                                                                   |  | Exercise of         |           | Exercise Price of   |  | Plans (Excluding    
|                                                                   |  | Outstanding Options |           | Outstanding Options |  | Securities Reflected
|Plan Category                                                      |  | and Rights          |           | and Rights          |  | in Column (a)) (1)  
|                                                                   |  |                     |           |                     |  |                     
|                                                                   |  | (a)                 |           | (b)                 |  | (c)                 
|Equity compensation plans approved by Aradigm
    stockholders     |  |                     | 6,483,826 |                     |  | $                    | 6.23 |  |  |  | 2,998,518 | 
|Equity compensation plans not approved by Aradigm
    stockholders |  |                     | 0         |                     |  |                      | 0    |  |  |  | 0         | 
|                                                                   |  |                     |           |                     |  |                      |      |  |  |  |           | 
|Totals:                                                            |  |                     | 6,483,826 |                     |  | $                    | 6.23 |  |  |  | 2,998,518 | 



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | 9,376,420, 1,570,186 and 105,924 shares are
    reserved for future issuance under the Companys 1996
    Equity Incentive Plan (the 1996 EIP), the Employee
    Stock Purchase Plan and the 1996 Non-Employee Directors
    Plan, respectively. The 1996 EIP contains an evergreen provision
    whereby the aggregate number of shares reserved for issuance is
    increased annually by a number of shares equal to 6% of the
    issued and outstanding common stock as determined on the date of
    the annual meeting of shareholders beginning with the 2001
    meeting (or some lesser number of shares as determined by the
    board of directors). Under the 1996 EIP, the aggregate increase
    in the number of shares to be reserved by operation of the
    evergreen provision will not exceed 10,000,000.






|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

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

|                                           |                            |                          |         |        |  |      |         |        |  |      |         |        |  |   |         |        |  |   |         |        | 
|------------------------------------------ | -------------------------- | ------------------------ | ------- | ------ |  | ---- | ------- | ------ |  | ---- | ------- | ------ |  | - | ------- | ------ |  | - | ------- | ------ | 
|                                           |                            |                         
|                                           |                            | Years Ended December 31,
|                                           |                            |                         
|                                           |                            | 2003                     |         | 2002   |  | 2001 |         | 2000   |  | 1999
|                                           |                            |                          |         |        |  |      |         |        |  |     
|Statements of Operations Data:             |                            |                          |         |        |  |      |         |        |  |      |         |        |  |   |         |        |  |   |         |       
|Contract and license revenues              |                            | $                        | 33,857  |        |  | $    | 28,967  |        |  | $    | 28,916  |        |  | $ | 20,303  |        |  | $ | 16,812  |       
|Operating expenses:                        |                            |                          |         |        |  |      |         |        |  |      |         |        |  |   |         |        |  |   |         |       
|                                           | Research and development   |                          |         | 49,636 |  |      |         | 54,680 |  |      |         | 58,836 |  |   |         | 48,176 |  |   |         | 33,625 | 
|                                           | General and administrative |                          |         | 10,391 |  |      |         | 10,394 |  |      |         | 9,355  |  |   |         | 9,271  |  |   |         | 7,849  | 
|                                           |                            |                          |         |        |  |      |         |        |  |      |         |        |  |   |         |        |  |   |         |       
|                                           | Total expenses             |                          |         | 60,027 |  |      |         | 65,074 |  |      |         | 68,191 |  |   |         | 57,447 |  |   |         | 41,474 | 
|                                           |                            |                          |         |        |  |      |         |        |  |      |         |        |  |   |         |        |  |   |         |       
|Loss from operations                       |                            |                          | (26,170 | )      |  |      | (36,107 | )      |  |      | (39,275 | )      |  |   | (37,144 | )      |  |   | (24,662 | )     
|Interest income                            |                            |                          | 338     |        |  |      | 818     |        |  |      | 1,324   |        |  |   | 3,110   |        |  |   | 1,947   |       
|Other income(2)                            |                            |                          |        |        |  |      |        |        |  |      | 6,675   |        |  |   |        |        |  |   |        |       
|Interest expense                           |                            |                          | (138    | )      |  |      | (642    | )      |  |      | (1,081  | )      |  |   | (1,528  | )      |  |   | (888    | )     
|                                           |                            |                          |         |        |  |      |         |        |  |      |         |        |  |   |         |        |  |   |         |       
|Net loss                                   |                            |                          | (25,970 | )      |  |      | (35,931 | )      |  |      | (32,357 | )      |  |   | (35,562 | )      |  |   | (23,603 | )     
|Deemed dividend                            |                            |                          |        |        |  |      |        |        |  |      | (10,722 | )      |  |   |        |        |  |   |        |       
|                                           |                            |                          |         |        |  |      |         |        |  |      |         |        |  |   |         |        |  |   |         |       
|Net loss applicable to common shareholders |                            | $                        | (25,970 | )      |  | $    | (35,931 | )      |  | $    | (43,079 | )      |  | $ | (35,562 | )      |  | $ | (23,603 | )     
|                                           |                            |                          |         |        |  |      |         |        |  |      |         |        |  |   |         |        |  |   |         |       

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##### Table of Contents



|                                                                           |                                                                                                    |                          |          |        |   |      |          |        |   |      |          |        |   |   |          |        |   |   |         |        |  
|-------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------- | ------------------------ | -------- | ------ | - | ---- | -------- | ------ | - | ---- | -------- | ------ | - | - | -------- | ------ | - | - | ------- | ------ | -
|                                                                           |                                                                                                    |                         
|                                                                           |                                                                                                    | Years Ended December 31,
|                                                                           |                                                                                                    |                         
|                                                                           |                                                                                                    | 2003                     |          | 2002   |   | 2001 |          | 2000   |   | 1999
|                                                                           |                                                                                                    |                          |          |        |   |      |          |        |   |     
|Basic and diluted loss per share applicable to
    common shareholders(1): |                                                                                                    |                          |          |        |   |      |          |        |   |      |          |        |   |   |          |        |   |   |         |       
|                                                                           | Net loss applicable to common shareholders                                                         |                          | $        | (0.52  | ) |      | $        | (1.19  | ) |      | $        | (1.98  | ) |   | $        | (2.07  | ) |   | $       | (1.66  | )
|                                                                           |                                                                                                    |                          |          |        |   |      |          |        |   |      |          |        |   |   |          |        |   |   |         |       
|                                                                           | Shares used in computing basic and diluted loss
    per share applicable to common shareholders(1) |                          |          | 50,196 |   |      |          | 30,261 |   |      |          | 21,792 |   |   |          | 17,196 |   |   |         | 14,216 |  
|                                                                           |                                                                                                    |                          |          |        |   |      |          |        |   |      |          |        |   |   |          |        |   |   |         |       
|Balance Sheet Data:                                                        |                                                                                                    |                          |          |        |   |      |          |        |   |      |          |        |   |   |          |        |   |   |         |       
|Cash, cash equivalents and short term investments                          |                                                                                                    | $                        | 29,770   |        |   | $    | 31,443   |        |   | $    | 71,164   |        |   | $ | 44,381   |        |   | $ | 31,259  |       
|Working capital                                                            |                                                                                                    |                          | 19,708   |        |   |      | 16,039   |        |   |      | 48,308   |        |   |   | 19,862   |        |   |   | 22,797  |       
|Total assets                                                               |                                                                                                    |                          | 95,218   |        |   |      | 97,129   |        |   |      | 132,100  |        |   |   | 71,371   |        |   |   | 50,790  |       
|Noncurrent portion of notes payable and capital
    lease obligations      |                                                                                                    |                          | 0        |        |   |      | 497      |        |   |      | 2,427    |        |   |   | 6,230    |        |   |   | 9,609   |       
|Redeemable convertible preferred stock                                     |                                                                                                    |                          | 23,669   |        |   |      | 30,665   |        |   |      | 30,735   |        |   |   |         |        |   |   |        |       
|Accumulated deficit                                                        |                                                                                                    |                          | (215,436 | )      |   |      | (189,443 | )      |   |      | (153,535 | )      |   |   | (110,441 | )      |   |   | (74,904 | )     
|Total shareholders equity                                                 |                                                                                                    | $                        | 52,970   |        |   | $    | 41,410   |        |   | $    | 71,149   |        |   | $ | 37,785   |        |   | $ | 24,157  |       
|                                                                           |                                                                                                    |                          |          |        |   |      |          |        |   |      |          |        |   |   |          |        |   |   |         |       



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | See Note 1 of Notes to Financial Statements
    for an explanation of shares used in computing basic and diluted
    net loss per share.                                                                                                                                                                                                                                                                                                                                                       
|   
|(2) | Other income consists of the gain related to
    forgiveness of outstanding notes and interests by Genentech,
    previously classified as an extraordinary item. In 2002, the
    Company early adopted Statement of Financial Accounting Standard
    (SFAS) 145, Rescission of FASB Statements
    No. 4, 44 and 64, Amendment of FASB 13 and Technical
    Corrections, which requires the reclassification of this
    type of extraordinary item as a component of operating results.






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

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

Overview

Since our inception in 1991, we have been engaged
in the development of needle free drug delivery systems. As of
December 31, 2003, we had an accumulated deficit of
$215.4 million. We have not been profitable since inception
and expect to incur additional operating losses over the next
several years as research and development efforts, preclinical
and clinical testing activities and manufacturing scale-up
efforts expand and as we plan and build our late-stage clinical
and early commercial production capabilities. To date, we have
not had any material product sales and do not anticipate
receiving any revenue from the sale of products in 2004. The
sources of working capital have been equity financings,
equipment lease financings, contract and license revenues and
interest earned on investments.

We have performed initial feasibility work on a
number of compounds and have been compensated for expenses
incurred while performing this work in several cases pursuant to
feasibility study agreements with third parties. Once
feasibility is demonstrated with respect to a potential product,
we seek to enter into development contracts with pharmaceutical
corporate partners. We currently have such agreements pursuant

20



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##### Table of Contents



to which we are developing pulmonary delivery
systems with Novo Nordisk A/S, to manage diabetes using insulin
and other blood glucose regulating compounds, and with
GlaxoSmithKline, to manage acute and breakthrough pain using
opioid analgesics.


The collaborative agreement with Novo Nordisk A/S
provides for reimbursement of research and development expenses
as well as additional payments to us as we achieve certain
significant milestones. We also expect to receive royalties from
this development partner based on revenues from sales of product
and to receive revenue from the manufacturing of unit-dose
packets and hand-held devices. We recognize revenues under the
terms of our collaborative agreement as the research and
development expenses are incurred, to the extent they are
reimbursable. During 2003, this partner-funded program
contributed approximately 99% of our total contract revenues.
Novo Nordisk A/S with its subsidiary is considered a related
party.

During December 2000, GlaxoSmithKline and we
amended the product development and commercialization agreement
whereby we assumed full control and responsibility for
conducting and financing the remainder of all development
activities. Under the amendment, unless we have terminated the
agreement, GlaxoSmithKline can restore its rights to participate
in development and commercialization of the product upon payment
of a restoration fee to us. Pursuant to the amended agreement,
we have made available to GlaxoSmithKline the results of our
Phase 2b trial for its consideration. At this time, we do
not believe that GlaxoSmithKline will elect to restore its
rights. If we elect to terminate the agreement and continue or
intend to continue any development activities, either alone or
in collaboration with a third party, we will be obligated to pay
an exit fee to GlaxoSmithKline at which time all rights related
to development and commercialization of the product will be
returned to us. If we elect to pay the immaterial exit fee it
will not have a material impact on our financial position or
operating results. However, we do not currently intend to
continue this program unless and until we are able to secure a
development and commercialization partner.

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

Critical Accounting Policies

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



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

Contract revenues consist of revenue from
collaboration agreements and feasibility studies. We recognize
revenue under the provisions of the Securities and Exchange
Commission issued Staff Accounting Bulletin No. 104,
Revenue Recognition (SAB 104). Under the
agreements, revenue is recognized as costs are incurred.
Deferred revenue represents the portion of all refundable and
nonrefundable research payments received that have not been
earned. In accordance with contract terms, milestone payments
from collaborative research agreements are considered
reimbursements for costs incurred under the agreements and,
accordingly, are generally recognized as revenue either upon the
completion of the milestone effort when payments are contingent
upon completion of the effort or are based on actual efforts
expended over the remaining term of the agreements when payments
precede the required efforts. Costs of contract revenues are
approximate to or are greater than such revenue and are included
in research and development expenses. Refundable development and
license fee payments are deferred until the specified
performance criteria are achieved. Refundable development and
license fee payments are generally not refundable once the
specific performance criteria are achieved and accepted.

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| |                  
| | -----------------
| | Long-Lived Assets

The Company reviews for impairment whenever
events or changes in circumstances indicate that the carrying
amount of property and equipment may not be recoverable in
accordance with SFAS 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. Determination
of recoverability is based on an estimate of undiscounted future
cash flows resulting from the use of the asset and its eventual
disposition. In the event that such cash flows are not expected
to be sufficient to recover the carrying amount of the assets,
the assets are written down to their estimated fair values and
the loss is recognized on the Statements of Operations.

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

Results of Operations



| |                                                 
| | ------------------------------------------------
| | Years Ended December 31, 2003, 2002
    and 2001

Contract Revenues.We reported revenues from collaborative contracts of
$33.9 million in 2003, compared to $29.0 million in
2002 and $28.9 million in 2001. The 17% increase in revenue
in 2003 compared to 2002 is primarily due to increases in
partner-funded project development revenue from Novo Nordisk
A/S, which was $33.5 million in 2003 compared to
$26.9 million in 2002 offset by declines in contract
revenue from other partner-funded programs, which was $311,000
in 2003 and $2.1 million in 2002. The decrease in other
partner-funded revenue is due to the completion of four programs
in 2002. The revenue in 2001 consisted of $26.0 million
from partner-funded project development revenue from Novo
Nordisk A/S, $1.5 million from partner-funded project
development revenue from GlaxoSmithKline, and $1.4 million
from contract revenue from other partner-funded programs. Costs
associated with contract research revenue are included in
research and development expenses.

Research and Development
Expenses.Research and development
expenses decreased in 2003 compared to 2002 and 2001. These
expenses were $49.6 million in 2003 compared to
$54.7 million in 2002 and $58.8 million in 2001.
Research and development expenses as a percentage of total
operating expenses were 83% in 2003, 84% in 2002, and 86% in
2001.

Research and development expenses associated with
collaborative agreements approximate contract revenue as these
expenses are incurred under the program agreements. Research and
development expenses in 2003 decreased by $5.1 million or
9% compared to 2002. The decrease in research and development
expenses is primarily due to a reduction in self-funded
pulmonary delivery development efforts and cost reduction
programs including a reduction in force implemented in July 2003
offset by increased Intraject program costs. Research and
development expenses in 2002 decreased by $4.1 million or
7% compared to 2001, primarily due to a reduction in development
efforts to support the ongoing program with Novo Nordisk A/S and
the pain management program and a reduction in manufacturing
scale-up efforts, offset by increases in expenses in other
funded and unfunded development programs.

These expenses represent proprietary research
expenses as well as the costs related to contract research
revenue and include salaries and benefits of scientific and
development personnel, laboratory supplies, consulting services
and the expenses associated with the development of
manufacturing processes. We expect research and development
spending will remain constant in the very near term as Intraject
development spending increases and AERx spending decreases. We
expect research and development spending to increase over the
next few years if we continue to expand our development
activities to support current and potential future
collaborations and initiate commercial manufacturing of the AERx
systems and to support the development and commercialization of
the Intraject system. Future research and development
expenditures

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cannot be predicted accurately as it depends in
part upon continued future success and funding levels supported
by our existing development collaborations, as well as obtaining
new collaborative agreements.


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

In 2003 we acquired the base technologies through
the purchase of selected assets from Weston Medical Group, plc
and began development of the Intraject needle-free subcutaneous
system, designed to comfortably and rapidly deliver drug to the
subcutaneous layer, such as, the abdominal area.

We have other partner-funded and self-funded
programs in development. Future research and development efforts
for these partner-funded programs are difficult to predict at
this time due to their early stage of development.

General and Administrative
Expenses.General and administrative
expenses were $10.4 million in 2003 compared to
$10.4 million in 2002 and $9.4 million in 2001. In
2003, general and administrative expenses were consistent with
2002, resulting from increased business development and investor
relations expense offset by lower facility and personnel costs.
General and administrative expenses increased in 2002 compared
to 2001 as a result of higher business development expenses,
including the hiring of additional personnel, and higher
facility support costs.

Interest Income.Interest income was approximately $300,000 in 2003 compared to
$800,000 in 2002 and $1.3 million in 2001. The decrease in
2002 and again in 2003 was primarily due to a combination of
interest income being earned on lower average cash and
investment balances and a decrease in interest rates earned on
invested cash balances. The contribution to interest income due
to the funds received from the preferred stock financing in
December 2001 was not material.

Interest Expense.Interest expense was approximately $100,000 in 2003 compared to
$600,000 in 2002 and $1.1 million in 2001. The decrease in
2002 is primarily due to lower outstanding capital lease and
equipment loan balances under various equipment and lease lines
of credit.

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

Net Loss.We
reported a net loss of $26.0 million in 2003 compared
$35.9 million in 2002 and $32.4 million in 2001.

Deemed Dividend.We
reported a deemed dividend of $10.7 million in 2001, which
related to the Series A redeemable convertible preferred
stock financing completed in December 2001. The deemed dividend
represents the discounted conversion price of the financing
compared to the fair market value of our common stock on the
issuance date of the preferred stock resulting in a beneficial
conversion to the preferred stockholders. The value of the
beneficial conversion feature is reported as a deemed dividend
and is included in the calculation of net loss applicable to the
common shareholders. No such deemed dividend was reported in
2003 or 2002.

Net Loss Applicable to Common
Shareholders.We reported a net loss
applicable to common shareholders of $26.0 million in 2003
compared to $35.9 million in 2002 and $43.1 million in
2001. Net loss applicable to common shareholders in 2001
included a deemed dividend to the Series A redeemable
convertible preferred stock financing completed in December
2001. The net loss applicable to common shareholders is used in
the calculation for basic and diluted loss per share applicable
to common shareholders.

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Liquidity and Capital Resources

Since inception, we have financed our operations
primarily through private placements and public offerings of our
capital stock, proceeds from equipment lease financings,
contract research funding and interest earned on investments. As
of December 31, 2003, we had cash, cash equivalents and
short-term investments of approximately $29.8 million.

In March 2003, we raised approximately
$14.2 million through the sale of 18,992,391 shares of
common stock at a price of $0.79 per share and warrants to
purchase 4,273,272 shares of common stock at $1.07 per
share to certain investors in a private placement.

In June and November 2003, the Company received
net proceeds of approximately $2.5 million and issued an
aggregate of 2,414,050 shares of Common Stock in connection
with the exercise of warrants by certain investors.

In November 2003, we raised approximately
$13.2 million through the sale of 7,780,550 shares of
our common stock at $1.80 per share and warrants to
purchase 1,945,133 shares of our common stock at
$2.50 per share to certain investors in a private placement.

Net cash used in operating activities in 2003 was
$24.8 million compared to $30.9 million in 2002 and
$29.1 million in 2001. The decrease in net cash used in
2003 resulted primarily from a decrease in net loss offset by
reductions of accounts payable and deferred revenue. The
decrease in accounts payable results primarily from timing of
payments of expenses associated with our development programs
and capital expenditures, while the decrease in deferred revenue
is due to our partners funding future development at a lower
level and the amortization of past milestone payments. The
increase in net cash used in 2002 compared to 2001 resulted
primarily from an increase in net loss, decreases in accounts
payable, other accrued liabilities and deferred revenue, offset
by a decrease in account receivable. The decrease in accounts
payable and other accrued liabilities results primarily from
timing of payments for expenses associated with our development
programs and capital expenditures, while the decrease in
deferred revenue is due primarily to our partners funding future
development at a lower level. The decrease in receivables is due
to the receipt of payments from our partners for billings
associated with our development activities.

Net cash used in investing activities in 2003 was
$8.2 million compared to $18.6 million in 2002 and
$14.7 million in 2001. The decrease in cash used in 2003
resulted from reductions in capital expenditures and proceeds
from maturing investments offset by the purchase of investment
products. Capital expenditures for the current year of
approximately $5.4 million relate primarily to
$3.0 million acquisition of Intraject assets, and
$2.4 million for commercial projects and development
equipment. Capital expenditures in 2002 of approximately
$11.2 million related primarily to manufacturing production
equipment. The increase in cash used in 2002 compared to 2001
resulted from a combination of reductions in capital
expenditures and proceeds from maturing investments offset by an
increase in the purchase of investments. Capital expenditures in
2001 of approximately $37.1 million related primarily to
the construction of our large-scale commercial manufacturing
facility. The cash used for proceeds from maturing investments
offset by the purchase of investments was $2.8 million in
2003, compared to $7.4 million in 2002 and an increase of
$22.4 million in 2001.

Net cash provided by financing activities in 2003
was $28.5 million compared to $2.3 million in 2002 and
$93.0 million in 2001. Financing activities in 2003
included the sale of common stock through private placements in
March and November 2003, which raised net proceeds of
approximately $27.3 million. In addition, net proceeds
received from the issuance of common stock upon exercise of
warrants and stock options, and under the employee stock
purchase plan was $3.1 million. The proceeds were offset by
$1.8 million of cash used for capital lease obligations.
The net proceeds from issuances of common stock in 2002 were
approximately $6.1 million. Financing activities in 2001
consisted of proceeds from the exercise of two put options
during the year from two of our partners, which raised net
proceeds of approximately $10.0 million, the sale of common
stock during the year using a common stock equity line, which
raised net proceeds of approximately $5.5 million, the sale
of common stock through a private placement in August 2001,
which raised net proceeds of approximately $13.8 million,
the sale of common stock to a major partner

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in October 2001, which raised net proceeds of
approximately $19.9 million and the sale of redeemable
convertible preferred stock in December 2001, which raised net
proceeds of approximately $45.4 million.


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

We continue to review our planned operations
through the end of 2003, and beyond. We particularly focus on
capital spending requirements to ensure that capital outlays are
not expended sooner than necessary. We expect our total capital
outlays for 2004 will be approximately $8.0 million.
Currently, we are contractually committed to approximately
$894,000 of the anticipated 2004 capital outlays. Capital
outlays beyond 2004 will depend on our ability to raise
additional capital and future partner funding arrangements. We
believe that our existing cash balances at December 31,
2003, funding commitments from corporate development partners
and interest earned on our investments should be sufficient to
meet our needs for at least the next 12 months. If our
current funding commitments from corporate development partners
are amended or terminated, we will need to obtain additional
sources of capital.

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

Off-Balance Sheet Financings and
Liabilities

Other than contractual obligations incurred in
the normal course of business, we do not have any off-balance
sheet financing arrangements or liabilities, guarantee
contracts, retained or contingent interests in transferred
assets or any obligation arising out of a material variable
interest in an unconsolidated entity. We do not have any
majority-owned subsidiaries that are not included in the
financial statements.

Contractual Obligations

The following summarizes our contractual
obligations at December 31, 2003, and the effect such
obligations are expected to have on our liquidity and cash flows
in future periods (in thousands):

|                                   |  |                       |        |           |  |           |       |           |  |         |        |  |  |   |       |  |  |   |        | 
|---------------------------------- |  | --------------------- | ------ | --------- |  | --------- | ----- | --------- |  | ------- | ------ |  |  | - | ----- |  |  | - | ------ | 
|                                   |  |                      
|                                   |  | Payment Due by Period
|                                   |  |                      
|                                   |  |                       |        | Less Than |  |           |       | After    
|Contractual Obligations            |  | Total                 |        | 1 Year    |  | 1-3 Years |       | 3-5 years |  | 5 years
|                                   |  |                       |        |           |  |           |       |           |  |        
|Capital Lease Obligations          |  | $                     | 513    |           |  | $         | 513   |           |  | $       |       |  |  | $ |      |  |  | $ |       | 
|Unconditional Purchase Obligations |  |                       | 894    |           |  |           | 894   |           |  |         |       |  |  |   |      |  |  |   |       | 
|Operating Lease Obligations        |  |                       | 58,434 |           |  |           | 5,334 |           |  |         | 10,274 |  |  |   | 9,463 |  |  |   | 33,363 | 
|                                   |  |                       |        |           |  |           |       |           |  |         |        |  |  |   |       |  |  |   |        | 
|Total Contractual Commitments      |  | $                     | 59,841 |           |  | $         | 6,741 |           |  | $       | 10,274 |  |  | $ | 9,463 |  |  | $ | 33,363 | 
|                                   |  |                       |        |           |  |           |       |           |  |         |        |  |  |   |       |  |  |   |        | 

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Recent Accounting Pronouncements

In May 2003, the Emerging Issues Task Force
(EITF) reached a consensus on EITF Issue No. 00-21,
Revenue Arrangements with Multiple Deliverables.
EITF 00-21 addresses certain aspects of the accounting by a
vendor for arrangements under which it will perform multiple
revenue-generating activities. In some arrangements, the
different revenue-generating activities (deliverables) are
sufficiently separable and there exists sufficient evidence of
their fair values to separately account for some or all of the
deliverables (that is, there are separate units of accounting).
In other arrangements, some or all of the deliverables are not
independently functional, or there is not sufficient evidence of
their fair values to account for them separately. This Issue
addresses when and how an arrangement involving multiple
deliverables should be divided into separate units of
accounting. EITF 00-21 does not change otherwise applicable
revenue recognition criteria. The guidance in this Issue is
effective for revenue arrangements entered into in fiscal
periods beginning after June 15, 2003. The adoption of
EITF 00-21 did not have a material effect on our financial
statements.

In January 2003, the FASB issued Interpretation
No. 46, Consolidation of Variable Interest
Entities (FIN 46) which was revised in December 2003.
FIN 46, as revised, requires that if an entity is the
primary beneficiary of variable interest entity, the assets,
liabilities, and results of operations of the variable interest
entity should be included in the Consolidated Financial
Statements of the entity. The provisions of FIN 46 are
effective immediately for all arrangements entered into after
January 31, 2003. For those arrangements entered into prior
to January 31, 2003, the provisions of FIN 46 are
required to be adopted at the beginning of the first interim or
annual period ending after March 15, 2004. The adoption of
FIN 46, as revised, is not expected to have a significant
impact on our financial position and results of operations.

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RISK FACTORS

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

We are an early-stage company.

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

We have a history of losses and anticipate
future losses.

We have never been profitable, and through
December 31, 2003, we have incurred a cumulative deficit of
approximately $215.4 million. We have not had any material
product sales and do not anticipate receiving any revenue from
product sales in 2004. We expect to continue to incur
substantial losses over at least the next several years as we:



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

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

We may not be able to develop our products
successfully.

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

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



| |   |                        
| | - | -----------------------
| |  | are safe and effective;

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

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

We may not be able to commercialize products
successfully.

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



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

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

We depend on collaborative partners and need
additional collaborative partners.

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

Novo Nordisk A/S has agreed to:



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

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

Although we have development arrangements with
other collaborative partners, our arrangement with Novo Nordisk
A/S is our only active funded development agreement. For the
year ended December 31, 2003, this partner-funded program
contributed approximately 99% of our total contract revenues.
Our agreement with Novo Nordisk A/S can be terminated under
certain conditions, including by either party on limited written
notice, by Novo Nordisk A/S by limited prior written notice upon
the occurrence of certain events, and by either party upon a
30-day written notice in the event that the other party commits
a material breach under the agreement and fails to remedy such
breach within the 60 days notice of such breach.

We will also need to enter into agreements with
other corporate partners to conduct the clinical trials,
manufacturing, marketing and sales necessary to commercialize
other potential products. In addition, our

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


We have limited manufacturing
experience.

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



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

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

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

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

We rely on a small number of vendors to supply
us with specialized equipment and tools.

We rely on a small number of vendors to supply us
with specialized equipment and tools for use in our development
and manufacturing processes. There can be no assurances that
these vendors will continue to supply us with such specialized
equipment and tools, nor can there be any assurances that we
could find alternative sources for such specialized equipment
and tools. A delay or interruption in development or
manufacturing resulting from our inability to acquire the
equipment and tools we need could have a material adverse effect
on our business.

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

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



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

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

We anticipate that our existing cash balances at
December 31, 2003, together with research and development
funding commitments from corporate development partners, and
projected interest income, will enable us to maintain our
current and planned operations for at least the next
12 months. However, there can be no assurances that these
sources of funding will be sufficient, that our cash
requirements will not change or that funding commitments from
our corporate development partners will not be amended or
terminated. In addition, subject to certain conditions, we have
a $20 million common stock purchase commitment from Novo
Nordisk A/S, which we would consider calling when the iDMS
program is making sufficiently good progress toward
commercialization to justify substantial additional investment
in commercial production capacity. However, this amount may not
be sufficient to cover all of the necessary investment, in which
case we would require additional capital in order to complete
commercial scale-up for the iDMS program. Moreover, if any of
these funding commitments from corporate development partners
are amended or terminated, we are also likely to require
additional sources of capital.

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

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

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

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manufacturing technologies, particularly those
associated with production of disposable unit-dose packets for
the AERx systems.


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

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

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

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

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

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

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

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

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


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

Human clinical trials typically are conducted in
three sequential phases, but the phases may overlap.
Phase 1 trials consist of testing the product in a small
number of patients or normal volunteers, primarily for safety,
at one or more dosage levels, as well as characterization of a
drugs pharmacokinetic and/or pharmacodynamic profile. In
Phase 2 clinical trials, in addition to safety, the
efficacy of the product is usually evaluated in a patient
population. Phase 3 trials typically involve additional
testing for safety and clinical efficacy in an expanded
population at geographically disperse sites. All of the phases
of clinical studies must be conducted in conformance with
FDAs bioresearch monitoring regulations. We cannot assure
you that we will be able to obtain necessary regulatory
approvals on a timely basis, if at all, for any of our potential
products. Even if granted, regulatory approvals may include
significant limitations on the uses for which products may be
marketed. Moreover, we cannot assure you that any required
approvals, once obtained, will not be withdrawn or that we will
remain in compliance with other regulatory requirements. If we,
or manufacturers of our components, fail to comply with
applicable FDA and other regulatory requirements, we, and they,
are subject to sanctions, including:



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

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

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

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

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The results of preclinical and clinical
testing are uncertain.

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

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

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

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

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

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

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

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

We depend on a small number of key management and
technical personnel. Losing any of these key employees could
harm our business and operations. Our success also depends on
our ability to attract and retain additional highly qualified
marketing, management, manufacturing, engineering and research
and

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development personnel. We face intense
competition in our recruiting activities and may not be able to
attract or retain qualified personnel.


We may be exposed to product
liability.

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

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

Third-party reimbursement for our products is
uncertain.

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

We use hazardous materials.

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

Our stock price is likely to remain
volatile.

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



| |   |                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------
| |  | investor perception of us;                                                                                                   
|
| |  | analyst recommendations;                                                                                                     
|
| |  | fluctuations in our operating results;                                                                                       
|
| |  | market conditions relating to the drug delivery
    industry;                                                                
|
| |  | announcements of technological innovations or new
    commercial products by us or our competitors;                          
|
| |  | publicity regarding actual or potential
    developments relating to products under development by us or our
    competitors;
|
| |  | failure to establish new collaborative
    relationships;                                                                    

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| |   |                                                                             
| | - | ----------------------------------------------------------------------------
| |  | developments or disputes concerning patent or
    proprietary rights;       
|
| |  | delays in the development or approval of our
    product candidates;        
|
| |  | regulatory developments in both the United States
    and foreign countries;
|
| |  | public concern as to the safety of drug delivery
    technologies;          
|
| |  | period-to-period fluctuations in financial
    results;                     
|
| |  | future sales of substantial amounts of common
    stock by shareholders; or 
|
| |  | economic and other external factors.                                        

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

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

At various times during the first half of 2003,
our common stock traded below $1.00. The Nasdaq has a
$1.00 per share minimum bid requirement, pursuant to which
our common stock could be de-listed from the Nasdaq National
Market if it trades below $1.00 for 30 consecutive trading days
and does not subsequently trade above $1.00 for 10 consecutive
days. If we are unable to meet the Nasdaq requirements to
maintain listing on the Nasdaq National Market, our common stock
could trade on the OTC Bulletin Board or in the pink
sheets maintained by the National Quotation
Bureau, Inc. Such alternatives are generally considered to
be less efficient markets, and our stock price, as well as the
liquidity of our common stock, will be adversely impacted as a
result.

We have implemented certain anti-takeover
provisions.

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

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




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, 2003, we had cash, cash
equivalents and short-term investments of $29.8 million
consisting of cash and highly liquid, short-term investments.
The market value of our short-term investments will decline by
an immaterial amount if market interest rates increase, and
therefore, our exposure to interest rate changes has been
immaterial. Declines of interest rates over time will, however,
reduce our interest

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income from our short-term investments. Our
outstanding equipment lease lines and capital lease obligations
are all at fixed interest rates and, therefore, have minimal
exposure to changes in interest rates.







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

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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, 2003 and 2002,
and the related statements of operations, redeemable convertible
preferred stock and shareholders equity, and cash flows
for each of the three years in the period ended
December 31, 2003. 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, 2003 and
2002, and the results of its operations and its cash flows for
each of the three years in the period ended December 31,
2003, in conformity with accounting principles generally
accepted in the United States.

As discussed in Note 1 to the financial
statements, effective December 31, 2002, the Company
adopted Statement of Financial Accounting Standards
No. 145, Rescission of FASB Statements No. 4,
44, and 64, Amendment of FASB Statement No. 13, and
Technical Corrections.



| |                      
| | ---------------------
| | /S/ ERNST & YOUNG LLP

Palo Alto, California

February 4, 2004


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ARADIGM CORPORATION

BALANCE SHEETS

|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                        |        |          |        |  |        |          |        | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------- | ------ | -------- | ------ |  | ------ | -------- | ------ | 
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                       
|                                                                                                                                                                                                                                     |                                                                                                                                          | December 31,                                                                          
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                       
|                                                                                                                                                                                                                                     |                                                                                                                                          | 2003                                                                                   |        | 2002    
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                        |        |         
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                       
|                                                                                                                                                                                                                                     |                                                                                                                                          | (In thousands,                                                                        
|                                                                                                                                                                                                                                     |                                                                                                                                          | except shares data)                                                                   
|ASSETS                                                                                                                                                                                                                              
|Current assets:                                                                                                                                                                                                                      |                                                                                                                                          |                                                                                        |        |          |        |  |        |         
|                                                                                                                                                                                                                                     | Cash and cash equivalents                                                                                                                |                                                                                        | $      | 18,327   |        |  | $      | 22,800   |       
|                                                                                                                                                                                                                                     | Short-term investments                                                                                                                   |                                                                                        |        | 11,443   |        |  |        | 8,643    |       
|                                                                                                                                                                                                                                     | Receivables                                                                                                                              |                                                                                        |        | 140      |        |  |        | 282      |       
|                                                                                                                                                                                                                                     | Current portion of notes receivable from officers
    and employees                                                                      |                                                                                        |        | 104      |        |  |        | 136      |       
|                                                                                                                                                                                                                                     | Prepaid and other current assets                                                                                                         |                                                                                        |        | 1,910    |        |  |        | 1,457    |       
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                        |        |          |        |  |        |         
|                                                                                                                                                                                                                                     |                                                                                                                                          | Total current assets                                                                   |        |          | 31,924 |  |        |          | 33,318 | 
|Property and equipment, net                                                                                                                                                                                                          |                                                                                                                                          |                                                                                        | 62,612 |          |        |  | 63,233 |         
|Noncurrent portion of notes receivable from
    officers and employees                                                                                                                                                               |                                                                                                                                          |                                                                                        | 294    |          |        |  | 169    |         
|Other assets                                                                                                                                                                                                                         |                                                                                                                                          |                                                                                        | 388    |          |        |  | 409    |         
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                        |        |          |        |  |        |         
|                                                                                                                                                                                                                                     |                                                                                                                                          | Total assets                                                                           |        | $        | 95,218 |  |        | $        | 97,129 | 
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                        |        |          |        |  |        |         
|                                                                                                                                                                                                                                    
|LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED
    STOCK AND
    SHAREHOLDERS EQUITY                                                                                                                                                
|Current liabilities:                                                                                                                                                                                                                 |                                                                                                                                          |                                                                                        |        |          |        |  |        |         
|                                                                                                                                                                                                                                     | Accounts payable                                                                                                                         |                                                                                        | $      | 885      |        |  | $      | 1,951    |       
|                                                                                                                                                                                                                                     | Accrued clinical and cost of other studies                                                                                               |                                                                                        |        | 149      |        |  |        | 291      |       
|                                                                                                                                                                                                                                     | Accrued compensation                                                                                                                     |                                                                                        |        | 2,021    |        |  |        | 2,195    |       
|                                                                                                                                                                                                                                     | Deferred revenue                                                                                                                         |                                                                                        |        | 7,891    |        |  |        | 10,682   |       
|                                                                                                                                                                                                                                     | Current portion of capital lease obligations                                                                                             |                                                                                        |        | 427      |        |  |        | 1,753    |       
|                                                                                                                                                                                                                                     | Other accrued liabilities                                                                                                                |                                                                                        |        | 843      |        |  |        | 407      |       
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                        |        |          |        |  |        |         
|                                                                                                                                                                                                                                     |                                                                                                                                          | Total current liabilities                                                              |        |          | 12,216 |  |        |          | 17,279 | 
|Noncurrent portion of deferred revenue                                                                                                                                                                                               |                                                                                                                                          |                                                                                        | 5,040  |          |        |  | 6,170  |         
|Capital lease obligations, less current portion                                                                                                                                                                                      |                                                                                                                                          |                                                                                        |       |          |        |  | 497    |         
|Noncurrent portion of deferred rent                                                                                                                                                                                                  |                                                                                                                                          |                                                                                        | 1,323  |          |        |  | 1,108  |         
|Commitments and contingencies                                                                                                                                                                                                        |                                                                                                                                          |                                                                                        |        |          |        |  |        |         
|Redeemable convertible preferred stock, no par
    value; 5,000,000 shares authorized; issued and outstanding
    shares: 1,544,626 in 2003 and 2,001,236 in 2002; liquidation
    preference of $37,380 in 2003 and $48,430 in 2002 |                                                                                                                                          |                                                                                        | 23,669 |          |        |  | 30,665 |         
|Shareholders equity:                                                                                                                                                                                                                |                                                                                                                                          |                                                                                        |        |          |        |  |        |         
|                                                                                                                                                                                                                                     | Common stock, no par value,
    100,000,000 shares authorized; issued and outstanding
    shares: 62,751,196 in 2003; 31,157,612 in 2002 |                                                                                        |        | 268,406  |        |  |        | 230,853  |       
|                                                                                                                                                                                                                                     | Accumulated deficit                                                                                                                      |                                                                                        |        | (215,436 | )      |  |        | (189,443 | )     
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                        |        |          |        |  |        |         
|                                                                                                                                                                                                                                     |                                                                                                                                          | Total shareholders equity                                                             |        |          | 52,970 |  |        |          | 41,410 | 
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                        |        |          |        |  |        |         
|                                                                                                                                                                                                                                     |                                                                                                                                          | Total liabilities, redeemable convertible
    preferred stock and shareholders equity |        | $        | 95,218 |  |        | $        | 97,129 | 
|                                                                                                                                                                                                                                     |                                                                                                                                          |                                                                                        |        |          |        |  |        |         

See accompanying notes.

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##### Table of Contents



ARADIGM CORPORATION

STATEMENTS OF OPERATIONS

|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |        |        | 
|----------------------------------------------------------------------------------------------- | -------------------------- | ------------------------------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                                                                |                            |                                      
|                                                                                                |                            | Years Ended December 31,             
|                                                                                                |                            |                                      
|                                                                                                |                            | 2003                                  |         | 2002   |        | 2001
|                                                                                                |                            |                                       |         |        |        |     
|                                                                                                |                            |                                      
|                                                                                                |                            | (In thousands, except per share data)
|Contract and license revenues                                                                   |                            |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                                                | Related parties            |                                       | $       | 33,546 |        |      | $       | 26,864 |        |   | $       | 26,031 |       
|                                                                                                | Unrelated parties          |                                       |         | 311    |        |      |         | 2,103  |        |   |         | 2,885  |       
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                                                |                            | Total revenues                        |         |        | 33,857 |      |         |        | 28,967 |   |         |        | 28,916 | 
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                                                | Research and development   |                                       |         | 49,636 |        |      |         | 54,680 |        |   |         | 58,836 |       
|                                                                                                | General and administrative |                                       |         | 10,391 |        |      |         | 10,394 |        |   |         | 9,355  |       
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                                                |                            | Total expenses                        |         |        | 60,027 |      |         |        | 65,074 |   |         |        | 68,191 | 
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Loss from operations                                                                            |                            |                                       | (26,170 | )      |        |      | (36,107 | )      |        |   | (39,275 | )     
|Interest income                                                                                 |                            |                                       | 338     |        |        |      | 818     |        |        |   | 1,324   |       
|Other income related to forgiveness of Genentech
    note                                       |                            |                                       |        |        |        |      |        |        |        |   | 6,675   |       
|Interest expense                                                                                |                            |                                       | (138    | )      |        |      | (642    | )      |        |   | (1,081  | )     
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Net loss                                                                                        |                            |                                       | (25,970 | )      |        |      | (35,931 | )      |        |   | (32,357 | )     
|Deemed dividend                                                                                 |                            |                                       |        |        |        |      |        |        |        |   | (10,722 | )     
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Net loss applicable to common shareholders                                                      |                            | $                                     | (25,970 | )      |        | $    | (35,931 | )      |        | $ | (43,079 | )     
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Basic and diluted loss per share applicable to
    common shareholders:                         |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Net loss applicable to common shareholders                                                      |                            | $                                     | (0.52   | )      |        | $    | (1.19   | )      |        | $ | (1.98   | )     
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       
|Shares used in computing basic and diluted loss
    per share applicable to common shareholders |                            |                                       | 50,196  |        |        |      | 30,261  |        |        |   | 21,792  |       
|                                                                                                |                            |                                       |         |        |        |      |         |        |        |   |         |       

See accompanying notes.

39



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##### Table of Contents



ARADIGM CORPORATION

STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED
STOCK AND

SHAREHOLDERS EQUITY


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

40



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##### Table of Contents



ARADIGM CORPORATION


STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED
STOCK AND

SHAREHOLDERS EQUITY  (Continued)


|                                                                                                           |                                                                     |                                    |           |              |   |             |        |          |   |             |            |               |   |         |         |        |   |   |   |   |   |   |   |   |   |   |          |     |         |   |         |     |         |  
|---------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------- | ---------------------------------- | --------- | ------------ | - | ----------- | ------ | -------- | - | ----------- | ---------- | ------------- | - | ------- | ------- | ------ | - | - | - | - | - | - | - | - | - | - | -------- | --- | ------- | - | ------- | --- | ------- | -
|                                                                                                           |                                                                     |                                    |           |              |   |             |        |          |   |             |            |               |   |        
|                                                                                                           |                                                                     | Redeemable                         |           |              |   |             |        |          |   |             |            |               |   |        
|                                                                                                           |                                                                     | Convertible                        |           |              |   |             |        |          |   |             |            |              
|                                                                                                           |                                                                     | Preferred Stock                    |           | Common Stock |   | Shareholder |        |          |   |             |            | Total        
|                                                                                                           |                                                                     |                                    |           |              |   | Notes       |        | Deferred |   | Accumulated |            | Shareholders
|                                                                                                           |                                                                     | Shares                             |           | Amount       |   | Shares      |        | Amount   |   | Receivable  |            | Compensation  |   | Deficit |         | Equity
|                                                                                                           |                                                                     |                                    |           |              |   |             |        |          |   |             |            |               |   |         |         |       
|                                                                                                           |                                                                     |                                   
|                                                                                                           |                                                                     | (In thousands, except shares data)
|Issuance of common stock for cash, net of
    issuance costs of $7,353 including warrants valued at $5,657 |                                                                     |                                    |          |              |   |             |       |          |   |             | 26,772,941 |               |   |         | 27,312  |        |   |   |  |   |   |   |  |   |   |   |         |     |         |   | 27,312  |    
|Issuance of common stock through conversion of
    Series A preferred stock                                |                                                                     |                                    | (456,610  | )            |   |             | (6,996 | )        |   |             | 1,826,440  |               |   |         | 6,996   |        |   |   |  |   |   |   |  |   |   |   |         |     |         |   | 6,996   |    
|Issuance of common stock under the employee stock
    purchase plan                                        |                                                                     |                                    |          |              |   |             |       |          |   |             | 553,028    |               |   |         | 596     |        |   |   |  |   |   |   |  |   |   |   |         |     |         |   | 596     |    
|Issuance of common stock upon exercise of stock
    options                                                |                                                                     |                                    |          |              |   |             |       |          |   |             | 27,125     |               |   |         | 11      |        |   |   |  |   |   |   |  |   |   |   |         |     |         |   | 11      |    
|Issuance of common stock upon exercise of warrants                                                         |                                                                     |                                    |           |              |   |             |        |          |   |             | 2,414,050  |               |   |         | 2,522   |        |   |   |   |   |   |   |   |   |   |   |          |     |         |   | 2,522   |    
|Issuance of options and warrants to purchase
    common stock for services                                 |                                                                     |                                    |          |              |   |             |       |          |   |             |           |               |   |         | 116     |        |   |   |  |   |   |   |  |   |   |   |         |     |         |   | 116     |    
|Comprehensive loss:                                                                                        |                                                                     |                                    |           |              |   |             |        |          |   |             |            |               |   |         |         |        |   |   |   |   |   |   |   |   |   |   |          |     |         |   |         |    
|Net loss                                                                                                   |                                                                     |                                    |          |              |   |             |       |          |   |             |           |               |   |         |        |        |   |   |  |   |   |   |  |   |   |   | (25,970  | )   |         |   | (25,970 | )  
|                                                                                                           | Other comprehensive income (loss):                                  |                                    |           |              |   |             |        |          |   |             |            |               |   |         |         |        |   |   |   |   |   |   |   |   |   |   |          |     |         |   |         |     |        
|                                                                                                           | Net change in unrealized loss on
    available-for-sale investments |                                    |           |             |   |             |        |         |   |             |            |              |   |         |         |       |   |   |   |  |   |   |   |  |   |   |          | (23 | )       |   |         | (23 | )      
|                                                                                                           |                                                                     | Total comprehensive loss           |           |              |  |             |        |          |  |             |            |               |  |         |         |        |  |   |   |   |  |   |   |   |  |   |          |     | (25,993 | ) |         |     | (25,993 | )
|                                                                                                           |                                                                     |                                    |           |              |   |             |        |          |   |             |            |               |   |         |         |        |   |   |   |   |   |   |   |   |   |   |          |     |         |   |         |    
|Balances at December 31, 2003                                                                              |                                                                     |                                    | 1,544,626 |              |   | $           | 23,669 |          |   |             | 62,751,196 |               |   | $       | 268,406 |        |   | $ | 0 |   |   | $ | 0 |   |   | $ | (215,436 | )   |         | $ | 52,970  |    
|                                                                                                           |                                                                     |                                    |           |              |   |             |        |          |   |             |            |               |   |         |         |        |   |   |   |   |   |   |   |   |   |   |          |     |         |   |         |    

See accompanying notes.

41



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##### Table of Contents



ARADIGM CORPORATION

STATEMENTS OF CASH FLOWS

|                                                                                |                                                           |                          |         |       |        |      |         |       |        |   |         |        |        |  
|------------------------------------------------------------------------------- | --------------------------------------------------------- | ------------------------ | ------- | ----- | ------ | ---- | ------- | ----- | ------ | - | ------- | ------ | ------ | -
|                                                                                |                                                           |                         
|                                                                                |                                                           | Years Ended December 31,
|                                                                                |                                                           |                         
|                                                                                |                                                           | 2003                     |         | 2002  |        | 2001
|                                                                                |                                                           |                          |         |       |        |     
|                                                                                |                                                           |                         
|                                                                                |                                                           | (In thousands)          
|Cash flows from operating activities:                                           |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Net loss                                                                        |                                                           | $                        | (25,970 | )     |        | $    | (35,931 | )     |        | $ | (32,357 | )     
|Adjustments to reconcile net loss to net cash
    used in operating activities: |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|                                                                                | Depreciation and amortization                             |                          |         | 5,983 |        |      |         | 5,749 |        |   |         | 4,500  |       
|                                                                                | Other income related to forgiveness of Genentech
    note |                          |         |      |        |      |         |      |        |   |         | (6,675 | )     
|                                                                                | Retirement of capital assets                              |                          |         |      |        |      |         | 114   |        |   |         |       |       
|                                                                                | Issuance of warrants and common stock for services        |                          |         | 116   |        |      |         | 11    |        |   |         | 48     |       
|                                                                                | Amortization of deferred compensation                     |                          |         |      |        |      |         | 54    |        |   |         | 162    |       
|                                                                                | Changes in operating assets and liabilities:              |                          |         |       |        |      |         |       |        |   |         |        |       
|                                                                                |                                                           | Receivables              |         |       | 142    |      |         |       | 1,067  |   |         |        | (1,279 | )
|                                                                                |                                                           | Other current assets     |         |       | (454   | )    |         |       | (645   | ) |         |        | (77    | )
|                                                                                |                                                           | Other assets             |         |       | 21     |      |         |       | 121    |   |         |        | 213    |  
|                                                                                |                                                           | Accounts payable         |         |       | (1,066 | )    |         |       | (3,346 | ) |         |        | 403    |  
|                                                                                |                                                           | Accrued compensation     |         |       | (174   | )    |         |       | 434    |   |         |        | 515    |  
|                                                                                |                                                           | Accrued liabilities      |         |       | 294    |      |         |       | (2,765 | ) |         |        | 375    |  
|                                                                                |                                                           | Deferred rent            |         |       | 215    |      |         |       | 808    |   |         |        | 300    |  
|                                                                                |                                                           | Deferred revenue         |         |       | (3,921 | )    |         |       | 3,410  |   |         |        | 4,788  |  
|                                                                                |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Net cash used in operating activities                                           |                                                           |                          | (24,814 | )     |        |      | (30,919 | )     |        |   | (29,084 | )     
|                                                                                |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Cash flows from investing activities:                                           |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Capital expenditures                                                            |                                                           |                          | (5,362  | )     |        |      | (11,157 | )     |        |   | (37,117 | )     
|Purchases of available-for-sale investments                                     |                                                           |                          | (9,962  | )     |        |      | (12,105 | )     |        |   | (5,732  | )     
|Proceeds from maturities of available-for-sale
    investments                  |                                                           |                          | 7,139   |       |        |      | 4,685   |       |        |   | 28,167  |       
|                                                                                |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Net cash used in investing activities                                           |                                                           |                          | (8,185  | )     |        |      | (18,577 | )     |        |   | (14,682 | )     
|                                                                                |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Cash flows from financing activities:                                           |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Proceeds from issuance of common stock, net                                     |                                                           |                          | 30,441  |       |        |      | 6,104   |       |        |   | 50,671  |       
|Proceeds from issuance of redeemable convertible
    preferred stock, net       |                                                           |                          |        |       |        |      | (70     | )     |        |   | 45,459  |       
|Proceeds from repayments of shareholder notes                                   |                                                           |                          |        |       |        |      |        |       |        |   | 131     |       
|Notes receivable from officers and employees                                    |                                                           |                          | (93     | )     |        |      |        |       |        |   | (186    | )     
|Payments on capital lease obligations and
    equipment loans                   |                                                           |                          | (1,822  | )     |        |      | (3,703  | )     |        |   | (3,076  | )     
|                                                                                |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Net cash provided by financing activities                                       |                                                           |                          | 28,526  |       |        |      | 2,331   |       |        |   | 92,999  |       
|                                                                                |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Net (decrease) increase in cash and cash
    equivalents                        |                                                           |                          | (4,473  | )     |        |      | (47,165 | )     |        |   | 49,233  |       
|Cash and cash equivalents at beginning of year                                  |                                                           |                          | 22,800  |       |        |      | 69,965  |       |        |   | 20,732  |       
|                                                                                |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Cash and cash equivalents at end of year                                        |                                                           | $                        | 18,327  |       |        | $    | 22,800  |       |        | $ | 69,965  |       
|                                                                                |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Supplemental disclosure of cash flow information:                               |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|                                                                                | Cash paid for interest                                    |                          | $       | 126   |        |      | $       | 499   |        |   | $       | 899    |       
|                                                                                |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Non-cash investing and financing activities:                                    |                                                           |                          |         |       |        |      |         |       |        |   |         |       
|Issuance of options and warrants to purchase
    common stock for services      |                                                           | $                        | 116     |       |        | $    | 11      |       |        | $ | 48      |       
|Issuance of common stock through conversion of
    Series A preferred stock     |                                                           |                          | 6,996   |       |        |      |        |       |        |   |        |       
|Issuance of warrants in conjunction with private
    placement of common stock  |                                                           | $                        | 5,657   |       |        | $    |        |       |        | $ | 979     |       
|Redeemable convertible preferred stock deemed,
    non-cash dividend            |                                                           | $                        |        |       |        | $    |        |       |        | $ | 10,722  |       

See accompanying notes.

42



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##### Table of Contents



ARADIGM CORPORATION

NOTES TO FINANCIAL STATEMENTS



|   |                                               
|-- | ----------------------------------------------
|1. | Summary of Significant Accounting
    Policies



| |                                           
| | ------------------------------------------
| | Organization and Basis of
    Presentation

Aradigm Corporation (the Company) is
a California corporation engaged in the development and
commercialization of non-invasive drug delivery systems.
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. The Company does
not anticipate receiving any revenue from the sale of products
in the upcoming year. 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. The
Company operates as a sole operating segment.



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

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



| |                          
| | -------------------------
| | Cash and Cash Equivalents

The Company considers all highly liquid
investments purchased with an original maturity of three months
or less to be cash equivalents. The Company places its cash and
cash equivalents in money market funds, commercial paper,
corporate notes and market auction preferreds.



| |            
| | -----------
| | Investments

Management determines the appropriate
classification of the Companys marketable securities,
which consist solely of debt securities, at the time of purchase
and re-evaluates such designation at each balance sheet date.
All marketable securities are classified as available-for-sale,
carried at estimated fair value and reported in either cash
equivalents or short-term investments. Unrealized gains and
losses on available-for-sale securities are excluded from
earnings and reported as a separate component of the statements
of redeemable convertible preferred stock and shareholders
equity until realized. Fair values of investments are based on
quoted market prices where available. Interest income is
recognized when earned and includes interest, dividends,
amortization of purchase premiums and discounts, and realized
gains and losses on sales of securities. The cost of securities
sold is based on the specific identification method. The Company
regularly reviews all of its investments for
other-than-temporary declines in fair value. When we determine
that the decline in fair value of an investment below our
accounting basis is other-than-temporary, the Company reduces
the carrying value of the securities held and records a loss in
the amount of any such decline. No such reductions have been
required during the past three years.



| |                 
| | ----------------
| | Notes Receivable

Notes receivable are related to advances granted
to employees for relocation. All amounts classified as current
are due within 12 months. All amounts classified as
long-term are due no later than April 2008. All balances are
believed to be collectible and are stated at approximate fair
value at December 31, 2003.



| |                              
| | -----------------------------
| | Depreciation and Amortization

The Company records property and equipment at
cost and calculates depreciation using the straight-line method
over the estimated useful lives of the respective assets.
Leasehold improvements are amortized over

43



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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

the shorter of the term of the lease or useful
life of the improvement. Amortization expense for assets
acquired under capital lease is included with depreciation
expense.

The estimated useful lives of property and
equipment are as follows:

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



| |                  
| | -----------------
| | Long-Lived Assets

In accordance with Statement of Financial
Accounting Standards (SFAS) No. 144, Accounting for
the Impairment or Disposal of Long-Lived Assets, the
Company reviews for impairment whenever events or changes in
circumstances indicate that the carrying amount of property and
equipment may not be recoverable. Determination of
recoverability is based on an estimate of undiscounted future
cash flows resulting from the use of the asset and its eventual
disposition. In the event that such cash flows are not expected
to be sufficient to recover the carrying amount of the assets,
the assets are written down to their estimated fair values and
the loss is recognized on the Statements of Operations.



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

Contract revenues consist of revenue from
collaboration agreements and feasibility studies the Agreements.
The Company recognizes its revenue under the provisions of the
Securities and Exchange Commission issued Staff Accounting
Bulletin No. 104 (SAB 104), Revenue
Recognition. Under the agreements, revenue is recognized
at the lesser of actual earned reimbursements received or
reimbursable costs incurred. Deferred revenue represents the
portion of all refundable and nonrefundable research payments
received that have not been earned. In accordance with contract
terms, milestone payments from collaborative research agreements
are considered reimbursements for costs incurred under the
agreements and, accordingly, are generally recognized as revenue
either upon the completion of the milestone effort when payments
are contingent upon completion of the effort or are based on
actual efforts expended over the remaining term of the
agreements when payments precede the required efforts. Costs of
contract revenues approximate such revenue and are included in
research and development expenses. Refundable development and
license fee payments are deferred until the specified
performance criteria are achieved at which time they generally
cease to be refundable.



| |                         
| | ------------------------
| | Research and Development

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



| |            
| | -----------
| | Advertising

Advertising costs are charged to sales and
marketing expense as incurred and were immaterial in all periods
presented.

44



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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)



| |                         
| | ------------------------
| | Stock Based Compensation

The Company has elected to follow Accounting
Principles Board Opinion No. (APB) 25, Accounting for
Stock Issued to Employees, and related interpretations in
accounting for its employee stock options. Compensation expense
is based on the difference, if any, between the fair value of
the Companys common stock and the exercise price of the
option or share right on the measurement date, which is
typically the date of grant. This amount is recorded as
Deferred stock compensation in the Balance Sheets
and amortized as a charge to operations over the vesting period
of the applicable options or share rights. In accordance with
SFAS 123, Accounting for Stock-Based
Compensation, as amended by SFAS 148,
Accounting for Stock-Based Compensation 
Transition and Disclosure, the Company has provided,
below, the pro forma disclosures of the effect on net loss and
loss per share as if SFAS 123 had been applied in measuring
compensation expense for all periods presented (in thousands,
except per share data).

|                                                                             |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |        |  
|---------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | ------------------------ | ------- | ------ | - | ---- | ------- | ------ | - | - | ------- | ------ | -
|                                                                             |                                                                                                             |                         
|                                                                             |                                                                                                             | Years Ended December 31,
|                                                                             |                                                                                                             |                         
|                                                                             |                                                                                                             | 2003                     |         | 2002   |   | 2001
|                                                                             |                                                                                                             |                          |         |        |   |     
|Net loss applicable to common
    shareholders  as reported                 |                                                                                                             | $                        | (25,970 | )      |   | $    | (35,931 | )      |   | $ | (43,079 | )     
|Add:                                                                         |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |       
|                                                                             | Stock-based employee compensation expense
    included in reported net income                               |                          |         |       |   |      |         | 54     |   |   |         | 162    |  
|Less:                                                                        |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |       
|                                                                             | Total stock-based employee compensation expense
    determined under fair value based method for all awards |                          |         | (5,400 | ) |      |         | (7,455 | ) |   |         | (6,397 | )
|                                                                             |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |       
|Pro forma net loss applicable to common
    shareholders                     |                                                                                                             | $                        | (31,370 | )      |   | $    | (43,332 | )      |   | $ | (49,314 | )     
|                                                                             |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |       
|Basic and diluted net loss per share applicable
    to common shareholders  |                                                                                                             |                          |         |        |   |      |         |        |   |   |         |       
|                                                                             | As reported                                                                                                 |                          | $       | (0.52  | ) |      | $       | (1.19  | ) |   | $       | (1.98  | )
|                                                                             | Pro forma                                                                                                   |                          | $       | (0.62  | ) |      | $       | (1.43  | ) |   | $       | (2.26  | )

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 using 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 2.5%, 3.9%, and 4.2% for the years ended
December 31, 2003, 2002 and 2001, respectively; a dividend
yield of 0.0%; the annual volatility factor of the expected
market price of the Companys common stock for 2003, 2002
and 2001 are 98.0%, 87.0%, and 87.0% respectively; and a
weighted average expected option life of four years. The
weighted average fair value of options granted during 2003, 2002
and 2001 with an exercise price equal to the fair value of the
Companys common stock on the date of grant was $0.75,
$2.67 and $3.59, respectively. Additionally, the weighted
average fair value of options granted during 2003 with an
exercise price greater than the fair value of the Companys
common stock on the day of grant was $1.41.

The Company accounts for options and warrants
issued to non-employees under SFAS 123 and Emerging Issues
Task Force Issue No. (EITF) 96-18, Accounting for Equity
Instruments that are Issued to Other than Employees for
Acquiring, or in Conjunction with Selling, Goods or
Services, using the Black-Scholes option pricing model.
The value of options and warrants are periodically remeasured
over their vesting terms.

45



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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)



| |             
| | ------------
| | Income Taxes

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



| |                   
| | ------------------
| | Net Loss Per Share

Historical net loss per share has been calculated
under SFAS 128, Earnings Per Share. Basic net
loss per share on a historical basis is computed using the
weighted-average number of shares of common stock outstanding
less the weighted-average number of shares subject to
repurchase. There were no shares subject to repurchase in the
years ended December 31, 2003, 2002 and 2001. No diluted
loss per share information has been presented in the
accompanying statements of operations since potential common
shares from stock options, warrants and redeemable convertible
preferred stocks are antidilutive. For the years ended
December 31, 2003, 2002 and 2001, the total number of
shares excluded from diluted loss per share relating to these
securities was 11,396,269, 8,283,600 and 10,038,525 shares,
respectively.



| |                       
| | ----------------------
| | Employee Benefit Plans

The Company has a 401(k) Plan which stipulates
that all full-time employees with at least three months of
employment can elect to contribute to the 401(k) Plan, subject
to certain limitations, up to 20% of salary on a pretax basis.
Subject to a maximum dollar match contribution of
$5,250 per year, the Company will match 50% of the first 6%
of the employees contribution on a pretax basis. The
Company expensed total employer matching contributions of
$483,000, $527,000 and $273,000 in 2003, 2002 and 2001,
respectively



| |                           
| | --------------------------
| | Significant Concentrations

Financial instruments that potentially subject
the Company to concentrations of credit risk consist primarily
of cash, cash equivalents and short-term investments. Risks
associated with these instruments are mitigated by banking with
and only purchasing commercial paper from creditworthy
institutions. The maximum amount of loss due to credit risk
associated with these financial instruments are their respective
fair values as stated in the Balance Sheet.

Although the Company has had development
arrangements with other collaborative partners, the arrangement
with Novo Nordisk A/S is its only active, funded development
agreement. For the year ended December 31, 2003, this
partner-funded program contributed approximately 99% of total
contract revenues. The agreement with Novo Nordisk A/S can be
terminated under certain conditions, including by either party
on limited written notice, by Novo Nordisk A/S by limited prior
written notice upon the occurrence of certain events, and by
either party upon a thirty day written notice in the event that
the other party commits a material breach under the agreement
and fails to remedy such breach within the sixty days
notice of such breach. Novo Nordisk A/S, a publicly traded
Danish company, is considered to be a related party due to its
ownership interest in the Company.



| |                            
| | ---------------------------
| | Comprehensive Income (Loss)

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

46



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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)



| |                                     
| | ------------------------------------
| | Changes in Accounting
    Principles

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



| |                                     
| | ------------------------------------
| | Recent Accounting
    Pronouncements

In May 2003, the Emerging Issues Task Force
(EITF) reached a consensus on EITF Issue No. 00-21,
Revenue Arrangements with Multiple Deliverables.
EITF 00-21 addresses certain aspects of the accounting by a
vendor for arrangements under which it will perform multiple
revenue-generating activities. In some arrangements, the
different revenue-generating activities (deliverables) are
sufficiently separable and there exists sufficient evidence of
their fair values to separately account for some or all of the
deliverables (that is, there are separate units of accounting).
In other arrangements, some or all of the deliverables are not
independently functional, or there is not sufficient evidence of
their fair values to account for them separately. This Issue
addresses when and how an arrangement involving multiple
deliverables should be divided into separate units of
accounting. EITF 00-21 does not change otherwise applicable
revenue recognition criteria. The guidance in this Issue is
effective for revenue arrangements entered into in fiscal
periods beginning after June 15, 2003. The adoption of
EITF 00-21 did not have a material effect on the financial
statements.

In January 2003, the FASB issued Interpretation
No. 46, Consolidation of Variable Interest
Entities (FIN 46) which was revised in December 2003.
FIN 46, as revised, requires a variable interest entity to
be consolidated by a company if that company is subject to a
majority of the risk of loss from the variable interest
entitys activities or entitled to receive a majority of
the entitys residual returns or both. A variable interest
entity is a corporation, partnership, trust, or any other legal
structures used for business purposes that either (a) does
not have equity investors with voting rights or (b) has
equity investors that do not provide sufficient financial
resources for the entity to support its activities. The
consolidation requirements of FIN 46 apply immediately to
variable interest entities created after January 31, 2003.
The consolidation requirements apply to older entities in the
first fiscal year or interim period ending after March 15,
2004. Certain of the disclosure requirements apply to all
financial statements issued after January 31, 2003,
regardless of when the variable interest entity was established.
The Company has evaluated the impact of FIN 46 and does not
believe implementation will have a significant effect on its
reported financial position or results.



| |                  
| | -----------------
| | Reclassifications

Certain reclassifications of prior year amounts
have been made to conform with current year presentation.
Specifically, the Company reclassified long term investments to
short term as all investments are recorded as available for sale.

47



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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)



|   |                      
|-- | ---------------------
|2. | Financial Instruments



| |                                     
| | ------------------------------------
| | Cash Equivalents and
    Investments

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

|                        |                                |              |        |        |  |   |        |        | 
|----------------------- | ------------------------------ | ------------ | ------ | ------ |  | - | ------ | ------ | 
|                        |                                |             
|                        |                                | December 31,
|                        |                                |             
|                        |                                | 2003         |        | 2002  
|                        |                                |              |        |       
|Cash equivalents:       |                                |              |        |        |  |   |        |       
|                        | Money market fund              |              | $      | 604    |  |   | $      | 4,953  | 
|                        | Commercial paper               |              |        | 17,723 |  |   |        | 17,796 | 
|                        |                                |              |        |        |  |   |        |       
|                        |                                | $            | 18,327 |        |  | $ | 22,749 |       
|                        |                                |              |        |        |  |   |        |       
|Short-term investments: |                                |              |        |        |  |   |        |       
|                        | Commercial paper               |              | $      | 5,522  |  |   |        |       | 
|                        | Corporate and Government notes |              |        | 5,921  |  |   | $      | 6,143  | 
|                        | Market auction preferreds      |              |        |       |  |   |        | 2,500  | 
|                        |                                |              |        |        |  |   |        |       
|                        |                                | $            | 11,443 |        |  | $ | 8,643  |       
|                        |                                |              |        |        |  |   |        |       

|                                                         |                                    |              |        |       |  |   |       |       | 
|-------------------------------------------------------- | ---------------------------------- | ------------ | ------ | ----- |  | - | ----- | ----- | 
|                                                         |                                    |             
|                                                         |                                    | December 31,
|                                                         |                                    |             
|                                                         |                                    | 2003         |        | 2002 
|                                                         |                                    |              |        |      
|Short Term investments:                                  |                                    |              |        |       |  |   |       |      
|Investments maturing in 90 days to less than
    1 year: |                                    |              |        |       |  |   |       |      
|                                                         | Commercial paper                   |              | $      | 5,522 |  |   | $     |       | 
|                                                         | Market auction preferred           |              |        |       |  |   |       | 2,500 | 
|                                                         | Corporate notes                    |              |        | 1,017 |  |   |       | 2,566 | 
|                                                         | Foreign debt securities            |              |        | 337   |  |   |       |       | 
|                                                         | US government agencies             |              |        | 2,080 |  |   |       |       | 
|                                                         |                                    |              |        |       |  |   |       |      
|                                                         | Total maturing in less than 1 year |              | $      | 8,956 |  |   | $     | 5,066 | 
|                                                         |                                    |              |        |       |  |   |       |      
|Investments maturing in 1 to 2 years:                    |                                    |              |        |       |  |   |       |      
|                                                         | Corporate notes                    |              | $      | 1,507 |  |   | $     | 3,577 | 
|                                                         | US government agencies             |              |        | 980   |  |   |       |       | 
|                                                         |                                    |              |        |       |  |   |       |      
|Total maturing in 1 to 2 years                           |                                    |              | 2,487  |       |  |   | 3,577 |      
|Total short term investments                             |                                    | $            | 11,443 |       |  | $ | 8,643 |      
|                                                         |                                    |              |        |       |  |   |       |      

As of December 31, 2003 and 2002, the
difference between the fair value and the amortized cost of
available-for-sale securities was $2,000 loss for 2003 and
$21,000 gain for 2002. Realized gains and losses on sales of
available-for-sale investments during the years ended
December 31, 2001, 2002 and 2003 were insignificant.

48



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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)



|   |                       
|-- | ----------------------
|3. | Property and Equipment

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

|                                               |  |              |         |      |  |   |         |  
|---------------------------------------------- |  | ------------ | ------- | ---- |  | - | ------- | -
|                                               |  |             
|                                               |  | December 31,
|                                               |  |             
|                                               |  | 2003         |         | 2002
|                                               |  |              |         |     
|Machinery and equipment                        |  | $            | 18,336  |      |  | $ | 17,807  |  
|Furniture and fixtures                         |  |              | 1,903   |      |  |   | 1,862   |  
|Lab equipment                                  |  |              | 4,050   |      |  |   | 3,986   |  
|Computer equipment and software                |  |              | 6,068   |      |  |   | 5,654   |  
|Leasehold improvements                         |  |              | 12,176  |      |  |   | 11,600  |  
|                                               |  |              |         |      |  |   |         |  
|                                               |  |              | 42,533  |      |  |   | 40,909  |  
|Less accumulated depreciation and amortization |  |              | (23,927 | )    |  |   | (17,944 | )
|                                               |  |              |         |      |  |   |         |  
|                                               |  |              | 18,606  |      |  |   | 22,965  |  
|Construction in progress                       |  |              | 44,006  |      |  |   | 40,268  |  
|                                               |  |              |         |      |  |   |         |  
|Property and equipment, net                    |  | $            | 62,612  |      |  | $ | 63,233  |  
|                                               |  |              |         |      |  |   |         |  

At December 31, 2003 and 2002, property and
equipment include assets under capitalized leases of
approximately $2,068,000 and $11,936,000, respectively.
Accumulated depreciation related to leased assets at
December 31, 2003 and 2002, was approximately $1,534,000
and $9,377,000, respectively.



|   |                                          
|-- | -----------------------------------------
|4. | Leases, Commitments and
    Contingencies

Amounts borrowed under the Companys
equipment lease lines of credit bear interest at rates ranging
from 9.8% to 14.6% and are collateralized by the related
equipment. Under the terms of the lease agreements, the Company
has the option to purchase the leased equipment at a negotiated
price at the end of each lease term. The Company leases its
office, laboratory and manufacturing facilities under several
operating leases expiring through the year 2016. Future minimum
lease payments under noncancelable operating and capital leases
at December 31, 2003 are as follows (amounts in thousands):

|                                                |  |           |        |         |  |   |      |  
|----------------------------------------------- |  | --------- | ------ | ------- |  | - | ---- | -
|                                                |  | Operating |        | Capital
|                                                |  | Leases    |        | Leases 
|                                                |  |           |        |        
|Years ending December 31:                       |  |           |        |         |  |   |      |  
|2004                                            |  | $         | 5,334  |         |  | $ | 513  |  
|2005                                            |  |           | 5,499  |         |  |   |     |  
|2006                                            |  |           | 4,775  |         |  |   |     |  
|2007                                            |  |           | 4,652  |         |  |   |     |  
|2008                                            |  |           | 4,811  |         |  |   |     |  
|2009 and thereafter                             |  |           | 33,363 |         |  |   |     |  
|                                                |  |           |        |         |  |   |      |  
|Total minimum lease payments                    |  | $         | 58,434 |         |  |   | 513  |  
|                                                |  |           |        |         |  |   |      |  
|Less amount representing interest               |  |           |        |         |  |   | (86  | )
|                                                |  |           |        |         |  |   |      |  
|Present value of future lease payments          |  |           |        |         |  |   | 427  |  
|Current portion of capital lease obligations    |  |           |        |         |  |   | (427 | )
|                                                |  |           |        |         |  |   |      |  
|Noncurrent portion of capital lease obligations |  |           |        |         |  | $ |     |  
|                                                |  |           |        |         |  |   |      |  

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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

Certain of the Companys operating leases
have rent escalation clauses and accordingly, the Company
recognizes rent expense on a straight-line basis. At
December 31, 2003, the Company had $1,323,000 of deferred
rent.

For the years ended December 31, 2003, 2002
and 2001, rent expense under operating leases totaled
$5,401,000, $5,898,000, and $5,476,000, respectively.

At December 31, 2003, the Company had
contractual non-cancelable purchase commitments of $894,000
related to capital equipment purchases.

Indemnification

The Company from time to time enters into
contracts that contingently require the Company to indemnify
parties against third party claims. These contracts primarily
relate to: (i) real estate leases, under which the Company
may be required to indemnify property owners for environmental
and other liabilities, and other claims arising from the
Companys use of the applicable premises, and
(ii) agreements with the Companys officers, directors
and employees, under which the Company may be required to
indemnify such persons from certain liabilities arising out of
such persons relationships with the company. To date, the
Company has made no payments related to such indemnifications
and no liabilities have been recorded for these obligations on
the balance sheets as of December 31, 2003 or 2002.

Legal Matters

From time to time, the Company is involved in
litigation arising out of the ordinary course of its business.
There are no known claims or pending litigation expected to have
a material effect on the Companys overall financial
position, results of operations, or liquidity.



|   |                                                                     
|-- | --------------------------------------------------------------------
|5. | Redeemable Convertible Preferred Stock and
    Common Stock Warrants

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

In March, June and July 2003, certain holders of
shares of the preferred stock elected to convert an aggregate of
456,610 shares of preferred stock to common stock. The
Company issued 1,826,440 shares of common stock in
connection with the conversion.

Through December 2003, the preferred stock is
entitled to cumulative dividends, which shall accrue at an
annual rate of 6%, payable only when and if declared by the
Board of Directors. At the option of the Company, dividends may
be paid in either cash or in shares of common stock, which will
be valued at a price equal to the then current market price. The
current market price of the common stock on any dividend payment
date shall be based on the closing price of the Companys
common stock as quoted on the Nasdaq Stock Market. There were no
dividends declared as of December 31, 2003.

The conversion rate of the preferred stock is
fixed and not subject to any adjustments except for stock
splits, stock dividends, combinations, reorganizations, mergers
or other similar events. Each share of outstanding preferred
stock will automatically convert into common stock upon either
the closing of a registered underwritten public offering
covering the offer and sale of common stock with gross proceeds
to the

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

Company exceeding $25 million or the date on
which the common stock closing bid price has been above
$10.59 per share for at least twenty consecutive trading
days.

Upon any liquidation, dissolution, redemption or
winding up of the Company, whether voluntary or involuntary, the
holders of outstanding preferred stock will be entitled to a
liquidation preference, equal to the original issue price plus
all accrued and unpaid dividends (as adjusted for any stock
dividends, combinations, splits, recapitalizations and other
similar events) to the preferred holders. Any remaining assets
will be available for distribution to holders of common stock.
Each holder of preferred stock shall have a number of votes
equal to the number of shares of common stock issuable upon
conversion of such holders shares of preferred stock and
shall have voting rights and powers equal to the voting rights
and powers of the Companys common stock. At
December 31, 2003 the total liquidation preference of all
outstanding preferred stock was approximately $37,380,000.



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

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

The preferred stock agreement provides that a
mandatory redemption is triggered if a change in control occurs.
Accordingly, in accordance with EITF D-98,
Classification and Measurement of Redeemable
Securities, which clarifies Rule #5-02.28 of
Regulation S-X previously adopted in accounting series
Release No. 268, Presentation in Financial Statements
of Redeemable Preferred Stock, the Company has classified
the preferred stock outside of permanent equity.



|   |                     
|-- | --------------------
|6. | Shareholders Equity

In November 2003 the Company issued
7,780,550 shares of common stock at $1.80 per share
and warrants to purchase 1,945,133 shares of common stock
at $2.50 per share to certain investors for an aggregate
purchase price of approximately $14.0 million in a private
placement. The warrants are exercisable at the election of the
warrant holders for a four-year term. The Company valued the
warrants using the Black-Scholes option pricing model using the
following assumptions: estimated volatility of 88%, risk-free
interest rate of 2.5%, no dividend yield, and an expected life
of 4 years, and recorded approximately $2,647,511 as
issuance costs related to the private placement. These warrants
are exercisable through November 2007.

In March 2003, the Company issued
18,992,391 shares of common stock at $0.79 per share
and warrants to purchase 4,273,272 shares of the common
stock at $1.07 per share to certain investors for an
aggregate purchase price of approximately $15.0 million in
a private placement. The warrants are exercisable at the
election of the warrant holders for a four-year term. The
Company valued the warrants using the Black-Scholes option
pricing model using the following assumptions: estimated
volatility of 84%, risk-free interest rate of 2.5%, no dividend
yield, and an expected life of 4 years, and recorded
approximately $1,882,733 as issuance costs related to the
private placement. In addition, in connection with this private
placement, the

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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

Company issued warrants (replacement
warrants) to purchase an aggregate of
4,016,024 shares of its common stock at $1.12 per
share to certain of the investors in the private placement in
exchange for the cancellation of an equal number of warrants to
purchase shares of the common stock at $6.97 per share,
held by the same investors. The Company valued the replacement
warrants using the Black-Scholes option pricing model using the
following assumptions: estimated volatility of 84%, risk-free
interest rate of 2.5%, no dividend yield, and an expected life
of 3.8 years, and recorded an additional $1,126,855 as
issuance costs related to the private placement. These warrants
are exercisable through March 2007.

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

In February 2002, the Company filed a Certificate
of Amendment to the Companys amended and restated Articles
of Incorporation with the Secretary of State of the State of
California to increase the Companys authorized number of
shares of common stock from 40,000,000 to
100,000,000 shares. The additional shares of common stock
authorized by the amendment have rights identical to the common
stock of the Company outstanding immediately before the filing
of the amendment. Issuances of common stock from the additional
authorized shares do not affect the rights of the holders of the
Companys common stock and preferred stock outstanding
immediately before the filing of the amendment, except for
effects that may be incidental to increasing the number of
shares of the Companys common stock outstanding, such as
dilution of the earnings per share and voting rights of holders
of other common stock.

In October 2001, the Company entered into a
common stock purchase agreement with Novo Nordisk
Pharmaceuticals. Under the terms of the agreement, Novo Nordisk
Pharmaceuticals committed to purchase up to $45 million of
the Companys common stock, of which 5,665,723 shares
for $3.53 per share, were purchased for a total purchase
price of $20 million, 10 business days after the
effective date of the agreement. The number of initial shares
was calculated by dividing the initial purchase price by the
average of the closing prices of the Companys common stock
on the Nasdaq for the thirty trading days immediately prior to
the effective date. Pursuant to the terms of the agreement, the
Company may elect to sell at its option, subject to certain
conditions, between $5 million and $10 million of
additional shares to Novo Nordisk Pharmaceuticals once every
three months beginning December 1, 2001 until the remaining
$25 million has been invested. The number of additional
shares shall be calculated by dividing the additional purchase
price by the average closing price of the Companys common
stock on the Nasdaq for the 30 trading days immediately
prior to the date of written notice by the Company to Novo
Nordisk Pharmaceuticals. Novo Nordisk Pharmaceuticals will hold
the shares to be purchased under the agreement for at least two
years from the effective date of each purchase, subject to
certain conditions.

In August 2001, the Company completed a private
placement of shares of common stock for gross proceeds of
$14.6 million to a group of institutional investors. Under
the terms of the private placement, the Company sold
3,639,316 shares of common stock at a price of
$4.00 per share. The Company also issued warrants in
connection with the private placement of common stock that
entitles investors to purchase 363,929 shares of common
stock at an exercise price of $5.41 per share or a 15%
premium to the Nasdaq National Market price on the closing date.
The Company valued the warrants using the Black-Scholes option
pricing model using the following assumptions: estimated
volatility of 78%, risk-free interest rate of 6.2%, no dividend
yield, and an expected life of four years, and recorded
approximately $978,969 as issuance costs related to the private
placement. These warrants are exercisable through
August 21, 2005.

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

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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

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



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

At December 31, 2003, the Company had
9,456,531 shares of its common stock reserved for issuance
upon exercise of common stock warrants, 9,482,344 shares
reserved for issuance upon exercise of options under all plans,
6,178,504 shares reserved for issuance upon conversion of
preferred stock and 1,570,186 available authorized shares under
the Employee Stock Purchase Plan.



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

During 2003 the Company received net proceeds of
approximately $2.6 million and issued an aggregate of
2,414,050 shares of common stock in connection with the
exercise of warrants.

In March 2003, the Company issued warrants in
connection with a financial relations service agreement that
entitles the holder to purchase 25,000 shares of common
stock which are exercisable at $0.83 per share and vests
over the 48 month service period of which 4,688 shares
vested during the year ended December 31, 2003. The Company
valued the warrants using the Black-Scholes option pricing model
using the following assumptions: estimated volatility of 84%,
risk-free interest rate of 2.5%, no dividend yield, and an
expected life of four years. The fair value of these warrants is
re-measured as the underlying warrants vest and is being
expensed over the vesting period of the warrants. For the year
ended December 31, 2003 the Company recorded $3,000 of
expense in connection with these warrants. These warrants are
exercisable through March 2008.

In October 2002, the Company issued warrants in
connection with a financial relations service agreement that
entitles the holder to purchase 75,000 shares of common
stock, 25,000 of which are exercisable at $1.99 per share,
25,000 shares of which are exercisable at $2.39 per
share and 25,000 shares of which are exercisable at
$2.79 per share. At the execution of the agreement
15,000 shares vested and the remaining shares shall vest
based on the achievement of various performance benchmarks set
forth in the agreement. The Company valued the warrants using
the Black-Scholes option pricing model using the following
assumptions: estimated volatility of 84%, risk-free interest
rate of 2.5%, no dividend yield, and an expected life of
5 years. The fair value of these warrants is re-measured as
the underlying warrants vest and is being expensed over the
vesting period of the warrants. For the year ended
December 31, 2003 the Company recognized $77,000 of expense
in connection with these warrants. The warrants are exercisable
through October 2007.



| |                                                                     
| | --------------------------------------------------------------------
| | 1996 Equity Incentive Plan and 1996
    Non-Employee Directors 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. The original
plan reserved 4.8 million shares for future authorization.
In May 2003, the Board approved an amendment to the 1996 Plan,
to increase the maximum number of shares available for issuance
under the evergreen feature of the 1996 Plan by 2.0 million
shares to 10.0 million. The aggregate reserved for
authorization is 14.8 million. As of December 31,
2003, the Company had 10,779,323 shares of common stock
authorized for issuance under the Plan. Options granted under
the Plan expire no later than 10 years from the date of
grant. Options granted under the Plan may be either incentive or
non-statutory stock options. 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

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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

combined voting power of all classes of stock of
the Company, the option price shall be at least 110% of the fair
value and shall not be exercisable more than five years after
the date of grant. During May 2001, the Companys
shareholders approved an amendment to the Plan to include an
evergreen provision. The evergreen provision will automatically
increase the number of shares reserved under the Plan, subject
to certain limitations, by 6% of the issued and outstanding
Common Stock of the Company or such lesser number of shares as
determined by the Board of Directors on the date of the annual
meeting of shareholders of each fiscal year beginning 2001 and
ending 2005.

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, 2003 and 2002, there were no outstanding notes
receivable from shareholders. Any unvested stock issued is
subject to repurchase agreements whereby the Company has the
option to repurchase unvested shares upon termination of
employment at the original issue price. The common stock has
voting rights but does not have resale rights prior to vesting.
The Company has repurchased a total of 38,294 shares in
accordance with these agreements. During 2003, the Company
granted options to purchase 1,812,750 shares of common
stock, none of which were exercised subject to repurchase
agreements.

The 1996 Non-Employee Directors Stock
Option Plan (the Directors Plan) had
225,000 shares of common stock authorized for issuance.
Options granted under the Directors Plan expire no later
than ten years from date of grant. The option price shall be at
100% of the fair value on the date of grant as determined by the
Board of Directors. The options generally vest quarterly over a
period of one year. During 2000, the Board of Directors approved
the termination of the Directors Plan. No more options can
be granted under the plan after its termination. The termination
of the Directors Plan will have no effect on the options
already outstanding. There was no activity in the
Directors Plan during the year ended December 31 2003
and as of December 31, 2003, 105,924 outstanding options
with exercise prices ranging from $8.25-$24.13 remained with no
additional shares available for grant.

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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

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

|                             |                    |                      |           |            |   |                 |           |                  |   |  |              |              |  |   |       |       | 
|---------------------------- | ------------------ | -------------------- | --------- | ---------- | - | --------------- | --------- | ---------------- | - |  | ------------ | ------------ |  | - | ----- | ----- | 
|                             |                    |                     
|                             |                    | Options Outstanding 
|                             |                    |                     
|                             |                    | Shares Available for |           | Number of  |   |                 |           | Weighted Average
|                             |                    | Grant of Options     |           | Shares     |   | Price Per Share |           | Exercise Price  
|                             |                    |                      |           |            |   |                 |           |                 
|Balance at December 31, 2000 |                    |                      | 742,293   |            |   |                 | 2,848,902 |                  |   |  | $0.33-$24.13 |              |  | $ | 13.25 |      
|                             | Options authorized |                      |           | 1,152,812  |   |                 |           |                 |   |  |              |             |  |   |       |      | 
|                             | Options granted    |                      |           | (1,960,310 | ) |                 |           | 1,960,310        |   |  |              | $3.34-$12.94 |  |   | $     | 5.36  | 
|                             | Options exercised  |                      |           |           |   |                 |           | (30,549          | ) |  |              | $5.33-$10.63 |  |   | $     | 6.70  | 
|                             | Options cancelled  |                      |           | 561,215    |   |                 |           | (561,215         | ) |  |              | $3.44-$23.00 |  |   | $     | 10.77 | 
|                             |                    |                      |           |            |   |                 |           |                  |   |  |              |              |  |   |       |      
|Balance at December 31, 2001 |                    |                      | 496,010   |            |   |                 | 4,217,448 |                  |   |  | $0.33-$24.13 |              |  | $ | 9.94  |      
|                             | Options authorized |                      |           | 1,783,393  |   |                 |           |                 |   |  |              |             |  |   |       |      | 
|                             | Options granted    |                      |           | (2,149,280 | ) |                 |           | 2,149,280        |   |  |              | $1.42-$4.82  |  |   | $     | 4.20  | 
|                             | Options exercised  |                      |           |           |   |                 |           | (7,500           | ) |  |              | $3.44        |  |   | $     | 3.44  | 
|                             | Options cancelled  |                      |           | 457,970    |   |                 |           | (480,470         | ) |  |              | $1.42-$23.00 |  |   | $     | 7.81  | 
|                             |                    |                      |           |            |   |                 |           |                  |   |  |              |              |  |   |       |      
|Balance at December 31, 2002 |                    |                      | 588,093   |            |   |                 | 5,878,758 |                  |   |  | $0.33-$24.13 |              |  | $ | 8.05  |      
|                             | Options authorized |                      |           | 3,042,618  |   |                 |           |                 |   |  |              |             |  |   |       |      | 
|                             | Options granted    |                      |           | (1,812,750 | ) |                 |           | 1,812,750        |   |  |              | $0.91-$2.16  |  |   | $     | 1.29  | 
|                             | Options exercised  |                      |           |           |   |                 |           | (27,125          | ) |  |              | $0.33-$0.95  |  |   | $     | 0.42  | 
|                             | Options cancelled  |                      |           | 1,180,557  |   |                 |           | (1,180,557       | ) |  |              | $0.95-$23.38 |  |   | $     | 7.83  | 
|                             |                    |                      |           |            |   |                 |           |                  |   |  |              |              |  |   |       |      
|Balance at December 31, 2003 |                    |                      | 2,998,518 |            |   |                 | 6,483,826 |                  |   |  | $0.37-$24.13 |              |  | $ | 6.23  |      
|                             |                    |                      |           |            |   |                 |           |                  |   |  |              |              |  |   |       |      

|                     |  |                                     |           |                  |  |                       |       |  |  |  |     | 
|-------------------- |  | ----------------------------------- | --------- | ---------------- |  | --------------------- | ----- |  |  |  | --- | 
|                     |  |                                    
|                     |  | Options Outstanding and Exercisable
|                     |  |                                    
|                     |  |                                     |           | Weighted Average
|                     |  |                                     |           | Weighted Average |  | Remaining Contractual
|Exercise Price Range |  | Number                              |           | Exercise Price   |  | Life (in years)      
|                     |  |                                     |           |                  |  |                      
|$ 0.37-$ 0.43        |  |                                     | 9,375     |                  |  | $                     | 0.41  |  |  |  | 1.4 | 
|$ 0.57-$ .057        |  |                                     | 5,874     |                  |  | $                     | 0.57  |  |  |  | 2.1 | 
|$ 0.91-$ 1.30        |  |                                     | 1,104,712 |                  |  | $                     | 1.02  |  |  |  | 9.2 | 
|$ 1.42-$ 2.11        |  |                                     | 622,050   |                  |  | $                     | 1.77  |  |  |  | 9.6 | 
|$ 2.16-$ 2.60        |  |                                     | 208,700   |                  |  | $                     | 2.55  |  |  |  | 8.8 | 
|$ 3.34-$ 4.88        |  |                                     | 2,122,078 |                  |  | $                     | 4.20  |  |  |  | 8.0 | 
|$ 5.11-$ 7.52        |  |                                     | 767,976   |                  |  | $                     | 6.16  |  |  |  | 6.4 | 
|$ 8.25-$12.25        |  |                                     | 778,981   |                  |  | $                     | 10.72 |  |  |  | 4.4 | 
|$12.44-$17.63        |  |                                     | 539,525   |                  |  | $                     | 15.60 |  |  |  | 5.7 | 
|$18.75-$24.13        |  |                                     | 324,555   |                  |  | $                     | 22.23 |  |  |  | 6.4 | 
|                     |  |                                     |           |                  |  |                       |       |  |  |  |     | 
|                     |  |                                     | 6,483,826 |                  |  | $                     | 6.23  |  |  |  | 7.5 | 
|                     |  |                                     |           |                  |  |                       |       |  |  |  |     | 

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. There were no such grants in
2003, 2002 and 2001. Amortization of deferred compensation
recognized in the years ended

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##### Table of Contents



ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

December 31, 2002 and 2001 was approximately
$54,000 and $162,000, respectively. Deferred compensation was
fully amortized as of December 31, 2002.



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

At the Annual Meeting of Shareholders, held on
May 15, 2003, the number of shares under the Employee Stock
Purchase Plan increased by 2,000,000 shares to
3,250,000 shares of common stock. Employees generally are
eligible to participate in the Purchase Plan if they have been
continuously employed by the Company for at least 10 days
prior to the first day of the offering period and are
customarily employed at least 20 hours per week and at
least five months per calendar year and are not a 5% or greater
stockholder. Shares may be purchased under the Purchase Plan at
85% of the lesser of the fair market value of the common stock
on the grant date or purchase date. Employee contributions,
through payroll deductions, are limited to the lesser of fifteen
percent of earnings or $25,000.

As of December 31, 2003 a total of
1,679,814 shares have been issued under the Purchase Plan,
leaving a balance of 1,570,186 available authorized shares.
Under SFAS No. 123, pro forma compensation cost is
reported for the fair value of the employees purchase
rights, which was estimated using the Black-Scholes model and
the following assumptions for 2003; expected volatility of
110.0%; risk-free interest rates of 1.2%; an average expected
life of four years and a dividend yield of 0.0%. The
weighted-average fair value of the purchase rights granted was
$0.56 per share in 2003. Pro-forma compensation expense of
$245,000 associated with shares granted under the Employee Stock
Purchase Plan has been included in the disclosure entitled
Stock Based Compensationin Note 1.



|   |                         
|-- | ------------------------
|7. | Collaborative Agreements



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

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

Through December 31, 2003, the Company
received from Novo Nordisk A/ S approximately
$128.7 million in product development and milestone
payments and, of this amount, the Company has recognized
approximately $115.8 million as contract revenue.

In 1998, the Company raised $5.0 million
through the sale of common stock to Novo Nordisk A/ S at a 25%
premium to the fair market price. In June 2001, the Company
raised an additional $5 million through the sale of common
stock to Novo Nordisk A/ S at the fair market price. In October
2001, the Company entered into a new common stock purchase
agreement with Novo Nordisk Pharmaceuticals. Under the new
agreement, Novo Nordisk Pharmaceuticals committed to purchase up
to $45 million of the Companys common stock at fair
market value specified in the agreement, of which
$20 million was invested initially. The Company has the
right at its option, subject to certain conditions, to sell
between $5 million and $10 million of additional
shares to Novo Nordisk Pharmaceuticals once every three months
beginning December 1, 2001 until the remaining amount of
$25 million has been invested. In July 2002, the Company
raised $5 million through the sale of common stock to Novo
Nordisk Pharmaceuticals under the terms of the agreement. At
December 31, 2003, Novo Nordisk A/ S and its affiliates
currently own approximately 11% of the Companys total
outstanding common stock on an as-converted basis. Novo Nordisk
A/ S will fund all product development costs incurred by the
Company under the terms of the agreement, while Novo Nordisk A/
S and the Company will co-fund final development of the AERx
device. The Company will be the initial manufacturer of all the
products covered by the agreement and will receive a share of
the overall gross profits

56



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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

resulting from Novo Nordisk A/ Ss sales of
the products. For the years ended December 31, 2003, 2002
and 2001, the Company recognized contract revenues of
$33.5 million, $26.9 million and $26.0 million,
respectively.



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

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

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

Through December 31, 2001, the Company had
received from GlaxoSmithKline and recognized as contract revenue
approximately $23.7 million in product development and
milestone payments. For the year ended December 31, 2001,
the Company recognized contract revenue of $1.5 million
related to this agreement. No product development and milestone
payments were received during 2003 or 2002 and as such, no
related revenues were recorded. In 1997, the Company raised
$5 million through the sale of common stock to
GlaxoSmithKline at a 25% premium to the fair market price. In
January 2001, the Company raised an additional $5 million
through the sale of common stock to GlaxoSmithKline at the fair
market price.



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

The Company entered into an agreement with
Genentech in May 1999. The agreement was to develop the drug
dornase alfa in the AERx system. Dornase alfa is the active
ingredient in the currently marketed Genentech product,
Pulmozyme. The agreement provided that development expenses
incurred by Aradigm would be reimbursed by Genentech in the form
of loans supported by promissory notes bearing interest at two
percent over the prime rate, which was 11.5% at
December 31, 2000. Principal and unpaid accrued interest
was due at the earlier of 15 days after FDA approval or
seven years after the effective date of the collaborative
agreement or May 21, 2006. The Company would also receive
certain milestone payments at various points of product
development.

57



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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

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

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

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

|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|-------------------------------------------- |  | ------------ | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                             |  |             
|                                             |  | December 31,
|                                             |  |             
|                                             |  | 2003         |        | 2002 |  | 2001
|                                             |  |              |        |      |  |     
|Deferred revenue  beginning balance         |  | $            | 16,852 |      |  | $    | 13,442 |   |  | $ | 8,654  |  
|Partner payments:                            |  |              |        |      |  |      |        |   |  |   |        |  
|Novo Nordisk A/S                             |  |              | 29,625 |      |  |      | 30,794 |   |  |   | 32,054 |  
|Other partner-funded programs                |  |              |       |      |  |      | 1,583  |   |  |   | 1,650  |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Total partner payments                       |  |              | 29,625 |      |  |      | 32,377 |   |  |   | 33,704 |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Contract revenue recognized:                 |  |              |        |      |  |      |        |   |  |   |        |  
|Novo Nordisk A/ S                            |  |              | 33,546 |      |  |      | 26,864 |   |  |   | 26,030 |  
|GlaxoSmithKline                              |  |              |       |      |  |      |       |   |  |   | 1,524  |  
|Other partner-funded programs                |  |              |       |      |  |      | 2,103  |   |  |   | 1,362  |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Total contract revenue recognized            |  |              | 33,546 |      |  |      | 28,967 |   |  |   | 28,916 |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Deferred revenue  ending balance            |  |              | 12,931 |      |  |      | 16,852 |   |  |   | 13,442 |  
|Less: Noncurrent portion of deferred revenue |  |              | (5,040 | )    |  |      | (6,170 | ) |  |   | (2,327 | )
|                                             |  |              |        |      |  |      |        |   |  |   |        |  
|Current portion of deferred revenue          |  | $            | 7,891  |      |  | $    | 10,682 |   |  | $ | 11,115 |  
|                                             |  |              |        |      |  |      |        |   |  |   |        |  



|   |                           
|-- | --------------------------
|8. | Related Party Transactions

Novo Nordisk A/ S and its affiliate, Novo Nordisk
Pharmaceuticals, Inc., are considered related parties and
at December 31, 2003 own approximately 11% of the
Companys total outstanding common stock (on an
as-converted basis).



| |                                      
| | -------------------------------------
| | Development and License
    Agreement

In June 1998, the Company executed a development
and commercialization agreement with Novo Nordisk A/ S to
jointly develop a pulmonary delivery system for administering
insulin by inhalation. Under the terms of the agreement, Novo
Nordisk A/ S has been granted exclusive rights to worldwide
sales and marketing rights for any products developed under the
terms of the agreement. Through December 31, 2003, the
Company received from Novo Nordisk A/ S approximately
$128.7 million in product development and milestone
payments and, of this amount, the Company has recognized
approximately $115.8 million as contract revenue. Novo
Nordisk A/ S will fund all product development costs incurred by
the Company under the terms of the agreement, while Novo Nordisk
A/ S and the Company will co-fund final development of the

58



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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

AERx device. The Company will be the initial
manufacturer of all the products covered by the agreement and
will receive a share of the overall gross profits resulting from
Novo Nordisk A/ Ss sales of the products. For the years
ended December 31, 2003, 2002 and 2001, the Company
recognized contract revenues of $33.5 million,
$26.9 million and $26.0 million, respectively. No
amounts were due to the Company from Novo Nordisk A/ S at
December 31, 2003 and 2002.



| |                                   
| | ----------------------------------
| | Securities Purchase
    Agreements

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

Between June 1998 and October 2001 the Company
raised $10 million through the sale of common stock to Novo
Nordisk A/ S.

Since the inception of the collaboration in June
1998 through December 31, 2003, the Company raised
$35 million through the sale of common stock to Novo
Nordisk A/ S.



|   |             
|-- | ------------
|9. | Income Taxes

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

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

|                                     |  |              |         |      |  |   |         |  
|------------------------------------ |  | ------------ | ------- | ---- |  | - | ------- | -
|                                     |  |             
|                                     |  | December 31,
|                                     |  |             
|                                     |  | 2003         |         | 2002
|                                     |  |              |         |     
|Net operating loss carryforward      |  | $            | 58,900  |      |  | $ | 54,900  |  
|Deferred revenue                     |  |              | 5,200   |      |  |   | 6,700   |  
|Research and development credits     |  |              | 11,900  |      |  |   | 9,200   |  
|Capitalized research and development |  |              | 11,400  |      |  |   | 2,000   |  
|Other                                |  |              | 1,200   |      |  |   | 1,200   |  
|                                     |  |              |         |      |  |   |         |  
|Total deferred tax assets            |  |              | 88,600  |      |  |   | 74,000  |  
|Valuation allowance                  |  |              | (88,600 | )    |  |   | (74,000 | )
|                                     |  |              |         |      |  |   |         |  
|Net deferred tax assets              |  | $            |        |      |  | $ |        |  
|                                     |  |              |         |      |  |   |         |  

Realization of deferred tax assets is dependent
upon future earnings, if any, the timing and amount of which are
uncertain. Accordingly, the net deferred tax assets have been
fully offset by a valuation allowance. The valuation allowance
increased by $14,600,000 and $14,400,000 during 2003 and 2002,
respectively.

As of December 31, 2003, the Company had net
operating loss carryforwards for federal income-tax purposes of
approximately $168,000,000, which expire in the years 2006
through 2023, and federal research and development tax credits
of approximately $8,400,000, which expire in the years 2006
through 2023. As of December 31, 2003, the Company had net
operating loss carryforwards for California income tax purposes
of

59



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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

approximately $200,000 which expire in the years
2005 through 2013 and California research and development tax
credits of approximately $5,200,000 which do not expire.

The use of the Companys net operating
losses and credit carryforwards may be subject to substantial
annual limitation due to ownership change limitations provided
by the Internal revenue Code and similar California provisions.
Such an annual limitation could result in the expiration of the
net operating losses and credits before utilization.



|    |                                                
|--- | -----------------------------------------------
|10. | Quarterly Results of Operations
    (Unaudited)

Following is a summary of the quarterly results
of operations for the years ended December 31, 2003 and
2002 (amounts in thousands):

|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |        |        |   |   |        |        |  
|----------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------- | --------- | ------ | -------- | - | ------------- | ------ | ------------ | - | - | ------ | ------ | - | - | ------ | ------ | -
|                                                                        |                                                                                                 | March 31, |        | June 30, |   | September 30, |        | December 31,
|                                                                        |                                                                                                 | 2003      |        | 2003     |   | 2003          |        | 2003        
|                                                                        |                                                                                                 |           |        |          |   |               |        |             
|Contract and license revenues                                           |                                                                                                 | $         | 7,690  |          |   | $             | 9,378  |              |   | $ | 9,843  |        |   | $ | 6,946  |       
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       
|Operating expenses:                                                     |                                                                                                 |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       
|                                                                        | Research and development                                                                        |           |        | 12,999   |   |               |        | 14,001       |   |   |        | 11,988 |   |   |        | 10,648 |  
|                                                                        | General and administrative                                                                      |           |        | 2,669    |   |               |        | 2,844        |   |   |        | 2,428  |   |   |        | 2,450  |  
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       
|                                                                        | Total expenses                                                                                  |           |        | 15,668   |   |               |        | 16,845       |   |   |        | 14,416 |   |   |        | 13,098 |  
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       
|Loss from operations                                                    |                                                                                                 |           | (7,978 | )        |   |               | (7,467 | )            |   |   | (4,573 | )      |   |   | (6,152 | )     
|Interest income                                                         |                                                                                                 |           | 108    |          |   |               | 86     |              |   |   | 68     |        |   |   | 76     |       
|Interest expense                                                        |                                                                                                 |           | (56    | )        |   |               | (39    | )            |   |   | (27    | )      |   |   | (16    | )     
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       
|Net loss                                                                |                                                                                                 | $         | (7,926 | )        |   | $             | (7,420 | )            |   | $ | (4,532 | )      |   | $ | (6,092 | )     
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       
|Basic and diluted loss per share applicable to
    common shareholders: |                                                                                                 |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       
|                                                                        | Net loss                                                                                        |           | $      | (0.22    | ) |               | $      | (0.15        | ) |   | $      | (0.08  | ) |   | $      | (0.10  | )
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       
|                                                                        | Shares used in computing basic and diluted loss
    per share applicable to common shareholders |           |        | 35,601   |   |               |        | 51,144       |   |   |        | 54,263 |   |   |        | 59,421 |  
|                                                                        |                                                                                                 |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       

60



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ARADIGM CORPORATION


NOTES TO FINANCIAL STATEMENTS 
(Continued)

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



|    |                              
|--- | -----------------------------
|11. | Subsequent Events (Unaudited)

Effective January 1, 2004, Aradigm amended
its operating lease for the building commonly known as 3929
Point Eden Way in the Britannia Point Eden Business Park,
Hayward, California, with its landlord, Hayward Point
Eden I Limited Partnership. The new agreement reduces the
aggregate annual lease payments by $1.1 million through
2006 and increases the aggregate annual payments by
$1.1 million from 2007 through 2010. In consideration for
the amended lease agreement, Aradigm will replace warrants to
purchase 135,000 shares of common stock at
$10.16-$21.72 per share with new warrants with an exercise
price equal to $1.71 per share. The incremental fair value
of the replacement warrants, as defined as, the fair value of
the new warrants less the fair value of the old warrants on date
of replacement, is $88,000 and the expense will be amortized on
a straight-line basis over the remaining life of the lease.

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

None.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

Evaluation of disclosure controls and
procedures:Based on their evaluation
of our disclosure controls and procedures (as defined in the
rules promulgated under the Securities Exchange Act of 1934, as
amended, our chief executive officer and our chief financial
officer concluded that our disclosure controls and procedures
were effective as of the end of the period covered by this
report.

We believe that a controls system, no matter how
well designed and operated, cannot provide absolute assurance
that the objectives of the controls system are met, and no
evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within a company
have been detected. Our disclosure controls and procedures are
designed to provide reasonable assurance of achieving their
objectives, and our chief executive officer and our chief
financial officer have concluded that these controls and
procedures are effective at the reasonable assurance
level.

Changes in internal
controls:There were no significant
changes in our internal controls over financial reporting during
the period covered by this report that have materially affected,
or are reasonably likely to materially affect, our internal
control over financial reporting.




PART III






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

Identification of Directors; Audit Committee
Information; Code of Ethics

The information required by this Item concerning
(i) the Companys directors, (ii) the
identification of the members of the Companys audit
committee, (iii) the identification of the Audit Committee
Financial Expert and (iv) the Companys Code of Ethics
is incorporated by reference from the section captioned
Proposal 1: Election of Directors contained in
the Companys Definitive Proxy Statement related to the
Annual Meeting of Shareholders to be held May 20, 2004, to
be filed by the Company with the Securities and Exchange
Commission (the Proxy Statement).

Identification of Executive Officers

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

Section 16(a) Compliance

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






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The information required by this Item is
incorporated by reference from the sections captioned
Compensation of Executive Officers,
Compensation of Directors, Compensation
Committee Interlocks and Insider Participation, the Report
of the Compensation Committee and the Proxy Graph contained in
the Proxy Statement.

62



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

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






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

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






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accountant Fees and
    Services

The information required by this item is
incorporated by reference from the section captioned
Proposal 3: Ratification of Selection of Independent
Auditors in the Proxy Statement.




PART IV






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

(a)(1) Financial Statements.

Included in Part II of this Report:

|                                                                                                                                     |  |           |    | 
|------------------------------------------------------------------------------------------------------------------------------------ |  | --------- | -- | 
|                                                                                                                                     |  | Page in  
|                                                                                                                                     |  | Form 10-K
|                                                                                                                                     |  |          
|Report of Ernst & Young
    LLP, Independent Auditors                                                                                |  |           | 37 | 
|Balance Sheets  December 31, 2003
    and 2002                                                                                      |  |           | 38 | 
|Statements of Operations  Years ended
    December 31, 2003, 2002 and 2001                                                          |  |           | 39 | 
|Statements of Redeemable Convertible Preferred
    Stock and Shareholders Equity  Years ended
    December 31, 2003, 2002 and 2001 |  |           | 40 | 
|Statements of Cash Flows  Years ended
    December 31, 2003, 2002 and 2001                                                          |  |           | 42 | 
|Notes to Financial Statements                                                                                                        |  |           | 43 | 

(2) Financial Statement
Schedules.

All schedules have been omitted because they are
not required.

(3) Exhibits.

|            |    |             |  |                                                                                                                   
|----------- | -- | ----------- |  | ------------------------------------------------------------------------------------------------------------------
|Exhibit No. |    | Description
|            |    |            
|            | 3  | .1(1)       |  | Amended and Restated Articles of Incorporation of
    the Company.                                                
|            | 3  | .2(5)       |  | Bylaws of the Company, as amended.                                                                                
|            | 3  | .3(15)      |  | Certificate of Determination of Series A
    Junior Participating Preferred Stock.                                
|            | 3  | .4(14)      |  | Certificate of Determination and Preferences of
    Series A Convertible Preferred Stock.                         
|            | 3  | .5(15)      |  | Certificate of Amendment of Amended and Restated
    Articles of Incorporation of the Company.                    
|            | 3  | .6(15)      |  | Certificate of Amendment of Certificate of
    Determination of Series A Junior Participating Preferred
    Stock.
|            | 4  | .1          |  | Reference is made to Exhibits 3.1, 3.2, 3.3,
    3.4, 3.5 and 3.6.                                                
|            | 4  | .2(1)       |  | Specimen common stock certificate.                                                                                
|            | 10 | .1(1)(2)    |  | Form of Indemnity Agreement between the
    Registrant and each of its directors and officers.                    
|            | 10 | .2(2)(11)   |  | Equity Incentive Plan, as amended (the
    Equity Incentive Plan).                                              

63



---



##### Table of Contents



|            |    |             |  |                                                                                                                                                                                                             
|----------- | -- | ----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |    | Description
|            |    |            
|            | 10 | .3(1)(2)    |  | Form of the Companys Incentive Stock Option
    Agreement under the Equity Incentive Plan.                                                                                                                 
|            | 10 | .4(1)(2)    |  | Form of the Companys Non-statutory Stock
    Option Agreement under the Equity Incentive Plan.                                                                                                             
|            | 10 | .5(1)(2)    |  | Form of the Companys Non-Employee
    Directors Stock Option Plan.                                                                                                                                        
|            | 10 | .6(1)(2)    |  | Form of the Companys Non-statutory Stock
    Option Agreement under the Non-Employee Directors Stock
    Option Plan.                                                                                     
|            | 10 | .7(2)(16)   |  | Employee Stock Purchase Plan, as amended.                                                                                                                                                                   
|            | 10 | .8(1)(2)    |  | Form of the Companys Employee Stock
    Purchase Plan Offering Document.                                                                                                                                   
|            | 10 | .9(1)       |  | Master Lease Agreement and Warrant, between the
    Company and Comdisco, Inc., dated June 9, 1995.                                                                                                         
|            | 10 | .11(4)*     |  | Product Development and Commercialization
    Agreement between the Company and SmithKline Beecham PLC.                                                                                                     
|            | 10 | .11(3)      |  | Lease Agreement for the property located at 3911
    Trust Way, Hayward, California, dated March 17, 1997,
    between the Company and Hayward Point Eden I Limited
    Partnership.                        
|            | 10 | .11a(3)     |  | First Amendment to Lease dated December 22,
    1997, between the Company and Hayward Point Eden I Limited
    Partnership.                                                                                 
|            | 10 | .11b(3)     |  | Second Amendment to Lease, dated January 28,
    1998, between the Company and Hayward Point Eden I Limited
    Partnership.                                                                                
|            | 10 | .12(3)      |  | Lease Agreement for the property located in
    Phase V of the Britannia Point Eden Business Park in
    Hayward, California, dated January 28, 1998, between the
    Company and Britannia Point Eden, LLC.
|            | 10 | .13(5)      |  | Common Stock Purchase Agreement dated
    April 3, 1998, between the Company and the purchasers named
    therein.                                                                                          
|            | 10 | .14(5)*     |  | Development and License Agreement, dated
    June 2, 1998, between the Company and Novo Nordisk A/ S.                                                                                                       
|            | 10 | .15(6)      |  | Rights Agreement, dated as of August 31,
    1998, between the Company and Bank Boston, N.A.                                                                                                                
|            | 10 | .15a(15)    |  | Amendment to Rights Agreement, dated as of
    October 22, 2001, by and between the Company and Fleet
    National Bank.                                                                                    
|            | 10 | .15b(15)    |  | Amendment to Rights Agreement, dated as of
    December 6, 2001, by and between the Company and EquiServe
    Trust Company.                                                                                
|            | 10 | .16(7)      |  | Common Stock Purchase Agreement dated
    January 27, 1999, between the Company and the purchasers
    named therein.                                                                                       
|            | 10 | .17(8)      |  | Lease Agreement for the property located at 2704
    West Winton Avenue, Hayward, California, dated
    September 11, 2000, between the Company and Winton
    Industrial Center, Inc.                      
|            | 10 | .17a(12)    |  | Amendment No. 1 to Standard Office/
    Warehouse Lease, dated March 1, 2001, by and between the
    Company and Winton Industrial Center, Inc.                                                             
|            | 10 | .18(8)      |  | Lease Agreement for the property located at 3930
    Point Eden Way, Hayward, California, dated July 1, 2000,
    between the Company and Hayward Point Eden I Limited
    Partnership.                     
|            | 10 | .19(9)      |  | Common Stock Purchase Agreement, dated as of
    November 3, 2000, by and between the Company and Acqua
    Wellington North American Equities Fund, Ltd.                                                   
|            | 10 | .20(10)*    |  | Amendment to GlaxoSmithKline agreement executed
    in December 2000.                                                                                                                                       
|            | 10 | .21(13)     |  | Securities Purchase Agreement, dated as of
    August 21, 2001, by and among the Company and the
    purchasers named therein.                                                                              
|            | 10 | .22(15)     |  | Stock Purchase Agreement, dated as of
    October 22, 2001, by and between the Company and Novo
    Nordisk Pharmaceuticals, Inc.                                                                           
|            | 10 | .23*(15)    |  | First Amendment to Development and License
    Agreement, dated as of October 22, 2001, between the
    Company and Novo Nordisk A/S.                                                                       
|            | 10 | .24(14)     |  | Securities Purchase Agreement, dated as of
    December 11, 2001, by and among the Company and the
    purchasers named therein.                                                                            

64



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##### Table of Contents



|            |    |             |  |                                                                                                                                            
|----------- | -- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |    | Description
|            |    |            
|            | 10 | .25(17)     |  | Securities Purchase Agreement, dated as of
    February 10, 2003, by and among the Company and the
    purchasers named therein.           
|            | 10 | .26(17)     |  | Warrant Repricing Agreement, dated as of
    February 10, 2003, by and between the Company and the
    persons listed on Exhibit A thereto.
|            | 10 | .27(18)     |  | Securities Purchase Agreement, dated as of
    November 7, 2003, by and among the Company and the
    purchasers named therein.            
|            | 10 | .28(19)     |  | Securities Purchase Agreement, dated as of
    November 14, 2003, by and among the Company and the
    purchasers named therein.           
|            | 23 | .1          |  | Consent of Ernst & Young
    LLP, Independent Auditors.                                                                                    
|            | 24 | .1          |  | Power of Attorney. Reference is made to the
    signature page.                                                                            
|            | 31 | .1          |  | Section 302 Certification of the Chief
    Executive Officer.                                                                              
|            | 31 | .2          |  | Section 302 Certification of the Chief
    Financial Officer.                                                                              
|            | 32 | .1          |  | Section 906 Certification of the Chief
    Executive Officer and the Chief Financial Officer.                                              



---



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



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



|     |                                                                                                     
|---- | ----------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the Companys
    Form 10-K filed for the year ended December 31, 2000.
|    
|(11) | Incorporated by reference to the Companys
    definitive proxy statement filed on April 11, 2001.  
|    
|(12) | Incorporated by reference to the Companys
    Form 10-Q filed on August 13, 2001.                  
|    
|(13) | Incorporated by reference to the Companys
    Form S-3 (No. 333-69614), as amended.                
|    
|(14) | Incorporated by reference to the Companys
    Form S-3 (No. 333-76584).                            
|    
|(15) | Incorporated by reference to the Companys
    Form 10-K filed for the year ended December 31, 2001.
|    
|(16) | Incorporated by reference to the Companys
    definitive proxy statement filed on January 4, 2002. 
|    
|(17) | Incorporated by reference to the Companys
    Form 10-Q filed on May 13, 2003.                     
|    
|(18) | Incorporated by reference to the Companys
    Form 8-K filed on November 12, 2003.                 
|    
|(19) | Incorporated by reference to the Companys
    Form 8-K filed on November 20, 2003.                 

65



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##### Table of Contents



(b) Reports on Form 8-K.

We filed two reports on Form 8-K during the
fourth quarter ended December 31, 2003 as follows:

|                  |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|----------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Date of Report    |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                  |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|November 7, 2003  |  | As of November 7, 2003, Aradigm Corporation
    entered into a Securities Purchase Agreement in which the
    Purchasers agreed to purchase from the Company, approximately
    7,502,775 shares of the Companys Common Stock at
    $1.80 per share and warrants to purchase approximately
    1,875,689 shares of the Common Stock at $2.50 per
    share, for an aggregate purchase price of approximately
    $13,505,000 in a private placement.
|November 14, 2003 |  | As of November 14, 2003, Aradigm Corporation
    entered into a Securities Purchase Agreement in which the
    Purchaser agreed to purchase from the Company,
    277,777 shares of the Companys Common Stock and
    warrants to purchase 69,444 shares of Common Stock at
    $2.50 per share, for an aggregate purchase price of
    $500,000 in a private placement.                                                                             

(c) Index to Exhibits.

See Exhibits listed under Item 15(a)(3).

(d) Financial Statement Schedules.

All schedules have been omitted because they are
not required.

66



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the Registrant
has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Hayward,
State of California, on the 18th day of March 2004.



| |                    
| | -------------------
| | ARADIGM CORPORATION



| |     |                        
| | --- | -----------------------
| | By: | /s/ RICHARD P. THOMPSON

| |                                     
| | ------------------------------------
| |                                     
| | Richard P. Thompson                 
| | Chairman and Chief Executive Officer

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

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

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

|                                             |  |                                                                                     |  |               
|-------------------------------------------- |  | ----------------------------------------------------------------------------------- |  | --------------
|Signature                                    |  | Title                                                                               |  | Date          
|                                             |  |                                                                                     |  |               
|                                            
|/s/ RICHARD P. THOMPSONRichard P. Thompson   |  | Chief Executive Officer and Director (Principal
    Executive Officer)              |  | March 18, 2004
|                                            
|/s/ THOMAS C. CHESTERMANThomas C. Chesterman |  | Sr. VP and Chief Financial Officer (Principal
    Financial and Accounting Officer) |  | March 18, 2004
|                                            
|/s/ FRANK H. BARKERFrank H. Barker           |  | Director                                                                            |  | March 18, 2004
|                                            
|/s/ STAN BENSONStan Benson                   |  | Director                                                                            |  | March 18, 2004
|                                            
|/s/ IGOR GONDAIgor Gonda                     |  | Director                                                                            |  | March 18, 2004
|                                            
|/s/ JOHN M. NEHRAJohn M. Nehra               |  | Director                                                                            |  | March 18, 2004

67



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##### Table of Contents



|                                         |  |          |  |               
|---------------------------------------- |  | -------- |  | --------------
|Signature                                |  | Title    |  | Date          
|                                         |  |          |  |               
|                                        
|/s/ WAYNE L. ROEWayne L. Roe             |  | Director |  | March 18, 2004
|                                        
|/s/ VIRGIL D. THOMPSONVirgil D. Thompson |  | Director |  | March 18, 2004

68



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##### Table of Contents






EXHIBIT INDEX

|            |    |             |  |                                                                                                                                                                                                             
|----------- | -- | ----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |    | Description
|            |    |            
|            | 3  | .1(1)       |  | Amended and Restated Articles of Incorporation of
    the Company.                                                                                                                                          
|            | 3  | .2(5)       |  | Bylaws of the Company, as amended.                                                                                                                                                                          
|            | 3  | .3(15)      |  | Certificate of Determination of Series A
    Junior Participating Preferred Stock.                                                                                                                          
|            | 3  | .4(14)      |  | Certificate of Determination and Preferences of
    Series A Convertible Preferred Stock.                                                                                                                   
|            | 3  | .5(15)      |  | Certificate of Amendment of Amended and Restated
    Articles of Incorporation of the Company.                                                                                                              
|            | 3  | .6(15)      |  | Certificate of Amendment of Certificate of
    Determination of Series A Junior Participating Preferred
    Stock.                                                                                          
|            | 4  | .1          |  | Reference is made to Exhibits 3.1, 3.2, 3.3,
    3.4, 3.5 and 3.6.                                                                                                                                          
|            | 4  | .2(1)       |  | Specimen common stock certificate.                                                                                                                                                                          
|            | 10 | .1(1)(2)    |  | Form of Indemnity Agreement between the
    Registrant and each of its directors and officers.                                                                                                              
|            | 10 | .2(2)(11)   |  | Equity Incentive Plan, as amended (the
    Equity Incentive Plan).                                                                                                                                        
|            | 10 | .3(1)(2)    |  | Form of the Companys Incentive Stock Option
    Agreement under the Equity Incentive Plan.                                                                                                                 
|            | 10 | .4(1)(2)    |  | Form of the Companys Non-statutory Stock
    Option Agreement under the Equity Incentive Plan.                                                                                                             
|            | 10 | .5(1)(2)    |  | Form of the Companys Non-Employee
    Directors Stock Option Plan.                                                                                                                                        
|            | 10 | .6(1)(2)    |  | Form of the Companys Non-statutory Stock
    Option Agreement under the Non-Employee Directors Stock
    Option Plan.                                                                                     
|            | 10 | .7(2)(16)   |  | Employee Stock Purchase Plan, as amended.                                                                                                                                                                   
|            | 10 | .8(1)(2)    |  | Form of the Companys Employee Stock
    Purchase Plan Offering Document.                                                                                                                                   
|            | 10 | .9(1)       |  | Master Lease Agreement and Warrant, between the
    Company and Comdisco, Inc., dated June 9, 1995.                                                                                                         
|            | 10 | .11(4)*     |  | Product Development and Commercialization
    Agreement between the Company and SmithKline Beecham PLC.                                                                                                     
|            | 10 | .11(3)      |  | Lease Agreement for the property located at 3911
    Trust Way, Hayward, California, dated March 17, 1997,
    between the Company and Hayward Point Eden I Limited
    Partnership.                        
|            | 10 | .11a(3)     |  | First Amendment to Lease dated December 22,
    1997, between the Company and Hayward Point Eden I Limited
    Partnership.                                                                                 
|            | 10 | .11b(3)     |  | Second Amendment to Lease, dated January 28,
    1998, between the Company and Hayward Point Eden I Limited
    Partnership.                                                                                
|            | 10 | .12(3)      |  | Lease Agreement for the property located in Phase
    V of the Britannia Point Eden Business Park in Hayward,
    California, dated January 28, 1998, between the Company and
    Britannia Point Eden, LLC.
|            | 10 | .13(5)      |  | Common Stock Purchase Agreement dated
    April 3, 1998, between the Company and the purchasers named
    therein.                                                                                          
|            | 10 | .14(5)*     |  | Development and License Agreement, dated
    June 2, 1998, between the Company and Novo Nordisk A/S.                                                                                                        
|            | 10 | .15(6)      |  | Rights Agreement, dated as of August 31,
    1998, between the Company and Bank Boston, N.A.                                                                                                                
|            | 10 | .15a(15)    |  | Amendment to Rights Agreement, dated as of
    October 22, 2001, by and between the Company and Fleet
    National Bank.                                                                                    
|            | 10 | .15b(15)    |  | Amendment to Rights Agreement, dated as of
    December 6, 2001, by and between the Company and EquiServe
    Trust Company.                                                                                
|            | 10 | .16(7)      |  | Common Stock Purchase Agreement dated
    January 27, 1999, between the Company and the purchasers
    named therein.                                                                                       
|            | 10 | .17(8)      |  | Lease Agreement for the property located at 2704
    West Winton Avenue, Hayward, California, dated
    September 11, 2000, between the Company and Winton
    Industrial Center, Inc.                      

69



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##### Table of Contents



|            |    |             |  |                                                                                                                                                                                        
|----------- | -- | ----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |    | Description
|            |    |            
|            | 10 | .17a(12)    |  | Amendment No. 1 to Standard Office/
    Warehouse Lease, dated March 1, 2001, by and between the
    Company and Winton Industrial Center, Inc.                                        
|            | 10 | .18(8)      |  | Lease Agreement for the property located at 3930
    Point Eden Way, Hayward, California, dated July 1, 2000,
    between the Company and Hayward Point Eden I Limited
    Partnership.
|            | 10 | .19(9)      |  | Common Stock Purchase Agreement, dated as of
    November 3, 2000, by and between the Company and Acqua
    Wellington North American Equities Fund, Ltd.                              
|            | 10 | .20(10)*    |  | Amendment to GlaxoSmithKline agreement executed
    in December 2000.                                                                                                                  
|            | 10 | .21(13)     |  | Securities Purchase Agreement, dated as of
    August 21, 2001, by and among the Company and the
    purchasers named therein.                                                         
|            | 10 | .22(15)     |  | Stock Purchase Agreement, dated as of
    October 22, 2001, by and between the Company and Novo
    Nordisk Pharmaceuticals, Inc.                                                      
|            | 10 | .23*(15)    |  | First Amendment to Development and License
    Agreement, dated as of October 22, 2001, between the
    Company and Novo Nordisk A/S.                                                  
|            | 10 | .24(14)     |  | Securities Purchase Agreement, dated as of
    December 11, 2001, by and among the Company and the
    purchasers named therein.                                                       
|            | 10 | .25(17)     |  | Securities Purchase Agreement, dated as of
    February 10, 2003, by and among the Company and the
    purchasers named therein.                                                       
|            | 10 | .26(17)     |  | Warrant Repricing Agreement, dated as of
    February 10, 2003, by and between the Company and the
    persons listed on Exhibit A thereto.                                            
|            | 10 | .27(18)     |  | Securities Purchase Agreement, dated as of
    November 7, 2003, by and among the Company and the
    purchasers named therein.                                                        
|            | 10 | .28(19)     |  | Securities Purchase Agreement, dated as of
    November 14, 2003, by and among the Company and the
    purchasers named therein.                                                       
|            | 23 | .1          |  | Consent of Ernst & Young
    LLP, Independent Auditors.                                                                                                                                
|            | 24 | .1          |  | Power of Attorney. Reference is made to the
    signature page.                                                                                                                        
|            | 31 | .1          |  | Section 302 Certification of the Chief
    Executive Officer.                                                                                                                          
|            | 31 | .2          |  | Section 302 Certification of the Chief
    Financial Officer.                                                                                                                          
|            | 32 | .1          |  | Section 906 Certification of the Chief
    Executive Officer and the Chief Financial Officer.                                                                                          



---



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



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



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

70



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##### Table of Contents





|     |                                                                                                     
|---- | ----------------------------------------------------------------------------------------------------
|(14) | Incorporated by reference to the Companys
    Form S-3 (No. 333-76584).                            
|    
|(15) | Incorporated by reference to the Companys
    Form 10-K filed for the year ended December 31, 2001.
|    
|(16) | Incorporated by reference to the Companys
    definitive proxy statement filed on January 4, 2002. 
|    
|(17) | Incorporated by reference to the Companys
    Form 10-Q filed on May 13, 2003.                     
|    
|(18) | Incorporated by reference to the Companys
    Form 8-K filed on November 12, 2003.                 
|    
|(19) | Incorporated by reference to the Companys
    Form 8-K filed on November 20, 2003.                 

71