##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549


Form 10-K

|   |  |                                                                                                 
|-- |  | ------------------------------------------------------------------------------------------------
|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 no. 0-18962

Cygnus, Inc.


(Exact name of Registrant as Specified in Its
Charter)


|                                                                                              |  |                                         
|--------------------------------------------------------------------------------------------- |  | ----------------------------------------
|Delaware                                                                                      |  | 94-2978092                              
|(State or Other Jurisdiction of
    Incorporation or Organization)                            |  | (I.R.S. Employer
    Identification No.)
|                                                                                             
|400 Penobscot Drive, Redwood City,
    California(Address of Principal Executive
    Offices) |  | 94063(Zip Code)                         

(650) 369-4300

(Registrants telephone number, including
area code)


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

None


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

Common Stock, $0.001 par value


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

The aggregate market value of the voting stock
held by non-affiliates of the Registrant, based upon the last
reported sale of its common stock on June 30, 2003 of $0.61
as reported on the Nasdaq OTC Bulletin Board was $23,380,127.
Shares of common stock held by each officer and director and
person who owns 5% or more of the outstanding common stock have
been excluded in that such persons may be deemed to be
affiliates. Determination of affiliate status for this purpose
is not a determination of affiliate status for any other purpose.

41,009,251

(Number of shares of common stock outstanding
as of March 24, 2004)


DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrants definitive
Proxy Statement to be filed pursuant to Regulation 14A for
its 2004 Annual Meeting of Stockholders are incorporated by
reference into Part III hereof.



---






---










CYGNUS, INC.

ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31,
2003


TABLE OF CONTENTS

|               |  |                                                                                                        |    |      |    | 
|-------------- |  | ------------------------------------------------------------------------------------------------------ | -- | ---- | -- | 
|               |  |                                                                                                        |    | Page
|               |  |                                                                                                        |    |     
|PART I        
|Item 1.        |  | Business                                                                                               |    |      | 2  | 
|Item 2.        |  | Properties                                                                                             |    |      | 11 | 
|Item 3.        |  | Legal Proceedings                                                                                      |    |      | 11 | 
|Item 4.        |  | Submission of Matters to a
    Vote of Security Holders                                                |    |      | 12 | 
|PART II       
|Item 5.        |  | Market for Registrants
    Common Equity and Related Stockholder Matters                              |    |      | 12 | 
|Item 6.        |  | Selected Financial Data                                                                                |    |      | 13 | 
|Item 7.        |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations              |    |      | 14 | 
|Item 7A.       |  | Quantitative and Qualitative Disclosures About
    Market Risk                                         |    |      | 31 | 
|Item 8.        |  | Financial Statements and
    Supplementary Data                                                        |    |      | 32 | 
|Item 9.        |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure               |    |      | 32 | 
|Item 9A.       |  | Controls and Procedures                                                                                |    |      | 32 | 
|PART III      
|Item 10.       |  | Directors and Executive
    Officers of the Registrant                                                 |    |      | 33 | 
|Item 11.       |  | Executive Compensation                                                                                 |    |      | 33 | 
|Item 12.       |  | Security Ownership of
    Certain Beneficial Owners and Management and Related Stockholder
    Matters |    |      | 33 | 
|Item 13.       |  | Certain Relationships and
    Related Transactions                                                     |    |      | 33 | 
|Item 14.       |  | Principal Accountant Fees
    and Services                                                             |    |      | 33 | 
|PART IV       
|Item 15.       |  | Exhibits, Financial
    Statement Schedules and Reports on Form 8-K                                    |    |      | 34 | 
|SIGNATURES     |  |                                                                                                        | 40 |     
|EXHIBIT INDEX  |  |                                                                                                        |    |     
|EXHIBIT 10.008
|EXHIBIT 10.124
|EXHIBIT 10.125
|EXHIBIT 10.126
|EXHIBIT 10.128
|EXHIBIT 10.508
|EXHIBIT 23.1  
|EXHIBIT 31.1  
|EXHIBIT 31.2  
|EXHIBIT 32.1  
|EXHIBIT 32.2  



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PART I






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

Overview

Some of the statements in this report,
including in the documents incorporated by reference, are
forward-looking statements that involve risks and uncertainties.
These forward-looking statements include statements about our
plans, objectives, expectations, intentions and assumptions and
other statements contained in this report, including in the
documents incorporated by reference, that are not statements of
historical fact. Forward-looking statements include but are not
limited to statements about our ability to find a new sales,
marketing and distribution partner or other strategic alliance,
including but not limited to a merger or an acquisition by a
third party; the capabilities and potential of the GlucoWatch G2
Biographer business; our ability to achieve market acceptance of
the GlucoWatch G2 Biographer; our ability to manufacture the
GlucoWatch G2 Biographer; our plans for other commercialization
alliances; and the speed and potential results of the regulatory
process. In some cases, you can identify these statements by
words such as may, will,
should, estimates, predicts,
potential, continues,
strategy, believes,
anticipates, plans, expects,
intends and similar expressions. We cannot guarantee
future results, levels of activity, performance or achievements.
Our actual results and the timing of certain events may differ
significantly from the results and timing discussed in this
report, including those under Risk Factors herein,
as well as in the documents incorporated by reference. All
forward-looking statements included in this report are based on
information available to us on the date hereof, and we assume no
obligation to update any such forward-looking
statements.

Cygnus was incorporated in California in 1985 and
was reincorporated as a Delaware corporation in 1995. Our
principal executive offices are located at 400 Penobscot Drive,
Redwood City, California 94063, our telephone number at that
address is (650) 369-4300 and our facsimile number at that
address is (650) 369-5318. Additionally, our corporate
website is www.cygn.com and our product website is
www.glucowatch.com.

We have developed and manufactured frequent,
automatic and non-invasive glucose monitoring devices. Our
devices are designed to provide more data to individuals and
their physicians and enable them to make better-informed
decisions on how to manage diabetes. We began the
U.S. market launch of our first-generation GlucoWatch®
Biographer on April 15, 2002. On March 21, 2002, the
U.S. Food and Drug Administration (FDA) approved our
second-generation product, the GlucoWatch G2® Biographer.
On August 28, 2002, we received approval from the FDA of
our supplemental pre-market approval (PMA) application for use
of the GlucoWatch G2 Biographer by children and adolescents
(ages 7 to 17). On December 4, 2003, we announced that
the FDA approved our third-generation product. Compared with our
second-generation product, this improved Biographer and
AutoSensor system focuses on enhancing customer satisfaction and
ease of use; however, it is not yet commercially available.

On December 23, 2003, we entered into an
Agreement for Global Resolution and Mutual Release of All Claims
(Global Resolution) with Sankyo Pharma Inc.
(Sankyo Pharma) that resolved and dismissed the
pending litigation filed on October 6, 2003, and terminated
our Sales, Marketing and Distribution Agreement and all other
contractual arrangements with Sankyo Pharma. The Global
Resolution provided for Sankyo Pharma to pay us
$30.0 million and also specified that neither party owed
any payments to the other party, thus allowing us to write off
certain liabilities and assets, resulting in a total net gain of
$75.8 million. Furthermore, Sankyo Pharma transferred title
to us of more than 20,000 GlucoWatch G2 Biographers and more
than 1.0 million AutoSensors that we had previously sold
and shipped to them. Sankyo Pharma is to provide certain
transition services related to distribution and customer
services until the earlier of June 30, 2004 or when we
notify Sankyo Pharma that they may discontinue such services,
and we are entitled to receive 30% of all monies received from
product sales by Sankyo Pharma during this transition period. In
light of these developments, we are not likely to manufacture
our G2 Biographer or third-generation product or develop new
products in the near future.

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We are currently seeking a new sales, marketing
and distribution partner or other strategic alliance, and we are
exploring the possibility of selling the company to a third
party. We have retained a financial advisor to lead this process.

Cygnus in the Year 2003

In May 2003, we entered into a new lease with the
property owners for our facility located in Redwood City,
California. The lease, which runs through April 30, 2009,
is for a building with approximately 38,000 square feet
that is used by us for administrative offices, laboratory space
and the final assembly lines for the Biographer.

In October 2003, we filed a complaint in the
Superior Court of the State of California for the County of
San Mateo against Sankyo Pharma and Sankyo Co., Ltd.
(Sankyo Japan) for breach of contract and
intentional interference with contract, respectively, relating
to the sales, marketing and distribution of our GlucoWatch
Biographer products. Thereafter, Sankyo Pharma filed
cross-claims against us for declaratory relief, breach of
contract and defamation.

Also in October 2003, we announced a reduction in
force of approximately 60% of our work force, and we suspended
our manufacturing activities and research and development
efforts for future products.

In October 2003, we terminated our second
building lease, which would have run through December 2003 and
which we had previously subleased to Maxygen, Inc. We
received full payment from Maxygen, Inc. for this early
termination, and in turn paid the remaining lease amount to the
property owner.

In November 2003, we announced the restructuring
of our arbitration payments to Sanofi-Synthelabo to extend each
of the payment periods by one year, with the possibility of
accelerated payments in the event that a settlement was reached
with Sankyo Pharma. In light of our $30.0 million cash
settlement from Sankyo Pharma, we paid $500,000 to
Sanofi-Synthelabo on December 30, 2003. The balance of
$11.5 million as of December 31, 2003 will be paid as
follows: $4.5 million is due in February 2005,
$4.0 million is due in February 2006, and $3.0 million
is due in February 2007. We also entered into Security
Agreements granting Sanofi-Synthelabo a subordinate security
interest in all of our assets, including our U.S. Patents
and patent applications then existing or thereafter arising, to
secure our obligation under the Amendment to the Final Award.

In December 2003, we announced that the FDA
approved our third-generation GlucoWatch Biographer; however,
this device is not yet commercially available.

In December 2003, we entered into the Global
Resolution with Sankyo Pharma that resolved and dismissed the
pending litigation filed on October 6, 2003, and terminated our
Sales, Marketing and Distribution Agreement and all other
contractual arrangements. The Global Resolution provided for
Sankyo Pharma to pay us $30.0 million and also specified
that neither party owed any payments to the other, thus allowing
us to write off certain liabilities and assets, resulting in a
total net gain of $75.8 million. Furthermore, Sankyo Pharma
transferred title to us of more than 20,000 GlucoWatch G2
Biographers and more than 1.0 million AutoSensors that we
had previously sold and shipped to them. Sankyo Pharma is to
provide certain transition services related to distribution and
customer services until the earlier of June 30, 2004 or
when we notify Sankyo Pharma that they may discontinue such
services, and we are entitled to receive 30% of all monies
received from product sales by Sankyo Pharma during this
transition period.

Also in December 2003, we dissolved Cygnus
International, Inc., a Delaware corporation and a wholly
owned subsidiary of Cygnus, Inc., which was established in
March 2001 for possible future international operations.

In 2003, the U.S. Patent and Trademark
Office issued to us 10 patents relating to our glucose
monitoring systems, including the GlucoWatch G2 Biographer. We
also received 7 patents from the European Patent Office and 1
patent from the Japanese Patent office in 2003 that relate to
our glucose monitoring systems.

In 2003, 5 scientific articles relating to our
GlucoWatch Biographers were published, 10 GlucoWatch Biographer
presentations were made at the American Diabetes Association
(ADA) meeting in New Orleans,

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Louisiana in June, and 6 presentations relating
to our GlucoWatch Biographers were made at the Diabetes
Technology Meeting in Burlingame, California in November.


Recent Developments

On January 30, 2004, we filed an application
to dissolve our U.K. subsidiary, Cygnus (UK) Limited, which
provided sales support and other administrative functions for
us. We now handle these functions directly from the United
States. This application to strike-off was filed with the
Companies House and published on March 16, 2004; we expect
our application to be granted in early third quarter 2004.

On February 12, 2004, we have retained First
Albany Capital Inc. to act as our exclusive financial advisor in
connection with a possible merger, consolidation,
reorganization, business combination, sale of a substantial
portion of our assets or sale of more than 50% of our stock, or
acquisition of the company. First Albany will receive fees that
are customary for this type of transaction, including a
market-rate contingent fee in the event that such a transaction
is consummated.

On February 23, 2004, using outside counsel,
we invoked the mediation provisions set forth in our Asset
Purchase Agreement with Ortho-McNeil Pharmaceutical, Inc.
(Ortho-McNeil), a Johnson & Johnson
company, relating to $34.6 million in potential milestone
payments, which are under dispute between the parties.

On February 25, 2004, the FDA approved our
PMA supplement that expanded our G2 Biographer labeling to
include a description of pre-treatment products and a method to
minimize effects of skin irritation without affecting the
accuracy of G2 Biographer glucose measurements. These
pre-treatment products are Kenalog® (Westwood-Squibb
Pharmaceuticals, Inc., Buffalo NY) aerosol spray and
Cortizone-10 Quick Shot® (Pfizer Inc., New York NY)
spray.

On March 23, 2004, we entered into an Exchange
Agreement with the debenture holders and retired all of our
outstanding Convertible Debentures in exchange for an aggregate
of $13.8 million in cash and 2.5 million shares of our
common stock. The shares received by the Convertible Debenture
holders are freely transferable pursuant to Rule 144(k)
under the Securities Act of 1933, as amended. As a result of
this exchange, $18.8 million in principal and interest that was
to be paid under the Convertible Debentures will not have to be
paid. In connection with the exchange, we also canceled all
outstanding warrants to purchase our common stock that had been
issued to the debenture holders and terminated the registration
rights agreement associated with the Convertible Debentures.
Additionally, the security interests in our assets held by the
debenture holders have been terminated.

On March 24, 2004, we notified our counterparty
that we have elected to terminate our remaining equity line
agreement, which had a commitment period ending December 31,
2004, in light of the fact that we do not believe we would have
been able to draw on this facility anytime in the foreseeable
future.

Diabetes

Diabetes typically is a chronic, progressively
debilitating disease in which the body loses its ability to
maintain normal glucose levels. Diabetes is a leading cause of
death by disease in the United States. Under normal conditions,
the body maintains proper glucose levels by releasing insulin, a
hormone secreted by the pancreas, in response to increases in
blood sugar. Insulin is a hormone that regulates the storage and
metabolism of glucose. Glucose levels must be maintained within
a specific concentration range to ensure optimal cellular
function and health. Diabetes develops when the pancreas is
unable to produce sufficient levels of insulin or the body is
unable to utilize insulin to effectively control glucose
metabolism. Diabetes can lead to severe long-term health
complications, including blindness, kidney disease, heart
disease, stroke, nerve damage and peripheral vascular disease,
potentially leading to amputation.

Diabetes usually is classified as Type 1 or Type
2. Type 1 diabetes is characterized by a severe lack of insulin
secretion by the bodys pancreas. Type 1 diabetes generally
occurs during childhood or adolescence, but can occur at any
age. Individuals with Type 1 diabetes require daily insulin
injections to survive. Type 2 diabetes is the most common form
of the disease and is characterized by the bodys inability
to produce

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enough insulin or to properly utilize insulin
because of tissue resistance to insulin. Type 2 diabetes
typically occurs in adulthood, although the incidence in younger
populations is increasing. Usually Type 2 diabetes is initially
managed with diet, exercise and oral medication, although many
people with Type 2 diabetes will eventually require daily
insulin injections.


The ADA estimates that, in 2002,
18.2 million people, or 6.3% of the population, in the
United States had diabetes, and that 29% of these people are
undiagnosed. The ADA reports that 1.3 million new cases of
diabetes are diagnosed in the United States each year in people
ages 20 and older. The risk of diabetes increases with age,
and the ADA reports that 18.3% of people ages 60 and older
in the United States have diabetes. In a 2002 report, the World
Health Organization (WHO) estimated that 177 million
people suffer from diabetes worldwide. The WHO report
anticipates that this number will increase to at least
300 million by 2025.

The ADA estimates that annual total
U.S. health care expenditures incurred by people with
diabetes climbed from $98 billion in 1997 to
$132 billion in 2002, including annual per-capita health
care costs for people with diabetes of $13,243 in 2002, compared
with $2,560 for people without diabetes in 2002. Of the
$132 billion in annual expenditures, direct medical
expenditures accounted for approximately $92 billion and
indirect costs, such as lost workdays, mortality, and permanent
disability, totaled approximately $40 billion.

Managing Diabetes with Glucose
Monitoring

Every persons glucose level varies during
the course of the day, depending upon factors such as diet,
insulin availability, exercise, illness and stress. To limit the
short-term and long-term effects of diabetes, people with
diabetes must maintain glucose levels within the proper range.
To do this, they must first measure their glucose levels and
then manage these levels by adjusting insulin intake, oral
medication, diet and exercise. They must then take additional
glucose measurements to gauge their individual response to the
adjustments. The more frequently people with diabetes test their
glucose levels and track their activities and food intake, the
better they will be able to understand and manage their
diabetes. Despite the benefits of frequent monitoring, the ADA
estimates that on average people with diagnosed diabetes test
only slightly more than once per day. We believe there is a
medical need for an improved device that enables individuals and
physicians to make better-informed diabetes management decisions.

To obtain a glucose sample with current
monitoring systems, users generally are required to prick one of
their fingertips, or an alternative site such as the forearm or
base of the thumb, with a lancing device, which typically
consists of a spring-loaded lancet that penetrates a measured
distance. After drawing a blood sample, users generally are
required to drop the blood sample on a disposable test strip or
bring the test strip into contact with the blood sample. To
obtain additional blood glucose readings, this process must be
repeated during the course of the day and can be inconvenient
and disruptive to an individuals lifestyle, as well as
painful, although alternative-site sampling reduces pain. We
believe these alternative-site methods are still inconvenient
for the user and do not provide the recommended frequent testing.

Numerous clinical studies validate the importance
of more intensive diabetes management, which includes more
frequent testing and more frequent insulin injections. The
landmark Diabetes Control and Complications Trial (DCCT),
sponsored by the National Institutes of Health (NIH) and
published in 1993, showed that long-term intensive glucose
monitoring and therapy slowed the onset and progression of eye,
kidney and nerve disease in people with Type 1 diabetes. In the
DCCT study, the protocol for intensive glucose management called
for blood glucose testing at least four times per day by people
with Type 1 diabetes. The DCCT demonstrated that the risk of
complications could be reduced by 76% for eye disease, 50% for
kidney disease and 60% for nerve disease by intensively managing
glucose levels. Similar studies in the United Kingdom and Japan
involving people with Type 2 diabetes support the importance of
intensive glucose control.

Despite the apparent long-term benefits of
intensive glucose monitoring and therapy, the DCCT also showed
that such intensive management resulted in approximately a
three-fold increase in severe low blood sugar, or hypoglycemia
(defined by the DCCT as requiring third-party assistance),
sometimes resulting in seizure or coma and often leading to
hospitalization. These events are particularly likely to occur
during sleep,

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when the patient is usually unable to recognize
and respond to the symptoms. In addition, when the body
experiences hypoglycemia over an extended period, the
bodys usual warning signs may become dull or switch off
altogether, resulting in a condition known as hypoglycemia
unawareness, in which the patient may experience a severe
hypoglycemic event without experiencing the symptoms that
usually precede such events. Fear of the consequences of severe
hypoglycemia (for example, fainting while driving) is a primary
factor deterring patients from intensively managing their
diabetes. The dilemma for patients is that they must risk the
more immediate short-term effects of hypoglycemia in order to
avoid the long-term effects of high blood sugar, or
hyperglycemia.


Our GlucoWatch G2 Biographer
Solution

Our GlucoWatch G2 Biographer provides readings
frequently, automatically and non-invasively, up to six times an
hour, for up to 13 hours, day or night, and is designed to
enable people with diabetes and their physicians and other
caregivers to identify trends and track patterns in glucose
levels that would be difficult to detect with current testing
techniques. The frequency of the measurements provides more
complete information about fluctuations in glucose levels, which
we believe enables better-informed decisions regarding diet,
medications and physical activities. The GlucoWatch G2
Biographer is not intended to replace existing glucose
measurement methods, but is intended to supplement blood glucose
testing and provide more frequent information about glucose
levels. In the United States, the GlucoWatch G2 Biographer is
sold as a adjunctive prescription device. Published data show
that children and adolescents using the Biographer are able to
significantly reduce high blood glucose and improve their
overall blood glucose control, as measured by the glycosylated
hemoglobin test (also referred to as the HbA1c test or GHb
test). Users are also able to detect much more hypoglycemia than
with conventional blood glucose monitoring, particularly while
wearing the Biographer at night, when hypoglycemia often goes
undetected. Our third-generation GlucoWatch Biographer and
AutoSensor system, which was recently approved by the FDA,
focuses on enhancing customer satisfaction and ease of use, but
is not yet commercially available.

The GlucoWatch G2 Biographer differs from other
glucose measuring systems in several important ways. Our
GlucoWatch G2 Biographer:



| |   |                                                                                                           
| | - | ----------------------------------------------------------------------------------------------------------
| |  | is non-invasive, collecting glucose through the
    skin, not from blood,                                 
|
| |  | automatically measures and displays glucose
    levels,                                                   
|
| |  | detects trends and tracks patterns in glucose
    levels, as opposed to a single, discrete reading,       
|
| |  | alerts a patient when glucose levels are too
    high, too low, or likely to be low within 20 minutes, and
|
| |  | stores more than 8,500 glucose values in an
    electronic diary.                                         

Our devices are the only products approved by the
FDA that provide frequent, automatic and non-invasive
measurements of glucose levels. We believe our products
represent the most significant commercial technological
advancement in self-monitoring of glucose levels since the
advent, approximately 20 years ago, of finger-stick blood
glucose measurement. Our GlucoWatch G2 Biographer system
consists of two components: a durable component known as the
Biographer, and a consumable component known as the AutoSensor.
The GlucoWatch G2 Biographer uses an extremely low electrical
current to extract glucose molecules through the skin, using
patented sampling processes. The glucose is extracted from
interstitial fluid that surrounds cells, rather than from blood,
eliminating the need for multiple finger or alternative-site
pricks to provide glucose readings. The G2 Biographer can be
worn on the forearm like a watch and functions like a computer,
analyzing and responding to data received from the AutoSensor.
The AutoSensor uses proprietary biosensor technology and snaps
into the back of the Biographer. The AutoSensor is calibrated
with a standard blood glucose measurement. After a two-hour
warm-up period during which no glucose readings are displayed,
the AutoSensor automatically and non-invasively extracts and
measures glucose as often as every 10 minutes for a period of up
to 13 hours before requiring replacement, thus the user can
receive up to six glucose readings per hour. An optional
Biographer accessory known as the Analyzer also has been
approved by the FDA, and this device downloads data from an
individuals Biographer into a personal computer. The
proprietary Analyzer software uses the data to generate
statistical reports and graphs that are designed to create a

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comprehensive picture of a patients recent
glucose level history and allow for analysis of patterns in
glucose levels.


Current methods for measuring glucose, in which
skin is lanced and a blood sample is obtained for measurement,
are inconvenient and disruptive to the user. Because of this,
the vast majority of people with diabetes do not perform the
frequent glucose testing that is necessary to provide adequate
information to manage diabetes, despite substantial clinical
evidence of the benefits of more intensive diabetes management.
We believe there is an unmet medical need for a device that can
provide and track frequent glucose readings automatically and
non-invasively.

Product Research and Development

Our product research and development efforts have
been focused on the performance, convenience and ease of use of
our products. We believe that as we make our glucose monitoring
systems increasingly easy and simple to use, market penetration
will increase, frequency of use will grow and diabetes
management will be improved. We announced the approval by the
FDA of our third-generation product in December 2003 and this
new Biographer and AutoSensor system focuses on enhancing
customer satisfaction and ease of use, but is not yet
commercially available because of the lack of a new sales,
marketing and distribution partner and as our existing G2
Biographer inventory. Specifically, the FDA approved
modifications to the signal processing routine and data point
screening parameters of the Biographer to reduce the number of
skipped readings, modifications to the DOWN alert of the
Biographer to increase the specificity of the alarm, and an
AutoSensor formulation change to improve Biographer calibration.
On February 25, 2004, the FDA approved our PMA supplement
that expanded our G2 Biographer labeling to include a
description of pre-treatment products and a method to minimize
effects of skin irritation without affecting the accuracy of G2
Biographer glucose measurements. These pre-treatment products
are Kenalog® (Westwood-Squibb Pharmaceuticals, Inc.,
Buffalo NY) aerosol spray and Cortizone-10 Quick Shot®
(Pfizer Inc., New York NY) spray. Given our current
financial situation as well as this recent FDA approval, we are
not currently conducting research and development, although
areas of focus have included further reducing the warm-up time,
extending the duration of use beyond 13 hours, and changing
the physical profile of the product.

Clinical Trials

Independent clinical trials are being conducted
in the United States and United Kingdom to examine the clinical
utility of our GlucoWatch G2 Biographer in diabetes management.
These trials are being funded by the NIH in the United States
and the National Health Service Health Technology Assessment
Commissioning Board in the United Kingdom. Both the U.S. and
U.K. trials are randomized, controlled trials that are examining
important health care outcomes, including glycosylated
hemoglobin levels and the frequency of hypoglycemia. The
U.S. trial (being conducted by a multicenter study group
called DirecNet) is focusing on adolescents, and the U.K. trial
(being conducted by a multicenter study group called MITRE) is
focusing on adults. We also provide products on a limited basis,
usually free of charge, to independent researchers for use in
their various clinical studies.

Research and Development Expenses

Research and development expenses have included
costs for scientific and product development personnel, material
used in the development and validation of high capacity
manufacturing processes, consultants, clinical trials, supplies,
depreciation of equipment used in research and product
development, and facilities allocations. Significant expenses
have been incurred in our efforts to increase our manufacturing
capacity of both the disposable AutoSensors and durable
Biographer and to maintain our quality system. We have also
devoted internal resources and conducted clinical trials to
expand the indications of our products. Research and development
expenditures totaled $5.1 million, $13.9 million, and
$27.4 million in the fiscal years 2003, 2002 and 2001,
respectively. Due to the significant uncertainties with respect
to the timing and outcome of our efforts to obtain a sales,
marketing and distribution partner or other strategic alliance,
as well as the FDA review process, we are unable to estimate the
future level of research and development activities.

7



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Our Business Strategy

We are currently seeking a new sales, marketing
and distribution partner or other strategic alliance, and we are
exploring the possibility of selling the company to a third
party. We have retained First Albany Capital Inc. to act as our
exclusive financial advisor in connection with a possible
merger, consolidation, reorganization, business combination,
sale of a substantial portion of our assets or sale of more than
50% of our stock, or acquisition of the company. First Albany
will receive fees that are customary for this type of
transaction, including a market-rate contingent fee in the event
that such a transaction is consummated. Our Biographer products
have not yet been widely accepted by the market due, we believe,
to a combination of factors, including adoption barriers for new
technology, the need for a paradigm shift in the management of
diabetes, lack of widespread medical reimbursement, and the
pricing and performance characteristics of the device. We do not
have the resources or infrastructure to perform the full range
of functions necessary to successfully market and sell our
products. Our products require a sizeable sales force to create
product awareness and provide education to health care
professionals and end user customers, a managed care sales force
to work with national and regional health plans to secure
medical reimbursement, significant advertising and promotional
resources, a variety of customer support and education programs,
a technical support group, logistics and distribution expertise
and personnel, and marketing management resources and personnel.
Thus, we must obtain a sales, marketing and distribution partner
or other strategic alliance, including but not limited to a
merger or an acquisition by a third party, if we are to continue
to sell our products. In the event that we are unsuccessful in
our efforts and our product sales do not significantly increase,
we may need to liquidate the company or sell some or all of its
assets.

Sales and Marketing

Under our Global Resolution, Sankyo Pharma is
required to provide certain transition services related to
distribution and customer services until the earlier of
June 30, 2004 or when we notify Sankyo Pharma that they may
discontinue such services; thereafter, we are solely responsible
for the sales, marketing and distribution of our products in the
United States. We do not anticipate having the ability to
effectively perform this function ourselves in our current
financial condition, and are seeking a sales, marketing and
distribution partner or other strategic alliance.

Reimbursement

In the United States, as well as in foreign
countries, government-funded or private insurance programs,
commonly known as third-party payors, pay a significant portion
of the cost of a patients medical expenses. A consistent
approach to reimbursement does not exist among all these payors.
Therefore, reimbursement can be quite different from payor to
payor. We believe that reimbursement is an important factor in
the success of medical devices. Currently, our products do not
have widespread reimbursement, although three national managed
care plans have established a reimbursement approach for our
products on a case-by-case basis upon a showing of medical
necessity. We do not believe our products will receive
widespread reimbursement in the near future, due to the lack of
a current sales, marketing and distribution partner and our lack
of expertise and resources in this area.

Manufacturing

Under the terms of our Global Resolution with
Sankyo Pharma, Sankyo Pharma transferred title to us of more
than 20,000 GlucoWatch G2 Biographers and more than
1.0 million AutoSensors that we had previously sold and
shipped to them. These supplies are more than adequate to meet
foreseeable demand in the near term, and we do not have any
plans to manufacture our G2 Biographer or third-generation
product in the immediate future. Prior to our suspension of
manufacturing, other companies manufactured for us the materials
for the durable portion of our glucose monitoring system, the G2
Biographer, and we performed the final assembly and testing of
the G2 Biographer at our facility in Redwood City, California,
which complies with all applicable regulatory requirements.
Other companies manufactured the materials for the disposable
portion of our system, the AutoSensor, which was assembled in a
third-party facility in Michigan, using equipment we own. This
facility has been inspected by the FDA and was determined to be
in compliance with

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applicable regulatory requirements. Final quality
testing of the AutoSensor was done at our Redwood City facility
to ensure that it met our specifications.


Intellectual Property

It is our policy to aggressively protect our
investments in technology and marketing by filing patent and
trademark applications in the United States and key foreign
countries. As of December 31, 2003, we had 35 issued
U.S. patents and 192 issued foreign patents, with
approximately 46 additional patent applications pending
worldwide. These patents and applications cover our algorithms
and data processing, biosensors, and reverse iontophoresis
methodologies for glucose and other analytes and represent more
than 30 patent families. As of December 31, 2003, we had 16
U.S. trademark registrations, with 6 U.S. trademark
applications pending or published, and 65 foreign trademark
registrations, with approximately 19 additional foreign
trademark applications pending. Our GlucoWatch
trademark is registered in the United States, the European
Community, Japan, and other countries.

Additionally, we have a license from The Regents
of the University of California relating to their U.S. and
foreign patents covering technology for transdermal extraction
of glucose and other analytes.

Customers

Our 2003 revenues consisted of product and
contract revenues. Of our product revenues, 93% related to sales
of our products to Sankyo Pharma in the United States. Prior to
termination of our agreements with Sankyo Pharma, we sold our
products to Sankyo Pharma at specified prices. The majority of
the remainder of our product revenues resulted from product
sales to end-user customers in the United Kingdom. In light of
our Global Resolution with Sankyo Pharma, we will not be selling
any additional products to Sankyo Pharma.

Of our contract revenues in 2003, 100% related to
a Small Business Innovation Research (SBIR) grant from the
NIH. We currently are not performing work under any SBIR grants
or contracts, and thus do not expect any contract revenues in
the near future.

Competition

The self-monitoring of blood glucose is a large
and growing market. The market is dominated by conventional
finger-stick blood measurement technologies, with
LifeScan, Inc. (a Johnson & Johnson company),
Roche Diagnostics Corporation, Bayer AG and Abbott Laboratories
having the largest market shares. Conventional finger-stick
technology requires the individual to draw blood from the
fingertip through the use of a lancet and then place the blood
on a test strip that is inserted into a meter. Although this has
been the standard of care for more than 20 years, many
customers find the procedure to be painful and inconvenient. New
products known as alternative-site technologies have been
introduced to reduce the pain of the lancing procedure. These
products use multiple sites, not just the fingertip, to extract
blood samples.

A number of companies are developing invasive
methods to monitor glucose concentrations in interstitial fluid
to provide frequent and automatic readings. For example,
Medtronic, Inc., through its subsidiary Medtronic MiniMed,
currently markets a device that must be inserted subcutaneously
by a physician into the patients abdominal region. Glucose
readings taken over a period of up to three days can only be
retrieved by a physician, who must extract the device and
download the data. A patient version of this device has recently
been approved by the FDA, although the user only receives alarms
and not glucose readings. Additionally, TheraSense, Inc.
(whose purchase by Abbott Laboratories was recently announced)
has a subcutaneous continuous glucose monitoring device under
FDA review. Companies are also developing technologies that
provide non-invasive extraction for episodic readings.

Government Regulation

On March 22, 2001, the FDA granted approval
for us to market and commercially distribute our
first-generation GlucoWatch Biographer. Then, on March 21,
2002, the FDA approved our second-generation product, the
GlucoWatch G2 Biographer. On August 28, 2002, we received
approval from the FDA of our

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supplemental PMA application for use of the
GlucoWatch G2 Biographer by children and adolescents
(ages 7 to 17). On December 4, 2003, we announced that
the FDA had approved our third-generation Biographer, which is
not yet commercially available.


In 1999, we received a CE Certificate for our
GlucoWatch Biographer, indicating that the product met the
essential requirements and other criteria of the European
Community Directive 93/42/ ECC. The CE Certificate is required
for selling products in the European Community. In the European
Community, the GlucoWatch Biographer does not require a
prescription.

Our manufacturing facility is subject to periodic
inspection by federal, state and foreign regulatory authorities
and has been registered by the FDA and licensed by the
California Department of Health Services, Food and Drug Branch.
Our quality assurance system is also subject to regulation by
both the FDA and the State of California. We also comply with
ISO 9001, EN 46001 and ISO 13485 standards. ISO standards were
developed to signify that companies have a quality manufacturing
system with products that meet international quality standards.
Our AutoSensors were commercially manufactured at a third-party
facility that also complies with applicable regulatory
requirements.

Employees

As of December 31, 2003, we had a total of
24 full-time employees, all in the United States. Of this
total number of employees, 13 were in technical functions and 11
were in general administration. None of our employees is
represented by a labor union. We have not experienced any
labor-related work stoppages and we believe we have good
relations with our employees. In October 2003, we reduced our
workforce by approximately 60%, primarily in the areas of
research and development and operations.

Executive Officers

The executive officers of the Company, who serve
at the discretion of the Board of Directors, are as follows, in
alphabetical order:

|                        |  |     |    |       |  |                                                                                                     
|----------------------- |  | --- | -- | ----- |  | ----------------------------------------------------------------------------------------------------
|Name                    |  | Age |    | Title
|                        |  |     |    |      
|Neil R. Ackerman, Ph.D. |  |     | 60 |       |  | Chief Technical Officer and Senior Vice
    President, Research & Development and Scientific Affairs
|Craig W. Carlson        |  |     | 56 |       |  | Chief Operating Officer, Chief Financial Officer
    and Senior Vice President                      
|John C Hodgman          |  |     | 49 |       |  | Chairman of the Board, President and Chief
    Executive Officer                                    
|Barbara G. McClung      |  |     | 49 |       |  | General Counsel and Senior Vice President                                                           

Neil R.
Ackerman, Ph.D.was appointed
Chief Technical Officer in December 2000 and has served as
Senior Vice President, Research & Development and
Scientific Affairs since September 1998. Dr. Ackerman
joined Cygnus in May 1994 as Vice President, Research &
Development and, from January 1997 to September 1998, he served
as Senior Vice President, Research & Development. From
1990 to May 1994, Dr. Ackerman served as Vice President of
Research and Development for Glycomed, leading its discovery
efforts on cardiovascular and inflammatory diseases. From 1982
to 1990, he was Research Director, Cancer and Inflammatory
Diseases with DuPont Pharmaceuticals. Prior to that time, he
held research and management positions at Syntex Corporation and
Pfizer, Inc. Dr. Ackerman received B.S. and Ph.D.
degrees from the University of Maryland and completed a
post-doctoral fellowship in immunology at Stanford University.

Craig W. Carlsonwas
appointed Chief Operating Officer in December 2000 and has
served as Chief Financial Officer since 1998. He joined Cygnus
in July 1993 as Vice President, Corporate Communications, became
Vice President, Strategic Planning and Corporate Marketing, then
assumed responsibility for finance and information technology in
1997 as Senior Vice President, Finance. From 1988 to 1993, he
was Vice President and Group Director at Young &
Rubicam Advertising in San Francisco. Prior to that,
Mr. Carlson

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was Vice President of Campbell-Mithun
Advertising. He holds a B.A. from Union College, an M.S. Ed.
from Hofstra University and an M.B.A. from Stanford University.


John C Hodgmanwas
appointed Chairman of the Board in 1999 and has served as a
director, President and Chief Executive Officer since August
1998. He was President, Cygnus Diagnostics from May 1995 to
August 1998, and was also Chief Financial Officer of
Cygnus, Inc. Mr. Hodgman joined Cygnus in August 1994
as Vice President, Finance and Chief Financial Officer. Prior to
joining Cygnus, Mr. Hodgman served as Vice President of
Operations and Finance and as Chief Financial Officer for
Central Point Software, a personal computer and networking
software company. Prior to that, he was Vice President of
Finance and Administration and Chief Financial Officer of Ateq
Corporation. Mr. Hodgman holds a B.S. degree from Brigham
Young University and an M.B.A. from the University of Utah.
Mr. Hodgman is also a director of Immersion Corporation and
AVI BioPharma, Inc.

Barbara G. McClungwas appointed General Counsel, Senior
Vice President and Corporate Secretary in December 1998.
Ms. McClung joined Cygnus in January 1998 as Vice
President, Intellectual Property. In August 1998,
Ms. McClung was promoted to Vice President and General
Counsel. Prior to joining Cygnus, from August 1990 to January
1998, she was Corporate Patent Counsel at Chiron Corporation, a
biotechnology company. Prior to that she was Patent Counsel at
E.I. du Pont de Nemours & Co. She is a member of the
California, Delaware and Pennsylvania bars, as well as being a
registered patent attorney before the United States Patent and
Trademark Office. Ms. McClung received a J.D. from the
University of Pennsylvania Law School, as well as a B.A. from
the University of California, San Diego, and an M.A. from
the University of Pennsylvania.

Available Information

Our corporate website is www.cygn.comand
our product website is www.glucowatch.com.We make
available free of charge, on or through our website, our annual,
quarterly and current reports, and any amendments to those
reports, as soon as reasonably practicable after we
electronically file such reports with the Securities and
Exchange Commission. Information contained on our website is not
part of this Report.






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

In the United States, we lease approximately
38,000 square feet in a building located in Redwood City,
California, and our lease runs through April 2009. This building
houses our administrative offices, laboratories, and final
assembly lines for the Biographer. On October 15, 2003, we
terminated our second building lease that would have run through
December 2003, which we had previously subleased to
Maxygen, Inc. We received full payment from
Maxygen, Inc. for this early termination, and in turn paid
the remaining lease amount to the property owner.

The applicable Cygnus manufacturing facility
complies with ISO 9001, EN 46001, ISO 13485 and United
States Quality System Regulations standards. We hold a Medical
Device Manufacturing License from the California Department of
Health Services, Food and Drug Branch and a Device Establishment
Registration Number from the Center for Devices and Radiological
Health branch of the FDA.






|        |                   
|------- | ------------------
|Item 3. | Legal Proceedings.

On October 6, 2003, we filed a complaint in
the Superior Court of the State of California for the County of
San Mateo against Sankyo Pharma and Sankyo Japan for breach
of contract and intentional interference with contract,
respectively, relating to the sales, marketing and distribution
of our GlucoWatch Biographer products. On November 6, 2003,
Sankyo Pharma filed an answer and cross-claims against us for
declaratory relief, breach of contract, and defamation. On
December 15, 2003 we filed a response to these claims, and
Sankyo Japan filed its answer.

On December 23, 2003, we entered into the
Global Resolution with Sankyo Pharma that resolved and dismissed
the pending litigation, and terminated our Sales, Marketing and
Distribution Agreement and all other contractual arrangements.
The Global Resolution provided for Sankyo Pharma to pay us
$30.0 million

11



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and also specified that neither party owed
payments to the other party, thus allowing us to write off
certain liabilities and assets, resulting in a total net gain of
$75.8 million. Furthermore, Sankyo Pharma transferred title
to us of more than 20,000 GlucoWatch G2 Biographers and more
than 1.0 million AutoSensors that we had previously sold
and shipped to them. Sankyo Pharma is to provide certain
transition services related to distribution and customer
services until the earlier of June 30, 2004 or when we
notify Sankyo Pharma that they may discontinue such services,
and we are entitled to receive 30% of all monies received from
product sales by Sankyo Pharma during this transition period.


On February 23, 2004, using outside counsel,
we invoked the mediation provisions set forth in our Asset
Purchase Agreement with Ortho-McNeil Pharmaceutical, Inc.
(Ortho-McNeil), a Johnson & Johnson
company, relating to $34.6 million in potential milestone
payments, which are under dispute between the parties.






|        |                                                         
|------- | --------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security
    Holders.

None.




PART II





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

On January 6, 2003, we received the
determination of the Nasdaq Listing Qualifications Panel to
transfer our common stock to the OTC Bulletin Board, effective
at the open of business on January 8, 2003. Our common
stock previously had been trading on the Nasdaq National Market
under the symbol CYGN since 1991. Our common stock
is currently trading on the OTC Bulletin Board under the symbol
CYGN. The following table sets forth, for the
periods indicated, the high and low sale prices per share of our
common stock as quoted on the Nasdaq National Market through
January 7, 2003, and as quoted on the OTC Bulletin Board
commencing January 8, 2003.

|                              |  |      |      |     |  |   |      | 
|----------------------------- |  | ---- | ---- | --- |  | - | ---- | 
|                              |  | High |      | Low
|                              |  |      |      |    
|Year Ended December 31, 2003: |  |      |      |     |  |   |      | 
|Fourth Quarter                |  | $    | 0.72 |     |  | $ | 0.07 | 
|Third Quarter                 |  |      | 0.67 |     |  |   | 0.36 | 
|Second Quarter                |  |      | 1.09 |     |  |   | 0.27 | 
|First Quarter                 |  |      | 0.72 |     |  |   | 0.25 | 
|                             
|Year Ended December 31, 2002: |  |      |      |     |  |   |      | 
|Fourth Quarter                |  | $    | 1.60 |     |  | $ | 0.62 | 
|Third Quarter                 |  |      | 3.05 |     |  |   | 0.63 | 
|Second Quarter                |  |      | 7.04 |     |  |   | 1.83 | 
|First Quarter                 |  |      | 5.65 |     |  |   | 3.48 | 

On March 24, 2004, the last reported sale of
our common stock on the OTC Bulletin Board was $0.46 per share
and there were 969 record holders of our common stock. We have
never paid any cash dividends on our capital stock. We
anticipate that we will retain our earnings, if any, to support
operations and to finance the growth and development of our
business. Therefore, we do not expect to pay cash dividends in
the foreseeable future.

Recent Sales of Unregistered
Securities

None.

12



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##### Table of Contents








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

The selected consolidated financial data
presented below are derived from the audited consolidated
financial statements of Cygnus, Inc. The following data
should be read in conjunction with the consolidated financial
statements and related notes, the information set forth under
Item 7. Managements Discussion and Analysis of
Financial Condition and Results of Operations and other
financial information included herein.

|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |        |        |  
|---------------------------------------------------------------------------------- | --------------------------------------------------------- | ------------------------------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | - | ------- | ------ | ------ | -
|                                                                                   |                                                           |                                      
|                                                                                   |                                                           | Years Ended December 31,             
|                                                                                   |                                                           |                                      
|                                                                                   |                                                           | 2003                                  |         | 2002   |        | 2001 |         | 2000   |        | 1999
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |     
|                                                                                   |                                                           |                                      
|                                                                                   |                                                           | (In thousands, except per share data)
|Consolidated Statement of Operations
    Data:                                     |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Revenues:                                                                          |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|                                                                                   | Net product revenues                                      |                                       | $       | 2,684  |        |      | $       | 3,453  |        |      | $       | 489    |        |   | $       |       |        |   | $       |       |       
|                                                                                   | Contract revenues                                         |                                       |         | 234    |        |      |         | 401    |        |      |         | 5,300  |        |   |         | 1,052  |        |   |         | 2,061  |       
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|                                                                                   |                                                           | Total revenues                        |         |        | 2,918  |      |         |        | 3,854  |      |         |        | 5,789  |   |         |        | 1,052  |   |         |        | 2,061  |  
|Costs and expenses:                                                                |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|                                                                                   | Costs of product revenues                                 |                                       |         | 15,447 |        |      |         | 6,396  |        |      |         | 271    |        |   |         |       |        |   |         |       |       
|                                                                                   | Research and development                                  |                                       |         | 5,119  |        |      |         | 13,883 |        |      |         | 27,405 |        |   |         | 21,170 |        |   |         | 15,745 |       
|                                                                                   | Sales, marketing, general and administrative              |                                       |         | 6,440  |        |      |         | 22,544 |        |      |         | 15,481 |        |   |         | 10,072 |        |   |         | 4,794  |       
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|                                                                                   |                                                           | Total costs and expenses              |         |        | 27,006 |      |         |        | 42,823 |      |         |        | 43,157 |   |         |        | 31,242 |   |         |        | 20,539 |  
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Loss from operations                                                               |                                                           |                                       | (24,088 | )      |        |      | (38,969 | )      |        |      | (37,368 | )      |        |   | (30,190 | )      |        |   | (18,478 | )     
|Interest and other income/(expense), net                                           |                                                           |                                       | 114     |        |        |      | 417     |        |        |      | 2,416   |        |        |   | 1,970   |        |        |   | 194     |       
|Interest expense                                                                   |                                                           |                                       | (2,210  | )      |        |      | (3,153  | )      |        |      | (3,721  | )      |        |   | (3,687  | )      |        |   | (3,690  | )     
|Gain from Sankyo Pharma settlement                                                 |                                                           |                                       | 75,825  |        |        |      |        |        |        |      |        |        |        |   |        |        |        |   |        |       
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Income/(loss) from continuing operations before
    tax                            |                                                           |                                       | 49,641  |        |        |      | (41,705 | )      |        |      | (38,673 | )      |        |   | (31,907 | )      |        |   | (21,974 | )     
|Provision for income taxes                                                         |                                                           |                                       | 199     |        |        |      | 23      |        |        |      | 527     |        |        |   | 100     |        |        |   | 200     |       
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Net income/(loss) from continuing operations                                       |                                                           |                                       | 49,442  |        |        |      | (41,728 | )      |        |      | (39,200 | )      |        |   | (32,007 | )      |        |   | (22,174 | )     
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Discontinued operations:                                                           |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|                                                                                   | Income from operations of a discontinued segment          |                                       |         |       |        |      |         |       |        |      |         |       |        |   |         |       |        |   |         | 3,031  |       
|                                                                                   | Gain on disposal of a segment                             |                                       |         |       |        |      |         |       |        |      |         |       |        |   |         |       |        |   |         | 16,308 |       
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Net income/(loss) before cumulative effect of a
    change in accounting principle |                                                           |                                       | 49,442  |        |        |      | (41,728 | )      |        |      | (39,200 | )      |        |   | (32,007 | )      |        |   | (2,835  | )     
|Cumulative effect of a change in accounting
    principle                          |                                                           |                                       |        |        |        |      |        |        |        |      |        |        |        |   | (5,026  | )      |        |   |        |       
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Net income/(loss)                                                                  |                                                           | $                                     | 49,442  |        |        | $    | (41,728 | )      |        | $    | (39,200 | )      |        | $ | (37,033 | )      |        | $ | (2,835  | )     
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Amounts per share, basic:                                                          |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Income/(loss) from continuing operations                                           |                                                           | $                                     | 1.28    |        |        | $    | (1.11   | )      |        | $    | (1.31   | )      |        | $ | (1.22   | )      |        | $ | (0.95   | )     
|Income from a discontinued segment                                                 |                                                           |                                       |        |        |        |      |        |        |        |      |        |        |        |   |        |        |        |   | 0.83    |       
|Cumulative effect of a change in accounting
    principle                          |                                                           |                                       |        |        |        |      |        |        |        |      |        |        |        |   | (0.19   | )      |        |   |        |       
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Net income/(loss)                                                                  |                                                           | $                                     | 1.28    |        |        | $    | (1.11   | )      |        | $    | (1.31   | )      |        | $ | (1.41   | )      |        | $ | (0.12   | )     
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Shares used in computation of amounts per share,
    basic                         |                                                           |                                       | 38,480  |        |        |      | 37,580  |        |        |      | 30,028  |        |        |   | 26,315  |        |        |   | 23,354  |       
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Amounts per share, diluted:                                                        |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|                                                                                   | Income/(loss) from continuing operations                  |                                       | $       | 1.01   |        |      | $       | (1.11  | )      |      | $       | (1.31  | )      |   | $       | (1.22  | )      |   | $       | (0.95  | )     
|                                                                                   | Income from a discontinued segment                        |                                       |         |       |        |      |         |       |        |      |         |       |        |   |         |       |        |   |         | 0.83   |       
|                                                                                   | Cumulative effect of a change in accounting
    principle |                                       |         |       |        |      |         |       |        |      |         |       |        |   |         | (0.19  | )      |   |         |       |       
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|                                                                                   |                                                           | Net income/(loss)                     |         | $      | 1.01   |      |         | $      | (1.11  | )    |         | $      | (1.31  | ) |         | $      | (1.41  | ) |         | $      | (0.12  | )
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       
|Shares used in computation of amounts per share,
    diluted                       |                                                           |                                       | 49,640  |        |        |      | 37,580  |        |        |      | 30,028  |        |        |   | 26,315  |        |        |   | 23,354  |       
|                                                                                   |                                                           |                                       |         |        |        |      |         |        |        |      |         |        |        |   |         |        |        |   |         |       

|                                                 |  |                |          |      |  |      |          |      |  |      |          |   |  |   |          |   |  |   |          |  
|------------------------------------------------ |  | -------------- | -------- | ---- |  | ---- | -------- | ---- |  | ---- | -------- | - |  | - | -------- | - |  | - | -------- | -
|                                                 |  |               
|                                                 |  | December 31,  
|                                                 |  |               
|                                                 |  | 2003           |          | 2002 |  | 2001 |          | 2000 |  | 1999
|                                                 |  |                |          |      |  |      |          |      |  |     
|                                                 |  |               
|                                                 |  | (In thousands)
|Consolidated Balance Sheet Data:                 |  |                |          |      |  |      |          |      |  |      |          |   |  |   |          |   |  |   |          |  
|Cash, cash equivalent and short-term investments |  | $              | 33,483   |      |  | $    | 26,617   |      |  | $    | 23,749   |   |  | $ | 22,939   |   |  | $ | 38,892   |  
|Working capital/(deficiency)                     |  | $              | 18,265   |      |  | $    | (12,438  | )    |  | $    | 6,480    |   |  | $ | 9,869    |   |  | $ | 30,111   |  
|Total assets                                     |  | $              | 37,707   |      |  | $    | 40,477   |      |  | $    | 35,681   |   |  | $ | 32,889   |   |  | $ | 46,976   |  
|Long-term obligations                            |  | $              | 14,830   |      |  | $    | 35,690   |      |  | $    | 33,101   |   |  | $ | 32,189   |   |  | $ | 38,476   |  
|Accumulated deficit                              |  | $              | (247,309 | )    |  | $    | (296,751 | )    |  | $    | (255,023 | ) |  | $ | (215,823 | ) |  | $ | (178,790 | )
|Stockholders equity/(net capital deficiency)    |  | $              | 6,822    |      |  | $    | (42,622  | )    |  | $    | (18,048  | ) |  | $ | (13,023  | ) |  | $ | (1,204   | )

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

Some of the statements in this report,
including in the documents incorporated by reference, are
forward-looking statements that involve risks and uncertainties.
These forward-looking statements include statements about our
plans, objectives, expectations, intentions and assumptions and
other statements contained in this report, including in the
documents incorporated by reference, that are not statements of
historical fact. Forward-looking statements include but are not
limited to statements about our ability to find a new sales,
marketing and distribution partner or other strategic alliance,
including but not limited to a merger or an acquisition by a
third party; the capabilities and potential of the GlucoWatch G2
Biographer business; our ability to achieve market acceptance of
the GlucoWatch G2 Biographer; our ability to manufacture the
GlucoWatch G2 Biographer; our plans for other commercialization
alliances; and the speed and potential results of the regulatory
process. In some cases, you can identify these statements by
words such as may, will,
should, estimates, predicts,
potential, continues,
strategy, believes,
anticipates, plans, expects,
intends and similar expressions. We cannot guarantee
future results, levels of activity, performance or achievements.
Our actual results and the timing of certain events may differ
significantly from the results and timing discussed in this
report, including those under Risk Factors herein,
as well as in the documents incorporated by reference. All
forward-looking statements included in this report are based on
information available to us on the date hereof, and we assume no
obligation to update any such forward-looking
statements.

This information should be read in conjunction
with our consolidated financial statements and accompanying
notes thereto in the F- pages of this report.

Overview

We have developed and manufactured frequent,
automatic and non-invasive glucose monitoring devices. Our
devices are designed to provide more data to individuals and
their physicians and enable them to make better-informed
decisions on how to manage diabetes. We began the
U.S. market launch of our first-generation GlucoWatch®
Biographer on April 15, 2002. On March 21, 2002, the
U.S. Food and Drug Administration (FDA) approved our
second-generation product, the GlucoWatch G2® Biographer.
On August 28, 2002, we received approval from the FDA of
our supplemental pre-market approval (PMA) application for
use of the GlucoWatch G2 Biographer by children and adolescents
(ages 7 to 17). On December 4, 2003, we announced that
the FDA approved our third-generation product. Compared with our
second-generation product, this improved Biographer and
AutoSensor system focuses on enhancing customer satisfaction and
ease of use; however, it is not yet commercially available.

On December 23, 2003, we entered into the
Global Resolution with Sankyo Pharma that resolved and dismissed
the pending litigation filed on October 6, 2003, and
terminated our Sales, Marketing and Distribution Agreement and
all other contractual arrangements with Sankyo Pharma. The
Global Resolution provided for Sankyo Pharma to pay us
$30.0 million and also specified that neither party owed
any payments to the other party, thus allowing us to write off
certain liabilities and assets, resulting in a total net gain of
$75.8 million. Furthermore, Sankyo Pharma transferred title
to us of more than 20,000 GlucoWatch G2 Biographers and more
than 1.0 million AutoSensors that we had previously sold
and shipped to them. Sankyo Pharma is to provide certain
transition services related to distribution and customer
services until the earlier of June 30, 2004 or when we
notify Sankyo Pharma that they may discontinue such services,
and we are entitled to receive 30% of all monies received from
product sales by Sankyo Pharma during this transition period. In
light of these developments, we are not likely to manufacture
our G2 Biographer or third-generation product or develop new
products in the near future. We are currently seeking a new
sales, marketing and distribution partner or other strategic
alliance, and we are exploring the possibility of selling the
company to a third party. We have retained a financial advisor
to lead this process.

On March 23, 2004, we entered into an Exchange
Agreement with the debenture holders and retired all of our
outstanding Convertible Debentures in exchange for an aggregate
of $13.8 million in cash and 2.5 million shares of our
common stock. As a result of this exchange, $18.8 million in
principal and interest that was to be paid under the Convertible
Debentures will not have to be paid. Although this exchange

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significantly reduces our liquidity in the near
term, we will benefit over the course of the repayment period
because we were able to retire the debentures at less than face
value. In connection with the exchange, we also canceled all
outstanding warrants to purchase our common stock that had been
issued to the debenture holders and terminated the registration
rights agreement associated with the Convertible Debentures.
Additionally, the security interests in our assets held by the
debenture holders have been terminated.


On March 24, 2004, we notified our counterparty
that we have elected to terminate our remaining equity line
agreement, which had a commitment period ending December 31,
2004, in light of the fact that we do not believe we would have
been able to draw on this facility anytime in the foreseeable
future. We have not utilized any portion of this equity line.
Because we did not expect to be able to draw on this facility,
as a practical matter, we do not expect our termination of this
equity line to have any impact on our liquidity.

Critical Accounting Policies

The preparation of our financial statements in
conformity with accounting principles generally accepted in the
United States requires management to make estimates and
assumptions that affect the amounts reported in our financial
statements and accompanying notes. Actual results could differ
materially from those estimates. Although there are numerous
policies associated with the preparation of our financial
statements, the following policies are currently considered
critical because of the level of managements estimates and
judgments required.



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

Product revenues are generated upon the sale of
our GlucoWatch Biographer and GlucoWatch G2 Biographers and
accessories in the United States and the United Kingdom. The
GlucoWatch Biographer systems consist of two integrated parts:
the durable Biographer and the disposable, single-use AutoSensor.

Product sales are recorded when all of the
following conditions have been met: product has been shipped,
transfer of title has taken place, there is persuasive evidence
of an arrangement, the price is fixed or determinable, and
collection is reasonably assured. Revenues generated from our
shipments of sample and practice Biographers were recognized
when all the above conditions are met, typically upon delivery
of these products to Sankyo Pharma, as the sales of such
products were not subject to future pricing adjustments. With
regard to product sales that were made directly by us to third
parties, from time to time we allowed customers to return
product for credit. In such instances, we deferred revenue until
the return period expired. We accrue for estimated warranty
costs and other allowances when the revenues from product sales
are recognized. The warranty expenses recorded to date have not
been significant and are within historical estimates.

Revenues in the United States generated from our
shipments of product to Sankyo Pharma for resale under our
now-terminated Sales, Marketing and Distribution Agreement were
deferred until the product was sold by Sankyo Pharma to its
third-party customers, because the net price of our product
sales to Sankyo Pharma was subject to certain contractual
pricing adjustments, such as rebates, discounts and certain fees
offered or paid by Sankyo Pharma to its third-party customers.
Product revenues recorded by us for the first three calendar
quarters of 2003 are net of these adjustments; however, product
revenues recorded for the fourth quarter ended December 31,
2003 were not subject to such adjustments because our Sales,
Marketing and Distribution Agreement with Sankyo Pharma had been
terminated pursuant to the Global Resolution. As a result of the
Global Resolution, the remaining $9.3 million balance in
Deferred revenues from Sankyo Pharma net of deferred costs
of products shipments previously deferred in our balance
sheet at the date of the Global Resolution was included as a
component of Gain from Sankyo Pharma settlement in
our statement of operations during the fourth quarter of 2003.
We do not expect any significant product revenues in 2004 unless
we obtain a sales, marketing and distribution partner or other
strategic alliance.

Our contract revenues may include up-front and
interim milestone payments from co-promotion; sales, marketing
and distribution; and development agreements. Milestone payments
are recorded as revenue based on the provisions of the
underlying agreement and the estimated period of continuing
obligations, generally the contract term. We received
$25.0 million in milestones from Sankyo Pharma under our
now-terminated Sales, Marketing and Distribution Agreement and
prior Co-Promotion Agreement, and these milestone payments

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had been deferred and had appeared in our balance
sheet as Deferred revenues from Sankyo Pharma.
Because the Sales, Marketing and Distribution Agreement was
terminated as part of the Global Resolution, this
$25.0 million was included as a component of Gain
from Sankyo Pharma settlement in our statement of
operations during the fourth quarter of 2003.


Our contract revenues also included payments
received pursuant to research grants. Revenues were recognized
based on the performance requirements of the grant contract and
as reimbursable expenses are incurred. We currently are not
performing work under any SBIR grants or contracts, and thus do
not expect any contract revenues in the near future.



| |                    
| | -------------------
| | Inventory Valuation

Inventory is stated at standard cost adjusted to
approximate the lower of actual cost (first-in, first-out
method) or market, after appropriate consideration is given to
obsolescence and inventory in excess of anticipated future
demand. However, due to the early stage of our product
commercialization activities, the estimates required in
inventory valuation, including production yields and normal
capacity, labor costs incurred in the production of each unit
and overhead costs applicable to manufacturing operations, are
inherently uncertain. Thus, actual results may differ from those
estimates.

For the quarter ended September 30, 2003, in
light of our then-ongoing litigation with Sankyo Pharma, our
subsequent reduction in force, and the excess product inventory
held by Sankyo Pharma, we concluded that it was unlikely that we
would continue to manufacture any products in the near future.
Thus, we determined that we would not be able to realize the
value of our remaining raw materials and work-in-process
inventories and wrote off a total of approximately
$4.9 million of these inventories at that time.

Under the terms of our Global Resolution, Sankyo
Pharma transferred title to us of more than 20,000 GlucoWatch G2
Biographers and more than 1.0 million AutoSensors that we
had previously sold and shipped to them. Because we do not have
a new sales, marketing and distribution partner or other
strategic alliance to sell our products, we anticipate minimal
demand for our products in the foreseeable near term. Therefore,
we assessed that the Sankyo Pharma finished goods inventory
received as part of the Global Resolution in December 2003 had
no realizable value at the time. Additionally, in December 2003,
we wrote off substantially all of our remaining finished goods
inventory, approximately $630,000, that had not been shipped or
sold to Sankyo Pharma. Our remaining inventory of $62,000 at
December 31, 2003 consisted of finished goods for sale in
the United Kingdom.

Prior to the approval by the FDA of our product
and our commercial processes, material was generally charged to
research and development expenses upon receipt and was not
carried as inventory in our financial statements. Accordingly,
for the year ended December 31, 2003, costs of product
revenues do not include previously expensed material.



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

We review equipment and improvements and other
long-lived assets for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may
not be recoverable. Recoverability is measured by comparison of
the carrying amount of the assets to the future net cash flows
that the assets are expected to generate. If such assets are
considered to be impaired, the impairment is recognized and is
measured as the amount by which the carrying amount of the
assets exceeds the fair value of the assets, evaluated by
considering the present value of future net cash flows. No
impairment charges were recorded during 2003 and 2001. In the
fourth calendar quarter of 2002, we recorded an impairment
charge of $1.5 million, primarily related to our
semi-automated back-up AutoSensor-manufacturing equipment, which
became obsolete in the fourth quarter of 2002 as a result of the
deployment of our fully automated manufacturing equipment. This
charge was included in sales, marketing, general and
administrative expenses. As of December 31, 2003, we do not
anticipate using our production equipment in the near term. We
have concluded that its current carrying amounts would be
recoverable if we enter into a new sales, marketing and
distribution agreement or other strategic alliance. We may also
use this equipment in research and development efforts, if any.
As a result, we have not recognized any impairment against these
assets at

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December 31, 2003. We will continue to
evaluate the realizable value of these assets, which may result
in future adjustments.


Results of Operations

Our results of operations have fluctuated from
period to period and are expected to continue to fluctuate in
the future based upon the progress and ultimate outcome of our
attempts to secure alternative strategic options (including, but
not limited to, a merger or an acquisition by a third party),
the demand for our products, product revenues and our costs of
product revenues, as well as the level of our expenses during
any given period. Historical results should not be viewed as
indicative of future operating results. We are also subject to
risks common to companies in our industry and in our current
position, including risks inherent in our need to find
alternative approaches or other strategic alliance for the
sales, marketing and distribution of our products in the United
States; enforcement of our patents and proprietary rights; need
for future capital, particularly in light of our stock currently
being listed on the OTC Bulletin Board; potential competition;
and uncertainty of future regulatory approvals. We have
experienced operating losses since our inception, and we expect
to continue to incur operating losses at least until we have
significant product sales, if we ever do. Because of the terms
of the Global Resolution, however, we recorded a non-operating
gain of approximately $75.8 million (Gain from Sankyo
Pharma settlement in our statement of operations) for the
quarter ended December 31, 2003, which resulted in net
income of $49.4 million for the year ended
December 31, 2003. We expect to continue our previous
experience of incurring operating losses in 2004. At
December 31, 2003, our accumulated deficit and our
stockholders equity were $247.3 million and
$6.8 million, respectively.

Comparison for the Years Ended
December 31, 2003 and 2002

Net product revenuesfor the year ended
December 31, 2003 were $2.7 million, compared to
$3.5 million for the year ended December 31, 2002.
Ninety four percent (94%) of net product revenues recognized for
the year ended December 31, 2003 resulted from sales of our
GlucoWatch G2 Biographers in the United States. Approximately
$1.2 million of our net product revenues recognized in 2003
related to sample and practice G2 Biographers and related
products shipped to Sankyo Pharma for use by their sales force.
Sample and practice G2 Biographers and related products were
sold to Sankyo Pharma at a fixed price that was not subject to
adjustment and therefore the revenues from these sales were
recognized upon Sankyo Pharmas receipt of the product.

Unit shipments from us to Sankyo Pharma of the
GlucoWatch G2 Biographers for the year ended December 31,
2003 were approximately 10,000 Biographers, approximately 2,600
of which were for resale to Sankyo Pharmas customers and
the remaining amount were sample and practice units. During the
year ended December 31, 2003, we shipped approximately
1.1 million AutoSensors, substantially all of which were to
Sankyo Pharma. Because the net price of some of our product
sales to Sankyo Pharma was subject to certain pricing
adjustments, we deferred product revenues related to product
shipments during 2003 of approximately $8.1 million and
this was a component of Deferred revenues from Sankyo
Pharma net of deferred costs of product shipments in our
balance sheet prior to the Global Resolution. The Deferred
revenues from Sankyo Pharma net of deferred costs of product
shipments reflected in our balance sheet prior to the
Global Resolution approximated $9.3 million, and this was
included as a component of Gain from Sankyo Pharma
settlement in our statement of operations during the
fourth quarter of 2003. We do not expect any significant product
revenues in 2004 unless we secure a sales, marketing and
distribution partner or other strategic alliance.

Contract revenuesfor the year ended
December 31, 2003 were $234,000, compared to $401,000 for
the year ended December 31, 2002. Contract revenues for the
years ended December 31, 2003 and 2002 included revenues
related to our NIH SBIR Phase I and II grants, and revenues
were recognized as research activities are performed. We
currently are not performing work under any SBIR grants or
contracts, and thus do not expect any contract revenues in the
near future.

Costs of product revenuesfor the year ended
December 31, 2003 were $15.4 million, compared to
$6.4 million for the year ended December 31, 2002.
Costs of product revenues for the year ended December 31,
2003 consisted of $3.7 million in material and other
production costs associated with the

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manufacturing of our products and
$5.3 million of underabsorbed indirect overhead
representing excess manufacturing capacity put in place to
accommodate our previously anticipated future requirements. In
addition, costs of product revenues for the year ended
December 31, 2003 included approximately $6.4 million
in expenses for the write-off of our inventory, primarily due to
the termination of our Sales, Marketing and Distribution
Agreement and all related contractual arrangements with Sankyo
Pharma.


Pursuant to our now-terminated Sales, Marketing
and Distribution Agreement with Sankyo Pharma, the sales price
to Sankyo Pharma of practice, sample and accessory products
approximated our costs. For the year ended December 31,
2003, approximately 46% of the revenues we recognized derived
from the sale of practice, sample and accessory products to
Sankyo Pharma, and this had a negative impact on our margins. In
addition, due to the fact that Sankyo Pharma was entitled to
receive a specified margin on product sales, our margins were
negatively impacted in periods when the allowed deductions were
high relative to Sankyo Pharmas sales to its third-party
customers, such as occurred in 2003. Also, average manufacturing
costs are greater at low unit volumes, such as the volumes
experienced during our initial commercialization in the United
States. As a partial offset to these negative impacts on our
product margins, however, costs of product revenues did not
include certain material and other product costs previously
expensed. Prior to commercialization, materials that we
purchased were expensed to research and development. We have
been able to use some of this material in our products sold. If
we were to include the costs that were previously expensed to
research and development but then used in our products sold, our
costs of product revenues would have been $390,000 greater than
the reported amounts for the year ended December 31, 2003.
Overall, we expect our product margins to vary from period to
period due to the mix of products sold (i.e., Biographers,
AutoSensors and accessories), actual utilization of our
manufacturing facilities, and financial terms of any future
sales, marketing and distribution arrangement or other strategic
alliance.

For the year ended December 31, 2003, we
deferred costs of approximately $5.2 million related to
deferred product revenues, and these costs were recorded as a
component of Deferred revenues from Sankyo Pharma net of
deferred costs of product shipments in our balance sheet.
The Deferred revenues from Sankyo Pharma net of deferred
costs of product shipments reflected in our balance sheet
prior to the Global Resolution with Sankyo Pharma approximated
$9.3 million, and this was included as a component of
Gain from Sankyo Pharma settlement in our statement
of operations. We expect our costs of product revenues to be
minimal in 2004 unless we secure a sales, marketing and
distribution partner or other strategic alliance.

Research and development expensesfor the year ended
December 31, 2003 were $5.1 million, compared to
$13.9 million for the year ended December 31, 2002.
Research and development expenses continued to decrease
significantly as we moved products into commercialization.
Research and development expenses included costs for scientific
and product development personnel, material used in the
development and validation of high capacity manufacturing
processes, consultants, clinical trials, supplies, maintenance
of our quality system, and depreciation of equipment used in
research and product development. In 2002, significant expenses
were incurred in our efforts to increase our manufacturing
capacity of both the disposable AutoSensors and durable
Biographer; however, these efforts decreased in 2003. We have
devoted internal resources and conducted clinical trials to
expand the indications of our products, specifically to the
pediatric segment, and to enhance features and the usability of
our products. Because we do not have systems in place to capture
the expenses incurred in each of the above areas, we are unable
to report the expenses incurred to date in each of the above
categories. We do not expect our research and development
expenses to increase during 2004 unless we secure a new sales,
marketing and distribution partner or other strategic alliance.

Sales, marketing, general and
administrative expensesfor the
year ended December 31, 2003 were $6.4 million,
compared to $22.5 million for the year ended
December 31, 2002. These amounts included $849,000 and
$14.2 million of sales and marketing expenses in the years
ended December 31, 2003 and 2002, respectively. Included in
the $14.2 million for 2002 is $10.0 million of
advertising and promotion expenses that were required under our
agreements with Sankyo Pharma. In 2003, we were not required to
incur any advertising and promotion expenses under these
agreements. The overall decrease of $16.1 million in sales,
marketing, general and administrative expenses compared to 2002
is primarily attributed to a decrease of $13.4 million in
sales and marketing expenses. Furthermore, sales, marketing,
general and administrative

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expenses in 2002 included an asset impairment
charge of $1.5 million, primarily related to semi-automated
back-up equipment for the production of AutoSensors, for which
we do not have foreseeable alternative uses.


Interest and other income/(expense), netfor the year ended
December 31, 2003 was $114,000 compared to $417,000 for the
year ended December 31, 2002. This decrease was primarily
due to the lower yields on lower average cash and investment
balances.

Interest expensefor the year ended
December 31, 2003 was $2.2 million, compared to
$3.2 million for the year ended December 31, 2002.
Included in interest expense for the years ended
December 31, 2003 and 2002 was the interest accrued on our
convertible debentures and the amortization of the value of the
warrants issued in connection with our financing agreements. The
interest rate on our convertible debenture notes decreased from
8.5% to 3.5% in the fourth quarter of 2002. In addition, the
principal balance due was reduced by a payment of
$2.0 million in June 2003. These two factors accounted for
the majority of the change in interest expense in 2003, compared
to 2002.

Gain from Sankyo Pharma settlementfor the year ended
December 31, 2003 was $75.8 million. The Global
Resolution provided for Sankyo Pharma to pay us
$30.0 million and also specified that neither party owed
any payments to the other party, thus allowing us to write off
certain liabilities and assets, resulting in a total net gain of
$75.8 million.

During the transition period in which Sankyo
Pharma provides certain distribution and customer services, we
are entitled to 30% of all monies received for products sold by
Sankyo Pharma. Amounts received will be recorded as additional
Gain from Sankyo Pharma settlement in our statement
of operations. This transition period ends on the earlier of
June 30, 2004 or when we notify Sankyo Pharma that they may
discontinue such services. Also, as part of the Global
Resolution, Sankyo Pharma transferred title to us of all
GlucoWatch G2 Biographer products that they currently owned,
which includes more than 20,000 GlucoWatch G2 Biographers and
more than 1.0 million AutoSensors.

The following table summarizes the components of
the gain from the Sankyo Pharma settlement, in thousands:

|                                                                                                                                                 |  |   |        | 
|------------------------------------------------------------------------------------------------------------------------------------------------ |  | - | ------ | 
|Cash settlement received from Sankyo Pharma in
    December 2003                                                                                 |  | $ | 30,000 | 
|Recognition of deferred revenues from Sankyo
    Pharma (milestone payments)                                                                     |  |   | 25,000 | 
|Recognition of deferred revenues from Sankyo
    Pharma net of deferred costs of $8,759 of product shipments                                     |  |   | 9,306  | 
|Write-off of current portion of amount due to
    Sankyo Pharma(1)                                                                               |  |   | 6,770  | 
|Write-off of long-term portion of amount due to
    Sankyo Pharma(2)                                                                             |  |   | 2,324  | 
|Write-off of other liabilities due to Sankyo
    Pharma, partially offset by a write-off of $1,083 accounts
    receivable from Sankyo Pharma(3) |  |   | 2,694  | 
|Less: Legal expenses incurred in Sankyo Pharma
    litigation                                                                                    |  |   | 269    | 
|                                                                                                                                                 |  |   |        | 
|Net gain from Sankyo Pharma settlement                                                                                                           |  | $ | 75,825 | 
|                                                                                                                                                 |  |   |        | 



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|    |                                                                                                                                                                                                                                                                            
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In fiscal 2002, we were required to reimburse
    Sankyo Pharma for their actual promotional expenses of
    $6.7 million and this payment, together with an amount we
    owed Sankyo Pharma for customer rebates, could have been
    deferred until second quarter 2004.
|   
|(2) | In fiscal 2002 and 2003, we were required to pay
    quarterly sales and marketing commissions to Sankyo Pharma;
    however, payment of these commissions could have been deferred
    to at least 2005.                                                                  
|   
|(3) | Other liabilities due to Sankyo Pharma primarily
    included customer advances and reserves for the replacement of
    stale-dated AutoSensors.                                                                                                                           

Provision for income taxesfor the year ended
December 31, 2003 was $199,000, substantially all of which
related to alternative minimum tax due from the gain from our
settlement with Sankyo Pharma. We were able to utilize net
operating loss carryforwards and research and development tax
credit carryforwards to offset

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other federal and state taxes. The provision for
taxes for the year ended December 31, 2002 was $23,000 and
related to U.K. taxes on income.


Comparison for the Years Ended
December 31, 2002 and 2001

Net product revenuesfor the year ended
December 31, 2002 were $3.5 million, compared to
$489,000 for the year ended December 31, 2001. Ninety
percent (90%) of net product revenues recognized for the year
ended December 31, 2002 resulted from sales of our
GlucoWatch Biographers in the United States. Approximately
$1.6 million of our net product revenue recognized in 2002
related to sample and practice G2 Biographers shipped to Sankyo
Pharma. The majority of the remaining net product revenues
reflected revenues for shipments of our first-generation
product. Customers who purchased our first-generation Biographer
in the United States had a right to a free upgrade to the G2
Biographer if requested within a specified time period. We
recognized revenue for our first-generation product only when we
shipped the free upgrades or when the upgrade period expired.
Net product revenues for the year ended December 31, 2001
resulted from the initial sales of our GlucoWatch Biographer in
the United Kingdom.

Unit shipments of the GlucoWatch Biographers for
the year ended December 31, 2002 were approximately 36,000
Biographers, of which approximately 2,000 were first-generation
products sold directly to end users and approximately 34,000
were second-generation products shipped to Sankyo Pharma, about
21,000 of which were for resale to Sankyo Pharmas
customers and the remaining amount were sample and practice
units. The majority of these shipped units reflected our initial
U.S. market entry of the second-generation Biographers.
During the year ended December 31, 2002, we shipped
approximately 527,000 AutoSensors, of which approximately
454,000 were shipped to Sankyo Pharma.

Contract revenuesfor the year ended
December 31, 2002 were $401,000, compared to
$5.3 million for the year ended December 31, 2001.
Contract revenues for the years ended December 31, 2002 and
2001 included revenues related to our NIH SBIR Phase I and
II grants and our two NIH Phase I SBIR contracts,
respectively. Revenues related to our NIH grants and contracts
were recognized as research activities are performed. Also
included in contract revenues for the year ended
December 31, 2001 was a milestone of $5.0 million
pursuant to our now-terminated Product Supply and Distribution
Agreement with Yamanouchi Pharmaceutical Co., Ltd. related to
FDA approval of our first-generation Biographer.

Costs of product revenuesfor the year ended
December 31, 2002 were $6.4 million, compared to
$271,000 for the year ended December 31, 2001. Costs of
product revenues for the year ended December 31, 2002
consisted of $5.0 million in material and other production
costs associated with the manufacturing of our products and
underabsorbed indirect overhead representing excess
manufacturing capacity put in place to accommodate our
previously anticipated future requirements. In addition, costs
of product revenues for the year ended December 31, 2002
included approximately $1.1 million in expenses from the
quarter ended June 30, 2002 related to the write-off of
obsolete first-generation Biographer inventory, caused by the
earlier-than-anticipated FDA approval of our second-generation
Biographer and its anticipated launch in the third quarter of
2002. In the quarter ended December 31, 2002, we also wrote
off $290,000 of material in excess of projected requirements and
for outdated literature and expired product. Subsequent to the
write-off of $1.1 million in the second quarter 2002, we
were able to utilize approximately $480,000 of this inventory,
primarily due to our redesign of the practice G2 Biographer to
allow for the use of some of this material. Our costs of product
revenues for the second half of the year ended December 31,
2002 would have been $480,000 higher if we had not previously
expensed the written-off material.

Pursuant to our now-terminated Sales, Marketing
and Distribution Agreement with Sankyo Pharma, the sales price
to Sankyo Pharma of practice and sample products approximated
our costs. For the year ended December 31, 2002,
approximately half of the revenues we recognized derived from
the sale of practice and sample products to Sankyo Pharma, which
had a negative impact on our margins. Another factor negatively
affecting our margin for 2002 was the cost of the G2 Biographers
shipped as free upgrades to our customers who purchased our
first-generation products. Customers who purchased our
first-generation product were eligible for a free upgrade if
they responded to our upgrade offer within a certain period of
time. We had initially deferred product revenues and costs of
product revenues for such first-generation products sold to

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customers who had the right to upgrade. We
recognized these revenues and costs of product revenues,
together with the cost of second-generation product shipped as
part of the upgrade offer, when we shipped the second-generation
product upgrade. Additionally, average manufacturing costs were
greater at low unit volumes. As a partial offset to these
negative impacts on our product margin, however, costs of
product revenues did not include certain material and other
product costs previously expensed. Prior to commercialization,
materials that we purchased were expensed to research and
development. We were able to use some of this material in our
products sold. If we were to include the costs that were
previously expensed to research and development but then used in
our products sold, our costs of product revenues would have been
$1.4 million greater than the reported amounts for the year
ended December 31, 2002.


For the year ended December 31, 2002, we
deferred costs of approximately $5.0 million related to
deferred product revenues, and these costs were recorded as a
component of Deferred revenues from Sankyo Pharma net of
deferred costs of product shipments in our balance sheet
as of December 31, 2002.

Research and development expensesfor the year ended
December 31, 2002 were $13.9 million, compared to
$27.4 million for the year ended December 31, 2001.
Research and development expenses decreased significantly as a
result of a reduction in material costs charged to research and
development expenses for commercial manufacturing scale-up.

Sales, marketing, general and
administrative expensesfor the
year ended December 31, 2002 were $22.5 million,
compared to $15.5 million for the year ended
December 31, 2001. These amounts included
$14.2 million and $7.4 million of sales and marketing
expenses in the years ended December 31, 2002 and 2001,
respectively. Included in the $14.2 million for 2002 was
$10.0 million of advertising and promotion expenses as
required under our now-terminated Sales, Marketing and
Distribution Agreement with Sankyo Pharma. The overall increase
of $7.0 million in sales, marketing, general and
administrative expenses over 2001 was primarily attributed to an
increase of $6.3 million in advertising and promotion
expenses. Sales, marketing, general and administrative expenses
in 2002 also included an asset impairment charge of
$1.5 million, primarily related to semi-automated back-up
equipment for the production of AutoSensors, for which we did
not have foreseeable alternative uses.

Interest and other income/(expense), netfor the year ended
December 31, 2002 was $417,000, compared to
$2.4 million for the year ended December 31, 2001.
Included in interest and other income/(expense), net for the
year ended December 31, 2001 was a gain of
$1.1 million resulting from the sale of certain marketable
equity securities and cash proceeds of $416,000 pursuant to our
1999 Ortho-McNeil agreement related to the sale of substantially
all of our drug delivery business. Excluding those gains,
interest income decreased by $500,000 when compared to 2001.
This decrease was primarily due to the lower yields on lower
average cash and investment balances.

Interest expensefor the year ended
December 31, 2002 was $3.2 million, compared to
$3.7 million for the year ended December 31, 2001. The
interest rate on our convertible debenture notes decreased from
8.5% to 3.5% in the fourth quarter of 2002, which accounted for
the majority of the change in interest expense in 2002, compared
to 2001.

Provision for income taxesfor the year ended
December 31, 2002 was $23,000 and related to
U.K. taxes on income. The provision for taxes for the year
ended December 31, 2001 was $527,000, of which $500,000 was
for foreign tax withholdings applicable to the milestone payment
from Yamanouchi Pharmaceutical Co., Ltd. and the remaining
$27,000 related to provisions for income taxes in the United
Kingdom.

Liquidity and Capital Resources

As of December 31, 2003, our cash, cash
equivalents and investments totaled $33.5 million,
primarily resulting from the $30.0 million received as part
of our Global Resolution with Sankyo Pharma.

Net cash provided by operating activities for the
year ended December 31, 2003 was $11.0 million,
compared to net cash used in operating activities of
$12.2 million for the year ended December 31, 2002.
Cash provided by operating activities during the year ended
December 31, 2003 was primarily due to our net income of
$49.4 million, partially offset by the non-cash portion of
the gain from the Sankyo Pharma settlement

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totaling $46.1 million, and
$3.5 million in payments of our Sanofi-Synthelabo
arbitration obligation. Cash from operating activities also
increased by $5.4 million, primarily as a result of
payments related to deferred revenues and advances received from
Sankyo Pharma prior to the Global Resolution. In addition, we
wrote off $6.4 million in inventory during 2003. Cash used
in operating activities during the year ended December 31,
2002 was primarily due to our net loss of $41.7 million and
payments totaling $8.4 million of our Sanofi-Synthelabo
arbitration obligation, partially offset by increases in
deferred revenues from Sankyo Pharma of $20.0 million,
deferred revenues from Sankyo Pharma net of deferred costs of
product shipments of $8.2 million, and amount due to Sankyo
Pharma of $7.2 million.


Net cash provided by investing activities of
$3.1 million for the year ended December 31, 2003
resulted primarily from the net sales and maturities of
investments of $3.2 million. Net cash provided by investing
activities of $2.8 million for the year ended
December 31, 2002 resulted primarily from the net sales and
maturities of investments of $3.4 million, partially offset
by capital expenditures of $601,000.

Net cash used in financing activities totaled
$4.1 million for the year ended December 31, 2003 and
included principal payments of $4.0 million pursuant to our
convertible debentures. Net cash provided by financing
activities totaled $15.7 million for the year ended
December 31, 2002 and included net proceeds of
$14.7 million from the 2002 public offering of our common
stock, net proceeds of $452,000 from sales of our common stock
under our equity lines and additional cash proceeds of $554,000,
primarily from sales of common stock under our employee stock
purchase plan.

As of December 31, 2003, our contractual
obligations for the next seven years are as follows:

|                                              |  |                |        |           |  |           |        |           |  |   |        |  |  |   |       | 
|--------------------------------------------- |  | -------------- | ------ | --------- |  | --------- | ------ | --------- |  | - | ------ |  |  | - | ----- | 
|                                              |  |               
|                                              |  | Amounts Due   
|                                              |  |               
|                                              |  |                |        | Less than |  |          
|Contractual Obligations                       |  | Total          |        | 1 Year    |  | 1-3 Years |        | 3-7 Years
|                                              |  |                |        |           |  |           |        |          
|                                              |  |               
|                                              |  | (In thousands)
|Convertible Debentures(1)                     |  | $              | 18,281 |           |  | $         | 14,281 |           |  | $ | 4,000  |  |  | $ |      | 
|Interest on Convertible Debentures(1)         |  |                | 493    |           |  |           | 424    |           |  |   | 69     |  |  |   |      | 
|Capital lease obligations                     |  |                | 82     |           |  |           | 82     |           |  |   |       |  |  |   |      | 
|Operating lease obligation                    |  |                | 4,709  |           |  |           | 840    |           |  |   | 1,734  |  |  |   | 2,135 | 
|Arbitration obligation (Sanofi-Synthelabo)    |  |                | 11,500 |           |  |           |       |           |  |   | 8,500  |  |  |   | 3,000 | 
|University of California minimum royalties(2) |  |                | 1,350  |           |  |           | 150    |           |  |   | 400    |  |  |   | 800   | 
|Other purchase obligations                    |  |                | 540    |           |  |           | 240    |           |  |   | 300    |  |  |   |      | 
|                                              |  |                |        |           |  |           |        |           |  |   |        |  |  |   |       | 
|Total contractual cash obligations            |  | $              | 36,955 |           |  | $         | 16,017 |           |  | $ | 15,003 |  |  | $ | 5,935 | 
|                                              |  |                |        |           |  |           |        |           |  |   |        |  |  |   |       | 



---



|    |                                                                                                                                                                                                                                                                                                                                          
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | On March 23, 2004, we entered into an Exchange
    Agreement with the debenture holders and retired all of our
    outstanding Convertible Debentures and associated warrants in
    exchange for an aggregate of $13.8 million in cash and
    2.5 million shares of our common stock. Thus, these amounts
    will not have to be paid.
|   
|(2) | Under our Exclusive License Agreement, effective
    January 31, 1995, as amended, and the minimum royalty
    payments terminate upon the last-to-expire patent licensed under
    this agreement. This expiration date is January 18, 2011.                                                                                            

The level of cash used in operating activities
during previous periods is not necessarily indicative of the
level of future cash usage. Our long-term cash and capital
expenditure requirements will depend upon numerous factors
including but not limited to (i) costs associated with
seeking and obtaining alternative approaches or other strategic
alliance for the sales, marketing and distribution of our
products in the United States, (ii) the time required to
obtain any regulatory approvals, (iii) additional
expenditures to support the manufacture of new products,
including conversion of existing G2 Biographers into
third-generation Biographers, (iv) the progress of our
research and development programs, if any, and (v) possible
expansion into new markets.

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As of December 31, 2003, we had existing
cash, cash equivalents and investments of $33.5 million.
However, we have incurred significant net operating losses since
our inception, including a loss from operations of
$24.1 million for the year ended December 31, 2003. We
have incurred negative cash flows from operations since our
inception, although our Global Resolution with Sankyo Pharma
provided us with positive cash flows from operating activities
for the year ended December 31, 2003. At December 31,
2003, our stockholders equity was $6.8 million and
our accumulated deficit was $247.3 million.

As of December 31, 2003, based upon current
expectations for operating losses and projected short-term
expenditures, we believe that existing cash, cash equivalents,
and investments of $33.5 million will be sufficient to meet
our existing operating expenses, contractual obligations, and
capital expenditure requirements, if any, at least for the next
12 months. Although there has been a substantial reduction
in our headcount, suspension of manufacturing and related
reduction in costs of product revenues and research and
development activities, and other cost-cutting measures, we also
expect to receive very little cash from future product revenues
without first obtaining a sales, marketing and distribution
partner or other strategic alliance. However, there can be no
assurance that we will not require further financing and, if we
do, that such financing will be available.

Income Taxes

At December 31, 2003, we had federal net
operating loss and research and development tax credit
carryforwards of $238.3 million and $6.5 million,
respectively. These carryforwards expire at various dates
beginning in 2004 and ending in 2023. For state income tax
purposes, at December 31, 2003 we had net operating loss
carryforwards of $67.0 million that expire at various dates
beginning in 2004 and ending in 2013, and state research and
development tax credit carryforwards of approximately
$4.7 million, which do not expire.

Because of the change-in-ownership provisions of
the Internal Revenue Code, a substantial portion of our net
operating loss and tax credit carryforwards may be subject to
annual limitations. The annual limitations may result in the
expiration of the net operating losses and tax credits before
utilization.

RISK FACTORS

In determining whether to invest in our
common stock, you should carefully consider the information
below in addition to all other information provided to you in
this report, including the information incorporated by reference
in this report. The statements under this caption are intended
to serve as cautionary statements within the meaning of the
Private Securities Litigation Reform Act of 1995. The following
information is not intended to limit in any way the
characterization of other statements or information under other
captions as cautionary statements for such
purpose.

Risks Related to Our Business



| |                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------
| | We must obtain a U.S. sales, marketing and
    distribution partner or other strategic alliance in the near
    future.

Under our now-terminated Sales, Marketing and
Distribution Agreement with Sankyo Pharma, we were totally
dependent upon Sankyo Pharma for the sales, marketing and
distribution of our products in the United States. Sankyo Pharma
is to provide certain transition services related to
distribution and customer services for us currently; however,
such services will cease on the earlier of June 30, 2004 or
when we notify Sankyo Pharma that they may discontinue such
services. Despite such transition services, we do not believe we
will be able to generate additional cash from product sales in
any significant amounts in the near term since there are no
current sales and marketing activities relating to our products.

We do not have the cash resources or
infrastructure to perform sales, marketing and distribution
functions ourselves. Under our current situation, we must
conserve and generate cash to finance our operations. Our
ability to continue as a going concern beyond 2004 is dependent
on our ability to generate sufficient cash flow to fund our
operations and meet our debt and other obligations on a timely
basis and to continue to keep our

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expenses as low as possible. There is no
certainty, however, that we will be able to generate sufficient
cash or to keep our expenses low enough.


We continue to evaluate alternative means of
financing to meet our needs on terms that are acceptable to us.
However, we may be unable to obtain necessary financing on
favorable terms or at all. For example, we may need to enter
into financing arrangements or modify our existing payment
obligations that may include sales of our common stock at
significant discounts to the market price, as well as causing
significant dilution to our existing stockholders.

If we cannot obtain a sales, marketing and
distribution partner or other strategic alliance in the near
future, we will need to sell some or all of our assets,
including our intellectual property, in which Sanofi-Synthelabo
has a security interest, to meet our debt obligations. If
substantial additional resources are not available, we may need
to cease our operations and seek protection under the bankruptcy
laws.



| |                                                                                                                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may be unable to satisfy our
    obligations. If we cannot pay amounts due under our obligations,
    we may need to sell equity securities, sell all or a portion of
    our assets, or cease our operations and seek protection under
    the bankruptcy laws.

As of December 31, 2003, we had total
liabilities of $30.9 million (net of unamortized debt
discount of $709,000), of which $16.1 million were current
liabilities and included $14.3 million related to our
Convertible Debentures. We owe $11.5 million to
Sanofi-Synthelabo, payable from February 2005 to February 2007;
however, none of this amount is included in current liabilities.
Our ability to meet our obligations and other liabilities
depends upon our future performance, which will depend upon
financial, business and other factors, many of which are beyond
our control. We may fail to generate sufficient cash flows in
the future to cover our fixed charges or to satisfy our
obligations. Historically, we have experienced significant
negative cash flows from operations. If we cannot generate
sufficient cash flows in the future to cover our fixed charges
or to permit us to satisfy our obligations, we may need to sell
equity securities or sell all or a portion of our assets. We may
not successfully complete any of these courses of action. In the
event of insolvency, bankruptcy, liquidation, reorganization,
dissolution or winding-up of our business or upon default or
acceleration related to our obligations, our assets would first
be available to pay the amounts due under our obligations.
Holders of our common stock would only receive any assets
remaining after satisfaction in full of all obligations and
preferred stock liquidation preferences, if any.



| |                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have historically incurred substantial
    losses, have a history of operating losses, and have an
    accumulated deficit. We expect continued operating
    losses.

We had net income of $49.4 million for the
year ended December 31, 2003 due to the $75.8 million
gain from the Sankyo Pharma settlement. At December 31, 2003,
our accumulated deficit and stockholders equity were
$247.3 million and $6.8 million, respectively. We have
experienced operating losses since our inception, and we expect
to continue to incur operating losses at least until we have
significant product sales, if we ever do. We may fail in our
efforts to find a sales, marketing and distribution partner or
alternative strategic alliance. Our products may never gain
market acceptance, and we may never generate significant
revenues or achieve profitability.



| |                                                                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have recently experienced a significant
    reduction in our workforce, which has had a material impact on
    our ability to manufacture our products and conduct research and
    development on future products.

On October 9, 2003, we announced a reduction
in force of approximately 60% of our workforce and, as of
December 31, 2003, we had 24 employees. Because of the
magnitude of the workforce reductions, these layoffs have had a
material adverse impact on our ability to manufacture our
products and our ability to conduct research and development and
to expand our operations in the future to meet the needs of our
customers. As a result of this reduction in force, we are not
currently producing any products and our manufacturing
operations have been suspended. Additionally, if we were to
secure a sales, marketing and distribution partner or other
strategic alliance, we would need to hire new employees or seek
to rehire former employees to regain core competencies in
manufacturing and research and development. We may fail in our

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efforts to hire such employees or to regain the
level of expertise that we possessed prior to our reductions in
force.




| |                                                                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we are to recommence manufacturing
    again, we may not be able to do so in a timely or cost-effective
    manner and also may not be able to obtain the necessary
    Biographer and AutoSensor components from third-party
    suppliers.

Prior to suspension of our manufacturing, we had
very limited medical device manufacturing experience and
depended on third-party suppliers for the manufacturing of our
Biographer and AutoSensor components. We were responsible for
manufacturing the GlucoWatch Biographer and we contracted with a
third party, Corium International, to manufacture our
AutoSensors. Thus, we were dependent upon Corium International
for such manufacturing. Our products must be manufactured in
compliance with regulatory requirements, in a timely manner and
in sufficient quantities, while maintaining product performance
and quality and a commercially feasible cost of manufacturing.
Given the current suspension of manufacturing, it will take time
and extra resources if we are to recommence such manufacturing.
Furthermore, we may encounter additional problems if we commence
commercial manufacturing of our third-generation product, as we
have not manufactured this product in large quantities.
Alternatively, we may decide to convert existing G2 Biographers
into third-generation Biographers, but we may not be successful
in our attempts to do so.

Our Biographer and AutoSensor were manufactured
from components purchased from outside suppliers, most of which
were our single source for such components. Some of these
companies are small enterprises that may encounter financial
difficulties because of their size. Prior to our suspension of
manufacturing, we were notified by one of our sole-source
component suppliers that they were encountering financial
difficulties. Although we have maintained our existing supply
contracts with such third parties (e.g., Hydrogel Design
Systems, Inc., Key Tronic Corporation, Sanmina Corporation and
E.I. du Pont de Nemours and Company, among others), we
do not have contracts with all our suppliers and, given the
suspension in our manufacturing, even suppliers with contracts
would perhaps need additional time and resources to produce such
components were we to instruct them to recommence supply. Even
after recommencing manufacturing, if we are able to do so (and
there is no assurance that we will be able to do so), if we
cannot, for whatever reason, obtain these components from our
suppliers or if the components obtained from these suppliers do
not pass quality standards, we will be required to obtain the
components from alternative suppliers. Additionally, in the
event a current supplier is unable to meet our component
requirements, we might not be able to rapidly find another
supplier of the particular component or an alternative supply of
the particular component at the same price or lead time. Any
interruption in the supply of Biographer or AutoSensor
components or excessive pricing of these components could
prevent us from manufacturing our products in the future or
could adversely affect our margins.

Third-party manufacturing contractors and
component suppliers may, for competitive reasons, support
directly or indirectly a company or product that competes with
one of our products. If such a third party terminates an
arrangement, cannot fund or otherwise satisfy its obligations
under its arrangements or disputes or breaches a contractual
commitment, then we would likely be required to seek an
alternative third-party manufacturer or supplier. If we were
unable to find a replacement third party, our capital
requirements could increase substantially and our business and
financial condition could be materially adversely affected. If
we were required to develop our own capabilities, we would
continue to incur significant start-up expenses and we would
compete with other companies that have experienced and
well-funded operations.



| |                                                                       
| | ----------------------------------------------------------------------
| | To date, our products have not been widely
    accepted by the market.

We have focused our efforts on a line of
frequent, automatic and non-invasive glucose monitoring devices
based on novel technologies. To date, the market has not widely
accepted our continuous-type monitoring products that measure
glucose from interstitial fluid, and our products are different
from the established blood glucose episodic monitors
commercially available and also require additional workload and
training. In addition, because our products are based on novel
technologies, there can be no assurance that unforeseen problems
will not develop with these technologies or that we will be able
to successfully address technological challenges that we may
encounter.

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Given the uncertainty of a new sales, marketing
and distribution partner, physicians may be hesitant to
prescribe our products for their patients. Our financial
situation has already caused substantial uncertainty relating to
product availability, warranty fulfillment, and the like.



| |                                                                                                                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If patients do not receive reimbursement
    from third-party health care payors, we may be unsuccessful in
    selling our products to a broad range of customers, and we do
    not have the capabilities to seek reimbursement for our
    products.

Successful commercialization of our products will
depend in large part on whether patients who purchase our
products will be reimbursed for the expense by third-party
payors, which include private insurance plans, Medicare,
Medicaid and other federal health care programs. Currently, our
products do not have widespread reimbursement. Third-payor
reimbursement occurs on a plan-by-plan and often case-by-case
basis. There can be no assurance that such reimbursement will be
available in a sufficient time frame, or at all. To obtain such
reimbursement, we will need to have a partner who has
substantial expertise and resources in managed care so as to
work with third-party health care payor organizations to obtain
broad reimbursement coverage. We do not have the resources,
expertise or infrastructure to perform such functions ourselves.
Third-party payors, including federal health care programs and
managed care and other private insurance plans, are increasingly
seeking to contain health care costs by limiting the coverage
of, and the amount of reimbursement for, new diagnostic
products. As a result, adequate levels of reimbursement may not
be available for patients, many of whom may therefore not
purchase our products. If meaningful reimbursement from
third-party payors is not available, or if the process of
obtaining such reimbursement takes too long, we may not be able
to achieve a level of market acceptance of our products, and we
may not be able to maintain price levels sufficient to realize
an adequate return on our investment.



| |                                                                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our product pipeline is severely limited,
    so the failure of the market to accept our glucose monitoring
    products could result in the failure of our entire
    business.

We are exclusively focused on a line of frequent,
automatic and non-invasive glucose monitoring devices. To be
successful, we will need to continue to develop glucose
monitoring products that address the needs of people with
diabetes; however, in light of our recent reduction in force and
expenses associated with product research and development, our
ability to produce new products has been materially impaired.
Our third-generation product has been approved by the FDA, but
we have no plans for its commercialization, or for converting
our G2 Biographers to third-generation products, unless we
obtain a sales, marketing and distribution partner or other
strategic alliance. Furthermore, without additional resources,
we are not currently working on developing future glucose
monitoring products.



| |                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may be subject to product recalls or
    product liability claims that are costly to defend and could
    limit our ability to sell our products in the future or could
    damage our reputation.

The design, development, manufacture and use of
our medical products involve an inherent risk of product recalls
and product liability claims and associated adverse publicity.
Makers of medical products may face substantial liability for
damages in the event of product failure or allegations that the
product caused harm. Product liability insurance is expensive
and, although we presently have such insurance, it is difficult
to maintain as well as to expand coverage under it. We may
become subject to product liability claims, our current
insurance may not cover potential claims and adequate insurance
may not be available on acceptable terms in the future. We also
could be held liable for damages in excess of the limits of our
insurance coverage. Regardless of insurance coverage, any claim
or product recall could result in non-compliance with FDA
regulations, force us to stop selling our products and create
significant adverse publicity that could harm our credibility
and decrease market acceptance of our products.

26



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| |                                                                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may not continue to receive regulatory
    approval of our products from the FDA or foreign agencies. If we
    do not receive regulatory approval from an agency, we will not
    be able to sell our products or generate revenue in that
    agencys jurisdiction.

The design, manufacturing, labeling, distribution
and marketing of our products are subject to extensive and
rigorous government regulation in the United States and certain
other countries where the process of obtaining and maintaining
required regulatory clearance or approvals is lengthy, expensive
and uncertain. The FDA may not approve additional future
enhancements and possible manufacturing changes, if any, to the
Biographers and the AutoSensors or it may require us to file one
or more new PMA applications rather than allowing us to
supplement our existing PMA application. Even if the FDA grants
us expedited review status on an application for approval,
obtaining approval of a PMA or a PMA supplement could take a
substantial period of time, and the FDA may not ultimately grant
such approval. Moreover, even if regulatory approval is granted,
such approval may include significant limitations on intended
uses for which any such products could be marketed.

A medical device and its manufacturer are subject
to continual review after approval, and later discovery of
previously unknown problems with a product or the manufacturing
process may result in restrictions on such product or the
manufacturer, including withdrawal of the product from the
market. Failure to comply with applicable regulatory
requirements may result in, among other things, fines,
suspensions of regulatory approvals, product recalls, operating
restrictions and criminal prosecution. In addition, new
government regulations may be established that could delay or
prevent regulatory approval of our potential products. We are
also subject to federal, state and local regulations regarding
workplace safety, environmental protection and hazardous
material controls, among others, and failure to comply with
these regulations may result in similar consequences.



| |                                                                                                              
| | -------------------------------------------------------------------------------------------------------------
| | If we fail to adequately protect our
    intellectual property, our competitive position could be
    harmed.

Development and protection of our intellectual
property are critical to our business. If we do not adequately
protect our intellectual property, both in the United States and
abroad, competitors may be able to use our technologies. Our
success depends in part on our ability to obtain patent
protection for our products and processes in both the United
States and other countries, protect trade secrets, and prevent
others from infringing on our proprietary rights.

There are numerous risks and uncertainties that
we face with respect to our patents and other proprietary
rights. Currently, many pending patent applications in the
United States are maintained in secrecy until issuance, and
publication of discoveries in the scientific or patent
literature tends to lag behind actual discovery by several
months. Thus, we may not have been the first to file patent
applications on our inventions. Our patent applications may not
issue into any patents. Once granted, the claims of any issued
patents may not afford meaningful protection for our
technologies or products. In addition, patents issued to us or
our licensors may not provide competitive advantages for our
products or may be challenged by our competitors and
subsequently narrowed, invalidated or circumvented. Competitors
may also independently develop similar or alternative
technologies or duplicate any of our technologies.

Litigation, interference proceedings, oppositions
or other proceedings that we may become involved in with respect
to our proprietary technologies could result in substantial cost
to us. Patent litigation is widespread in our industry, and any
patent litigation could harm our business. Costly litigation
might be necessary to protect our proprietary rights, and we may
not have the required resources to pursue such litigation or to
protect our rights. An adverse outcome in litigation with
respect to the validity of any of our patents could subject us
to significant liabilities to third parties, divert the
attention of management and technical personnel from other
business concerns, require disputed rights to be licensed to or
from third parties or require us to cease using a product or
technology or lose our exclusive rights with respect to such
technology.

We also rely upon trade secrets, proprietary
know-how and continuing technological innovation to remain
competitive. Confidentiality agreements with our employees,
consultants and other third parties with access to proprietary
information could be breached, and we might not have adequate
remedies for any such breach.

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Additionally, our trade secrets and know-how
could otherwise become known or be independently developed by
third parties.




| |                                                                                                                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our products could infringe on the
    intellectual property rights of others, possibly causing us to
    engage in costly litigation and, if we are not successful,
    causing us to pay substantial damages and prohibiting us from
    selling our products.

Third parties may assert infringement or other
intellectual property claims against us based on their patents
or other intellectual property claims. We may have to pay
substantial damages, possibly including treble damages, for past
infringement if it is ultimately determined that our products
infringe a third partys patents. Furthermore, we may be
prohibited from selling our products before we obtain a license
that, if available at all, may require us to pay substantial
royalties. Even if infringement claims against us are without
merit, defending a lawsuit takes significant time, may be
expensive and may divert managements attention from other
business concerns and also divert efforts of our technical
personnel.



| |                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If any of our license agreements or other
    contracts for intellectual property related to our products are
    terminated or made non-exclusive, our ability to develop,
    manufacture or market our products may be materially
    impaired.

We have entered into agreements with third
parties, including The Regents of the University of California,
for licenses of certain intellectual property related to the
Biographers and the AutoSensors. Pursuant to these agreements,
we have been granted rights to certain technologies related to
our products. These agreements impose on us specific
obligations, including, in the case of the University of
California, license fees, royalty payments, and
commercialization milestones. If we fail to meet our obligations
under any of these agreements, the license or other rights may
be terminated or, in the case of an exclusive arrangement, be
made non-exclusive. Additionally, in the event we decide to seek
bankruptcy protection, patent holders who license their
technology to us, including the University of California, may
assert rights to terminate their licenses with us or to contest
the transfer or sale of such licenses in the bankruptcy process.
Although we would challenge any such assertions, there can be no
assurance that our challenge would be successful. If any such
license or other right is terminated, we may lose our ability to
incorporate the applicable technology into our products or to
use such technology in the manufacture of our products, possibly
impairing our ability to produce or market the GlucoWatch
Biographer or other products. If any such license or other right
is made non-exclusive, we may be unable to prevent others from
developing, manufacturing and marketing devices based on the
same or similar technologies.



| |                                                                                                             
| | ------------------------------------------------------------------------------------------------------------
| | We may be unable to build brand loyalty
    because our trademarks and trade names may not be
    protected.

Our registered or unregistered trademarks or
trade names, such as the marks GlucoWatch and
G2, may be challenged, canceled, infringed upon,
circumvented, declared generic or determined to be infringing on
other marks. We may not be able to protect our rights to these
trademarks and trade names, without which we may be unable to
build brand loyalty. Brand recognition is critical to our
short-term and long-term marketing strategies, especially if we
commercialize future enhancements to our products. Moreover, if
our trademarks are found to infringe on marks belonging to third
parties, we may be forced to market our products under a
different name, possibly requiring a costly and difficult
re-branding effort, and we could be ordered to pay damages to a
third party.



| |                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We do business on a very limited basis in
    the United Kingdom and do not have any plans to enter other
    international markets; thus, the success of our business depends
    on our success in the U.S. market.

We currently sell the GlucoWatch G2 Biographer on
a very limited basis in the United Kingdom, which has a National
Health Service (NHS); our products are not currently reimbursed
by the NHS. We have established a contract with a third-party
authorized representative in the United Kingdom, and the
product-ordering, logistics, and technical-support functions,
although minimal, are handled by us. If we are unable to support
these necessary functions or generate sufficient revenues from
such sales, we may not be able to continue to sell our products
in the United Kingdom. We may never be able to secure necessary

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commercialization agreements in countries other
than the United States and the United Kingdom, despite the fact
that we have CE certification in the European Community. If we
are unable to secure these necessary agreements for other
countries, we may not be able to sell our products or, even if
such sales are possible, to broadly launch our products in other
countries.


Risks Related to Our Industry



| |                                                                                                                                                                                                     
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Intense competition in the market for
    glucose diagnostic products could prevent us from increasing or
    sustaining our revenues and prevent us from achieving or
    sustaining profitability.

The medical device industry, particularly the
market encompassing our GlucoWatch G2 Biographer, is intensely
competitive, and we compete with other providers of personal
glucose monitors. Currently, the market is dominated by blood
glucose monitoring products sold by a few major companies. These
companies have established products and distribution channels.
In addition, several companies are marketing alternative-site
devices to monitor glucose levels in a painless manner or in a
manner involving less pain than that associated with finger
sticking. Furthermore, companies are developing a variety of
methods to extract interstitial fluid and measure the glucose
concentration therein, as well as developing devices to monitor
glucose on a frequent and automatic basis. At least one such
product is now under review by the FDA, and an alarms-only
product recently received FDA approval. Another technology that
some companies are pursuing utilizes infrared spectroscopy,
which uses radiation to measure glucose levels. There can be no
assurance that other products will not be accepted more readily
in the marketplace than the GlucoWatch Biographer or will not
render our current or future devices noncompetitive or obsolete.
Additionally, the GlucoWatch G2 Biographer or our
third-generation product may fail to replace any currently used
devices or systems.

Furthermore, a number of companies have developed
or are seeking to develop new diabetes drugs or treatments that
could reduce or eliminate demand for all glucose monitoring
systems. In addition, many of our competitors and potential
competitors have substantially greater resources, larger
research and development staffs and facilities and significantly
greater experience in developing, manufacturing and marketing
glucose monitoring devices than we do. Competition within the
glucose monitoring industry could result in price reductions for
glucose monitoring devices such that we may not be able to sell
our products at a price level adequate for us to realize a
return on our investment.



| |                                                                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Competition for qualified personnel exists
    in our industry and in northern California. If we are unable to
    retain or hire key personnel, we may not be able to sustain or
    grow our business.

Our ability to continue as an ongoing business
and to find a sales, marketing and distribution partner or other
strategic alliance depends significantly upon retaining our
remaining key personnel, which is difficult in light of our
current business situation. In the event that we find such a
partner or alliance and recommence manufacturing and possibly
research and development, we will need to attract highly
qualified personnel in these areas. We face competition for such
personnel, and we may not be able to attract and retain these
individuals. We compete with numerous pharmaceutical, health
care and software companies, as well as universities and
non-profit research organizations, in the northern California
business area. The loss of key personnel or our inability to
hire and retain additional qualified personnel in the future
could prevent us from maintaining our business. There can be no
assurance that we will continue to be able to attract and retain
sufficient qualified personnel.

Risks Related to Our Common Stock



| |                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our common stock is subject to the
    requirements for penny stocks, which could adversely affect our
    stockholders ability to sell and the market price of their
    shares.

Our stock fits the definition of a penny stock.
The Securities Exchange Act of 1934, as amended, defines a penny
stock as any equity security that is not traded on a national
securities exchange or authorized for quotation on the Nasdaq
National Market and that has a market price of less than $5.00
per share, with certain exceptions. Penny stocks are subject to
Rule 15(g) under the Securities and Exchange Act of 1934,
as amended, which imposes additional sales practice disclosure
and market-making requirements on broker/

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dealers who sell or make a market in such
securities. The rules require that, prior to a transaction in a
penny stock not otherwise exempt from the rules, the
broker/dealer must:




| |   |                                                                                                                                                                             
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | deliver a standardized risk disclosure document
    that provides information about penny stocks and the risks in
    the penny stock market;                               
|
| |  | provide the customer with current bid and offer
    quotations for the penny stock;                                                                                         
|
| |  | disclose the compensation of the broker/dealer
    and its salesperson in connection with the transaction;                                                                  
|
| |  | provide the customer monthly account statements
    showing the market value of each penny stock held in the
    customers account; and                                    
|
| |  | make a special written determination that the
    penny stock is a suitable investment for the customer and
    receive the customers written agreement to the transaction.

These requirements may have the effect of
reducing the liquidity and trading volume of our stock. As a
result, it may be more difficult for stockholders to sell their
shares of our stock and these requirements may adversely affect
the price other investors are willing to pay for our stock.



| |                                                                                                                                         
| | ----------------------------------------------------------------------------------------------------------------------------------------
| | Our stock price is volatile and
    stockholders may not be able to resell Cygnus shares at or above
    the price they paid, or at all.

The market price for shares of our common stock
has been highly volatile. Factors, such as new product
introductions by our competitors; our ability to obtain a sales,
marketing and distribution partner or other strategic alliance;
sales levels of our products; litigation outcomes; regulatory
approvals or delays or recalls of our products or those of our
competitors; developments relating to our patents or proprietary
rights or those of our competitors; results of clinical trials
for products of our competitors; and period-to-period
fluctuations in financial results, may have a significant impact
on the market price of our common stock. Additionally, following
periods of volatility in the market price for a companys
securities, securities class action litigation may be
instituted. Such litigation could result in substantial costs to
us and further divert managements attention and resources.



| |                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------
| | Issuances by us of authorized preferred
    stock can have adverse effects, including dilution and
    discouragement of takeovers.

Our certificate of incorporation contains certain
provisions that may delay or prevent a takeover. The Company
currently has 5.0 million shares of authorized and unissued
preferred stock. Our Board of Directors has the authority to
determine the price, rights, preferences and restrictions,
including voting and conversion rights, of these shares without
any further action or vote by the stockholders. The rights of
the holders of common stock will be subject to, and may be
adversely affected by, the rights of the holders of preferred
stock that may be issued in the future. Such provisions could
adversely affect the holders of common stock in a variety of
ways, including by potentially discouraging, delaying or
preventing a takeover of our company and by diluting stockholder
ownership.



| |                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Provisions of our charter documents and
    Delaware law may inhibit a takeover, thus limiting the price
    investors might be willing to pay in the future for our common
    stock.

Provisions in our Restated Certificate of
Incorporation and Bylaws may have the effect of delaying or
preventing an acquisition of our Company or a merger in which we
are not the surviving company and may otherwise prevent or slow
changes in our Board of Directors and management. In addition,
because we are incorporated in Delaware, we are governed by the
provisions of Section 203 of the Delaware General

Corporation Law. These provisions could
discourage an acquisition of our company or other change in
control transaction and thereby negatively impact the price that
investors might be willing to pay in the future for our common
stock.


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| |                                                                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We do not pay cash dividends and do not
    anticipate paying any dividends in the future, so any short-term
    return on a stockholders investment will depend on the
    market price of our shares, which is volatile.

We have never paid any cash dividends on our
stock. We anticipate that we will retain our earnings, if any,
to support operations and to finance our business. Therefore, we
do not expect to pay cash dividends in the foreseeable future.
Any short-term return on a stockholders investment will
depend only on the market price of our shares and the
stockholders ability to liquidate their investment.






|         |                                                                
|-------- | ---------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    About Market Risk.



| |                   
| | ------------------
| | Interest Rate Risk

Our exposure to market risk for changes in
interest rates relates primarily to our investment portfolio and
our long-term debt obligations. We do not use derivative
financial instruments in our investment portfolio. We place our
investments with high credit quality issuers and, by policy,
limit the amount of credit exposure to any one issuer. As stated
in our policy, we are averse to principal loss and ensure the
safety and preservation of our invested funds by limiting
default risk, market risk and reinvestment risk.

We mitigate default risk by investing in only the
highest credit quality securities. The portfolio includes only
marketable securities with active secondary or resale markets to
ensure portfolio liquidity.

We had no cash flow exposure due to interest rate
changes for our $18.3 million convertible debentures, which
all had fixed rates. We also have no cash flow exposure due to a
rate change for our Sanofi-Synthelabo arbitration obligation, as
such obligation is not interest-bearing. We primarily have
entered into debt obligations to support general corporate
purposes, including capital expenditures and working capital
needs.

31



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##### Table of Contents



The table below presents principal amounts and
related weighted-average interest rates by year of maturity for
our investment portfolio and debt obligations.

|             |                                                         |                    |   |        |   |              |   |       |   |      |   |       |  |      |   |   |  |  |   |   |  |  |   |        |   |  |   |        | 
|------------ | ------------------------------------------------------- | ------------------ | - | ------ | - | ------------ | - | ----- | - | ---- | - | ----- |  | ---- | - | - |  |  | - | - |  |  | - | ------ | - |  | - | ------ | 
|             |                                                         |                    |   |        |   |             
|             |                                                         | Period of Maturity |   |        |   | Fair Value  
|             |                                                         |                    |   |        |   | December 31,
|             |                                                         | 2004               |   | 2005   |   | 2006         |   | 2007  |   | 2008 |   | Total |  | 2003
|             |                                                         |                    |   |        |   |              |   |       |   |      |   |       |  |     
|Assets:      |                                                         |                    |   |        |   |              |   |       |   |      |   |       |  |      |   |   |  |  |   |   |  |  |   |        |   |  |   |       
|             | Cash equivalents                                        |                    | $ | 31,518 |   |              |   | $    |   |      | $ |      |  |      | $ |  |  |  | $ |  |  |  | $ | 31,518 |   |  | $ | 31,518 | 
|             | Average variable rate                                   |                    |   | 0.91   | % |              |   |      |   |      |   |      |  |      |   |  |  |  |   |  |  |  |   | 0.91   | % |  |   |       | 
|             | Short-term investments                                  |                    | $ |       |   |              |   | $    |   |      | $ |      |  |      | $ |  |  |  | $ |  |  |  | $ |       |   |  | $ |       | 
|             | Fixed rate                                              |                    |   | 0.00   | % |              |   |      |   |      |   |      |  |      |   |  |  |  |   |  |  |  |   | 0.00   | % |  |   |       | 
|             | Total investments                                       |                    | $ | 31,518 |   |              |   | $    |   |      | $ |      |  |      | $ |  |  |  | $ |  |  |  | $ | 31,518 |   |  | $ | 31,518 | 
|             | Total average rate                                      |                    |   | 0.91   | % |              |   |      |   |      |   |      |  |      |   |  |  |  |   |  |  |  |   | 0.91   | % |  |   |       | 
|Liabilities: |                                                         |                    |   |        |   |              |   |       |   |      |   |       |  |      |   |   |  |  |   |   |  |  |   |        |   |  |   |       
|             | Convertible Debentures including current
    portion(1) |                    | $ | 14,281 |   |              | $ | 4,000 |   |      | $ |      |  |      | $ |  |  |  | $ |  |  |  | $ | 18,281 |   |  | $ | 18,281 | 
|             | Fixed rate                                              |                    |   | 3.50   | % |              |   | 3.50  | % |      |   |      |  |      |   |  |  |  |   |  |  |  |   | 3.50   | % |  |   |       | 



---



|    |                                                                                                                                                                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | On March 23, 2004, we entered into an Exchange
    Agreement with the debenture holders and retired all of our
    outstanding Convertible Debentures and associated warrants in
    exchange for an aggregate of $13.8 million in cash and
    2.5 million shares of our common stock. Thus, this amount
    will not have to be paid.



| |                      
| | ---------------------
| | Foreign Exchange Risk

Effective June 28, 2000, we established
Cygnus (UK) Limited, a wholly owned subsidiary of
Cygnus, Inc., in the United Kingdom. On January 30,
2004, we filed an application to dissolve this subsidiary, which
provided sales support and other administrative functions for
us. We now handle these functions directly from the United
States. This application to strike-off was filed with the
Companies House and published on March 16, 2004; we expect
our application to be granted in early third quarter 2004. Our
exposure to gains and losses resulting from foreign currency
exchange transaction fluctuations on foreign net assets was not
material as of December 31, 2003 or 2002. No material
foreign exchange transaction gain or loss has been recorded in
our consolidated financial statements during the year ended
December 31, 2003. We do not anticipate any material
adverse effect on our financial position, results of operations
or cash flows resulting from foreign exchange transaction
fluctuations in the future.






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

The consolidated financial statements and
supplementary data for the years ended December 31, 2003,
2002 and 2001 are incorporated herein by reference and submitted
as a separate section of this Form 10-K. (See Item 15.)






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

Not applicable.






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

a) Evaluation of disclosure controls and
procedures. Our Chief Executive Officer and our Chief
Financial Officer, after evaluating the effectiveness of the
Companys disclosure controls and procedures,
as defined in the Securities Exchange Act of 1934, as amended
(the Exchange Act), Rules 13a-15e or 15d-15e as
of the end of the period covered by this report (the
Evaluation Date), have concluded that, as of the
Evaluation Date, our disclosure controls and procedures were
adequate based on the evaluation of these controls and
procedures required by paragraph (b) of the Exchange Act
Rules 13a-15 or 13d-15.

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b) Changes in internal controls. No
change in our internal controls over financial reporting
identified in connection with the evaluation required by
paragraph (d) of Exchange Act Rules 13a-15 or 15d-15
that occurred during our fourth fiscal quarter has materially
affected, or is reasonably likely to materially affect, our
internal controls over financial reporting.




PART III






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

We incorporate by reference the information
concerning our directors set forth under the heading
Proposal One  Re-election of Directors in
our definitive Proxy Statement to be filed pursuant to
Regulation 14A for our 2004 Annual Meeting of Stockholders.

Information concerning our Executive Officers is
set forth in Part I of this Form 10-K.

We incorporate by reference the information set
forth under the heading Section 16(a) Beneficial
Ownership Reporting Compliance in our definitive Proxy
Statement to be filed pursuant to Regulation 14A for our
2004 Annual Meeting of Stockholders.

We have adopted a code of ethics that applies to
all of our executive officers and directors, a copy of which is
available at http://www.cygn.com/corporate overview.






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

We incorporate by reference the information set
forth under the heading Executive Compensation and Other
Information in our definitive Proxy Statement to be filed
pursuant to Regulation 14A for our 2004 Annual Meeting of
Stockholders.






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

We incorporate by reference the information set
forth under the heading Security Ownership of Directors
and Executive Officers in our definitive Proxy Statement
to be filed pursuant to Regulation 14A for our 2004 Annual
Meeting of Stockholders.

We incorporate by reference the information set
forth under the heading Equity Compensation Plan
Information in our definitive Proxy Statement to be filed
pursuant to Regulation 14A for our 2004 Annual Meeting of
Stockholders.






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

We incorporate by reference the information set
forth under the heading Executive Compensation and Other
Information in our definitive Proxy Statement to be filed
pursuant to Regulation 14A for our 2004 Annual Meeting of
Stockholders.






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

We incorporate by reference the information
concerning our auditor fees set forth under the heading
Principal Auditors Fees and Services in our
definitive Proxy Statement to be filed pursuant to
Regulation 14A for our 2004 Annual Meeting of Stockholders.

33



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PART IV






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

a) Financial Statements and Report of
Ernst & Young LLP, Independent Auditors

|                                                                                                                                      |  |      |     | 
|------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | --- | 
|                                                                                                                                      |  | Page
|                                                                                                                                      |  |     
|Report of Ernst & Young
    LLP, Independent Auditors                                                                                 |  |      | F-2 | 
|Consolidated Balance Sheets as of
    December 31, 2003 and 2002                                                                      |  |      | F-3 | 
|Consolidated Statements of Operations for the
    years ended December 31, 2003, 2002 and 2001                                        |  |      | F-4 | 
|Consolidated Statements of Stockholders
    Equity/(Net Capital Deficiency) for the years ended
    December 31, 2003, 2002 and 2001 |  |      | F-5 | 
|Consolidated Statements of Cash Flows for the
    years ended December 31, 2003, 2002 and 2001                                        |  |      | F-6 | 
|Notes to Consolidated Financial Statements for
    the year ended December 31, 2003                                                   |  |      | F-7 | 

b) Reports on Form 8-K

The following Current Reports on Form 8-K
were filed during the fourth quarter of 2003:

On October 7, 2003, we filed a Current
Report on Form 8-K, reporting under Item 9 that we
filed a lawsuit against Sankyo Pharma Inc. and Sankyo Co., Ltd.
in excess of $450 million relating to the GlucoWatch
Biographer business.

On October 9, 2003, we filed a Current
Report on Form 8-K, reporting under Item 9 a reduction
in force of approximately 60% of our work force.

On November 10, 2003, we filed a Current
Report on Form 8-K, reporting under Item 9 the
restructuring of the remaining royalty payments owed to
Sanofi-Synthelabo pursuant to a 1997 Final Arbitration Award. We
also reported that Sankyo Pharma filed an answer and
cross-claims against Cygnus for declaratory relief, breach of
contract, and defamation in response to the Companys
lawsuit filed on October 6, 2003.

On November 13, 2003, we filed a Current
Report on Form 8-K, reporting under Item 12 our
earnings release and financial results for the quarter ended
September 30, 2003.

On December 5, 2003, we filed a Current
Report on Form 8-K, reporting under Item 5 that the
FDA approved our supplemental PMA application for our
third-generation GlucoWatch Biographer.

On December 23, 2003, we filed a Current
Report on Form 8-K, reporting under Item 5 that we had
settled the lawsuit between Cygnus and Sankyo Pharma regarding
distribution and marketing of the GlucoWatch G2 Biographer in
the United States.

c) Schedules

All other schedules are omitted, as they are
either not required or the required information is included in
the financial statements or notes thereto.

d) Exhibits

The following exhibits are filed herewith or
incorporated by reference:

| |   |     |  |                                                                                                                                                                                               
| | - | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3 | .01 |  | Bylaws of the Registrant, as amended,
    incorporated by reference to Exhibit 3.01 of
    Registrants Form 10-Q for the quarter ended
    June 30, 2002.                                    
| | 3 | .02 |  | Restated Articles of Incorporation of the
    Registrant, as amended to date, incorporated by reference to
    Exhibit 3.02 of Registrants Form 10-Q for the
    quarter ended June 30, 2002.

34



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##### Table of Contents



| |    |      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -- | ---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 4  | .01  |  | Specimen of Common Stock Certificate of the
    Registrant, incorporated by reference to Exhibit 4.1 of the
    Registrants Registration Statement on Form S-1 (File
    No. 33-38363) filed on December 21, 1990
    (Form S-1).                                                                                                                                                                                                                                                                                                                                                         
| | 4  | .02  |  | Amended and Restated Rights Agreement dated
    October 27, 1998 between the Registrant and ChaseMellon
    Shareholder Services, L.L.C. (the Rights Agent
    successor to Chemical Trust), which includes the Certificate of
    Determination for the Series A Junior Participating
    Preferred Stock as Exhibit A, the form of Rights
    Certificate as Exhibit B and the Summary of Rights to
    purchase Preferred Shares as Exhibit C, incorporated by
    reference to Exhibit 99.2 of the Registrants
    Form 8-A12B/ A (File No. 0-18962) filed on
    December 14, 1998.
| | 4  | .03  |  | Registration Rights Agreement dated June 30,
    1999 between the Registrant and Cripple Creek Securities,
    L.L.C., incorporated by reference to Exhibit 4.11 of the
    Registrants Form 10-Q for the quarter ended
    June 30, 1999.                                                                                                                                                                                                                                                                                                                                                
| | 4  | .04  |  | Registration Rights Agreement dated June 29,
    1999 between the Registrant and the listed Investors on
    Schedule I thereto, incorporated by reference to
    Exhibit 4.12 of the Registrants Form 10-Q for
    the quarter ended June 30, 1999.                                                                                                                                                                                                                                                                                                                                      
| | 4  | .05  |  | Registration Rights Agreement dated
    October 1, 2001 between Cygnus, Inc. and Cripple Creek
    Securities, L.L.C., incorporated by reference to
    Exhibit 4.1 of the Registrants Registration Statement
    on Form S-3 (File No. 333-71524) filed on
    October 12, 2001.                                                                                                                                                                                                                                                                                                         
| | 10 | .001 |  | Ten-year Industrial Net Lease Agreement (Building
    No. 2) dated September 27, 1988 between the Registrant
    and Seaport Centre Venture Phase I, incorporated by
    reference to Exhibit 10.26 of the Registrants
    Form S-1.                                                                                                                                                                                                                                                                                                                                                      
| | 10 | .002 |  | Ten-year Industrial Net Lease Agreement (Building
    No. 8) dated September 27, 1988 between the Registrant
    and Seaport Centre Venture Phase I, incorporated by
    reference to Exhibit 10.27 of the Registrants
    Form S-1.                                                                                                                                                                                                                                                                                                                                                      
| | 10 | .003 |  | First Amendment to Ten-year Industrial Net Lease
    Agreement (Building No. 2) dated June 9, 1998 between
    the Registrant and Metropolitan Life Insurance Company, a
    New York corporation (predecessor in interest to Seaport
    Centre Venture Phase I), incorporated by reference to
    Exhibit 10.30 of the Registrants Form 10-K for
    the period ending December 31, 1998.                                                                                                                                                                                               
| | 10 | .004 |  | Third Amendment to Ten-year Industrial Net Lease
    Agreement (Building No. 8) dated June 9, 1998 between
    the Registrant and Metropolitan Life Insurance Company, a
    New York corporation (predecessor in interest to Seaport
    Centre Venture Phase I), incorporated by reference to
    Exhibit 10.29 of the Registrants Form 10-K for
    the period ending December 31, 1998.                                                                                                                                                                                               
| | 10 | .005 |  | Sublease dated March 30, 2001 between the
    Registrant and Maxygen, Inc., incorporated by reference to
    Exhibit 10.010 of the Registrants Form 10-Q for
    the period ending March 31, 2001.                                                                                                                                                                                                                                                                                                                                                                                        
| | 10 | .006 |  | Fourth Amendment to Ten-year Industrial Net Lease
    Agreement (Building No. 8) dated October 18, 2002
    between the Registrant and Metropolitan Life Insurance Company,
    a New York corporation (predecessor in interest to Seaport
    Centre Venture Phase I), incorporated by reference to
    Exhibit 10.006 of the Registrants Form 10-K for
    the period ending December 31, 2002.                                                                                                                                                                                         
| | 10 | .007 |  | Second Amendment to Ten-Year Industrial Net Lease
    Agreement (Building 8) dated May 1, 2003 between the
    Registrant and Metropolitan Life Insurance Company, a
    New York corporation (predecessor in interest to Seaport
    Centre Venture Phase I), incorporated by reference to
    Exhibit 10.007 of the Registrants Form 10-Q for
    the period ending June 30, 2003.                                                                                                                                                                                                      
| | 10 | .008 |  | Lease Termination Agreement dated
    October 15, 2003 between the Registrant and Metropolitan
    Life Insurance Company, a New York corporation (predecessor
    in interest to Seaport Centre Venture Phase I).                                                                                                                                                                                                                                                                                                                                                                         
| | 10 | .009 |  | through 10.099 reserved.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | 10 | .101 |  | Structured Equity Line Flexible Financing
    Agreement, dated June 30, 1999 between the Registrant and
    Cripple Creek Securities, L.L.C., incorporated by reference to
    Exhibit 1 of the Registrants Form 8-K filed on
    July 2, 1999.                                                                                                                                                                                                                                                                                                                                           

35



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##### Table of Contents



| |    |      |  |                                                                                                                                                                                                                                                                                                          
| | -- | ---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10 | .102 |  | Convertible Debenture and Warrant Purchase
    Agreement dated June 29, 1999 between the Registrant and
    the listed Investors on Schedule I thereto, incorporated by
    reference to Exhibit 10.41 of the Registrants
    Form 10-Q for the quarter ended June 30, 1999.                            
| | 10 | .103 |  | Form of 8.5% Convertible Debentures Due
    June 29, 2004, incorporated by reference to
    Exhibit 10.42 of the Registrants Form 10-Q for
    the quarter ended June 30, 1999.                                                                                                                         
| | 10 | .104 |  | Form of Common Stock Purchase Warrant,
    incorporated by reference to Exhibit 10.43 of the
    Registrants Form 10-Q for the quarter ended
    June 30, 1999.                                                                                                                                         
| | 10 | .105 |  | Amendment No. 1 to Structured Equity Line
    Flexible Financing Agreement dated September 29, 1999
    between the Registrant and Cripple Creek Securities, L.L.C.,
    incorporated by reference to Exhibit 1.1 of the
    Registrants Form 8-K filed on October 7, 1999.                             
| | 10 | .106 |  | Form of Note Purchase Agreement dated as of
    February 3, 1998 between the Registrant and certain
    institutional Investors, incorporated by reference to
    Exhibit 10.38 of the Registrants Form 8-K dated
    February 4, 1998.                                                                 
| | 10 | .107 |  | Form of Common Stock Purchase Agreement dated
    February 2, 1998 between the Registrant and certain
    institutional Investors, incorporated by reference to
    Exhibit 10.29 of the Registrants Form 8-K dated
    February 4, 1998.                                                               
| | 10 | .108 |  | Amendment No. 2 to Structured Equity Line
    Flexible Financing Agreement between the Registrant and Cripple
    Creek Securities, L.L.C., dated March 27, 2000,
    incorporated by reference to Exhibit 10.109 of the
    Registrants Form 10-Q for the quarter ended
    March 31, 2000.            
| | 10 | .109 |  | Amendment No. 3 to Structured Equity Line
    Flexible Financing Agreement between the Registrant and Cripple
    Creek Securities, L.L.C., dated May 9, 2000, incorporated
    by reference to Exhibit 10.110 of the Registrants
    Form 10-Q for the quarter ended June 30, 2000.                    
| | 10 | .110 |  | Amendment No. 4 to Structured Equity Line
    Flexible Financing Agreement between the Registrant and Cripple
    Creek Securities, L.L.C., dated October 27, 2000,
    incorporated by reference to Exhibit 10.111 of the
    Registrants Form 10-K for the period ending
    December 31, 2000.       
| | 10 | .111 |  | Letter Agreement re Termination of Equity Line of
    Credit dated March 23, 2001 between the Registrant and
    Cripple Creek Securities, L.L.C., incorporated by reference to
    Exhibit 10.112 of Registrants Form 10-Q for the
    quarterly period ending March 31, 2001.                         
| | 10 | .112 |  | Structured Equity Line Flexible Financing
    Agreement dated March 23, 2001 between the Registrant and
    Cripple Creek Securities, L.L.C., incorporated by reference to
    Exhibit 1.1 of the Registrants Registration Statement
    on Form S-3/ A (File No. 333-49020) filed on
    April 9, 2001.
| | 10 | .113 |  | Structured Equity Line Flexible Financing
    Agreement dated October 1, 2001 between the Registrant and
    Cripple Creek Securities, L.L.C., incorporated by reference to
    Exhibit 1.1 of the Registrants Registration Statement
    on Form S-3 (File No. 333-71524) filed
    October 12, 2001.  
| | 10 | .114 |  | First Amendment to Convertible Debenture and
    Warrant Purchase Agreement dated August 21, 2002,
    incorporated by reference to Exhibit 99.2 of the
    Registrants Form 8-K filed August 23, 2002.                                                                                                 
| | 10 | .115 |  | First Amendment to 8.5% Convertible
    Debentures Due June 29, 2004, incorporated by reference to
    Exhibit 99.3 of the Registrants Form 8-K filed
    August 23, 2002.                                                                                                                              
| | 10 | .116 |  | First Amendment to 8.5% Convertible
    Debentures Due September 29, 2004, incorporated by
    reference to Exhibit 99.4 of the Registrants
    Form 8-K filed August 23, 2002.                                                                                                                         
| | 10 | .117 |  | Second Amendment to 8.5% Convertible
    Debentures Due June 29, 2004, incorporated by reference to
    Exhibit 99.1 of the Registrants Form 8-K filed
    September 20, 2002.                                                                                                                          
| | 10 | .118 |  | Second Amendment to 8.5% Convertible
    Debentures Due September 29, 2004, incorporated by
    reference to Exhibit 99.2 of the Registrants
    Form 8-K filed September 20, 2002.                                                                                                                     
| | 10 | .119 |  | First Amendment to Structured Equity Line
    Flexible Financing Agreement dated March 23, 2001 between
    the Registrant and Cripple Creek Securities, L.L.C. dated
    September 17, 2002, incorporated by reference to
    Exhibit 99.3 of the Registrants Form 8-K filed
    September 20, 2002.   

36



---



##### Table of Contents



| |     |      |  |                                                                                                                                                                                                                                                                                                             
| | --- | ---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10  | .120 |  | First Amendment to Structured Equity Line
    Flexible Financing Agreement dated October 1, 2001 between
    the Registrant and Cripple Creek Securities, L.L.C. dated
    September 17, 2002, incorporated by reference to
    Exhibit 99.4 of the Registrants Form 8-K filed
    September 20, 2002.     
| | 10  | .121 |  | Third Amendment to 8.5% Convertible
    Debentures Due June 29, 2004 dated December 7, 2002,
    incorporated by reference to Exhibit 4.9 of the
    Registrants Registration Statement on Form S-3/ A
    (333-100301) filed on December 10, 2002.                                                        
| | 10  | .122 |  | Third Amendment to 8.5% Convertible
    Debentures Due September 29, 2004 dated December 7,
    2002, incorporated by reference to Exhibit 4.10 of the
    Registrants Registration Statement on Form S-3/ A
    (333-100301) filed on December 10, 2002.                                                  
| | 10  | .123 |  | Security Agreement between Registrant and certain
    institutional Investors dated August 21, 2002, incorporated
    by reference to Exhibit 99.1 of the Registrants
    Registration Statement on Form S-3/ A (333-100301) filed on
    December 10, 2002.                                               
| | 10  | .124 |  | Amendment to the Final Arbitration Award between
    Registrant and Sanofi-Synthelabo dated November 3, 2003.                                                                                                                                                                                               
| | 10  | .125 |  | Security Agreement between Registrant and
    Sanofi-Synthelabo dated November 3, 2003.                                                                                                                                                                                                                     
| | 10  | .126 |  | Grant of Security Interest (Patents) between
    Registrant and Sanofi-Synthelabo dated January 18, 2004.                                                                                                                                                                                                   
| | 10  | .127 |  | Exchange Agreement between Registrant and the
    debenture holders dated March 23, 2004, incorporated by
    reference as Exhibit 99.2 of the Registrants
    Form 8-K filed March 25, 2004.                                                                                                              
| | 10  | .128 |  | Notice of Termination of Structured Equity Line
    Flexible Financing Agreement dated March 24, 2004.                                                                                                                                                                                                      
| | 10  | .129 |  | through 10.199 Reserved.                                                                                                                                                                                                                                                                                    
| | *10 | .201 |  | Product Supply and Distribution Agreement between
    the Registrant and Yamanouchi Pharmaceutical Co., Ltd. dated
    July 14, 1996, incorporated by reference to
    Exhibit 10.2 of the Registrants Form 10-Q for
    the quarter ended June 30, 1996. [Confidential Treatment
    Requested]           
| | *10 | .202 |  | Product Supply Agreement between the Registrant
    and Contract Manufacturing, Inc. dated July 15, 1997,
    incorporated by reference as Exhibit 10.202 of the
    Registrants Form 10-K for the period ending
    December 31, 1999. [Confidential Treatment Requested]                                 
| | *10 | .203 |  | Supply Agreement between the Registrant and Key
    Tronic Corporation dated December 1, 1999, incorporated by
    reference to Exhibit 10.205 of the Registrants
    Form 10-K for the period ending December 31, 1999.
    [Confidential Treatment Requested]                                            
| | *10 | .204 |  | Supply Agreement between the Registrant and
    Hydrogel Design Systems, Inc. dated December 31, 1999,
    incorporated by reference to Exhibit 10.206 of the
    Registrants Form 10-K for the period ending
    December 31, 1999. [Confidential Treatment Requested]                                    
| | *10 | .205 |  | Supply Agreement between the Registrant and
    Sanmina Medical Products Division, a division of Sanmina
    Corporation, dated March 1, 2000, incorporated by reference
    to Exhibit 10.207 of the Registrants Form 10-Q
    for the quarter ended June 30, 2000. [Confidential
    Treatment Requested]
| | *10 | .206 |  | Supply Agreement between the Registrant and E.I.
    du Pont de Nemours & Co. dated June 23, 2000,
    incorporated by reference to Exhibit 10.208 of the
    Registrants Form 10-Q for the quarter ended
    June 30, 2000. [Confidential Treatment Requested]                                            
| | *10 | .207 |  | Reserved.                                                                                                                                                                                                                                                                                                   
| | *10 | .208 |  | Reserved.                                                                                                                                                                                                                                                                                                   
| | *10 | .209 |  | Termination Agreement between the Registrant and
    Yamanouchi Pharmaceutical Co., Ltd. dated February 26,
    2001, incorporated by reference to Exhibit 10.211 of the
    Registrants Form 10-K for the period ending
    December 31, 2000. [Confidential Treatment Requested]                         
| | *10 | .210 |  | Co-Promotion Agreement between the Registrant and
    Sankyo Pharma Inc. dated November 28, 2001, incorporated by
    reference to Exhibit 2.10 of the Registrants
    Form 10-K for the period ending December 31, 2001.
    [Confidential Treatment Requested]                                           

37



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##### Table of Contents



| |     |      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | --- | ---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | *10 | .211 |  | Sales, Marketing and Distribution Agreement
    between the Registrant and Sankyo Pharma Inc. dated July 8,
    2002, incorporated by reference to Exhibit 10.211 of the
    Registrants Form 10-Q/ A for the period ending
    September 30, 2002. [Confidential Treatment Requested]                                                                                                                                                       
| | *10 | .212 |  | Reserved.                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | *10 | .213 |  | Reserved.                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | *10 | .214 |  | First Amendment to the Sales, Marketing and
    Distribution Agreement between the Registrant and Sankyo Pharma
    Inc. dated January 23, 2003, incorporated by reference to
    Exhibit 10.214 of the Registrants Form 10-K for
    the period ending December 31, 2002. [Confidential
    Treatment Requested]                                                                                                                            
| | *10 | .215 |  | Supply Agreement between the Registrant and
    Sankyo Pharma Inc. dated January 23, 2003, incorporated by
    reference to Exhibit 10.215 of the Registrants
    Form 10-K for the period ending December 31, 2002.
    [Confidential Treatment Requested]                                                                                                                                                                                  
| | *10 | .216 |  | Memorandum of Understanding (TheraCom) to the
    Sales, Marketing and Distribution Agreement between the
    Registrant and Sankyo Pharma Inc. dated January 23, 2003,
    incorporated by reference to Exhibit 10.216 to the
    Registrants Form 10-K for the period ending
    December 31, 2002. [Confidential Treatment Requested]                                                                                                     
| | 10  | .217 |  | Binding purchase commitment letter dated
    March 19, 2003 by Sankyo Pharma Inc., incorporated by
    reference to Exhibit 10.217 of the Registrants
    Form 10-Q for the period ending March 31, 2003.                                                                                                                                                                                                                                    
| | 10  | .218 |  | Deferral of advertising and promotional amount
    letter dated March 19, 2003 by Sankyo Pharma Inc.,
    incorporated by reference to Exhibit 10.218 of the
    Registrants Form 10-Q for the period ending
    March 31, 2003.                                                                                                                                                                                                             
| | 10  | .219 |  | Manufacturing Agreement dated May 1, 2003
    between the Registrant and Key Tronic Corporation, incorporated
    by reference to Exhibit 10.219 of the Registrants
    Form 10-Q for the period ending June 30, 2003.                                                                                                                                                                                                                       
| | 10  | .220 |  | Agreement for Global Resolution and Mutual
    Release of All Claims between the Registrant and Sankyo Pharma
    Inc. dated December 23, 2003, incorporated by reference to
    Exhibit 99.3 of the Registrants Form 8-K filed
    December 23, 2003.                                                                                                                                                                                       
| | 10  | .221 |  | through 10.299 Reserved.                                                                                                                                                                                                                                                                                                                                                                                                                      
| | *10 | .301 |  | Exclusive License Agreement between the
    Registrant and The Regents of the University of California dated
    January 31, 1995, incorporated by reference to
    Exhibit 10.301 of the Registrants Form 10-K for
    the period ending December 31, 1999. [Confidential
    Treatment Requested]                                                                                                                                          
| | *10 | .302 |  | License Agreement Amendment between the
    Registrant and The Regents of the University of California dated
    April 23, 1998, incorporated by reference to
    Exhibit 10.302 of the Registrants Form 10-K for
    the period ending December 31, 1999. [Confidential
    Treatment Requested]                                                                                                                                            
| | *10 | .303 |  | Second Amendment to the Exclusive License
    Agreement Dated January 31, 1995 for Device for
    Iontophoretic Non-Invasive Sampling or Delivery of Substances
    between the Registrant and The Regents of the University of
    California dated September 19, 2002, incorporated by
    reference to Exhibit 10.303 of the Registrants
    Form 10-Q/ A for the period ending September 30, 2002.
    [Confidential Treatment Requested]
| | 10  | .304 |  | through 10.399 Reserved.                                                                                                                                                                                                                                                                                                                                                                                                                      
| | *10 | .401 |  | Asset Purchase Agreement dated November 17,
    1999 between the Registrant and Ortho-McNeil
    Pharmaceutical, Inc., incorporated by reference to
    Exhibit 10.49 of the Registrants Form 8-K filed
    December 30, 1999. [Confidential Treatment Requested]                                                                                                                                                                            
| | 10  | .402 |  | through 10.499 Reserved.                                                                                                                                                                                                                                                                                                                                                                                                                      
| | 10  | .501 |  | Registrants 1999 Stock Incentive Plan (as
    Amended and Restated January 27, 2003), incorporated by
    reference to Exhibit 10.501 of the Registrants
    Form 10-K for the period ending December 31, 2002.                                                                                                                                                                                                                             

38



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| |    |      |  |                                                                                                                                                                                                                                                      
| | -- | ---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10 | .502 |  | Registrants Amended 1991 Employee Stock
    Purchase Plan (as Amended and Restated March 1, 2000),
    incorporated by reference to Exhibit 10.502 of the
    Registrants Form 10-K for the period ending
    December 31, 1999.                   
| | 10 | .503 |  | Written Compensation Agreement dated
    August 28, 1998 between the Registrant and André F.
    Marion, incorporated by reference to Exhibit 99.7 of the
    Registrants Form S-8 Registration (File
    No. 333-67331) filed on November 16, 1998.
| | 10 | .504 |  | Stock Option Agreement between the Registrant and
    André F. Marion, incorporated by reference to
    Exhibit 99.8 of the Registrants Form S-8 (File
    No. 333-67331) filed November 16, 1998.                                                  
| | 10 | .505 |  | Form of Employment Agreement between the
    Registrant and each of the Companys Officers, incorporated
    by reference to Exhibit 10.511 of the Registrants
    Form 10-K for the period ending December 31, 2000.                               
| | 10 | .506 |  | Form of Employment Agreement between the
    Registrant and Key Employees, incorporated by reference to
    Exhibit 10.512 of the Registrants Form 10-K for
    the period ending December 31, 2000.                                                
| | 10 | .507 |  | Form of Indemnification Agreement for Directors
    and Officers, incorporated by reference to Exhibit 10.513
    of the Registrants Form 10-K for the period ending
    December 31, 2000.                                                         
| | 10 | .508 |  | Form of Retention Letter Agreement between the
    Registrant and each of the Companys Officers dated
    December 18, 2003.                                                                                                                        
| | 23 | .1   |  | Consent of Ernst & Young
    LLP, Independent Auditors.                                                                                                                                                                                              
| | 24 | .1   |  | Power of Attorney (see page 48).                                                                                                                                                                                                                     
| | 31 | .1   |  | Certification of Principal Executive Officer
    Pursuant to Securities Exchange Act Rule 13a-14, as adopted
    pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                          
| | 31 | .2   |  | Certification of Principal Financial Officer
    Pursuant to Securities Exchange Act Rule 13a-14, as adopted
    pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                          
| | 32 | .1   |  | Certification of Principal Executive Officer
    Pursuant to 18 U.S.C. Section 1350, as adopted
    pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                       
| | 32 | .2   |  | Certification of Principal Financial Officer
    Pursuant to 18 U.S.C. Section 1350, as adopted
    pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                       



---



|  |                                                                                                                 
|- | ----------------------------------------------------------------------------------------------------------------
|* | A confidential treatment request has been applied
    for or granted with respect to a portion of this document.

39



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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, Registrant has
duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized, on the 26th day of
March, 2004.



| |             
| | ------------
| | CYGNUS, INC.



| |    |                   
| | -- | ------------------
| | By | /s/ JOHN C HODGMAN

| |                                                    
| | ---------------------------------------------------
| |                                                    
| | Chairman, President and Chief Executive
    Officer
| | (Principal Executive Officer)                      

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each
person whose signature appears below constitutes and appoints
John C Hodgman attorney-in-fact for the undersigned, with
the power of substitution, for the undersigned in any and all
capacities, to sign any and all amendments to this Report on
Form 10-K, and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that
said attorney-in-fact, or his substitute or 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
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/ JOHN C HODGMANJohn C Hodgman       |  | Chairman of the Board of Directors, President and
    Chief Executive Officer (Principal Executive Officer)                                       |  | March 26, 2004
|                                      
|/s/ CRAIG W. CARLSONCraig W. Carlson   |  | Chief Operating Officer, Chief Financial Officer
    and Senior Vice President (Principal Financial Officer and
    Principal Accounting Officer) |  | March 26, 2004
|                                      
|/s/ ANDRÉ F. MARIONAndré F. Marion     |  | Vice Chairman of the Board of Directors                                                                                                           |  | March 26, 2004
|                                      
|/s/ FRANK T. CARYFrank T. Cary         |  | Director                                                                                                                                          |  | March 26, 2004
|                                      
|/s/ RICHARD G. ROGERSRichard G. Rogers |  | Director                                                                                                                                          |  | March 26, 2004
|                                      
|/s/ WALTER B. WRISTONWalter B. Wriston |  | Director                                                                                                                                          |  | March 26, 2004

40



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##### Table of Contents



CYGNUS, INC.

CONSOLIDATED FINANCIAL STATEMENTS

For the Years Ended December 31, 2003,
2002 and 2001


Contents

|                                                      |                                                                              |  |     |     | 
|----------------------------------------------------- | ---------------------------------------------------------------------------- |  | --- | --- | 
|Report of Ernst & Young
    LLP, Independent Auditors |                                                                              |  | F-2 |    
|Audited Consolidated Financial Statements:            |                                                                              |  |     |    
|                                                      | Consolidated Balance Sheets                                                  |  |     | F-3 | 
|                                                      | Consolidated Statements of Operations                                        |  |     | F-4 | 
|                                                      | Consolidated Statements of Stockholders
    Equity/(Net Capital Deficiency) |  |     | F-5 | 
|                                                      | Consolidated Statements of Cash Flows                                        |  |     | F-6 | 
|                                                      | Notes to Consolidated Financial Statements                                   |  |     | F-7 | 

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##### Table of Contents



REPORT OF ERNST & YOUNG
LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders of
Cygnus, Inc.

We have audited the accompanying consolidated
balance sheets of Cygnus, Inc. as of December 31, 2003
and 2002, and the related consolidated statements of operations,
stockholders equity/(net capital deficiency), and cash
flows for each of the three years in the period ended
December 31, 2003. These financial statements are the
responsibility of Cygnus, Inc.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
consolidated financial position of Cygnus, Inc. at
December 31, 2003 and 2002, and the consolidated 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.



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

Palo Alto, California

January 30, 2004, except for


Note 12, as to which the date


is March 23, 2004


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##### Table of Contents



CYGNUS, INC.

CONSOLIDATED BALANCE SHEETS

|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |          |         |  
|--------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------- | ------ | -------- | ------ |  | ------ | -------- | ------- | -
|                                                                                                    |                                                                                                                                                                                 |                                                                        
|                                                                                                    |                                                                                                                                                                                 | December 31,                                                           
|                                                                                                    |                                                                                                                                                                                 |                                                                        
|                                                                                                    |                                                                                                                                                                                 | 2003                                                                    |        | 2002    
|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |         
|                                                                                                    |                                                                                                                                                                                 |                                                                        
|                                                                                                    |                                                                                                                                                                                 | (In thousands, except per                                              
|                                                                                                    |                                                                                                                                                                                 | share data)                                                            
|ASSETS                                                                                             
|Current assets:                                                                                     |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    | Cash and cash equivalents                                                                                                                                                       |                                                                         | $      | 33,483   |        |  | $      | 23,415   |        
|                                                                                                    | Short-term investments                                                                                                                                                          |                                                                         |        |         |        |  |        | 3,202    |        
|                                                                                                    | Accounts receivable from Sankyo Pharma (see
    Note 2)                                                                                                                         |                                                                         |        |         |        |  |        | 497      |        
|                                                                                                    | Inventories                                                                                                                                                                     |                                                                         |        | 62       |        |  |        | 6,628    |        
|                                                                                                    | Current portion of employee notes receivable                                                                                                                                    |                                                                         |        | 25       |        |  |        | 57       |        
|                                                                                                    | Other current assets                                                                                                                                                            |                                                                         |        | 750      |        |  |        | 1,172    |        
|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    |                                                                                                                                                                                 | Total current assets                                                    |        |          | 34,320 |  |        |          | 34,971  |  
|Equipment and improvements:                                                                         |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    | Manufacturing, office and laboratory equipment                                                                                                                                  |                                                                         |        | 11,908   |        |  |        | 15,626   |        
|                                                                                                    | Leasehold improvements                                                                                                                                                          |                                                                         |        | 377      |        |  |        | 610      |        
|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    |                                                                                                                                                                                 |                                                                         | 12,285 |          |        |  | 16,236 |         
|                                                                                                    | Less accumulated depreciation and amortization                                                                                                                                  |                                                                         |        | (9,080   | )      |  |        | (11,189  | )      
|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    |                                                                                                                                                                                 | Net equipment and improvements                                          |        |          | 3,205  |  |        |          | 5,047   |  
|Long-term portion of employee notes receivable                                                      |                                                                                                                                                                                 |                                                                         | 15     |          |        |  | 105    |         
|Other assets                                                                                        |                                                                                                                                                                                 |                                                                         | 167    |          |        |  | 354    |         
|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    |                                                                                                                                                                                 | TOTAL ASSETS                                                            |        | $        | 37,707 |  |        | $        | 40,477  |  
|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                   
|LIABILITIES AND STOCKHOLDERS EQUITY/(NET
    CAPITAL DEFICIENCY)                                  
|Current liabilities:                                                                                |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    | Accounts payable                                                                                                                                                                |                                                                         | $      | 814      |        |  | $      | 2,518    |        
|                                                                                                    | Accrued compensation                                                                                                                                                            |                                                                         |        | 381      |        |  |        | 2,628    |        
|                                                                                                    | Other accrued liabilities                                                                                                                                                       |                                                                         |        | 505      |        |  |        | 605      |        
|                                                                                                    | Advances from Sankyo Pharma (see Note 2)                                                                                                                                        |                                                                         |        |         |        |  |        | 1,382    |        
|                                                                                                    | Deferred revenues from Sankyo Pharma (see
    Note 2)                                                                                                                           |                                                                         |        |         |        |  |        | 25,000   |        
|                                                                                                    | Deferred revenues from Sankyo Pharma net of
    deferred costs of product shipments (see Note 2)                                                                                |                                                                         |        |         |        |  |        | 8,199    |        
|                                                                                                    | Current portion of Convertible Debentures                                                                                                                                       |                                                                         |        | 14,281   |        |  |        | 4,000    |        
|                                                                                                    | Current portion of capital lease obligations                                                                                                                                    |                                                                         |        | 74       |        |  |        | 77       |        
|                                                                                                    | Current portion of arbitration obligation                                                                                                                                       |                                                                         |        |         |        |  |        | 3,000    |        
|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    |                                                                                                                                                                                 | Total current liabilities                                               |        |          | 16,055 |  |        |          | 47,409  |  
|Long-term portion of arbitration obligation                                                         |                                                                                                                                                                                 |                                                                         | 11,500 |          |        |  | 12,000 |         
|Long-term portion of Convertible Debentures, net
    of discount of $709 in 2003 and $1,902 in 2002 |                                                                                                                                                                                 |                                                                         | 3,291  |          |        |  | 16,379 |         
|Long-term portion of amount due to Sankyo Pharma
    (see Note 2)                                   |                                                                                                                                                                                 |                                                                         |       |          |        |  | 7,237  |         
|Other long-term liabilities                                                                         |                                                                                                                                                                                 |                                                                         | 39     |          |        |  | 74     |         
|Commitments and contingencies                                                                       |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|Stockholders equity/(net capital
    deficiency):                                                  |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    | Preferred stock, $0.001 par value:
    5,000 shares authorized; no shares issued and outstanding                                                                                |                                                                         |        |         |        |  |        |         |        
|                                                                                                    | Common stock, $0.001 par value:
    95,000 shares authorized; issued and outstanding: 38,480
    and 38,479 shares at December 31, 2003 and
    December 31, 2002, respectively |                                                                         |        | 38       |        |  |        | 38       |        
|                                                                                                    | Additional paid-in capital                                                                                                                                                      |                                                                         |        | 254,093  |        |  |        | 254,091  |        
|                                                                                                    | Accumulated deficit                                                                                                                                                             |                                                                         |        | (247,309 | )      |  |        | (296,751 | )      
|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    |                                                                                                                                                                                 | Stockholders equity/(net capital
    deficiency)                       |        |          | 6,822  |  |        |          | (42,622 | )
|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         
|                                                                                                    |                                                                                                                                                                                 | TOTAL LIABILITIES AND STOCKHOLDERS
    EQUITY/(NET CAPITAL DEFICIENCY) |        | $        | 37,707 |  |        | $        | 40,477  |  
|                                                                                                    |                                                                                                                                                                                 |                                                                         |        |          |        |  |        |         

See accompanying notes.

F-3



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##### Table of Contents



CYGNUS, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |        |        | 
|-------------------------------------------------------------------- | --------------------------------------------------- | ------------------------------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                                     |                                                     |                                      
|                                                                     |                                                     | Years Ended December 31,             
|                                                                     |                                                     |                                      
|                                                                     |                                                     | 2003                                  |         | 2002   |        | 2001
|                                                                     |                                                     |                                       |         |        |        |     
|                                                                     |                                                     |                                      
|                                                                     |                                                     | (In thousands, except per share data)
|Revenues:                                                            |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                     | Net product revenues                                |                                       | $       | 2,684  |        |      | $       | 3,453  |        |   | $       | 489    |       
|                                                                     | Contract revenues                                   |                                       |         | 234    |        |      |         | 401    |        |   |         | 5,300  |       
|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                     |                                                     | Total revenues                        |         |        | 2,918  |      |         |        | 3,854  |   |         |        | 5,789  | 
|Costs and expenses:                                                  |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                     | Costs of product revenues                           |                                       |         | 15,447 |        |      |         | 6,396  |        |   |         | 271    |       
|                                                                     | Research and development                            |                                       |         | 5,119  |        |      |         | 13,883 |        |   |         | 27,405 |       
|                                                                     | Sales, marketing, general and administrative        |                                       |         | 6,440  |        |      |         | 22,544 |        |   |         | 15,481 |       
|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                     |                                                     | Total costs and expenses              |         |        | 27,006 |      |         |        | 42,823 |   |         |        | 43,157 | 
|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|Loss from operations                                                 |                                                     |                                       | (24,088 | )      |        |      | (38,969 | )      |        |   | (37,368 | )     
|                                                                     | Interest and other income/(expense), net            |                                       |         | 114    |        |      |         | 417    |        |   |         | 2,416  |       
|                                                                     | Interest expense                                    |                                       |         | (2,210 | )      |      |         | (3,153 | )      |   |         | (3,721 | )     
|                                                                     | Gain from Sankyo Pharma settlement (see
    Note 2) |                                       |         | 75,825 |        |      |         |       |        |   |         |       |       
|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|Income/(loss) before income taxes                                    |                                                     |                                       | 49,641  |        |        |      | (41,705 | )      |        |   | (38,673 | )     
|Provision for income taxes                                           |                                                     |                                       | 199     |        |        |      | 23      |        |        |   | 527     |       
|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|Net income/(loss)                                                    |                                                     | $                                     | 49,442  |        |        | $    | (41,728 | )      |        | $ | (39,200 | )     
|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|Net income/(loss) per share, basic                                   |                                                     | $                                     | 1.28    |        |        | $    | (1.11   | )      |        | $ | (1.31   | )     
|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|Shares used in computation of net
    income/(loss) per share, basic |                                                     |                                       | 38,480  |        |        |      | 37,580  |        |        |   | 30,028  |       
|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|Net income/(loss) per share, diluted                                 |                                                     | $                                     | 1.01    |        |        | $    | (1.11   | )      |        | $ | (1.31   | )     
|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |       
|Shares used in computation of income/(loss)
    per share, diluted   |                                                     |                                       | 49,640  |        |        |      | 37,580  |        |        |   | 30,028  |       
|                                                                     |                                                     |                                       |         |        |        |      |         |        |        |   |         |       

See accompanying notes.

F-4



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##### Table of Contents



CYGNUS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY/

(NET CAPITAL DEFICIENCY)


|                                                                                                                |  |                |    |            |  |             |         |               |  |                     |          |   |  |   |        |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------------- |  | -------------- | -- | ---------- |  | ----------- | ------- | ------------- |  | ------------------- | -------- | - |  | - | ------ | - |  | - | ------- | -
|                                                                                                                |  |                |    |            |  |             |         | Accumulated   |  | Total              
|                                                                                                                |  |                |    | Additional |  |             |         | Other         |  | Stockholders      
|                                                                                                                |  | Common         |    | Paid-in    |  | Accumulated |         | Comprehensive |  | Equity/(net capital
|                                                                                                                |  | Stock          |    | Capital    |  | Deficit     |         | Income/(loss) |  | deficiency)        
|                                                                                                                |  |                |    |            |  |             |         |               |  |                    
|                                                                                                                |  |               
|                                                                                                                |  | (In thousands)
|Balances at December 31, 2000                                                                                   |  | $              | 27 |            |  | $           | 201,011 |               |  | $                   | (215,823 | ) |  | $ | 1,762  |   |  | $ | (13,023 | )
|Issuance of 283 shares of common stock under
    the 1999 Stock Incentive Plan and Employee Stock Purchase Plan |  |                | 1  |            |  |             | 1,270   |               |  |                     |         |   |  |   |       |   |  |   | 1,271   |  
|Issuance of 18 shares of common stock
    pursuant to equity lines, net of issuance costs                       |  |                |   |            |  |             | 142     |               |  |                     |         |   |  |   |       |   |  |   | 142     |  
|Issuance of 246 shares of common stock in
    lieu of cash bonus                                                |  |                |   |            |  |             | 1,907   |               |  |                     |         |   |  |   |       |   |  |   | 1,907   |  
|Stock-based compensation                                                                                        |  |                |   |            |  |             | 71      |               |  |                     |         |   |  |   |       |   |  |   | 71      |  
|Issuance of 5,121 shares of common stock
    pursuant to equity lines, net of issuance costs                    |  |                | 5  |            |  |             | 32,541  |               |  |                     |         |   |  |   |       |   |  |   | 32,546  |  
|Net loss                                                                                                        |  |                |   |            |  |             |        |               |  |                     | (39,200  | ) |  |   |       |   |  |   | (39,200 | )
|Net change in unrealized gain on
    available-for-sale securities                                              |  |                |   |            |  |             |        |               |  |                     |         |   |  |   | (1,762 | ) |  |   | (1,762  | )
|                                                                                                                |  |                |    |            |  |             |         |               |  |                     |          |   |  |   |        |   |  |   |         |  
|Comprehensive loss                                                                                              |  |                |   |            |  |             |        |               |  |                     |         |   |  |   |       |   |  |   | (40,962 | )
|                                                                                                                |  |                |    |            |  |             |         |               |  |                     |          |   |  |   |        |   |  |   |         |  
|Balances at December 31, 2001                                                                                   |  |                | 33 |            |  |             | 236,942 |               |  |                     | (255,023 | ) |  |   |       |   |  |   | (18,048 | )
|Issuance of 226 shares of common stock under
    the 1999 Stock Incentive Plan and Employee Stock Purchase Plan |  |                |   |            |  |             | 554     |               |  |                     |         |   |  |   |       |   |  |   | 554     |  
|Issuance of 338 shares of common stock in
    lieu of cash bonuses                                              |  |                |   |            |  |             | 1,408   |               |  |                     |         |   |  |   |       |   |  |   | 1,408   |  
|Stock-based compensation                                                                                        |  |                |   |            |  |             | 4       |               |  |                     |         |   |  |   |       |   |  |   | 4       |  
|Issuance of 170 shares of common stock
    pursuant to equity lines, net of issuance costs                      |  |                |   |            |  |             | 452     |               |  |                     |         |   |  |   |       |   |  |   | 452     |  
|Public offering of 4,600 shares of common
    stock, net of issuance costs                                      |  |                | 5  |            |  |             | 14,731  |               |  |                     |         |   |  |   |       |   |  |   | 14,736  |  
|Net and comprehensive loss                                                                                      |  |                |   |            |  |             |        |               |  |                     | (41,728  | ) |  |   |       |   |  |   | (41,728 | )
|                                                                                                                |  |                |    |            |  |             |         |               |  |                     |          |   |  |   |        |   |  |   |         |  
|Balances at December 31, 2002                                                                                   |  |                | 38 |            |  |             | 254,091 |               |  |                     | (296,751 | ) |  |   |       |   |  |   | (42,622 | )
|Issuance of 1.6 shares of common stock under
    the 1999 Stock Incentive Plan                                  |  |                |   |            |  |             | 1       |               |  |                     |         |   |  |   |       |   |  |   | 1       |  
|Stock-based compensation                                                                                        |  |                |   |            |  |             | 1       |               |  |                     |         |   |  |   |       |   |  |   | 1       |  
|Net and comprehensive income                                                                                    |  |                |   |            |  |             |        |               |  |                     | 49,442   |   |  |   |       |   |  |   | 49,442  |  
|                                                                                                                |  |                |    |            |  |             |         |               |  |                     |          |   |  |   |        |   |  |   |         |  
|Balances at December 31, 2003                                                                                   |  | $              | 38 |            |  | $           | 254,093 |               |  | $                   | (247,309 | ) |  | $ |       |   |  | $ | 6,822   |  
|                                                                                                                |  |                |    |            |  |             |         |               |  |                     |          |   |  |   |        |   |  |   |         |  

See accompanying notes.

F-5



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##### Table of Contents



CYGNUS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                          |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |         |        |        |         |  
|------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------ | ----------------------------------------------------------------------- | ----------------------------------------------------------------------------------- | ------------------------------------------------------- | ------- | ------ | ------ | ------- | ----- | ------ | ------- | ------- | ------ | ------ | ------- | -
|                                                                          |                                                                                                        |                                                                        
|                                                                          |                                                                                                        | Years Ended December 31,                                               
|                                                                          |                                                                                                        |                                                                        
|                                                                          |                                                                                                        | 2003                                                                    |                                                                                     | 2002                                                    |         | 2001  
|                                                                          |                                                                                                        |                                                                         |                                                                                     |                                                         |         |       
|                                                                          |                                                                                                        |                                                                        
|                                                                          |                                                                                                        | (In thousands)                                                         
|Cash flows from operating
    activities:                                 |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|                                                                          | Net income/(loss)                                                                                      |                                                                         | $                                                                                   | 49,442                                                  |         |        | $      | (41,728 | )     |        | $       | (39,200 | )     
|                                                                          | Adjustments to reconcile net income/(loss) to net
    cash provided by/(used in) operating activities: |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |         |       
|                                                                          |                                                                                                        | Depreciation and amortization                                           |                                                                                     |                                                         | 1,921   |        |        |         | 2,041 |        |         |         | 1,751  |       
|                                                                          |                                                                                                        | Realized gain on sale of investments                                    |                                                                                     |                                                         |        |        |        |         |      |        |         |         | (1,144 | )     
|                                                                          |                                                                                                        | (Gain)/loss on sales of equipment                                       |                                                                                     |                                                         | (4      | )      |        |         | 19    |        |         |         | 124    |       
|                                                                          |                                                                                                        | Impairment of fixed assets                                              |                                                                                     |                                                         |        |        |        |         | 1,491 |        |         |         |       |       
|                                                                          |                                                                                                        | Amortization of deferred financing costs                                |                                                                                     |                                                         | 1,397   |        |        |         | 1,435 |        |         |         | 1,435  |       
|                                                                          |                                                                                                        | Stock-based compensation                                                |                                                                                     |                                                         | 1       |        |        |         | 4     |        |         |         | 2,120  |       
|                                                                          |                                                                                                        | Non-cash portion of gain from Sankyo Pharma
    settlement (see Note 2) |                                                                                     |                                                         | (46,094 | )      |        |         |      |        |         |         |       |       
|                                                                          |                                                                                                        | Change in operating assets and liabilities:                             |                                                                                     |                                                         |         |        |        |         |       |        |         |         |        |       
|                                                                          |                                                                                                        |                                                                         | Accounts receivable from Sankyo Pharma                                              |                                                         |         | (586   | )      |         |       | (497   | )       |         |        |       |        
|                                                                          |                                                                                                        |                                                                         | Inventories                                                                         |                                                         |         | 6,566  |        |         |       | (4,641 | )       |         |        | (1,987 | )      
|                                                                          |                                                                                                        |                                                                         | Other assets                                                                        |                                                         |         | 532    |        |         |       | 26     |         |         |        | (815   | )      
|                                                                          |                                                                                                        |                                                                         | Other                                                                               |                                                         |         | 2      |        |         |       | 28     |         |         |        | 80     |        
|                                                                          |                                                                                                        |                                                                         | Accounts payable and other accrued liabilities                                      |                                                         |         | (1,808 | )      |         |       | 870    |         |         |        | 1,698  |        
|                                                                          |                                                                                                        |                                                                         | Accrued compensation                                                                |                                                         |         | (2,247 | )      |         |       | 503    |         |         |        | 2,501  |        
|                                                                          |                                                                                                        |                                                                         | Advances from Sankyo Pharma                                                         |                                                         |         | 2,395  |        |         |       | 1,382  |         |         |        |       |        
|                                                                          |                                                                                                        |                                                                         | Deferred revenues from Sankyo Pharma                                                |                                                         |         |       |        |         |       | 20,000 |         |         |        | 5,000  |        
|                                                                          |                                                                                                        |                                                                         | Deferred revenues from Sankyo Pharma net of
    deferred costs of product shipments |                                                         |         | 1,107  |        |         |       | 8,199  |         |         |        |       |        
|                                                                          |                                                                                                        |                                                                         | Amount due to Sankyo Pharma                                                         |                                                         |         | 1,857  |        |         |       | 7,237  |         |         |        |       |        
|                                                                          |                                                                                                        |                                                                         | Arbitration obligation                                                              |                                                         |         | (3,500 | )      |         |       | (8,390 | )       |         |        | 390    |        
|                                                                          |                                                                                                        |                                                                         | Other long-term liabilities                                                         |                                                         |         | 39     |        |         |       | (161   | )       |         |        | (158   | )      
|                                                                          |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|                                                                          |                                                                                                        |                                                                         |                                                                                     | Net cash provided by/(used in) operating
    activities |         |        | 11,020 |         |       |        | (12,182 | )       |        |        | (28,205 | )
|                                                                          |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|Cash flows from investing
    activities:                                 |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|                                                                          | Capital expenditures                                                                                   |                                                                         |                                                                                     | (83                                                     | )       |        |        | (601    | )     |        |         | (2,552  | )     
|                                                                          | Proceeds from sales of equipment                                                                       |                                                                         |                                                                                     | 7                                                       |         |        |        | 5       |       |        |         | 1       |       
|                                                                          | Purchases of investments                                                                               |                                                                         |                                                                                     | (800                                                    | )       |        |        | (14,246 | )     |        |         | (11,394 | )     
|                                                                          | Sales of investments                                                                                   |                                                                         |                                                                                     | 4,000                                                   |         |        |        | 15,550  |       |        |         | 9,844   |       
|                                                                          | Maturity of investments                                                                                |                                                                         |                                                                                     |                                                        |         |        |        | 2,074   |       |        |         | 10,671  |       
|                                                                          |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|                                                                          |                                                                                                        |                                                                         |                                                                                     | Net cash provided by investing activities               |         |        | 3,124  |         |       |        | 2,782   |         |        |        | 6,570   |  
|                                                                          |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|Cash flows from financing
    activities:                                 |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|                                                                          | Issuance of common stock                                                                               |                                                                         |                                                                                     | 1                                                       |         |        |        | 15,742  |       |        |         | 33,817  |       
|                                                                          | Principal payments of Convertible Debentures                                                           |                                                                         |                                                                                     | (4,000                                                  | )       |        |        |        |       |        |         | (3,089  | )     
|                                                                          | Principal payments of capital lease obligations                                                        |                                                                         |                                                                                     | (77                                                     | )       |        |        | (69     | )     |        |         | (9      | )     
|                                                                          |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|                                                                          |                                                                                                        |                                                                         |                                                                                     | Net cash provided by/(used in) financing
    activities |         |        | (4,076 | )       |       |        | 15,673  |         |        |        | 30,719  |  
|                                                                          |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|Net increase in cash and cash equivalents                                 |                                                                                                        |                                                                         | 10,068                                                                              |                                                         |         |        | 6,273  |         |       |        | 9,084   |        
|Cash and cash equivalents at the beginning of the
    year                |                                                                                                        |                                                                         | 23,415                                                                              |                                                         |         |        | 17,142 |         |       |        | 8,058   |        
|                                                                          |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|Cash and cash equivalents at the end of the year                          |                                                                                                        | $                                                                       | 33,483                                                                              |                                                         |         | $      | 23,415 |         |       | $      | 17,142  |        
|                                                                          |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|Supplemental disclosure of cash flow
    information:                     |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|                                                                          | Interest paid                                                                                          |                                                                         | $                                                                                   | 757                                                     |         |        | $      | 220     |       |        | $       | 102     |       
|                                                                          | Foreign income taxes paid                                                                              |                                                                         | $                                                                                   | 21                                                      |         |        | $      | 27      |       |        | $       | 500     |       
|Supplemental schedule of non-cash investing
    and financing activities: |                                                                                                        |                                                                         |                                                                                     |                                                         |         |        |        |         |       |        |         |        
|                                                                          | Assets acquired under capital leases                                                                   |                                                                         | $                                                                                   |                                                        |         |        | $      |        |       |        | $       | 229     |       
|                                                                          | Value of shares granted in lieu of cash bonus                                                          |                                                                         | $                                                                                   |                                                        |         |        | $      | 1,408   |       |        | $       | 1,907   |       

See accompanying notes.

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##### Table of Contents



CYGNUS, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

For the Year Ended December 31,
2003




|        |                                                                         
|------- | ------------------------------------------------------------------------
|Note 1: | Basis of Presentation and Summary of
    Significant Accounting Policies



| |                        
| | -----------------------
| | Description of Business

Cygnus was incorporated in California in 1985 and
was merged into a Delaware corporation in 1995. We have
developed and manufactured new and improved glucose monitoring
devices. Our products are designed to provide more data to
individuals and their physicians and enable them to make
better-informed decisions on how to manage diabetes. Our
GlucoWatch Biographer line of products consists of frequent,
automatic and non-invasive glucose monitoring devices.



| |                                         
| | ----------------------------------------
| | Global Resolution with Sankyo
    Pharma

On July 8, 2002, we entered into a Sales,
Marketing and Distribution Agreement with Sankyo Pharma for the
sales, marketing, managed care and governmental contracting, and
distribution or our GlucoWatch G2 Biographer and our other
similar glucose monitoring products (see Note 2, Cygnus and
Sankyo Pharma). On October 6, 2003, we filed a complaint in
the Superior Court of the State of California for the County of
San Mateo against Sankyo Pharma and Sankyo Japan for breach
of contract and intentional interference with contract relating
to the sales, marketing and distribution of our GlucoWatch
Biographer products. On December 15, 2003, Sankyo Pharma
filed cross-claims against us for declaratory relief, breach of
contract, and defamation.

On December 23, 2003, we entered into a
Global Resolution with Sankyo Pharma that resolved and dismissed
the pending litigation, and terminated our sales, marketing and
distribution agreement and all other contractual arrangements
(See Note 2, Cygnus and Sankyo Pharma). The Global
Resolution provided for Sankyo Pharma to pay us
$30.0 million and also specified that neither party owed
any payments to the other party, thus allowing us to write off
certain liabilities and assets, resulting in a total net gain of
$75.8 million. Furthermore, Sankyo Pharma transferred title
to us of more than 20,000 GlucoWatch G2 Biographers and more
than 1.0 million AutoSensors that we had previously sold
and shipped to them. Sankyo Pharma is to provide certain
transition services related to distribution and customer
services until the earlier of June 30, 2004 or when we
notify Sankyo Pharma that they may discontinue such services,
and we are entitled to receive 30% of all monies received from
product sales during this transition period. In light of these
developments, we are not likely to manufacture our G2 Biographer
or third-generation product or develop new products in the near
future.

We are currently seeking a new sales, marketing
and distribution partner or other strategic alliance, and we are
exploring the possibility of selling the company to a third
party. Our Biographer products have not yet been widely accepted
by the market due, we believe, to a combination of factors,
including adoption barriers for new technology, the need for a
paradigm shift in the management of diabetes, lack of widespread
medical reimbursement, and the pricing and performance
characteristics of the device. We do not have the resources or
infrastructure to perform the full range of functions necessary
to successfully market and sell our products. Our products
require a sizeable sales force to create product awareness and
provide education to health care professionals and end user
customers, a managed care sales force to work with national and
regional health plans to secure medical reimbursement,
significant advertising and promotional resources, a variety of
customer support and education programs, a technical support
group, logistics and distribution expertise and personnel, and
marketing management resources and personnel. Thus, we must
obtain a sales, marketing and distribution partner or other
strategic alliance, including but not limited to a merger or an
acquisition by a third party, if we are to continue to sell our
products. In the event that we are unsuccessful in our efforts
and our product sales do not significantly increase, we may need
to liquidate the company or sell some or all of its assets.

F-7



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                       
| | ----------------------
| | Basis of Consolidation

The consolidated financial statements include the
accounts of Cygnus and our wholly owned U.K. subsidiary after
elimination of all material inter-company balances and
transactions.



| |                       
| | ----------------------
| | Financial Presentation

Certain prior year amounts have been reclassified
to conform to the current years presentation.



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

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

Due to the current uncertainty surrounding our
business situation, the realization of values for our long-lived
assets is based on significant estimates.



| |                                      
| | -------------------------------------
| | Customer and Other
    Concentrations

One customer, Sankyo Pharma, provided 93% of our
2003 product revenues, and one customer, NIH, provided 100% of
our 2003 contract revenues. In light of our Global Resolution
with Sankyo Pharma, we will not be selling any additional
products to Sankyo Pharma. We currently are not performing work
under any SBIR grants or contracts, and thus do not expect any
contract revenues in the near future.

Our Biographer and AutoSensor products have been
manufactured from components purchased from outside suppliers,
most of whom are our single source for such components. If we
are unable, for whatever reason, to obtain these components from
our suppliers or if the components obtained from these suppliers
do not pass quality standards, we will be required to obtain the
components from alternative suppliers.

AutoSensors have been manufactured by an
independent third party based in Michigan that is our sole
source for such outsourced manufacturing. All manufacturing
facilities used in the manufacturing of our products are subject
to inspection and approval requirements of the FDA. If this
third party is unable to manufacture the required quantities of
AutoSensor for whatever reason, we will be required to make
alternative arrangements that will be subject to FDA approval
before commercial manufacturing.

We maintain our cash, cash equivalents and
investments primarily with a bank and two brokerage houses that
management believes are creditworthy. This practice is
consistent with our policy to maintain high liquidity and to
ensure safety of principal.



| |                             
| | ----------------------------
| | Foreign Currency Translation

The functional currency of our foreign subsidiary
in the United Kingdom is the British pound and the reporting
currency of this subsidiary is the United States dollar.
Monetary assets and liabilities of our foreign subsidiary
denominated in foreign currency are translated into United
States dollar equivalents at the exchange rate in effect on the
balance sheet date. Revenues and expenses are translated at the
weighted average exchange rate for the year. Transaction gains
and losses are included in operating results and have been
insignificant for all periods presented.



| |                         
| | ------------------------
| | Deferred Financing Costs

Deferred financing costs of $486,000 and $114,000
related to costs incurred originally in 1999 in connection with
our convertible debenture financings of $14.0 million and
$3.0 million, respectively. These

F-8



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

costs were amortized over the term of the related
debentures and included in interest expense. As of
December 31, 2003, the remaining unamortized amount was
$66,000.



| |                                            
| | -------------------------------------------
| | Accounting for Stock-Based
    Compensation

We issue stock options to our employees and
outside directors and provide them the right to purchase our
stock pursuant to stockholder-approved stock option programs. We
account for our stock-based compensation plans under the
intrinsic-value method of accounting as defined by Accounting
Principles Board Opinion No. 25 (APB 25),
Accounting for Stock Issued to Employees, and
related interpretations. We have elected to follow APB 25
in accounting for our employee stock options because the
alternative fair value accounting provided for under Financial
Accounting Standards Board (FASB) Statement No. 123
(FAS 123), Accounting for Stock Based
Compensation, requires the use of option valuation models
that were not developed for use in valuing employee stock
options. Under APB 25, because the exercise price of our
employee and director stock options equals the market price of
the underlying stock on the date of grant, no compensation
expense is recognized for these grants.

For purposes of disclosure pursuant to
FAS 123, as amended by FASB Statement No. 148
(FAS 148), Accounting for Stock-Based
Compensation  Transition and Disclosure, the
estimated fair value of employee and director stock options is
amortized to expense over the vesting periods of the options.

The following table illustrates the effect on net
income/(loss) and net income/(loss) per share if we had applied
the fair value recognition provisions of FAS 123 to
stock-based employee and director compensation (in thousands,
except per share amounts):

|                                                                                                                              |                      |                          |        |      |  |      |         |       |   |   |         |       |  
|----------------------------------------------------------------------------------------------------------------------------- | -------------------- | ------------------------ | ------ | ---- |  | ---- | ------- | ----- | - | - | ------- | ----- | -
|                                                                                                                              |                      |                         
|                                                                                                                              |                      | Years Ended December 31,
|                                                                                                                              |                      |                         
|                                                                                                                              |                      | 2003                     |        | 2002 |  | 2001
|                                                                                                                              |                      |                          |        |      |  |     
|Net income/(loss), as reported                                                                                                |                      | $                        | 49,442 |      |  | $    | (41,728 | )     |   | $ | (39,200 | )    
|Add: Stock-based employee compensation expense
    included in reported net loss                                              |                      |                          |       |      |  |      |        |       |   |   | 2,919   |      
|Deduct: Total stock-based employee compensation
    expense determined under fair value method for all awards, net
    of tax |                      |                          | (1,119 | )    |  |      | (2,873  | )     |   |   | (6,249  | )    
|                                                                                                                              |                      |                          |        |      |  |      |         |       |   |   |         |      
|Pro forma net income/(loss)                                                                                                   |                      | $                        | 48,323 |      |  | $    | (44,601 | )     |   | $ | (42,530 | )    
|                                                                                                                              |                      |                          |        |      |  |      |         |       |   |   |         |      
|Net income/(loss), per share:                                                                                                 |                      |                          |        |      |  |      |         |       |   |   |         |      
|                                                                                                                              | Basic, as reported   |                          | $      | 1.28 |  |      | $       | (1.11 | ) |   | $       | (1.31 | )
|                                                                                                                              | Basic, pro forma     |                          | $      | 1.26 |  |      | $       | (1.19 | ) |   | $       | (1.42 | )
|                                                                                                                              | Diluted, as reported |                          | $      | 1.01 |  |      | $       | (1.11 | ) |   | $       | (1.31 | )
|                                                                                                                              | Diluted, pro forma   |                          | $      | 0.99 |  |      | $       | (1.19 | ) |   | $       | (1.42 | )

F-9



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Pro forma information regarding net income/(loss)
and net income/(loss) per share is required by FAS 123,
which also requires that the information be determined as if we
had accounted for our employee stock options granted under the
fair value method of FAS 123. For the years ended
December 31, 2003, 2002, and 2001, the estimated grant date
fair value for stock options granted was $778,000,
$3.6 million, and $6.7 million, respectively. The fair
value for the options was estimated at the date of grant using
the Black-Scholes option valuation model with the following
weighted-average assumptions:

|                        |  |              |      |      |  |      |      |   |  |  |      |  
|----------------------- |  | ------------ | ---- | ---- |  | ---- | ---- | - |  |  | ---- | -
|                        |  |             
|                        |  | Years Ended 
|                        |  | December 31,
|                        |  |             
|                        |  | 2003         |      | 2002 |  | 2001
|                        |  |              |      |      |  |     
|Risk-free interest rate |  |              | 2.82 | %    |  |      | 2.93 | % |  |  | 4.20 | %
|Volatility              |  |              | 1.05 |      |  |      | 0.87 |   |  |  | 0.83 |  
|Dividend yield          |  |              | 0    |      |  |      | 0    |   |  |  | 0    |  
|Expected life (years)   |  |              | 3    |      |  |      | 5    |   |  |  | 5    |  

Effective January 8, 2003, our Board of
Directors suspended the Amended 1991 Employee Stock Purchase
Plan, as last amended and restated February 12, 2002,
because our stock had been delisted from trading on the Nasdaq
National Market. Thus, no shares were purchased pursuant to the
Employee Stock Purchase Plan during the year ended
December 31, 2003. The valuations related to the shares
granted pursuant to the Employee Stock Purchase Plan in 2002 and
2001 were calculated using the following assumptions:

|                        |  |              |      |      |  |  |      |  
|----------------------- |  | ------------ | ---- | ---- |  |  | ---- | -
|                        |  |             
|                        |  | Years Ended 
|                        |  | December 31,
|                        |  |             
|                        |  | 2002         |      | 2001
|                        |  |              |      |     
|Risk-free interest rate |  |              | 1.13 | %    |  |  | 4.20 | %
|Volatility              |  |              | 1.25 |      |  |  | 0.83 |  
|Dividend yield          |  |              | 0    |      |  |  | 0    |  
|Expected life (years)   |  |              | 0.5  |      |  |  | 0.5  |  

The Black-Scholes option valuation model was
developed for use in estimating the fair value of traded options
that have no vesting restrictions and are fully transferable. In
addition, option valuation models require the input of highly
subjective assumptions, including the expected stock-price
volatility. Because our employee stock options have
characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions
can materially affect the fair value estimate, in
managements opinion the existing models do not necessarily
provide a reliable single measure of the fair value of our
employee stock options.

All stock options and warrants granted to
consultants and other non-employees are accounted for at fair
value, determined by using the Black-Scholes valuation model, in
accordance with the Emerging Issues Task Force (EITF) Consensus
No. 96-18, Accounting for Equity Investments that are
issued to other than Employees for Acquiring, or in Conjunction
with Selling, Goods or Services. These options are subject
to periodic revaluation over their vesting terms. The
assumptions used to value stock-based awards to consultants are
similar to those used for employees (except for the expected
life, for which the contractual life of the award is used
instead of the expected life).



| |                                                               
| | --------------------------------------------------------------
| | Accounting for Impairment or Disposal of
    Long-Lived Assets

We review equipment and improvements and other
long-lived assets for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may
not be recoverable. Recoverability is measured by comparison of
the carrying amount of the assets to the future net cash flows
that the assets are expected to generate. If such assets are
considered to be impaired, the impairment is recognized and is

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CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

measured as the amount by which the carrying
amount of the assets exceeds the fair value of the assets,
evaluated by considering the present value of future net cash
flows. No impairment charges were recorded during 2003 and 2001.
In the fourth calendar quarter of 2002, we recorded an
impairment charge of $1.5 million, primarily related to our
semi-automated back-up AutoSensor-manufacturing equipment, which
became obsolete in the fourth quarter of 2002 as a result of the
deployment of our fully automated manufacturing equipment. This
charge was included in sales, marketing, general and
administrative expenses. As of December 31, 2003, we do not
anticipate using our production equipment in the near term. We
have concluded that its current carrying amounts would be
recoverable if we enter into a new sales, marketing and
distribution agreement or other strategic alliance. We may also
use this equipment in research and development efforts, if any.
As a result, we have not recognized any impairment against these
assets at December 31, 2003. We will continue to evaluate
the realizable value of these assets, which may result in future
adjustments.



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

Product revenues are generated upon the sale of
our GlucoWatch Biographer and GlucoWatch G2 Biographers and
accessories in the United States and the United Kingdom. The
GlucoWatch Biographer systems consist of two integrated parts:
the durable Biographer and the disposable, single-use AutoSensor.

Product sales are recorded when all of the
following conditions have been met: product has been shipped,
transfer of title has taken place, there is persuasive evidence
of an arrangement, the price is fixed or determinable, and
collection is reasonably assured. Revenues generated from our
shipments of sample and practice Biographers were recognized
when all the above conditions are met, typically upon delivery
of these products to Sankyo Pharma, as the sales of such
products were not subject to future pricing adjustments. With
regard to product sales that were made directly by us to third
parties, from time to time we allowed customers to return
product for credit. In such instances, we deferred revenue until
the return period expired. We accrue for estimated warranty
costs and other allowances when the revenues from product sales
are recognized. The warranty expenses recorded to date have not
been significant and are within historical estimates.

Revenues in the United States generated from our
shipments of product to Sankyo Pharma for resale under our
now-terminated Sales, Marketing and Distribution Agreement were
deferred until the product was sold by Sankyo Pharma to its
third-party customers, because the net price of our product
sales to Sankyo Pharma was subject to certain contractual
pricing adjustments, such as rebates, discounts and certain fees
offered or paid by Sankyo Pharma to its third-party customers.
Product revenues recorded by us for the first three calendar
quarters of 2003 are net of these adjustments; however, product
revenues recorded for the fourth quarter ended December 31,
2003 were not subject to such adjustments because our Sales,
Marketing and Distribution Agreement with Sankyo Pharma had been
terminated pursuant to the Global Resolution. As a result of the
Global Resolution, the remaining $9.3 million balance in
Deferred revenues from Sankyo Pharma net of deferred costs
of products shipments previously deferred in our balance
sheet at the date of the Global Resolution was included as a
component of Gain from Sankyo Pharma settlement in
our statement of operations during the fourth quarter of 2003.
We do not expect any significant product revenues in 2004 unless
we obtain a sales, marketing and distribution partner or other
strategic alliance.

Our contract revenues may include up-front and
interim milestone payments from co-promotion; sales, marketing
and distribution; and development agreements. Milestone payments
are recorded as revenue based on the provisions of the
underlying agreement and the estimated period of continuing
obligations, generally the contract term. We received
$25.0 million in milestones from Sankyo Pharma under our
now-terminated Sales, Marketing and Distribution Agreement and
prior Co-Promotion Agreement, and these milestone payments had
been deferred and had appeared in our balance sheet as
Deferred revenues from Sankyo Pharma. Because the
Sales, Marketing and Distribution Agreement was terminated as
part of the Global Resolution,

F-11



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CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

this $25.0 million was included as a
component of Gain from Sankyo Pharma settlement in
our statement of operations during the fourth quarter of 2003.

Our contract revenues also included payments
received pursuant to research grants. Revenues were recognized
based on the performance requirements of the grant contract and
as reimbursable expenses are incurred. We currently are not
performing work under any SBIR grants or contracts, and thus do
not expect any contract revenues in the near future.

We evaluate the collectability of our trade
receivables based on our customers abilities to meet their
financial obligations and generally do not require collateral.
We determine amounts to be past due based on the terms and
conditions set forth in the purchase agreements. We did not have
any significant trade receivables outstanding as of
December 31, 2003.



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

Research and development expenses have included
costs for scientific and product development personnel, material
used in the development and validation of high capacity
manufacturing processes, consultants, clinical trials, supplies,
maintenance of our quality system, depreciation of equipment
used in research and product development, and facilities
allocations. Research and development costs are expensed as
incurred. Research and development expenses also include costs
associated with research and development grants. These expenses
approximate the revenue recognized.



| |                     
| | --------------------
| | Advertising Expenses

We expense advertising costs as incurred. We did
not incur any advertising expenses in 2003. Advertising expenses
incurred by us were $3.5 million and $920,000 in 2002 and
2001, respectively.



| |                            
| | ---------------------------
| | Net Income/(Loss) Per Share

Basic and diluted net income/(loss) per share are
computed using the weighted average number of shares of common
stock outstanding. Shares issuable from stock options, warrants
and convertible debentures were excluded from the diluted loss
per share computation in 2002 and 2001, as their effect is
anti-dilutive. Diluted net income per share for 2003 includes
the effects of approximately 20,000 stock options and the
effects of $22.3 million in convertible debentures
outstanding at the beginning of 2003 that would have converted
at that time to approximately 11.1 million shares of common
stock; however, it does not include the effect of
6.0 million options to purchase our common stock under the
treasury stock method because the option exercise prices were
greater than the average market price of our common stock for
the year.



| |                                                      
| | -----------------------------------------------------
| | Cash, Cash Equivalents and Short-Term
    Investments

We consider all highly liquid investments with a
maturity from the date of purchase of three months or less to be
cash equivalents. We invest our excess cash in high credit
quality, highly liquid instruments. These investments have
included treasury notes, federal agency securities, auction rate
certificates, auction rate preferred stock and commercial paper.

We consider all short-term investments as
available-for-sale. As such, short-term investments are carried
at estimated fair value and any related unrealized gains and
losses included in stockholders equity/(net capital
deficiency). Realized gains and losses and declines in value
judged to be other than temporary on available-for-sale
securities are included in other income and expense and have
been immaterial to date. The cost of securities sold is based on
the specific identification method. Interest and dividends on
securities classified as available-for-sale are included in
interest and other income.

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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

As of December 31, 2003 and 2002, cash and
cash equivalents were $33.5 million and $23.4 million,
respectively. As of December 31, 2003 and 2002, short-term
investments were $0 and $3.2 million, respectively. Our
cash and cash equivalents are maintained in money market funds
and our short-term investments are held as auction rate
certificates. As of December 31, 2003 and 2002, the costs
approximated the estimated fair values for all investments. All
cash equivalents and investments as of December 31, 2003
and 2002 have maturity dates of less than one year.



| |          
| | ---------
| | Inventory

Inventory is stated at standard cost, adjusted to
approximate the lower of actual cost (first-in, first out
method) or market, after appropriate consideration has been
given to obsolescence and inventory in excess of anticipated
future demand.

For the quarter ended September 30, 2003, in
light of our then-ongoing litigation with Sankyo Pharma, our
subsequent reduction in force, and the excess product inventory
held by Sankyo Pharma, we concluded that it was unlikely that we
would continue to manufacture any products in the near future.
Thus, we determined that we would not be able to realize the
value of our remaining raw materials and work-in-process
inventories and wrote off a total of approximately
$4.9 million of these inventories at that time. We also
wrote off $831,000 in prepaid inventory orders with one of our
sole source component suppliers.

Under the terms of our Global Resolution, Sankyo
Pharma transferred title to us of more than 20,000 GlucoWatch G2
Biographers and more than 1.0 million AutoSensors that we
had previously sold and shipped to them. Because we do not have
a new sales, marketing and distribution partner or other
strategic alliance to sell our products, we anticipate minimal
demand for our products in the foreseeable near term. Therefore,
we assessed that the Sankyo Pharma finished goods inventory
received as part of the Global Resolution in December 2003 had
no realizable value at the time. Additionally, in December 2003,
we wrote off substantially all of our remaining finished goods
inventory, approximately $630,000, that had not been shipped or
sold to Sankyo Pharma. Our remaining inventory of $62,000 at
December 31, 2003 consisted of finished goods for sale in
the United Kingdom.

Prior to the approval by the FDA of our product
and our commercial processes, material was generally charged to
research and development expenses upon receipt and was not
carried as inventory in our financial statements. Accordingly,
for the year ended December 31, 2003, costs of product
revenues do not include previously expensed material. If we were
to include the costs that were previously expensed, but then
used in our products sold, our costs of product revenues would
have been $390,000 greater than the reported amounts for the
year ended December 31, 2003.



| |                            
| | ---------------------------
| | Shipping and Handling Costs

Shipping and handling costs incurred by us are
included in the costs of product revenues in the consolidated
statements of operations.



| |                           
| | --------------------------
| | Equipment and Improvements

Equipment and improvements are recorded at cost.
Depreciation of equipment is computed on a straight-line basis
over the estimated useful lives of 18 months to
60 months. Leasehold improvements and assets recorded under
capital leases are amortized using the straight-line method over
the shorter of the estimated useful life of the assets or the
term of the leases.

F-13



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



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

Comprehensive income/(loss) includes changes in
stockholders equity/(net capital deficiency) during the
period, except those resulting from investments by stockholders
and distributions to stockholders. Other comprehensive
income/(loss) consists primarily of unrealized gains and losses
on available-for-sale securities.



| |                    
| | -------------------
| | Segment Information

We operate in one segment, the development and
manufacture of glucose monitoring products, and in two
geographic regions, the United States and the United Kingdom. We
are evaluated by our Chief Executive Officer, who is the
designated Chief Operating Decision Maker, on a single-segment
basis. Product revenues with customers in these geographic
regions were as follows (in thousands):

|               |  |                          |       |      |  |      |       |  |  |   |     | 
|-------------- |  | ------------------------ | ----- | ---- |  | ---- | ----- |  |  | - | --- | 
|               |  |                         
|               |  | Years Ended December 31,
|               |  |                         
|               |  | 2003                     |       | 2002 |  | 2001
|               |  |                          |       |      |  |     
|United States  |  | $                        | 2,533 |      |  | $    | 3,098 |  |  | $ |    | 
|United Kingdom |  |                          | 151   |      |  |      | 355   |  |  |   | 489 | 
|               |  |                          |       |      |  |      |       |  |  |   |     | 
|Total          |  | $                        | 2,684 |      |  | $    | 3,453 |  |  | $ | 489 | 
|               |  |                          |       |      |  |      |       |  |  |   |     | 

All of our long-lived assets are located in the
United States.



|        |                         
|------- | ------------------------
|Note 2: | Cygnus and Sankyo Pharma

On July 8, 2002, we entered into a Sales,
Marketing and Distribution Agreement with Sankyo Pharma that
superseded and replaced our prior November 28, 2001
Co-Promotion Agreement with them. Under the new agreement,
Sankyo Pharma was responsible for sales, marketing, managed care
and government contracting, and distribution of our GlucoWatch
G2 Biographer and our other similar glucose monitoring products
for a period of 12 years beginning on April 1, 2002.
Under this agreement, Sankyo Pharma was also required to pay us
an additional $15.0 million in milestone payments, thus
bringing total milestone payments, including milestone payments
received under the November 2001 Co-Promotion Agreement, to
$25.0 million, all of which were received. For its sales,
marketing and distribution activities, Sankyo Pharma was
entitled to a margin equivalent to a predetermined percentage of
Sankyo Pharmas net sales to its third-party customers. For
Sankyo Pharma to receive its specified margin, the following
calculations were made. First, Sankyo Pharmas net sales
were determined by subtracting certain allowed deductions such
as rebates, discounts and fees, including
TheraCom, Inc.s costs for product dispensing and
patient reimbursement services, from Sankyo Pharmas gross
sales. Next, the amount that Sankyo Pharma paid us for the
products we shipped to them was subtracted from Sankyo
Pharmas net sales. The sales and marketing commission we
owed to Sankyo Pharma was then calculated so that Sankyo Pharma
received its specified margin. The predetermined percentage was
15% for net sales in the first year after our first-generation
Biographer launch. Beginning April 1, 2003 and continuing
for one year, this predetermined percentage increased to 30%.
Payment of a quarterly sales and marketing commission, which
constituted a portion of this predetermined percentage to which
Sankyo Pharma was entitled, for the years 2002 and 2003 was
deferred. As of December 23, 2003, total sales and
marketing commissions of $2.3 million had been accrued. For
2002, we were required to reimburse Sankyo Pharma for their
actual promotional expenses of $6.7 million and this
payment, together with an amount we owed Sankyo Pharma for
customer rebates, could have been deferred until second quarter
2004.

On October 6, 2003, we filed a complaint in
the Superior Court of the State of California for the County of
San Mateo against Sankyo Pharma and Sankyo Japan for breach
of contract and intentional interference with contract relating
to the sales, marketing and distribution of our GlucoWatch
Biographer products. On November 6, 2003, Sankyo Pharma
filed an answer and cross-claims against us for declaratory
relief, breach of contract, and defamation.

F-14



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

On December 23, 2003, we entered into an
Agreement for Global Resolution and Mutual Release of All Claims
with Sankyo Pharma that resolved and dismissed the pending
litigation, and terminated our Sales, Marketing and Distribution
Agreement as well as all other contractual arrangements. The
Global Resolution provided for Sankyo Pharma to pay us
$30.0 million and also specified that neither party owed
any payments to the other party, thus allowing us to write off
certain liabilities and assets, resulting in a total net gain of
$75.8 million. The following table summarizes the
components of this gain, in thousands:

|                                                                                                                                              |  |   |        | 
|--------------------------------------------------------------------------------------------------------------------------------------------- |  | - | ------ | 
|Cash settlement received from Sankyo Pharma in
    December 2003                                                                              |  | $ | 30,000 | 
|Recognition of deferred revenues from Sankyo
    Pharma (milestone payments)                                                                  |  |   | 25,000 | 
|Recognition of deferred revenues from Sankyo
    Pharma net of deferred costs of $8,759 of product shipments                                  |  |   | 9,306  | 
|Write-off of current portion of amount due to
    Sankyo Pharma                                                                               |  |   | 6,770  | 
|Write-off of long-term portion of amount due to
    Sankyo Pharma                                                                             |  |   | 2,324  | 
|Write-off of other liabilities due to Sankyo
    Pharma, partially offset by a write-off of $1,083 accounts
    receivable from Sankyo Pharma |  |   | 2,694  | 
|Less: Legal expenses incurred in Sankyo Pharma
    litigation                                                                                 |  |   | 269    | 
|                                                                                                                                              |  |   |        | 
|Net gain from Sankyo Pharma settlement                                                                                                        |  | $ | 75,825 | 
|                                                                                                                                              |  |   |        | 

During the transition period in which Sankyo
Pharma provides certain distribution and customer services, we
are entitled to 30% of all monies received for products sold by
them. Amounts received will be recorded as additional Gain
from Sankyo Pharma settlement in our statement of
operations. This transition period ends on the earlier of
June 30, 2004 or when we notify Sankyo Pharma that they may
discontinue such services.



|        |                                                     
|------- | ----------------------------------------------------
|Note 3: | Manufacturing and Other Contractual
    Arrangements

In 1997, we entered into a Product Supply
Agreement with Contract Manufacturing, Inc.
(CMI), now Corium International
(Corium), to manufacture our AutoSensors. In
December of 1996, we had hired the owner of CMI as a
non-officer, part-time employee of Cygnus, Inc. However,
this individuals employment with us terminated in March
2000 and, subsequently, we entered into a consulting agreement
in 2001 under which he received 10,000 shares of Cygnus
common stock upon a performance milestone. This consulting
agreement has now expired. Two former Cygnus executive officers
have joined Corium. During 2003, 2002, and 2001, we paid Corium
$3.3 million, $4.6 million and $4.9 million,
respectively, for manufacturing services provided to us.
Currently, we have suspended our manufacturing activities and
thus Corium is not manufacturing AutoSensors for us at this
time. We also bought certain of our capital manufacturing
equipment for the AutoSensor from a company previously under the
control of the owner of Corium. During 2003, we did not purchase
capital equipment from this company; however, in 2002 and 2001,
we purchased capital equipment for $600,000 and
$1.8 million, respectively.

In 1995, we entered into an Exclusive License
Agreement with The Regents of the University of California
relating to reverse iontophoresis patent rights. We were
obligated to start paying royalties after the first commercial
sale of our GlucoWatch Biographer, which occurred in 2001 in the
United Kingdom. In 2003, we paid annual minimum royalties of
$100,000 to the University of California. In 2004, these annual
minimum royalties will increase to $150,000, and in 2005 and
thereafter, until expiration of the Exclusive License Agreement,
these minimum royalties will be $200,000 per year.

F-15



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|        |                       
|------- | ----------------------
|Note 4: | Leases and Commitments



| |               
| | --------------
| | Capital Leases

We currently have two capital lease agreements.
Assets leased under capital leases are included in equipment at
a total cost of $229,000 with related accumulated depreciation
of $169,000 at December 31, 2003. Upon the expiration of
these leases, we have a one-dollar ($1.00) buy-out purchase
option. As of December 31, 2003, aggregate liabilities of
$82,000 were outstanding under these agreements and were secured
by assets with a net book value of $60,000 and a letter of
credit with a value of $89,000.

The future aggregate principal payments of
minimum lease payments under capital leases as of
December 31, 2003 are as follows:

|                                               |  |                |     |  
|---------------------------------------------- |  | -------------- | --- | -
|                                               |  | Capital Leases
|                                               |  |               
|                                               |  | (In thousands)
|Year ending December 31, 2004                  |  | $              | 82  |  
|                                               |  |                |     |  
|Total minimum lease payments                   |  |                | 82  |  
|Less amount representing interest              |  |                | (8  | )
|                                               |  |                |     |  
|Present value of minimum lease payments        |  |                | 74  |  
|Current portion of capital lease obligations   |  |                | (74 | )
|                                               |  |                |     |  
|Long-term portion of capital lease obligations |  | $              | 0   |  
|                                               |  |                |     |  



| |                
| | ---------------
| | Operating Lease

In the United States, we lease our facility under
a noncancelable operating lease expiring in April of 2009. The
terms of the lease provides for rental payments on a graduated
scale. We recognize rent expense on a straight-line basis over
the period of the lease.

On October 15, 2003, we terminated our
second building lease that would have run through December 2003,
which we had previously subleased. We received full payment from
our sublessee for this early termination, and in turn paid the
remaining lease amount to the property owner.

Rent expense amounted to $826,000,
$1.0 million and $1.1 million, net of sublease
payments of $371,000, $789,000 and $814,000, for the years ended
December 31, 2003, 2002 and 2001, respectively. Future
noncancelable lease payments on December 31, 2003 are as
follows:

|                               |      |                |       |     | 
|------------------------------ | ---- | -------------- | ----- | --- | 
|                               |      | Minimum       
|                               |      | Future Rental 
|                               |      | Commitments   
|                               |      |               
|                               |      | (In thousands)
|Years ending December 31, 2004 |      | $              | 840   |    
|                               | 2005 |                |       | 856 | 
|                               | 2006 |                |       | 878 | 
|                               | 2007 |                |       | 901 | 
|                               | 2008 |                |       | 924 | 
|                               | 2009 |                |       | 310 | 
|                               |      |                |       |    
|Total minimum lease payments   |      | $              | 4,709 |    
|                               |      |                |       |    

F-16



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|        |                      
|------- | ---------------------
|Note 5: | Financing Instruments

See Note 12, Subsequent Events, regarding
the March, 2004 retirement of our Convertible Debentures and
associated warrants and termination of our remaining equity line.

In June 1999, we entered into two financing
arrangements: a Convertible Debenture and Warrant Purchase
Agreement and a Structured Equity Line Flexible Financing
Agreement. As of December 31, 2003, the total outstanding
balance plus accrued interest on our Convertible Debentures
totaled $18.3 million. Since June 1999, we entered into two
additional equity line agreements in 2000 and 2001
(collectively, the equity lines); however, only our
third equity line was in place on December 31, 2003. As of
December 31, 2003, we had received aggregate proceeds of
$57.2 million pursuant to our prior equity lines.



| |                       
| | ----------------------
| | Convertible Debentures

In June 1999, we entered into a Convertible
Debenture and Warrant Purchase Agreement, which was subsequently
amended (Convertible Debenture Agreement). As of
December 31, 2003, the total outstanding balance plus
accrued interest on the Convertible Debentures, as defined
below, totaled $18.3 million.

Under the Convertible Debenture Agreement,
8.5% convertible debentures with a principal amount of
$14.0 million due June 29, 2004 were issued at a
conversion price of $12.705 per share (June 2004
Debentures). The Convertible Debenture Agreement also
provided for the issuance of an additional $6.0 million of
convertible debentures consisting of two $3.0 million
tranches (additional tranches) for similar terms and
conditions, except for the determination of conversion prices
upon issuance of additional tranches. The conversion prices for
the additional tranches were to be determined based on certain
market-based formulas defined in the Convertible Debenture
Agreement. In September 1999, we issued convertible debentures
for $3.0 million pursuant to the terms of the additional
tranches. The first additional tranche due on
September 29, 2004 had a conversion price of $11.8663
(September 2004 Debentures, together with the June
2004 Debentures, the Convertible Debentures). The
$3.0 million under the second additional tranche was still
available as of December 31, 2003, subject to approval by
both parties. The Convertible Debentures had a stated interest
rate of 8.5% per annum and an effective interest rate of
13.5% per annum. The effective interest rate included a
non-cash charge of $6.6 million for the amortization of the
fair value of warrants, computed on the basis of a Black-Scholes
valuation model, issued in connection with the Convertible
Debentures.

In conjunction with the issuance of Convertible
Debentures, in June 1999 and September 1999, we issued to the
debenture holders warrants to purchase 606,061 shares and
139,050 shares of common stock, respectively, at the
exercise prices of $13.86 per share and $16.18 per
share, respectively. Each group of warrants had a contractual
term of five years from the date of the respective grants. At
the dates of the grants, the fair values ascribed to these
warrants were $5.0 million and $1.1 million,
respectively, based on a Black-Scholes valuation model. The
valuation of $5.0 million was determined using the
following assumptions for volatility, interest rate, stock
price, and dividend rate: 0.9985, 5.8%, $11.19, and 0.0%,
respectively. The valuation of $1.1 million was determined
using the following assumptions for volatility, interest rate,
stock price, and dividend rate: 0.9923, 5.85%, $11.06, and 0.0%,
respectively. These values were recorded as debt discount and
were being amortized on a straight-line basis as additional
interest expense over the terms of the Convertible Debentures.
We recorded amortization of $1.2 million for each of the
years ended December 31, 2003, 2002 and 2001. As of
December 31, 2003, the aggregate unamortized fair value of
the warrants amounted to $709,000.

Also in connection with the issuance of
Convertible Debentures, we issued to the placement agent
warrants to purchase 50,000 shares of common stock at the
exercise price of $13.86 per share. At the date of grant,
the fair value ascribed to the warrants was $417,000, based on a
Black-Scholes valuation using the following assumptions for
volatility, interest rate, stock price, and dividend rate:
0.9985, 5.8%, $11.19, and

F-17



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

0.0%, respectively. This amount was recorded as
deferred financing cost and was being amortized on a
straight-line basis as additional interest expense over the term
of the Convertible Debentures. We recorded amortization of
$83,000 for the year ended December 31, 2003. As of
December 31, 2003, the aggregate unamortized fair value of
the warrants amounted to $42,000.

Under the original terms of the Convertible
Debenture and Warrant Purchase Agreement dated June 29,
1999 and the Convertible Debentures, if Cygnus were to have been
delisted from the Nasdaq National Market, the debenture holders
could have declared that a default had occurred and could have
required immediate payment of the outstanding principal and
interest balances. To address this contingency, we entered into
an agreement with the debenture holders on August 21, 2002
to amend the Convertible Debenture and Warrant Purchase
Agreement and the Convertible Debentures to specify that as long
as our stock is trading on any market or exchange, including the
OTC Bulletin Board, there was no default under these agreements.
Thus, in January 2003, when our stock was transferred to the OTC
Bulletin Board, this was not a default under the Convertible
Debentures, as amended. The debenture holders also agreed to
reduce the interest rate on the Convertible Debentures from 8.5%
to 3.5% per annum, to be paid quarterly, effective
October 1, 2002, on the then-new principal amount of
$22.3 million.

The Convertible Debentures, as amended, also
allowed for limited conversions into stock at a price premium
(101% or 107%, depending on the market price) to the market
price of our common stock, with certain minimum conversion
prices established. For the period of October 1, 2002 to
December 31, 2002, the minimum conversion price was
$3.50 per share. For the period of January 1, 2003 to
March 31, 2003, the minimum conversion price was
$2.00 per share. Conversions could not exceed 8% of the
trading volume for a given month, and were limited to
$500,000 per month, unless our common stock traded at or
above $3.50 for that month.

On December 7, 2002, we further amended the
Convertible Debentures to establish a minimum conversion price
of $1.054 per share of common stock for the period
beginning April 1, 2003 for the remaining term of the
Convertible Debentures, resulting in a maximum of
474,383 shares per month that might have been converted
under the Convertible Debentures, again subject to the
limitation of 8% of the trading volume for the month.
Furthermore, the Convertible Debentures, as amended, could not
have been converted to the extent such conversion would result
in their holders in the aggregate being deemed to beneficially
own more than 9.9% of our total issued and outstanding common
stock. Separately, we entered into a Security Agreement to grant
security interests to all of our assets, with the exception of
our U.S. patents and patent applications, to the debenture
holders as contemplated by the prior amendments to the
Convertible Debentures.

Pursuant to the August 21, 2002 amendment to
our Convertible Debentures, we paid $2.0 million in
principal to the debenture holders on June 26, 2003, and
$2.0 million on December 30, 2003, as the holders had
not converted any shares of stock, thus reducing the principal
to $18.3 million. These payments resulted in the maturity
dates of equal amounts of the remaining principal being extended
for one year. Thus, the $2.0 million paid in June 2003 and
the $2.0 million paid in December 2003 extended the
maturity date for $4.0 million from June 29, 2004 to
June 29, 2005.

As of December 31, 2003, $10.4 million
in principal was due June 29, 2004, $3.9 million in
principal was due September 29, 2004, and $4.0 million
in principal was due June 29, 2005, minus any amounts that
the holders might have converted into shares of stock or amounts
we might have prepaid.



| |            
| | -----------
| | Equity Line

In March 2001, we entered into an additional
equity line agreement and, as of December 31, 2003, we had
not utilized any portion of this equity line, which had a
maximum aggregate issue price of $29.0 million and a
commitment period ending December 31, 2004. We did not
receive any proceeds in 2003 from any of

F-18



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

our equity lines. On September 17, 2002, we
amended our equity line agreement so that it would be available
as long as our stock were listed on either the Nasdaq National
Market or the SmallCap Market. The amendment also added an
alternative 15-day investment period to the existing 30-day,
60-day and 90-day investment periods and limited the
investors required purchase amount with certain trading
volume limitations. Since our stock was not listed on either the
Nasdaq National Market or Nasdaq SmallCap Market, our investors
under the equity line agreement might have elected to suspend or
terminate this agreement, in which case we would not have been
able to utilize any of the $29.0 million available under
this equity line agreement. Even if these investors elected not
to suspend or terminate our equity line agreement, we believe,
as a practical matter, we would not have been able to draw on
the equity line agreement for the foreseeable future. So long as
our stock was not listed on a national exchange or quoted on the
Nasdaq National Market or the SmallCap Market, we believe that
it would not have been practical for us to draw on our equity
line in light of (i) the penny stock rules that require the
underwriter to undertake relatively burdensome disclosure
obligations in connection with issuances of penny stock
securities such as ours, (ii) our need to individually
comply with each states blue sky laws governing unlisted
securities issuances, and (iii) the relatively high level
of dilution that issuances would have at current market prices
for our stock.

In connection with our prior equity lines, we
issued to the investors five-year warrants to purchase up to
748,000 shares of common stock at exercise prices ranging
from $4.65 to $20.40. In May 2003, the investors voluntarily
surrendered all of these warrants. No consideration was provided
to the investors in connection with this surrender of warrants.

We also issued warrants to our placement agent in
connection with our prior equity lines. In 2000, we issued a
five-year warrant to purchase 11,178 shares of common stock
at an exercise price of $9.85, which expires in May 2006. In
2001, we issued a five-year warrant to purchase
49,914 shares of common stock at an exercise price of
$7.74, which expires in January 2007. In 2002, we issued a
five-year warrant to purchase 16,511 shares of common stock
at an exercise price of $3.72, which expires in August 2008.

Note 6:     Stockholders
Equity/(Net Capital Deficiency)

Preferred
Share Purchase Rights Plan

Our Stockholder Rights Plan (Plan)
expired on September 21, 2003. Previously, pursuant to the
Plan, the Board of Directors had declared a dividend
distribution of one Preferred Share Purchase Right
(Right) for each outstanding share of common stock,
issuable on or after October 18, 1993, to stockholders of
record on that date. All such Rights have expired.

Common
Stock

In fiscal years 2002 and 2001, we issued 338,000
and 246,000 shares of our common stock, respectively, to
our employees in lieu of paying a cash bonus. The value of the
common stock issued was $1.4 million and $1.9 million
in 2002 and 2001, respectively. In fiscal year 2003, no such
shares of common stock were issued to our employees.

Warrants

We account for all warrants issued in connection
with services rendered on the basis of the fair value of the
warrants. We estimate the fair value of such instruments using
the Black-Scholes valuation model, and the fair value thus
computed is then recognized over the period for which the
underlying services are rendered. Our outstanding warrants were
issued in connection with our prior equity lines and Convertible
Debentures. Warrants issued in connection with the equity lines
were reflected as additional costs of financing and additional
paid-in-capital, and thus had no net impact on our financial
statements. Warrants issued in connection with the Convertible
Debentures were reflected as additional costs and were being
amortized to

F-19



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

interest expense over the remaining life of the
Convertible Debentures. The following table summarizes the
warrants outstanding as of December 31, 2003:

|          |  |                |         |          |  |            |       |               |  |  |          |  |  |   |           | 
|--------- |  | -------------- | ------- | -------- |  | ---------- | ----- | ------------- |  |  | -------- |  |  | - | --------- | 
|          |  | Number of      |         |          |  |            |       | Fair Value of
|Date of   |  | Shares Covered |         | Exercise |  | Expiration |       | Warrants at  
|Warrants  |  | by Warrants    |         | Price    |  | Date       |       | Issuance     
|          |  |                |         |          |  |            |       |              
|*06/29/99 |  |                | 606,061 |          |  | $          | 13.86 |               |  |  | 06/29/04 |  |  | $ | 5,048,488 | 
|+06/29/99 |  |                | 50,000  |          |  | $          | 13.86 |               |  |  | 06/29/04 |  |  | $ | 416,507   | 
|*09/29/99 |  |                | 139,050 |          |  | $          | 16.18 |               |  |  | 09/29/04 |  |  | $ | 1,106,838 | 
|#05/09/01 |  |                | 11,178  |          |  | $          | 9.85  |               |  |  | 05/09/06 |  |  | $ | 51,195    | 
|#01/08/02 |  |                | 49,914  |          |  | $          | 7.74  |               |  |  | 01/08/07 |  |  | $ | 163,219   | 
|#08/01/03 |  |                | 16,511  |          |  | $          | 3.72  |               |  |  | 08/01/08 |  |  | $ | 2,642     | 



---



|  |                                                                                                                                                                                                                       
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|* | Issued to the investors in connection with our
    Convertible Debentures, however these warrants
    (745,111 shares) were retired as part of our Convertible
    Debenture exchange. See Note 12, Subsequent Events.



|  |                                                                                 
|- | --------------------------------------------------------------------------------
|+ | Issued to the placement agent in connection with
    our Convertible Debentures.
| 
|# | Issued to the placement agent in connection with
    our prior equity lines.    

Employee
Stock Purchase Plan

Effective January 8, 2003, our Board of
Directors suspended the Amended 1991 Employee Stock Purchase
Plan, as last amended and restated February 12, 2002, due
to the fact that our stock was delisted from trading on the
Nasdaq National Market. As of December 31, 2003, a total of
869,000 shares of common stock were reserved for issuance
to eligible employees under the Stock Purchase Plan. During
2003, 2002 and 2001, 0 shares, 200,000 shares and
140,000 shares, respectively, were purchased under the
Stock Purchase Plan, with grant date fair values for shares
issued of $0, $288,000, and $350,000, respectively.

Stock
Incentive Plan

The 1999 Stock Incentive Plan (Stock
Plan) authorizes the Board of Directors to grant stock
options, restricted stock, stock units, stock appreciation
rights and other awards to be made to employees and consultants.
Since its inception and through December 31, 2003, a total
of up to 11.4 million shares of common stock have been
authorized for issuance under the Stock Plan. As of
December 31, 2003, 7.0 million shares of common stock
were still available for future issuance under the Stock Plan,
of which 405,000 were available for grant. The Stock Plan will
terminate in 2013, unless sooner terminated by the Board of
Directors or extended by the Board of Directors and approved by
the stockholders. Under the Stock Plan, stock options must be
granted at no less than the fair market value on the date of
grant. Options generally vest over a two-year or four-year
period and are exercisable for a term of ten years after
issuance, unless otherwise determined by the Board of Directors
or a committee thereof.

Effective January 27, 2003, the Board of
Directors amended the Stock Plan in order to comply with the
California General Corporations Law. Our common stock was
delisted from trading on the Nasdaq National Market System
effective with the opening of business on January 8, 2003
and commenced trading on the OTC Bulletin Board that same day.
We are now required to comply with certain provisions of the
California General Corporations Law from which we were
previously exempt prior to the delisting.

Under the Stock Plan, stock may be sold and
issued to eligible recipients and stock bonuses or rights to
purchase common stock may be granted by the Board of Directors
or a committee thereof for past services at the fair market
value on the date of grant. The Board may impose certain
repurchase rights in favor of Cygnus

F-20



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

in the event that an employee is terminated prior
to certain predetermined vesting dates. As of December 31,
2003, 2002 and 2001, no shares were subject to repurchase.

A summary of our stock option summary for the
years ended December 31, 2003, 2002 and 2001 is as follows:

|                                                               |  |                |       |          |  |                |      |          |  |                |       |          |  |   |       |  |  |  |       |   |  |   |       | 
|-------------------------------------------------------------- |  | -------------- | ----- | -------- |  | -------------- | ---- | -------- |  | -------------- | ----- | -------- |  | - | ----- |  |  |  | ----- | - |  | - | ----- | 
|                                                               |  |                |       |          |  |               
|                                                               |  | 2003           |       | 2002     |  | 2001          
|                                                               |  |                |       |          |  |               
|                                                               |  | Number of      |       | Weighted |  | Number of      |      | Weighted |  | Number of      |       | Weighted
|                                                               |  | Shares         |       | Average  |  | Shares         |      | Average  |  | Shares         |       | Average 
|                                                               |  | Underlying     |       | Exercise |  | Underlying     |      | Exercise |  | Underlying     |       | Exercise
|                                                               |  | Options        |       | Price    |  | Options        |      | Price    |  | Options        |       | Price   
|                                                               |  |                |       |          |  |                |      |          |  |                |       |         
|                                                               |  | (In thousands) |       |          |  | (In thousands) |      |          |  | (In thousands) |       |         
|Total outstanding at beginning of year                         |  |                | 4,015 |          |  | $              | 8.71 |          |  |                | 4,072 |          |  | $ | 9.68  |  |  |  | 3,296 |   |  | $ | 10.79 | 
|Granted                                                        |  |                | 3,630 |          |  | $              | 0.40 |          |  |                | 1,241 |          |  | $ | 1.79  |  |  |  | 1,217 |   |  | $ | 5.55  | 
|Exercised                                                      |  |                | (2    | )        |  | $              | 0.46 |          |  |                | (278  | )        |  | $ | 0.37  |  |  |  | (143  | ) |  | $ | 3.50  | 
|Forfeited                                                      |  |                | (929  | )        |  | $              | 4.72 |          |  |                | (993  | )        |  | $ | 6.21  |  |  |  | (297  | ) |  | $ | 7.95  | 
|Expired                                                        |  |                | (99   | )        |  | $              | 1.23 |          |  |                | (27   | )        |  | $ | 14.38 |  |  |  | (1    | ) |  | $ | 14.13 | 
|                                                               |  |                |       |          |  |                |      |          |  |                |       |          |  |   |       |  |  |  |       |   |  |   |       | 
|Outstanding at end of year                                     |  |                | 6,615 |          |  | $              | 4.82 |          |  |                | 4,015 |          |  | $ | 8.71  |  |  |  | 4,072 |   |  | $ | 9.68  | 
|                                                               |  |                |       |          |  |                |      |          |  |                |       |          |  |   |       |  |  |  |       |   |  |   |       | 
|Exercisable at end of year                                     |  |                | 4,040 |          |  | $              | 7.23 |          |  |                | 2,764 |          |  | $ | 10.24 |  |  |  | 2,389 |   |  | $ | 11.15 | 
|Weighted-average fair value of options granted
    during year |  |                |       |          |  | $              | 0.21 |          |  |                |       |          |  | $ | 3.69  |  |  |  |       |   |  | $ | 3.16  | 

A summary of our stock option position as of
December 31, 2003 is as follows:

|                         |  |                     |       |                  |  |           |      |                |  |           |       |  |  |  |       |  |  |   |       | 
|------------------------ |  | ------------------- | ----- | ---------------- |  | --------- | ---- | -------------- |  | --------- | ----- |  |  |  | ----- |  |  | - | ----- | 
|                         |  |                     |       |                 
|                         |  | Options Outstanding |       | Exercisable     
|                         |  |                     |       |                 
|                         |  |                     |       | Weighted-        |  | Weighted- |      |                |  | Weighted-
|                         |  |                     |       | Average          |  | Average   |      |                |  | Average  
|                         |  |                     |       | Remaining        |  | Exercise  |      |                |  | Exercise 
|Range of Exercise Prices |  | Number              |       | Contractual Life |  | Price     |      | Number         |  | Price    
|                         |  |                     |       |                  |  |           |      |                |  |          
|                         |  | (In thousands)      |       | (In years)       |  |           |      | (In thousands) |  |          
|$ 0.00 - $ 0.12          |  |                     | 787   |                  |  |           | 9.88 |                |  | $         | 0.12  |  |  |  |      |  |  | $ |      | 
|$ 0.39 - $ 0.46          |  |                     | 2,425 |                  |  |           | 9.11 |                |  | $         | 0.46  |  |  |  | 1,078 |  |  | $ | 0.46  | 
|$ 0.47 - $ 5.00          |  |                     | 1,324 |                  |  |           | 7.12 |                |  | $         | 4.08  |  |  |  | 911   |  |  | $ | 4.15  | 
|$ 5.75 - $14.50          |  |                     | 1,340 |                  |  |           | 4.23 |                |  | $         | 9.41  |  |  |  | 1,326 |  |  | $ | 9.41  | 
|$15.13 - $22.50          |  |                     | 739   |                  |  |           | 4.66 |                |  | $         | 17.18 |  |  |  | 725   |  |  | $ | 17.21 | 
|                         |  |                     |       |                  |  |           |      |                |  |           |       |  |  |  |       |  |  |   |       | 
|                         |  |                     | 6,615 |                  |  |           | 7.32 |                |  | $         | 4.82  |  |  |  | 4,040 |  |  | $ | 7.23  | 
|                         |  |                     |       |                  |  |           |      |                |  |           |       |  |  |  |       |  |  |   |       | 

F-21



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Common Stock
Reserved for Future Issuance

At December 31, 2003, the total number of
shares of common stock reserved for issuance is as follows:

|                                                                   |  |                |        | 
|------------------------------------------------------------------ |  | -------------- | ------ | 
|                                                                   |  | (In thousands)
|Stock Incentive Plan                                               |  |                | 7,021  | 
|Employee Stock Purchase Plan                                       |  |                | 869    | 
|Convertible Debentures (assumed conversion price
    of $1.054)(1) |  |                | 17,344 | 
|Outstanding warrants(1)                                            |  |                | 873    | 
|                                                                   |  |                |        | 
|Total common stock reserved                                        |  |                | 26,107 | 
|                                                                   |  |                |        | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | On March 23, 2004, we entered into an Exchange
    Agreement with the debenture holders and retired all of our
    outstanding Convertible Debentures and associated warrants (745)
    in exchange for an aggregate of $13.8 million in cash and
    2.5 million shares of our common stock. Thus, reserves of
    18,089 shares relating to the Convertible Debentures and
    associated warrants have been eliminated. See Note 12,
    Subsequent Events.

Note 7:     Income
Taxes

The provision for income taxes consists of the
following:

|         |  |                          |     |      |  |      |    |  |  |   |     | 
|-------- |  | ------------------------ | --- | ---- |  | ---- | -- |  |  | - | --- | 
|         |  |                         
|         |  | Years Ended December 31,
|         |  |                         
|         |  | 2003                     |     | 2002 |  | 2001
|         |  |                          |     |      |  |     
|         |  |                         
|         |  | (In thousands)          
|Current: |  |                          |     |      |  |      |    |  |  |   |     | 
|Federal  |  | $                        | 198 |      |  | $    |   |  |  | $ |    | 
|State    |  |                          |    |      |  |      |   |  |  |   |    | 
|Foreign  |  |                          | 1   |      |  |      | 23 |  |  |   | 527 | 
|         |  |                          |     |      |  |      |    |  |  |   |     | 
|Total    |  | $                        | 199 |      |  | $    | 23 |  |  | $ | 527 | 
|         |  |                          |     |      |  |      |    |  |  |   |     | 

A reconciliation of income taxes computed at the
U.S. statutory federal income tax rate with the provision
for income taxes included in the statements of operations is as
follows:

|                             |                                            |                          |     |         |   |      |    |         |   |   |     |         |  
|---------------------------- | ------------------------------------------ | ------------------------ | --- | ------- | - | ---- | -- | ------- | - | - | --- | ------- | -
|                             |                                            |                         
|                             |                                            | Years Ended December 31,
|                             |                                            |                         
|                             |                                            | 2003                     |     | 2002    |   | 2001
|                             |                                            |                          |     |         |   |     
|                             |                                            |                         
|                             |                                            | (In thousands)          
|U.S. federal taxes (benefit) |                                            |                          |     |         |   |      |    |         |   |   |     |        
|                             | At statutory rate                          |                          | $   | 17,374  |   |      | $  | (14,188 | ) |   | $   | (13,328 | )
|                             | Federal alternative minimum taxes          |                          |     | 198     |   |      |    |        |   |   |     |        |  
|                             | State income taxes                         |                          |     |        |   |      |    |        |   |   |     |        |  
|                             | Foreign income taxes                       |                          |     | 1       |   |      |    | 23      |   |   |     | 527     |  
|                             | Unutilized/(utilized) net operating losses |                          |     | (17,374 | ) |      |    | 14,188  |   |   |     | 13,328  |  
|                             |                                            |                          |     |         |   |      |    |         |   |   |     |        
|Total                        |                                            | $                        | 199 |         |   | $    | 23 |         |   | $ | 527 |        
|                             |                                            |                          |     |         |   |      |    |         |   |   |     |        

F-22



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Deferred income taxes reflect the net tax effects
of temporary differences between the carrying amounts of assets
and liabilities for financial reporting purposes and the amounts
used for income tax purposes. Significant components of our
deferred tax assets are as follows:

|                                                  |  |                |          |      |  |   |          |  
|------------------------------------------------- |  | -------------- | -------- | ---- |  | - | -------- | -
|                                                  |  |               
|                                                  |  | December 31,  
|                                                  |  |               
|                                                  |  | 2003           |          | 2002
|                                                  |  |                |          |     
|                                                  |  |               
|                                                  |  | (In thousands)
|Deferred tax assets:                              |  |                |          |      |  |   |          |  
|Net operating loss carryforwards                  |  | $              | 85,067   |      |  | $ | 84,200   |  
|Research and development tax credit carryforwards |  |                | 9,531    |      |  |   | 9,230    |  
|Arbitration obligation accrual                    |  |                | 4,600    |      |  |   | 6,000    |  
|Capitalized research & development                |  |                | 4,404    |      |  |   | 5,150    |  
|Deferred revenue                                  |  |                |         |      |  |   | 15,810   |  
|Other                                             |  |                | 132      |      |  |   | 1,080    |  
|                                                  |  |                |          |      |  |   |          |  
|Total deferred tax assets                         |  |                | 103,734  |      |  |   | 121,470  |  
|Valuation allowance for deferred tax assets       |  |                | (103,734 | )    |  |   | (121,470 | )
|                                                  |  |                |          |      |  |   |          |  
|Net deferred tax assets                           |  | $              |         |      |  | $ |         |  
|                                                  |  |                |          |      |  |   |          |  

Realization of deferred tax assets is dependent
on future earnings, if any, the timing and amount of which are
uncertain. Accordingly, a valuation allowance in an amount equal
to the net deferred tax assets as of December 31, 2003 and
2002 has been established to reflect these uncertainties. The
valuation allowance decreased by $17.7 million in 2003 and
increased by $14.7 million and $11.0 million in 2002
and 2001, respectively. Approximately $714,000 of the valuation
allowance for deferred tax assets relates to benefits of stock
option deductions that, when recognized, will be allocated
directly to contributed capital.

At December 31, 2003, we had federal net
operating loss and research and development tax credit
carryforwards of $238.3 million and $6.5 million,
respectively. These carryforwards expire at various dates
beginning in 2004 and ending in 2023. For state income tax
purposes, at December 31, 2003 we had net operating loss
carryforwards of $67.0 million that expire at various dates
beginning in 2004 and ending in 2013, and state research and
development tax credits of approximately $4.7 million,
which do not expire.

Because of the change-in-ownership provisions of
the Internal Revenue Code of 1986, as amended, a substantial
portion of our net operating loss and tax credit carryforwards
may be subject to annual limitations. The annual limitation may
result in the expiration of net operating losses and tax credits
before utilization.

Note 8:     Arbitration
Obligation

On December 11, 1997, the International
Court of Arbitration issued a Final Award, which was not
appealable, in an arbitration matter between Sanofi, S.A., now
Sanofi-Synthelabo, and Cygnus related to transdermal hormone
replacement therapy systems. This Final Award against Cygnus of
$37.0 million was entered as a judgment of the United
States District Court for the Northern District of California.
An initial payment of $14.0 million was made within
14 days of the Final Award and in 1997 we accrued an
aggregate remaining liability of $23.0 million for the
following: (i) payments of an aggregate amount equal to
$17.0 million as royalty payments for the period 2001
through 2005, payable 60 days after the end of each fiscal
year ($2.0 million of which was paid in February 2002 for
the year 2001, $3.0 million of which was paid in February
2003 for the year 2002, $4.0 million of which was to be
paid for the year 2003, $4.0 million of which was to be
paid for the year 2004 and $4.0 million of which was to be
paid for the year 2005), and (ii) a convertible promissory
note bearing interest at 6.5% per annum in the principal
amount of $6.0 million, issued in December 1997, which was
paid in full in cash with accrued annual interest of $390,000 in
January 2002.

F-23



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The underlying agreement, which was the subject
matter of the arbitration, was terminated on December 15,
1999.

Effective November 3, 2003, we entered into
an agreement with Sanofi-Synthelabo to extend the periods of
time for the remaining arbitration obligation payments. Under
the Amendment to the Final Arbitration Award, the accrued
aggregate remaining liability of $12.0 million for the
years 2003, 2004 and 2005 is to be paid as follows in light of
our $30.0 million cash settlement received from Sankyo
Pharma: (i) $500,000 of such payment was paid to
Sanofi-Synthelabo on December 30, 2003,
(ii) $4.5 million is due in February 2005,
(iii) $4.0 million is due in February 2006, and
(iv) $3.0 million is due in February 2007. As of
December 31, 2003, the aggregate amount payable under this
obligation was $11.5 million. We also entered into Security
Agreements granting Sanofi-Synthelabo a subordinate security
interest in all of our assets, including our U.S. Patents
and patent applications then existing or thereafter arising, to
secure our obligation under the Amendment to the Final Award.

Note 9:     Sale
of Drug Delivery Business

On December 15, 1999, we completed the sale
of substantially all of our drug delivery business segment
assets to Ortho-McNeil. Under the terms of our agreement,
Ortho-McNeil was subject to paying up to an additional
$55.0 million in cash, contingent on the achievement of
certain milestones. These potential milestone payments are
dependent upon the achievement by Ortho-McNeil of certain
technical and regulatory accomplishments and timely submissions
of regulatory documents related to the Ortho Evra®
(Johnson & Johnson, New Brunswick, New Jersey)
transdermal contraceptive patch. The achievement of these
milestones was not within our control. Of this
$55.0 million, we believe $20.4 million potential
payments were not paid to us because certain Ortho-McNeil
accomplishments were not met, resulting in $34.6 million
left in potential milestone payments, which are under dispute.
Both parties have retained outside legal counsel and, on
February 23, 2004, we invoked the mediation provisions set
forth in our Asset Purchase Agreement, see Note 12,
Subsequent Events.

Note 10:     Employee
Benefit Plan

We have an employee savings plan
(Plan) covering substantially all employees that
qualifies as a deferred salary arrangement under
Section 401(k) of the Internal Revenue Code. In 2003, the
Plan provided for eligible employee contributions up to
$12,000 per year (up to $14,000 for those employees
ages 50 and older) and for the Company to match a portion
of the contributions. For the years ended December 31,
2003, 2002 and 2001, we incurred contribution expenses of
$116,000, $67,000 and $77,000, respectively.

Note 11:     Warranties
and Indemnification

We offer a one-year warranty on our Biographer
from the date of sale to the end-user customer. We accrue for
estimated warranty costs and other allowances when the revenues
from product sales are recognized. The warranty costs recorded
to date have not been significant and are within historical
estimates. We periodically assess the adequacy of our recorded
warranty liability and adjust the amount as necessary.

Note 12:     Subsequent
Events

On February 23, 2004, we invoked the
mediation provisions set forth in our Asset Purchase Agreement
with Ortho-McNeil relating to $34.6 million in disputed
milestone payments.

On March 23, 2004, we entered into an
Exchange Agreement with the debenture holders and retired all of
our outstanding Convertible Debentures in exchange for an
aggregate of $13.8 million in cash and 2.5 million
shares of our common stock. As a result of this exchange,
$18.8 million in principal and interest that was to be paid
under the Convertible Debentures will not have to be paid. As of
December 31, 2003, the

F-24



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##### Table of Contents



CYGNUS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

principal and accrued interest on the Convertible
Debentures totaled $18.3 million. We expect to record a
non-cash gain on the retirement of our Convertible Debentures
during the quarter ending March 31, 2004. In connection
with the exchange, we also canceled all outstanding warrants to
purchase our common stock that had been issued to the debenture
holders and terminated the registration rights agreement
associated with the Convertible Debentures. Additionally, the
security interests in our assets held by the debenture holders
have been terminated.

On March 24, 2004, we notified our
counterparty that we have elected to terminate our remaining
equity line agreement, which had a commitment period ending
December 31, 2004.



|         |                                                                                        
|-------- | ---------------------------------------------------------------------------------------
|Note 13: | Selected Quarterly Financial Data (in
    thousands, except per share data) (unaudited)

|                                                                       |  |                    |        |               |  |          |        |           |  |              |        |               |  |          |        |           |  |   |         |   |  |   |         |   |  |   |         |   |  |   |        |  
|---------------------------------------------------------------------- |  | ------------------ | ------ | ------------- |  | -------- | ------ | --------- |  | ------------ | ------ | ------------- |  | -------- | ------ | --------- |  | - | ------- | - |  | - | ------- | - |  | - | ------- | - |  | - | ------ | -
|                                                                       |  |                   
|                                                                       |  | Three Months Ended
|                                                                       |  |                   
|                                                                       |  | December 31,       |        | September 30, |  | June 30, |        | March 31, |  | December 31, |        | September 30, |  | June 30, |        | March 31,
|                                                                       |  | 2003               |        | 2003          |  | 2003     |        | 2003      |  | 2002         |        | 2002          |  | 2002     |        | 2002     
|                                                                       |  |                    |        |               |  |          |        |           |  |              |        |               |  |          |        |          
|Total revenues                                                         |  | $                  | 931    |               |  | $        | 1,100  |           |  | $            | 539    |               |  | $        | 348    |           |  | $ | 1,714   |   |  | $ | 1,558   |   |  | $ | 316     |   |  | $ | 266    |  
|Costs of product revenues(1)                                           |  |                    | 2,863  |               |  |          | 7,520  |           |  |              | 3,271  |               |  |          | 1,793  |           |  |   | 2,777   |   |  |   | 1,276   |   |  |   | 1,788   |   |  |   | 555    |  
|Total other costs and expenses                                         |  |                    | 2,013  |               |  |          | 2,156  |           |  |              | 3,539  |               |  |          | 3,851  |           |  |   | 9,937   |   |  |   | 9,702   |   |  |   | 9,280   |   |  |   | 7,508  |  
|                                                                       |  |                    |        |               |  |          |        |           |  |              |        |               |  |          |        |           |  |   |         |   |  |   |         |   |  |   |         |   |  |   |        |  
|Loss from operations                                                   |  |                    | (3,945 | )             |  |          | (8,576 | )         |  |              | (6,271 | )             |  |          | (5,296 | )         |  |   | (11,000 | ) |  |   | (9,420  | ) |  |   | (10,752 | ) |  |   | (7,797 | )
|Interest income/(expense) and other, net                               |  |                    | (571   | )             |  |          | (491   | )         |  |              | (521   | )             |  |          | (513   | )         |  |   | (411    | ) |  |   | (782    | ) |  |   | (768    | ) |  |   | (775   | )
|Gain from Sankyo Pharma settlement                                     |  |                    | 75,825 |               |  |          |       |           |  |              |       |               |  |          |       |           |  |   |        |   |  |   |        |   |  |   |        |   |  |   |       |  
|                                                                       |  |                    |        |               |  |          |        |           |  |              |        |               |  |          |        |           |  |   |         |   |  |   |         |   |  |   |         |   |  |   |        |  
|Income/(loss) before income taxes                                      |  |                    | 71,309 |               |  |          | (9,067 | )         |  |              | (6,792 | )             |  |          | (5,809 | )         |  |   | (11,411 | ) |  |   | (10,202 | ) |  |   | (11,520 | ) |  |   | (8,572 | )
|Provision for income taxes                                             |  |                    | 197    |               |  |          |       |           |  |              | 1      |               |  |          | 1      |           |  |   | 1       |   |  |   | 4       |   |  |   | 6       |   |  |   | 12     |  
|                                                                       |  |                    |        |               |  |          |        |           |  |              |        |               |  |          |        |           |  |   |         |   |  |   |         |   |  |   |         |   |  |   |        |  
|Net income/(loss)                                                      |  | $                  | 71,112 |               |  | $        | (9,067 | )         |  | $            | (6,793 | )             |  | $        | (5,810 | )         |  | $ | (11,412 | ) |  | $ | (10,206 | ) |  | $ | (11,526 | ) |  | $ | (8,584 | )
|                                                                       |  |                    |        |               |  |          |        |           |  |              |        |               |  |          |        |           |  |   |         |   |  |   |         |   |  |   |         |   |  |   |        |  
|Net income/(loss) per share, basic                                     |  | $                  | 1.85   |               |  | $        | (0.24  | )         |  | $            | (0.18  | )             |  | $        | (0.15  | )         |  | $ | (0.30   | ) |  | $ | (0.27   | ) |  | $ | (0.30   | ) |  | $ | (0.24  | )
|                                                                       |  |                    |        |               |  |          |        |           |  |              |        |               |  |          |        |           |  |   |         |   |  |   |         |   |  |   |         |   |  |   |        |  
|Shares used in computation of net income/(loss)
    per share, basic   |  |                    | 38,480 |               |  |          | 38,480 |           |  |              | 38,479 |               |  |          | 38,479 |           |  |   | 38,479  |   |  |   | 38,362  |   |  |   | 38,189  |   |  |   | 35,292 |  
|                                                                       |  |                    |        |               |  |          |        |           |  |              |        |               |  |          |        |           |  |   |         |   |  |   |         |   |  |   |         |   |  |   |        |  
|Net income/(loss) per share, diluted                                   |  | $                  | 1.24   |               |  | $        | (0.24  | )         |  | $            | (0.18  | )             |  | $        | (0.15  | )         |  | $ | (0.30   | ) |  | $ | (0.27   | ) |  | $ | (0.30   | ) |  | $ | (0.24  | )
|                                                                       |  |                    |        |               |  |          |        |           |  |              |        |               |  |          |        |           |  |   |         |   |  |   |         |   |  |   |         |   |  |   |        |  
|Shares used in computation of net income/(loss)
    per share, diluted |  |                    | 57,757 |               |  |          | 38,480 |           |  |              | 38,479 |               |  |          | 38,479 |           |  |   | 38,479  |   |  |   | 38,362  |   |  |   | 38,189  |   |  |   | 35,292 |  
|                                                                       |  |                    |        |               |  |          |        |           |  |              |        |               |  |          |        |           |  |   |         |   |  |   |         |   |  |   |         |   |  |   |        |  



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|    |                                                                                
|--- | -------------------------------------------------------------------------------
|(1) | Certain costs have been reclassified to conform
    to current classifications.

F-25



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##### Table of Contents






EXHIBIT INDEX

|       |  |                                                                                                                                                                                                                   
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.008 |  | Lease Termination Agreement dated
    October 15, 2003 between the Registrant and Metropolitan
    Life Insurance Company, a New York corporation (predecessor
    in interest to Seaport Centre Venture Phase I).
|10.124 |  | Amendment to the Final Arbitration Award between
    Registrant and Sanofi-Synthelabo dated November 3, 2003.                                                                                                     
|10.125 |  | Security Agreement between Registrant and
    Sanofi-Synthelabo dated November 3, 2003.                                                                                                                           
|10.126 |  | Grant of Security Interest (Patents) between
    Registrant and Sanofi-Synthelabo dated January 18, 2004.                                                                                                         
|10.128 |  | Notice of Termination of Structured Equity Line
    Flexible Financing Agreement dated March 24, 2004.                                                                                                            
|10.508 |  | Form of Retention Letter Agreement between the
    Registrant and each of the Companys Officers dated
    December 18, 2003.                                                                                     
|23.1   |  | Consent of Ernst & Young
    LLP, Independent Auditors.                                                                                                                                                           
|31.1   |  | Certification of Principal Executive Officer
    Pursuant to Securities Exchange Act Rule 13a-14, as adopted
    pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                       
|31.2   |  | Certification of Principal Financial Officer
    Pursuant to Securities Exchange Act Rule 13a-14, as adopted
    pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                       
|32.1   |  | Certification of Principal Executive Officer
    Pursuant to 18 U.S.C. Section 1350, as adopted
    pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                    
|32.2   |  | Certification of Principal Financial Officer
    Pursuant to 18 U.S.C. Section 1350, as adopted
    pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.