<PAGE>
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                                 UNITED STATES
 
                       SECURITIES AND EXCHANGE COMMISSION
 
                             WASHINGTON, D.C. 20549
 
                            ------------------------
 
                                   FORM 10-K
 
<TABLE>
<S>        <C>
(X)        Annual report pursuant to Section 13 or 15(d) of the Securities Act of 1934 for the
           fiscal year ended December 31, 1998 or
( )        Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
           1934.
</TABLE>
 
                          COMMISSION FILE NO. 0-18962
 
                            ------------------------
 
                                  CYGNUS, INC.
 
             (Exact name of registrant as specified in its charter)
 
<TABLE>
<S>                          <C>
         DELAWARE               94-2978092
      (State or other        (I.R.S. Employer
      jurisdiction of
     incorporation or         Identification
       organization)               No.)
</TABLE>
 
              400 PENOBSCOT DRIVE, REDWOOD CITY, CALIFORNIA 94063
 
             (Address of principal executive offices and 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 _X_ No  ___
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [  ]
 
The aggregate market value of voting stock held by non-affiliates of the
registrant, based upon the closing price of Common Stock on MARCH 18, 1999 as
reported on the Nasdaq National Market was APPROXIMATELY $153,328,872.
Determination of affiliate status for this purpose is not a determination of
affiliate status for any other purpose.
 
                                   22,101,459
 
      (Number of shares of common stock outstanding as of MARCH 18, 1999)
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
Registrant's Consolidated financial statements for the fiscal year ended
December 31, 1998 and definitive Proxy Statement to be filed pursuant to
Regulation 14A for its 1999 Annual Meeting of Stockholders is incorporated by
reference into Part III hereof.
 
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<PAGE>

                                       CYGNUS, INC.
                             1998 ANNUAL REPORT ON FORM 10-K



                                    TABLE OF CONTENTS

<TABLE>
<CAPTION>                                                                                             PAGE
                                                                                                      ----
<S>                                                                                                   <C>
PART I

Item 1.   Business ....................................................................................  2
Item 2.   Properties .................................................................................. 13
Item 3.   Legal Proceedings ........................................................................... 14
Item 4.   Submission of Matters to a Vote of Security Holders ......................................... 14

PART II

Item 5.   Market for Registrant's Common Equity and Related Stockholder Matters ....................... 17
Item 6.   Selected Financial Data ..................................................................... 18
Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations ....... 19
Item 7A.  Quantitative and Qualitative Disclosures About Market Risk .................................. 30
Item 8.   Financial Statements and Supplementary Data ................................................. 31
Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure ........ 31

PART III

Item 10.  Directors and Executive Officers of the Registrant .......................................... 32
Item 11.  Executive Compensation ...................................................................... 32
Item 12.  Security Ownership of Certain Beneficial Owners and Management .............................. 32
Item 13.  Certain Relationships and Related Transactions .............................................. 32

PART IV

Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K ............................. 33

SIGNATURES ............................................................................................ 38
</TABLE>





                                                  1

<PAGE>

                                             PART I

ITEM 1.  BUSINESS

OVERVIEW

     THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND 
UNCERTAINTIES RELATING TO THE FUTURE FINANCIAL PERFORMANCE OF CYGNUS, INC. 
("CYGNUS" OR THE "COMPANY"), AND ACTUAL EVENTS OR RESULTS MAY DIFFER 
MATERIALLY. IN EVALUATING SUCH STATEMENTS, STOCKHOLDERS AND INVESTORS SHOULD 
SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED UNDER THE CAPTION "RISK 
FACTORS" CONTAINED IN THE MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL 
CONDITION AND RESULTS OF OPERATIONS WHICH COULD CAUSE ACTUAL RESULTS TO 
DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS. 
THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY RELEASE THE RESULTS OF ANY 
REVISIONS TO THESE FORWARD-LOOKING STATEMENTS WHICH MAY BE MADE TO REFLECT 
EVENTS OR CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCES 
OF UNANTICIPATED EVENTS.

     Cygnus, Inc. ("Cygnus" or the "Company")  is engaged in the development 
and manufacture of diagnostic and drug delivery systems, utilizing 
proprietary technologies to satisfy unmet medical needs cost effectively. The 
Company's current efforts are primarily focused on two core areas: an 
automatic and continuous glucose monitoring device (the GlucoWatch-Registered 
Trademark- monitor) and transdermal drug delivery systems.

     The Company was incorporated in California in 1985 and was merged into a 
Delaware corporation in September 1995. The Company's principal executive 
offices are located at 400 Penobscot Drive, Redwood City, California 94063, 
and its telephone number at that address is (650) 369-4300.

     On August 11, 1998, John Hodgman was appointed President, Chief Executive 
Officer and Director by Cygnus' Board of Directors following the resignation 
of Gregory B. Lawless. In addition, Andre Marion, who is a Cygnus Director, 
was named Vice Chairman of the Board of Directors. Gary Cleary continues his 
duties as Chairman of the Board of Directors and Chief Technical Officer.

THE GLUCOWATCH -Registered Trademark- SYSTEM. 

     The Company's GlucoWatch monitor represents a potential advance in 
diabetes care technology as compared to the currently prevailing "finger 
stick" blood monitoring method. The GlucoWatch monitor is designed to measure 
glucose automatically and continuously through the ease and convenience of a 
device worn like a  wristwatch. Worldwide sales of blood glucose 
self-monitoring products were approximately $2.5 billion in 1997 (Boston 
Biomedical Consultants, Inc.). It is estimated that more than 40 million  
people in North America, Europe, Japan and Korea have diabetes. In the United 
States ("U.S.")  alone, more than ten million people have been diagnosed, 
with another five  million believed to have the condition. The number of 
people with diabetes is expected to continue to grow with the aging of the 
population, while the number  of diagnosed cases is also expected to increase 
with changes in diagnostic  standards and new diagnostic technologies. 
Clinical studies sponsored by the  National Institutes of Health ("NIH") 
indicate that better management of glucose levels through more frequent 
testing would enable people with diabetes to reduce or significantly delay 
many serious diabetes-related health complications. However, largely due to 
the pain of repetitive finger sticking and the associated disruption of 
daily life, the Company believes most people with diabetes currently test 
their glucose levels less than half as often as recommended. As a result of 
the drawbacks of the finger stick method, the Company believes that there is 
a significant unmet demand for an automatic and continuous glucose-monitoring 
device.

     To address this unmet demand, the Company is developing the GlucoWatch 
monitor, which is expected to reduce or eliminate significant drawbacks of 
the finger stick  testing technique. The device, which is worn like a 
wristwatch, is designed to automatically extract and measure glucose levels 
through intact skin up to three times per hour. The extracted glucose is 
collected in a consumable component called the AutoSensor, which is attached 
to the back of the device and replaced approximately every twelve hours. The 
GlucoWatch monitor potentially offers a combination of features not available 
in currently marketed devices,  such as an electronic memory to store and 
display glucose levels; the ability to download stored information to 
personal computers to analyze glucose data and trends;

                                      2

<PAGE>


alerts indicating hypo- and hyperglycemic conditions; and event markers which 
record factors that affect glucose levels. The GlucoWatch monitor can be worn 
during the day and night for continuous glucose monitoring. The Company 
believes the GlucoWatch monitor will provide the frequent testing and trend 
analysis of glucose levels necessary to enable people with diabetes to better 
manage their condition and eliminate the repetitive pain and inconvenience 
associated with the finger stick monitoring method. The Company believes this 
unique combination of features will result in better control of glucose 
levels, improved quality of life and more cost-effective healthcare. 

     In developing the GlucoWatch monitor, the Company has sought to design a 
device that would offer the above features and be safe and effective for 
home use by patients with diabetes. In December 1998, Cygnus completed 
extensive development clinical studies using a version of the GlucoWatch 
monitor designed for commercial sale. These studies were conducted on people 
with diabetes by independent clinical investigators across the U.S. The 
results of these studies demonstrated that the GlucoWatch monitor is able to 
measure glucose levels with accuracy and precision. The results of the most 
controlled testing portion of the development clinical studies exceeded 
Cygnus' internal performance accuracy target values. The protocols for the 
development clinical studies were designed to be the same as the protocols 
used in its registration clinical studies which, if successfully completed, 
will lead to its completed United States Food and Drug Administration ("FDA") 
submission for clearance to market the device. Although the Company believes 
its clinical results to date are encouraging, no assurance can be given that 
data generated in the registration clinical studies will be as favorable as 
data generated in clinical trials to date or that, even if such data are as 
favorable, such data will provide a sufficient basis for the approval of the 
GlucoWatch monitor by the FDA.

     On January 25, 1999 the Company submitted the first part of the 
Pre-Market Approval Application ("PMA") to the FDA. This submission included 
a variety of information, including manufacturing documentation. The Company 
intends to submit the remainder of the PMA by the end of June 1999. The 
product PMA will include analysis of a series of clinical studies totaling 
more than 500 people which were completed in December 1998, as well as at 
least two additional studies.

     In 1996, the Company entered into collaboration agreements with Becton 
Dickinson & Company ("Becton Dickinson") and Yamanouchi Pharmaceutical Co., 
Ltd. ("Yamanouchi") for the commercialization of the GlucoWatch monitor. 
Under the Yamanouchi agreement, Cygnus granted Yamanouchi the marketing and 
distribution rights of the GlucoWatch monitor in Japan and Korea. Cygnus is 
eligible to receive up-front and milestone payments prior to 
commercialization and to receive a percentage of the product's future 
commercial success. Under the Becton Dickinson agreement, the Company had 
granted Becton Dickinson exclusive worldwide marketing and distribution 
rights, with the exception of Japan and Korea. On March 31, 1998, the Company 
announced the termination of its agreement with Becton Dickinson. 
Consequently, the Company will not receive any future milestone payments 
under the Becton Dickinson agreement and will not be obligated to share 
future revenue, if any, associated with commercialization of the GlucoWatch 
monitor. The Company is currently in discussions with a number of companies 
to establish an alliance for the commercialization of the GlucoWatch monitor 
to provide for distribution, sales, marketing, and customer service support 
in North America and Europe. There can be no assurance that the Company will 
be able to enter into new collaborative arrangements. 

     In 1998, the Company entered into long term agreements with E.I. du Pont 
de Nemours & Company ("DuPont") for the development and supply of thick film 
materials for Cygnus' GlucoWatch monitor. A key component of the GlucoWatch 
monitor is the sensor, which Cygnus developed with DuPont's materials. The 
agreements call for continued cooperation for future sensor technology 
developments and continued supply of materials.  

TRANSDERMAL DRUG DELIVERY SYSTEMS.

     Transdermal drug delivery systems provide for the controlled release of 
drugs directly into the bloodstream through intact skin. The Company's 
transdermal drug delivery products are thin multilayer systems, in the form 
of small adhesive patches. Transdermal delivery can provide a number of 
advantages over conventional methods of drug administration, including 
enhanced efficacy, increased safety, greater convenience and improved patient 
compliance. By delivering a steady flow of drugs into the bloodstream over an 
extended period of time, transdermal systems can avoid the "peak and valley" 
effect of traditional oral or injectable therapy and can enable more 
controlled, effective treatment. By avoiding first pass metabolism through 
the gastrointestinal tract and the liver, the therapeutically


                                        3

<PAGE>

equivalent dosage for the transdermal delivery of certain compounds can be 
significantly less than the corresponding oral dosage, potentially reducing 
dosage-related side-effects.

     The Company's transdermal product line is focused on contraception, 
hormone replacement therapy and smoking cessation. The Company has received 
FDA approval for two products, one of which is currently marketed, the 
Nicotrol-Registered Trademark- (Pharmacia AB, Stockholm, Sweden) nicotine 
patch. The Company has strategic collaborations for its transdermal products 
with Ortho-McNeil Pharmaceutical, Inc. ("Ortho"), a subsidiary of Johnson & 
Johnson (contraception), American Home Products ("AHP") Corporation and 
Sanofi S.A. ("Sanofi") (hormone replacement therapy), and Pharmacia & Upjohn 
("Pharmacia") (smoking cessation).

     The FemPatch-Registered Trademark- (Warner-Lambert Co., Morris Plains, 
NJ) system, commercially launched in 1997, is a low-dose, 7-day estrogen 
replacement transdermal patch for the treatment of menopausal symptoms. 
Sanofi, the Company's worldwide licensee, had sublicensed U.S. marketing 
rights to Warner-Lambert. In November 1998, Warner-Lambert terminated its 
agreement with Sanofi, which also terminated the Supply Agreement between 
Warner-Lambert and the Company. Consequently, the Company does not expect 
product revenue related to the FemPatch system in 1999.

     In July 1998, the Company was notified by AHP, the licensee for two of 
the Company's transdermal hormone replacement products, that AHP wanted to 
discuss the status of their agreement with the Company. In November 1998, the 
Company and AHP entered into an Amendment to their Agreement. (For more on 
the AHP amendment, see "Contract Revenue," under Management's Discussion and 
Analysis of Financial Condition and Results of Operations.)  

PORTFOLIO OF PRODUCTS

     The data in the following table summarize Cygnus' current product 
portfolio, the potential indications, development status and licensees of 
marketing and distribution rights.  The data in the table are qualified by 
reference to the more detailed descriptions set forth herein.  Development of 
the various products listed is being funded by the designated licensee or 
distributor, the Company, or both.  The Company has additional products in 
early development, which are not listed below, and is conducting a number of 
new product feasibility studies.

                                      4

<PAGE>

                                   PRODUCT PORTFOLIO

<TABLE>
<CAPTION>
PRODUCT                INDICATIONS         STATUS (1)                        MARKETING
                                                                             RIGHTS
<S>                       <C>                 <C>                               <C>

DIAGNOSTIC SYSTEMS:
CONTINUOUS, AUTOMATIC GLUCOSE MONITORING:

  GlucoWatch Monitor      Diabetes             Registration clinicals           Yamanouchi
                                                                                Cygnus

DRUG DELIVERY SYSTEMS:
TRANSDERMAL DRUG DELIVERY:

SMOKING CESSATION:

  Nicotrol Patch         Smoking cessation     Commercialized in North          Pharmacia & Upjohn, Inc.;
                                               America and certain European     Johnson & Johnson (2)
                                               countries


  Nicotine Patch         Smoking cessation     Pre-clinical                     Undisclosed

HORMONE REPLACEMENT:
  Low-Dose Estrogen
   7-Day:

  FemPatch System        Menopausal symptoms   Commercialized in North          Sanofi (3)
                                               America 

  Estrogen 7-Day         Menopausal symptoms   Submitted New Drug               American Home Products
                                               Application ("NDA") and 
                                               European Dossier

  Estrogen/Progestin:
  Combination 3.5-Day    Menopausal symptoms   Phase 3 clinicals                American Home Products

CONTRACEPTION:
  Estrogen/Progestin:
  Combination 7-Day      Contraception         Phase 3 clinicals                Johnson & Johnson (4)

OTHER PRODUCTS:
Clonazepam               Anti-epileptic        Pre-clinical                     National Institutes of
                                                                                Health ("NIH") (5)
Mucosal Disk             Breath freshening     Marketing Authorization Filed    Undisclosed
Mucosal Disk             Sore throat           Marketing Authorization Filed    Undisclosed
</TABLE>

(1)   The Company's drug delivery products are generally developed in the 
      following stages: development, prototype, pre-clinical studies in 
      preparation to file an Investigational New Drug Application ("IND"), 
      clinical trials, and regulatory submission.
(2)   Pharmacia has worldwide rights and has sublicensed rights in North 
      America to Johnson & Johnson.
(3)   In November 1998, Warner-Lambert terminated its agreement with Sanofi, 
      which also terminated the Supply Agreement between Warner-Lambert and 
      the Company. 
(4)   The Company's agreement with Johnson & Johnson grants Johnson & Johnson 
      exclusive rights to the estrogen/progestin combination 7-day contraception
      product.
(5)   Product being funded through the first clinical trial by an NIH grant.

                                        5

<PAGE>

AUTOMATIC AND CONTINUOUS GLUCOSE MONITORING

MARKET OPPORTUNITY

     People with diabetes measure blood glucose levels to adjust their diet 
and insulin use to better control their glucose levels in order to prevent 
diabetes-related complications. Currently, to measure their glucose levels, 
people with diabetes must stick their fingers with a lancet, draw blood and 
place a drop of blood on a glucose reagent strip inserted in an instrument 
which provides a glucose reading. Each day of testing can involve numerous 
sticks and the complete procedure is not only painful but disruptive to daily 
life. As a result of this pain and disruption, the Company believes most 
people with diabetes monitor their blood glucose levels less than twice per 
day, instead of the recommended four to seven times per day. Even at this 
level of testing, the market for products for self-monitoring of glucose 
levels by people with diabetes is quite substantial.

     Worldwide sales of products for the self-monitoring of blood glucose 
levels were approximately $2.5 billion in 1997. The Company believes that 
approximately 80% to 90% of the sales were related to disposable glucose 
reagent strips for finger stick monitoring (Boston Biomedical Consultants, 
Inc.). In the U.S., a relatively small segment of people with diabetes who 
measure their glucose level account for the majority of testing; for example, 
of these people, just 19% (about 1.6 million) account for 52% of the tests 
performed. It is estimated that more than 40 million people in North America, 
Europe, Japan and Korea have diabetes. In the U.S. alone, more than ten 
million people have been diagnosed with diabetes, with another five million 
believed to be undiagnosed. The number of people diagnosed with diabetes has 
been growing and is expected to continue to grow due to the aging of the 
population, changes in diagnostic standards and new diagnostic technologies. 
Specifically, the diagnostic standards in the U.S. have been changed such 
that a fasting plasma glucose value of greater than or equal to 126 mg/dL now 
indicates a diagnosis of diabetes, whereas such diagnosis previously required 
a value of greater than or equal to 140 mg/dL. Diabetes can lead to severe 
complications over time, including blindness, loss of kidney function and 
peripheral neuropathy, causing circulation problems to the arms and legs and 
pain and potential amputation. The American Diabetes Association ("ADA") 
estimated that the complications arising from diabetes cost the U.S. 
healthcare system in excess of $45 billion in 1992. These complications are 
largely a consequence of years of poor management of glucose levels by people 
with diabetes. Results of the Diabetes Control and Complication Trial, a 
major clinical trial sponsored by the National Institutes of Health ("NIH") 
and published in 1993, showed that more frequently monitored blood glucose 
levels and rigid adherence to a program of diet, exercise and insulin 
injections could prevent or significantly delay the onset of many of the 
long-term complications of diabetes.

THE GLUCOWATCH MONITOR

     The Company believes that there is an unmet demand for automatic and 
continuous glucose monitoring. To address this unmet demand, the Company has 
developed the GlucoWatch monitor, which is worn like a wristwatch and, after 
calibrating each new AutoSensor with a standard blood glucose monitor, 
automatically extracts and measures glucose levels painlessly through intact 
skin every twenty or thirty minutes. The GlucoWatch monitor then displays and 
stores current and past glucose levels and trend data. The extracted glucose 
is collected in a consumable component called the AutoSensor, which is 
attached to the back of the device and replaced approximately every twelve 
hours. The GlucoWatch monitor potentially offers, in a portable and discreet 
device, a combination of features not available in currently marketed 
devices. These include frequent data collection, electronic memory to store 
and display glucose levels, personal computer downloading for trend analysis, 
alerts indicating hypo- and hyperglycemic conditions and event markers which 
record factors that affect glucose levels. The GlucoWatch monitor is designed 
to be worn day and night for continuous glucose monitoring. The GlucoWatch 
monitor is expected to reduce or eliminate significant drawbacks of the 
finger stick technique, such as the pain of repetitive sticking and the 
disruption of normal activities caused by indiscreet, cumbersome procedures. 
The Company believes the GlucoWatch monitor can lead to improved disease 
management, enabling people with diabetes to prevent or delay severe 
complications associated with the condition.

     The GlucoWatch monitor extracts glucose molecules through intact skin 
utilizing a patented sampling process called electroosmosis (or "reverse 
iontophoresis"). The extracted glucose is collected and measured by an 
AutoSensor, a replaceable component which includes an enzyme-containing 
hydrogel and electrodes for electroosmotic extraction and biosensing. The 
glucose collected in the AutoSensor triggers an electro-chemical reaction in 
the AutoSensor, generating

                                       6

<PAGE>

electrons. The biosensor measures the electrons and an application specific 
integrated circuit ("ASIC") in the GlucoWatch monitor equates the number of 
electrons to a concentration of glucose in the blood. The GlucoWatch monitor 
automatically measures glucose levels at twenty minute intervals. The 
GlucoWatch monitor displays the most recent readings and trends at the push 
of a button. Its electronic memory capabilities permit the retrieval and 
downloading of data, allowing longer-term trend analysis for better disease 
management.

     The GlucoWatch monitor system was designed to be simple and easy to use. 
Each day the rechargeable battery is replaced. In addition, an AutoSensor is 
attached on the back of the GlucoWatch monitor, which will provide twelve 
hours of glucose measurements after a three-hour warm-up period. A finger 
stick blood glucose measurement is input into the GlucoWatch monitor for 
calibration. Measurements will then be generated painlessly, bloodlessly and 
automatically by the GlucoWatch monitor, providing up to thirty-six glucose 
measurements over a twelve-hour period.

     The Company believes approximately 80% to 90% of current sales in the 
glucose monitoring market come from the consumable test strips on which a 
drop of blood is placed and inserted into a meter. The GlucoWatch monitor 
uses a similar approach. The "monitoring device" is designed to function for 
a number of years, while the consumable AutoSensor is designed to provide 
twelve hours of measurements. 

REGULATORY APPROVAL

     For FDA approval of the GlucoWatch monitor, the Company is currently 
conducting registration clinical studies. In response to conversations with 
the FDA, the Company intends to complete the submission of a Pre-Market 
Approval Application ("PMA") by June 1999 for the GlucoWatch monitor for 
adults with diabetes. On January 25, 1999 the Company submitted the first 
part of the PMA to the FDA. This submission included a variety of 
information, including manufacturing documentation. 

     Although the Company believes its clinical results to date are 
encouraging, no assurance can be given that data generated in the 
registration clinical studies will be as favorable as data generated in 
clinical trials to date or that, even if such data are as favorable, such 
data will provide a sufficient basis for the approval of the GlucoWatch 
monitor by the FDA. In addition, there can be no assurance that if the 
product is cleared for marketing by the FDA that all of the potential 
features of the GlucoWatch monitor would be approved for use or that the 
intended usage described above would be approved.

COMPETITION 

     The glucose monitoring market is highly competitive. Currently the 
market is dominated by finger stick blood glucose monitoring products. This 
monitoring technique presents a number of barriers to generating more 
frequent blood glucose measurements, including the pain of repetitive finger 
lancing and the disruption of normal activities, as people with diabetes 
typically do not want to go through the finger stick process in public. 
Several companies are attempting to develop non-invasive or less invasive 
methods to monitor glucose levels. One technology that a number of companies 
are pursuing is the use of infrared spectroscopy, which uses radiation to 
measure glucose levels. Other companies are attempting to develop a variety 
of methods to extract interstitial fluid and measure the glucose 
concentration therein. The Company believes that none of the currently 
marketed finger stick products nor other products in development have the 
range of features and benefits offered by the GlucoWatch monitor to address 
the unmet needs. 

TRANSDERMAL DRUG DELIVERY SYSTEMS

     Transdermal drug delivery systems provide for the controlled release of 
drugs directly into the bloodstream through intact skin. The Company's 
transdermal drug delivery products are thin multilayer systems, in the form 
of small adhesive patches. Transdermal delivery can provide a number of 
advantages over conventional methods of drug administration, including 
enhanced efficacy, increased safety, greater convenience and improved patient 
compliance. By delivering a steady flow of drugs into the bloodstream over an 
extended period of time, transdermal systems can avoid the "peak and valley" 
effect of traditional oral or injectable therapy and can enable more 
controlled, effective treatment. By avoiding first pass metabolism through 
the gastrointestinal tract and the liver, the therapeutically

                                    7

<PAGE>

equivalent dosage for the transdermal delivery of certain compounds can be 
significantly less than the corresponding oral dosage, potentially reducing 
dosage-related side-effects.
 
     Cygnus has established a comprehensive, integrated approach to the 
development of transdermal delivery systems. Cygnus develops a unique product 
profile for each transdermal product based on an evaluation of several key 
variables that change with each drug and therapeutic indication. Based on its 
assessment of the product profile and the interrelationship between the drug 
and the physical and biological characteristics of the skin, Cygnus 
formulates the appropriate materials and designs the structure of the 
transdermal system to achieve desired product characteristics such as 
comfort, extended wear, delayed or enhanced onset and controlled release.

CONTRACEPTION

     The contraceptive market is estimated, by industry sources, to have had 
1997 worldwide sales of $2.9 billion. The market is dominated by oral 
contraceptive pills. There are no transdermal patches currently marketed for 
contraception. The Company believes a seven-day contraceptive patch could 
lead to improved dosing compliance and is developing such a product under an 
agreement with Ortho-McNeil Pharmaceutical, Inc. ("Ortho"), a subsidiary of 
Johnson & Johnson. Ortho has exclusive worldwide marketing rights to the 
product. Cygnus has received up-front payments and will receive milestone 
payments as well as a percentage of net sales, if and when the product is 
commercialized, and is responsible for the development and manufacture of the 
product. This product is currently in Phase 3 clinical trials.
 
HORMONE REPLACEMENT
 
     The hormone replacement market is large, with $1.33 billion in sales 
worldwide in 1997, and is expected to grow as more women reach the age of 
menopause (Med Ad News, May 1998). The Company believes that its transdermal 
hormone replacement products have a competitive advantage over certain 
transdermal hormone replacement products as a result of superior patient 
comfort profile as well as applicable seven-day extended delivery systems. 
 
     Cygnus has two hormone replacement products in development: a 7-day 
estrogen patch, for which the New Drug Application ("NDA") has been submitted 
to the FDA, and the European Dossier has been submitted to the European 
authorities; and a 3.5-day estrogen/progestin combination patch, which is 
currently in Phase 3 clinical trials. These products are being developed 
under an agreement with American Home Products. Under the terms of the 
agreement, American Home Products has worldwide marketing rights with respect 
to the products resulting from the collaboration. Cygnus received up-front 
fees and is entitled to receive milestone payments as well as a percentage of 
net sales on all products to be manufactured by Cygnus for the worldwide 
market. In addition, AHP pays for all clinical trial expenses. Cygnus is 
otherwise responsible for financing the development and manufacture of the 
products. Cygnus will pay Sanofi a percentage of net sales on the two 
products licensed to American Home Products subject to certain minimums. In 
July 1998, the Company was notified by AHP that AHP wanted to discuss the 
status of their agreement with the Company. In November 1998, the Company and 
AHP entered into an Amendment to their Agreement. (For more on the AHP 
amendment see "Contract Revenue," under Management's Discussion and Analysis 
of Financial Condition and Results of Operations.) 

     The FemPatch system, commercially launched in 1997, is a low-dose, 7-day 
estrogen replacement transdermal patch for the treatment of menopausal 
symptoms. Sanofi, the Company's worldwide licensee, has sublicensed U.S. 
marketing rights to Warner-Lambert. In November 1998, Warner-Lambert 
terminated its agreement with Sanofi, which also terminated the Supply 
Agreement between Warner-Lambert and the Company.

SMOKING CESSATION
 
     The smoking cessation market is estimated to have had 1997 worldwide 
sales of $555.0 million (Drug Store News, September 7, 1998). The Company's 
Nicotrol product was initially introduced in the U.S. as a prescription 
product in 1992 and subsequently approved for over-the-counter sale in the 
U.S. in 1996. The Nicotrol patch is currently marketed in North America by 
Johnson & Johnson and in many European countries by Pharmacia. Cygnus 
receives royalties on the worldwide sales of the Nicotrol patch. Cygnus is 
also collaborating with an undisclosed partner for a different 
over-the-counter nicotine transdermal system.  This product is currently in 
the pre-clinical stage.  

                                     8

<PAGE>

DEPENDENCE ON NEW PRODUCTS; UNCERTAINTY OF MARKET ACCEPTANCE

     For the Company to be successful, it will need to develop, license, or 
acquire new products.  Several products based on the Company's technologies 
are currently under development by Cygnus and its licensees. Many of these 
products (including the GlucoWatch monitor) will require significant 
additional development and investment, including preclinical and clinical 
testing, prior to their commercialization. From time to time the Company has 
experienced delays or setbacks in the development of certain of its products. 
For example, the Company experienced development delays in the 
miniaturization of the GlucoWatch monitor. There can be no assurance that the 
Company will be able to successfully address problems that may arise during 
the development and commercialization process.  In addition, there can be no 
assurance that such products or future products (including the GlucoWatch 
monitor) can or will be successfully developed, prove to be safe and 
effective in clinical trials, meet applicable regulatory standards, be 
capable of being manufactured in commercial quantities at reasonable cost, be 
marketed successfully or achieve market acceptance.  Product development 
efforts can be terminated by the Company or its licensees and there can be no 
assurance that initial product development efforts or third party 
collaborations will be successful.  If any of the Company's development 
programs are not successfully completed, required regulatory approvals or 
clearances are not obtained, or products for which approvals or clearances 
are obtained are not commercially successful, the Company's business, 
financial condition and results of operations could be materially and 
adversely affected.

     The Company's business is subject to the risks inherent in the 
development of new products using new technologies and approaches. There can 
be no assurance that unforeseen problems will not develop with these 
technologies or applications, that the Company will be able to successfully 
address technological challenges it encounters in its research and 
development programs or that commercially feasible products will ultimately 
be developed by the Company.

     Before the Company can market the GlucoWatch monitor, it must first 
conduct registration clinical trials using a version of the product designed 
for commercial sale, prepare a submission to the FDA and obtain clearance or 
approval from the FDA. Approval from other U.S. or foreign government 
regulatory agencies may also be required. Each of these stages will involve 
certain risks and challenges. The Company has completed research clinical 
studies using a commercial version of the product and is conducting 
registration clinical trials for submission to the FDA. There can be no 
assurance that the commercial product will produce results that support the 
necessary regulatory filings and approvals. In addition, if the Company 
receives the necessary regulatory approvals for the GlucoWatch monitor, there 
can be no assurance that unforeseen problems will not occur in product 
manufacturing and commercial scale-up or marketing or product distribution.  
Any such occurrence could significantly delay the commercialization of the 
GlucoWatch monitor or prevent its market introduction entirely. Furthermore, 
if the GlucoWatch monitor is successfully developed, the commercial success 
of the GlucoWatch monitor will depend on its acceptance in the market.

GOVERNMENT REGULATION; NO ASSURANCE OF REGULATORY APPROVALS

     The design, manufacturing, labeling, distribution and marketing of the 
Company's products are subject to extensive and rigorous government regulation 
in the U.S. and certain other countries where the process of obtaining and 
maintaining required regulatory clearance or approvals is lengthy, expensive 
and uncertain. In order for the Company to market its products in the U.S., 
the Company must obtain clearance or approval from the FDA. To date, the 
Company has two products which have received FDA approval, the Nicotrol patch 
and the FemPatch system. Before a regulatory submission can be filed with the 
FDA, a product must undergo extensive clinical trials. The Company's drug 
delivery systems require the filing of a NDA or an Abbreviated New Drug 
Application ("ANDA") with the FDA and the FDA's approval of the NDA or ANDA. 
Devices such as the GlucoWatch monitor under development by the Company will 
require the filing and FDA clearance or approval of a medical device 
submission. The time required for regulatory approval of the Company's 
products after a filing is uncertain. There can be no assurance that problems 
will not arise that could delay or prevent the commercialization of the 
Company's products or that the FDA and foreign regulatory agencies will be 
satisfied with the results of clinical trials or approve the marketing of any 
products. Moreover, even if regulatory approval is granted, such approval may 
include significant limitations on indicated uses for which any such products 
could be marketed.
                                     9
<PAGE>

     On January 25, 1999 the Company submitted the first part of the PMA to 
the FDA for the GlucoWatch monitor. This submission included a variety of 
information, including manufacturing documentation. The Company intends to 
submit the remainder of the PMA by the end of June 1999. The product PMA will 
include analysis of a series of clinical studies totaling more than 500 
people which were completed in December 1998, as well as at least two 
additional studies.

     A drug or 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 or 
products from the market. Failure to comply with applicable regulatory 
requirements may, among other things, result in 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 the Company's potential 
products. Cygnus is also subject to federal, state and local regulations 
regarding work place safety, environmental protection and hazardous and 
controlled substance controls, among others.

     In order for the Company to market its products in Europe and certain 
other foreign jurisdictions, the Company and its distributors and agents must 
obtain required regulatory registrations or approvals and otherwise comply 
with extensive regulations regarding safety, efficacy and quality in those 
jurisdictions. Specifically, certain foreign regulatory bodies have adopted 
various regulations governing product standards, packaging requirements, 
labeling requirements, import restrictions, tariff regulations, duties and 
tax requirements. These regulations vary from country to country. In order to 
commence sales of the GlucoWatch monitor in Europe, the Company must receive 
CE mark certification, which is an international symbol of quality and 
compliance with applicable European medical device directives. To obtain CE 
certification, the Company must pass a review of the GlucoWatch monitor 
technical file by a European Community notified body. Failure to receive CE 
mark certification or other foreign regulatory approvals could have a 
material adverse effect on the Company's business, financial condition and 
results of operations. There can be no assurance that the Company will obtain 
any other required regulatory registrations or approvals in such countries or 
that it will not be required to incur significant costs in obtaining or 
maintaining such regulatory registrations or approvals. Delays in obtaining 
any registrations or approvals required to market the Company's products, 
failure to receive these registrations or approvals, or future loss of 
previously obtained registrations or approvals could have a material adverse 
effect on the Company's business, financial condition and results of 
operations.

COMPETING PRODUCTS AND CHANGES IN TECHNOLOGY

     A large number of companies are involved or are becoming involved in the 
development and commercialization of products incorporating diagnostic and 
drug delivery systems. This field is highly competitive, and Cygnus believes 
that competition will substantially increase in the future.  A number of 
companies have invested, and are continuing to invest, significant resources 
in the development of diagnostic and drug delivery systems. Many of these 
companies have greater financial, research and development and other 
resources than Cygnus, as well as more experience than Cygnus in 
commercializing diagnostic and transdermal drug delivery products. Such 
companies may improve existing drug formulations and products more 
efficiently than Cygnus or may design and develop new diagnostic and 
transdermal drug delivery products which are more accepted in the marketplace 
than the Company's products.

     The Company's primary competitors in the glucose monitoring industry are 
expected to be companies that currently market finger stick method products. 
These companies have established products and distribution channels. In 
addition, a number of companies are engaged in the development of products 
using technology that is different than that used by Cygnus, but that are 
also intended to permit less painful or painless glucose monitoring. These 
technologies include infrared spectroscopy, which uses radiation to measure 
glucose levels, and a variety of methods (including, in one case, transdermal 
technology) to extract interstitial fluid and measure the glucose 
concentration therein.  The Company is not aware of any products under 
development that potentially offer the range of benefits of the GlucoWatch 
monitor. However, there can be no assurance that these products will not be 
more accepted in the marketplace than the GlucoWatch monitor or will not 
render the Company's glucose monitor uncompetitive or obsolete.  A number of 
companies have developed or are seeking to develop new drugs to treat 
diabetes that could reduce demand for glucose monitoring systems. In 
addition, many of the Company's competitors and potential competitors have 
substantially greater resources, research and development staffs and 
facilities than the Company and have significantly greater experience than 
the Company in developing, manufacturing and marketing glucose

                                  10

<PAGE>

monitoring devices. Competition within the glucose monitoring industry could 
also result in price reductions for glucose monitoring devices such that the 
Company may not be able to sell the GlucoWatch monitor at a price level 
adequate for the Company to realize a return on its investment.

     The drug delivery industry is a rapidly evolving field. A number of 
other companies, including major pharmaceutical companies, are also 
developing and marketing transdermal and other similar systems for the 
controlled delivery of drugs. Products currently on the market or under 
development by competitors deliver the same drugs or other drugs to treat the 
same indications as many of the products under development by the Company. 
The first pharmaceutical product to reach the market in a therapeutic area 
often obtains and maintains significant market share relative to later 
entrants to the market. The Company's transdermal products will also compete 
with drugs marketed not only in similar drug delivery systems but also in 
traditional dosage forms such as oral administration, bolus injection and 
continuous infusion. New drugs, new therapeutic approaches or future 
developments in alternative drug delivery technologies, such as time-release 
capsules, liposomes, inhalants, and implants, may provide therapeutic or cost 
advantages over the drug delivery systems being developed by the Company.

MANUFACTURING; DEPENDENCE ON THIRD PARTY SUPPLIERS

     Any manufacture of the Company's products is subject to current good 
manufacturing practices ("cGMP") requirements prescribed by the FDA and other 
standards prescribed by the appropriate regulatory agency in the country of 
use. Additionally, the Company's agreements with licensees either specify 
pricing formulas for products manufactured and sold by Cygnus to its 
licensees or specify that prices will be negotiated in the future. There can 
be no assurance that prices for the Company's products will cover the 
manufacturing costs for these products in light of the Company's limited 
manufacturing experience and general supply and demand conditions in the 
marketplace.

     The Company's GlucoWatch monitor has not yet been manufactured for 
commercial sale, and the Company has no experience manufacturing the 
GlucoWatch monitor in the volumes that would be necessary for the Company to 
achieve significant commercial sales. To successfully commercialize the 
GlucoWatch monitor, the device will have to be manufactured in compliance 
with regulatory requirements, in a timely manner and in sufficient quantities 
while maintaining product performance, quality and acceptable manufacturing 
costs. There can be no assurance that the Company will be able to establish 
and maintain reliable, full scale manufacturing of the GlucoWatch monitor at 
commercially reasonable prices. Manufacturers often encounter difficulties in 
scaling up production of new products, including problems involving product 
performance, production yields, quality control and assurance and shortages 
of personnel. In addition, manufacturing facilities will be subject to cGMP 
regulations, including possible preapproval inspection, international quality 
standards and other regulatory requirements. Difficulties encountered by the 
Company in manufacturing scale-up or failure by the Company to implement and 
maintain manufacturing facilities in accordance with cGMP regulations, 
international quality standards or other regulatory requirements could result 
in a delay or termination of production, which could have a material adverse 
effect on the Company's business, financial condition and results of 
operations.

     In the past, the Company has experienced these problems in scaling up 
its products for commercial launch.  There can be no assurance that similar 
problems will not be encountered in the future. In addition, there can be no 
assurance that the Company will be able to achieve and maintain product 
performance quality and reliability if and when producing the GlucoWatch 
monitor in the quantities required for commercialization, nor that the 
GlucoWatch monitor can be assembled and manufactured at an acceptable cost.

     The GlucoWatch monitor will be manufactured from components purchased 
from outside suppliers, most of which are the Company's single source for 
such components. In the event the Company is unable to obtain these 
components from its suppliers, the Company would be required to obtain 
components from alternate suppliers. Any interruption in the supply of 
GlucoWatch monitor components could have a material adverse effect on the 
Company's business, financial condition and results of operations.

     The Company received ISO 9002 certification in 1997. Consequently, the 
Company expects to receive approval for the use of the "CE" mark for sales of 
its products in Europe in 1999. 

     Several materials used in the Company's transdermal products are 
currently obtained from single sources. Although the Company has not 
experienced difficulty acquiring these materials for the manufacture of its 
products for

                                    11

<PAGE>

sale or clinical trials, there can be no assurance that supply interruptions 
will not occur or that the Company will not have to obtain substitute 
vendors, if such vendors are available, which could require additional 
regulatory submissions and approvals. Any such interruption of supplies could 
have a material adverse effect on the Company's ability to develop, 
manufacture and sell its transdermal products.

     The Company leases a 21,000 square foot manufacturing facility which has 
been used in both commercial and  clinical supply production. The Company 
believes it has sufficient capacity to support the planned market 
introduction of its current drug delivery products for the next 3-5 years. 
The Company is currently establishing its commercial AutoSensor manufacturing 
operations in an existing third-party facility. Each of the foregoing 
facilities complies with applicable regulatory requirements. 

THIRD-PARTY REIMBURSEMENT

     Successful commercialization of certain of the Company's products may 
depend in part on the availability of reimbursement from third-party health 
care payors, such as private insurance plans and the government. There can be 
no assurance that such reimbursement will be available.  Third-party payors 
are increasingly attempting to contain health care costs by limiting both 
coverage and the level of reimbursement for new therapeutic and diagnostic 
products. There can be no assurance that adequate levels of reimbursement 
will be available to enable the Company to achieve market acceptance of the 
GlucoWatch monitor or other new products under development or to maintain 
price levels sufficient to realize an appropriate return on its investment. 
In certain international countries, the period of time needed to obtain such 
reimbursement can be lengthy.  The Company may delay the launch of its 
products into certain countries until eligibility for reimbursement is 
established. This could potentially have an adverse effect on the Company.

SENIOR CONVERTIBLE NOTES

     In February 1998, the Company entered into Note Purchase Agreements with 
certain institutional investors to issue and sell approximately $43 million 
of 4% Senior Subordinated Convertible Notes due in 2005 (the "Notes"). On 
October 28, 1998, the Company restructured the Notes. Key provisions in the 
restructured Notes include the repayment of $18.5 million in principal 
(reducing the principal balance from $43 million to $24.5 million) in October 
1998, a delay in the convertibility of the majority of the Notes to June 30, 
1999 or after, modification of conversion prices of the Notes, the ability of 
the Company to redeem at par at any time all or part of the new principal 
amount of the Notes, an increase in the interest rate to 5.5% paid annually 
on the new principal balance and the change in the final maturity of the 
Notes to October 1, 2000. 

     Under the terms of the restructured Notes, all of the remaining $24.5 
million principal amount of the Notes are redeemable by the Company at par 
including accrued interest. In addition, $18.5 million of the Notes will not 
be able to be converted into Common Stock by the Note Holders until June 30, 
1999 or later, effectively a five-month delay from the original terms of the 
Notes. The restructured Notes were divided into three tranches. The first 
tranche had an original principal amount of  $6 million and was convertible 
in whole or in part into Common Stock at any time, at a price that was fixed 
until June 30, 1999 ($3.54), and was subject to a potential upward adjustment 
on February 1, 1999 based on certain market formulas. As of December 31, 
1998, $1.9 million of the first tranche had been converted into Common Stock. 
The balance of the first tranche was fully converted in January 1999. The 
second tranche also has an original principal amount of $6 million and cannot 
be converted into Common Stock until June 30, 1999, at which time it becomes 
convertible in whole or in part. On June 30, 1999, the conversion price of 
the second tranche will be $6.89, which was established on February 1, 1999, 
based on certain market formulas. Subsequent to June 30, 1999, the conversion 
price of the second tranche will be determined based on other market 
formulas. The third tranche of the restructured Notes has an original 
principal amount of $12.5 million and cannot be converted into Common Stock 
until July 1, 1999. Beginning July 1, 1999, no more than 15% of the second 
and third  tranches  may  be converted  per calendar  month  at a conversion 
price formulated from market prices. Any portions of the 15% monthly amounts 
of the second and third tranches that are not converted in the relevant month 
may be rolled over for conversion in future months. If the Company called the 
second tranche of Notes  ($6 million) for redemption before February 1, 1999, 
the Note Holders would have been entitled to convert not more than 50% of 
such Notes called before the redemption occurs.  No such call was made by the 
Company prior to February 1, 1999. If the Company calls the third tranche of 
Notes ($12.5 million) for redemption before July 1, 1999, the Note Holders 
will not be entitled to convert any portion of such tranche so called. The 
Note Holders will otherwise be entitled to convert Notes called for 
redemption before the redemption occurs, at conversion prices based on market 
formulas. 

                                   12

<PAGE>

     The terms of the restructured Notes contained beneficial conversion 
features relative to the first tranche which resulted in a non-cash charge to 
earnings of $4.2 million. Future tranches of the restructured Notes may also 
have similar beneficial conversion features. Such beneficial features, if 
any, are contingent upon future events including timing of conversion and 
market prices at the time of conversion and accordingly the Company is not 
able to estimate any potential charges at this time. 

PATENTS AND PROPRIETARY RIGHTS

     It is the Company's policy to aggressively protect its investments in 
technology and marketing by filing patent and trademark applications in the 
U.S. and key foreign countries. The Company also relies on trade secrets, 
know-how, licensing opportunities, and collaborative relationships to develop 
and maintain its competitive position.
 
     As of December 1998, the Company had approximately 45 issued U.S. 
patents and about 94 foreign patents issued or allowed. These patents cover 
various aspects of transdermal technology, including transdermal patch 
formulations (such as those used in hormone replacement therapy, 
contraception, and nicotine dependence therapy) and glucose monitoring 
systems. The Company has more than 100 patent applications pending worldwide, 
including the U.S. The Company has 3 U.S. trademark registrations, with 5 
trademark applications pending; and 19 foreign trademark registrations, with 
52 trademark applications pending.

     The Company's GlucoWatch system incorporates technology developed 
in-house as well as technology licensed exclusively to the Company by the 
Regents of the University of California ("Regents"). Regents holds several 
U.S. patents covering technology for transdermal extraction of glucose and 
other analytes. Corresponding foreign patent applications are also pending or 
granted. The Company has an exclusive license worldwide under these patents. 

EMPLOYEES

     As of December 31, 1998, the Company had 143 full time employees. Of 
this total number of employees, 59 were engaged in research and development, 
including process development, 34 in scientific affairs and quality 
assurance, 29 in general administrative, and 21 in operations. None of the 
Company's employees is represented by a labor union. Cygnus has experienced 
no work stoppages and it believes its employee relations are good.
 
     The Company's success will depend in large part on the continued 
services of its scientific, managerial and manufacturing personnel. The loss 
of a significant group of key personnel could have a material adverse effect 
on the Company. The Company's success also depends upon its ability to 
continue to attract and retain other highly qualified scientific, managerial 
and manufacturing personnel. Competition for such personnel is intense. In 
this respect, the Company competes with numerous pharmaceutical and health 
care companies, as well as universities and nonprofit research organizations. 
There can be no assurance that the Company will continue to be able to 
attract and retain sufficient qualified personnel.

ITEM 2.  PROPERTIES

     Cygnus leases approximately 92,000 square feet in four buildings. Three 
are located in Redwood City, California and the fourth is located in Menlo 
Park, California. The first, approximately 38,000 square feet, is the 
headquarters building, used for laboratories and administrative offices. The 
second, approximately 21,000 square feet, is used for manufacturing, 
laboratories and support offices. The third facility, also in Redwood City, 
California, has approximately 11,000 square feet, of which approximately 
8,000 square feet are utilized for additional administrative offices. The 
fourth facility, which is located in Menlo Park, has approximately 22,000 
square feet, and is used for storage of manufacturing materials and final 
products.

     The three facilities in Redwood City are leased through 2003 with an 
option to renew at the then-prevailing market rent through 2008. The facility 
in Menlo Park is leased over a three year period ending in October 1999.

     The manufacturing facility was designed and constructed to comply with 
ISO 9002 and cGMP standards. Cygnus holds drug and medical device 
manufacturing licenses from the California Department of Health Services, has 
an application on file with the U.S. Drug Enforcement Agency for the 
manufacture of controlled drug products in this

                                    13
<PAGE>

facility, and is registered with the FDA as a drug establishment. The Company 
believes it has sufficient capacity to meet current operating requirements 
and satisfy foreseeable future demands for its current drug delivery 
products. The Company is currently establishing its commercial AutoSensor 
manufacturing operations in an existing third-party facility which complies 
with applicable regulatory requirements.

     As the Company completes the development of its products, it will begin 
evaluating its existing manufacturing plans, under which a new manufacturing 
site may become necessary.

ITEM 3.  LEGAL PROCEEDINGS

     On November 20, 1998, the American Arbitration Association issued the 
final award on the arbitration proceedings between Cygnus and Pharmacia & 
Upjohn ("Pharmacia") relating to the Nicotrol patch, Cygnus' smoking 
cessation patch. Pursuant to the findings from the arbitration proceedings, 
Cygnus was awarded $4.3 million for prevailing in some of its claims and 
Pharmacia was awarded $1.6 million for prevailing in some of its claims. 
Accordingly, Cygnus realized a net amount of $2.7 million. By way of 
background, Cygnus initiated these proceedings in May 1997 based on an 
agreement between Cygnus and Pharmacia, which provided that Pharmacia would 
be obligated to pay Cygnus for, among other things, existing inventory costs 
and certain purchase order commitments.  Pharmacia disputed their obligations 
regarding certain of the inventory costs and certain purchase order 
commitments. In March 1998, Pharmacia added a counterclaim against Cygnus in 
the arbitration, seeking approximately $1.5 million in reimbursement for an 
alleged overpayment in royalties for Nicotrol units shipped in 1996 and 1997. 
Cygnus' claim and Pharmacia's counterclaim commenced on June 15, 1998 before 
a panel of the American Arbitration Association. This final and unappealable 
decision settles all claims and counterclaims submitted to this Arbitration 
by the Parties.  See the Company's quarterly reports on Form 10-Q for the 
quarter ended March 31, 1998, June 30, 1998 and September 30, 1998, filed 
with the Securities and Exchange Commission ("SEC") on May 15, 1998, 
August 4, 1998 and November 16, 1998, respectively, and the Company's annual 
report on Form 10-K for the year ended December 31,1997, filed with the SEC 
on February 6, 1998.
 
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     A Special Meeting of Stockholders of Cygnus, Inc. was held on 
December 1, 1998. The following item was voted upon by the stockholders:

<TABLE>
<CAPTION>
                                                                           Votes
                                                  ----------------------------------------------------------
                                                                                                   Broker
                                                  Affirmative       Negative      Abstain         Non-Votes
                                                  ------------      --------      --------        ----------
<S>                                               <C>               <C>           <C>             <C>

To approve the Company's amendment of
the Restated Certificate of Incorporation to
effect a one-for-three reverse stock split
Proposal of the Company's outstanding
Common Stock as set forth in the Cygnus,           16,773,772        547,427       91,601                  0
Inc. Proxy Statement for Special Meeting of
Stockholders, dated November 10, 1998.
(For further details, see "Management's
Discussion and Analysis of Financial
Condition and Results of Operation".)
</TABLE>

                                                    14

<PAGE>

                                           EXECUTIVE OFFICERS

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

<TABLE>
<CAPTION>
NAME                           AGE            TITLE
<S>                            <C>            <C>

Neil R. Ackerman, Ph.D.        55             Senior Vice President, Research & Development

Craig W. Carlson               51             Appointed Chief Financial Officer and Senior
                                              Vice President, Finance effective December 8,
                                              1998

Gary W. Cleary, Ph.D.          56             Chairman of the Board of Directors and Chief
                                              Technical Officer

James F. Grady, Jr., Ph.D.     50             Senior Vice President, Human Resources &
                                              Administration

John C. Hodgman                45             Appointed President, Chief Executive Officer and 
                                              Director effective August 11, 1998

Stephen N. Kirnon              36             President, Drug Delivery Division

Andre S. Marion                63             Appointed Vice Chairman of the Board of
                                              Directors effective August 11, 1998

Barbara G. McClung             44             Vice President, General Counsel and appointed 
                                              Secretary effective December 8, 1998
</TABLE>

     DR. ACKERMAN joined Cygnus in May of 1994 as Vice President, Research & 
Development. In January 1997, Dr. Ackerman was promoted to 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 focused on cardiovascular and inflammatory diseases. From 
1982 to 1990, he was Research Director, Cancer and Inflammatory Diseases with 
DuPont Pharmaceuticals, responsible for leading a 100-person staff that had 
the objective of discovering therapeutics for cancer, inflammatory and 
immune-based diseases. Prior to that he was employed by Syntex Corporation 
and Pfizer, Inc. in research and management capacities. Dr. Ackerman received 
B.S. and Ph.D. degrees from the University of Maryland and completed a 
post-doctoral fellowship at Stanford University.

     MR. CARLSON was appointed Chief Financial Officer and Senior Vice 
President, Finance effective December 8, 1998.  He joined Cygnus in July 1993 
as Vice President, Corporate Communications, then became Vice President, 
Strategic Planning and Corporate Marketing. Mr. Carlson most recently served 
as Senior Vice President, Finance, with responsibilities for the finance, 
information technology and corporate communications functions at

                                     15

<PAGE>

Cygnus.  From 1988 to July 1993, he was Vice President and Group Director at 
Young & Rubicam Advertising in San Francisco. Prior to that, Mr. Carlson was 
Vice President of Campbell-Mithun Advertising. He holds a B.A. from Union 
College and an M.B.A. from Stanford University.

     DR. CLEARY, the Company's founder and Chairman of the Board of 
Directors, also served as the Company's President and Chief Executive Officer 
from its inception until July 1986. Since 1986, Dr. Cleary has served as 
Chief Technical Officer of the Company. During his professional career, Dr. 
Cleary has served as an investigator with the U.S. Food and Drug 
Administration and held research and management positions at Cutter Labs, 
Alza Corporation, Key Pharmaceuticals, Inc. and Genentech Inc. Dr. Cleary 
holds an M.B.A. in Health Sciences from the University of Miami, a Ph.D. in 
Pharmaceutical Sciences from Rutgers University and a Pharm.D. in Pharmacy 
from the University of  California, San Francisco.

     DR. GRADY joined the Company in May 1993 as Vice President, Human 
Resources. From June 1995 to September 1997, Dr. Grady also served as Vice 
President of Operations at the Company. In September 1997, he was appointed 
Senior Vice President, Human Resources and Administration. From January 1989 
to May 1993, Dr. Grady led the human resources department for a division of 
Beckman Instruments. From 1986 to January 1989, Dr. Grady held various 
positions with SmithKline Beckman (now SmithKline Beecham), including 
Director of Compensation & Organizational Development for its worldwide 
research and development business unit. He received a B.S. in Psychology and 
a Ph.D. in Education from the University of Pittsburgh.

     MR. HODGMAN was appointed President, Chief Executive Officer and 
Director in August 1998. From May 1995 to August 1998, Mr. Hodgman served as 
President, Cygnus Diagnostics, for which he was responsible for all 
commercialization efforts for the GlucoWatch monitor, and Chief Financial 
Officer. 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 Chief Financial Officer for 
Central Point Software, a personal computer and networking software company. 
Prior to that, he was the 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. KIRNON joined Cygnus in April 1993 as Director, Business Development 
and, subsequently, he was promoted to Vice President, Business Development. 
In September 1997, Mr. Kirnon was promoted to President, Drug Delivery 
Division, and he is responsible for all efforts of the Drug Delivery 
Division. Prior to joining Cygnus, Mr. Kirnon served as the National Sales & 
Marketing Manager for BioGenex, Inc. Prior to that, he held various positions 
in sales, marketing, and operations as part of the fast track management 
program for SmithKline Beecham. Mr. Kirnon holds a B.A. in Biochemical 
Sciences from Harvard University and an M.B.A. from Pepperdine University in 
General Management.

     MR. MARION, a Cygnus Director, was named Vice Chairman of Cygnus in 
August 1998. Mr. Marion founded Applied Biosystems, Inc., a supplier of 
instruments for biotechnology research, and served as President, Chief 
Executive Officer and Chairman of the Board prior to its merger with The 
Perkin-Elmer Corporation in 1993. He then served as Vice President, The 
Perkin-Elmer Corporation and President of the Applied Biosystems Division 
until his retirement in February 1995. Mr. Marion is also a director of 
Molecular Devices Corp., Applied Imaging and a private company.

     MS. McCLUNG joined the Company in January 1998 as Vice President, 
Intellectual Property. In August 1998, Ms. McClung was promoted to Vice 
President and General Counsel. Ms. McClung was also appointed Secretary, 
effective December 8, 1998. From August 1990 to January 1998, she was 
Corporate Patent Counsel at Chiron Corporation.  Prior to that she was Patent 
Counsel at DuPont.  She is a member of the California, Delaware, and 
Pennsylvania bars as well as being a registered patent attorney before the US 
Patent and Trademark Office. Ms. McClung received a JD 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.

                                    16

<PAGE>

                                     PART II


ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

     The market price for shares of the Company's Common Stock has been 
highly volatile. Factors such as the results of preclinical studies and 
clinical trials for Cygnus' products or products of its competitors, 
announcements of technological innovations, strategic relationships, new 
product introductions by the Company or its competitors, governmental 
regulation, regulatory approvals or delays or developments relating to patent 
or proprietary rights, as well as period-to-period fluctuations in financial 
results, may have a significant impact on the market price of the Common 
Stock. Additionally, in recent years, the stock market has experienced 
extreme price and volume fluctuations.

     The Company's Common Stock trades on the Nasdaq National Market tier of 
the Nasdaq Stock Market -SM- under the symbol "CYGN." The following table sets
forth, for the periods indicated, the high and low closing sale prices per 
share of the Common Stock as reported by the national market.


<TABLE>
<CAPTION>
                 1998:                         High          Low
                                               ----          ---
                <S>                            <C>           <C>

                       First Quarter           $20 5/8        $16
                       Second Quarter           13 1/2          5 25/32
                       Third Quarter            10 1/4          3 1/16
                       Fourth Quarter            6 7/8          2 5/8

                 1997:                         High           Low
                                               ----           ----

                       First Quarter          $16 5/8         $13 3/8
                       Second Quarter          17 1/4          10 5/8
                       Third Quarter           19 3/4          16
                       Fourth Quarter          24 5/8          18 3/4
</TABLE>


     As of December 31, 1998, there were approximately 557 record holders of 
the Company's Common Stock.  Cygnus has not paid any cash dividends since its 
inception and does not expect to pay any cash dividends on its Common Stock 
in the foreseeable future. In addition, the Company is precluded from paying 
any dividends under certain of its financing arrangements. 

                                       17

<PAGE>

ITEM 6.   SELECTED FINANCIAL DATA

     The selected consolidated financial data presented below are derived 
from the audited consolidated financial statements of  Cygnus, Inc. The 
financial consolidated statements as of December 31, 1998, 1997 and for each 
of the three years in the three-year period ended December 31, 1998 are 
included elsewhere herein. The selected financial data as of December 31, 
1996, 1995, and 1994 and for each of the years in the two-year period ended 
December 31, 1995, are derived from audited consolidated financial statements 
not included herein. The data should be read in conjunction with the 
consolidated financial statements and related notes, the information set 
forth under "Management's Discussion and Analysis of  Financial Conditions 
and Results of Operations" and other financial information included herein.

No dividends have been paid for any of the periods presented.

<TABLE>
<CAPTION>
                                                                       Year Ended December 31,
                                                    ---------------------------------------------------------
                                                    1998          1997         1996         1995         1994
                                                    ----          ----         ----         ----         ----
<S>                                                 <C>           <C>          <C>          <C>          <C>
                                                                (In thousands, except per share data)
CONSOLIDATED STATEMENT OF OPERATIONS DATA:

  Product revenues                                 $    587    $  4,212      $  17,211    $  3,704    $  1,917
  Contract revenues                                  10,178      14,106         13,085      12,579      14,533
  Royalty and other revenues                            890      11,184          5,907       2,723       4,820
                                                    -------      ------        -------      ------      ------
       Total revenues                                11,655      29,502         36,203      19,006      21,270

  Costs and expenses:
    Costs of products sold                            3,478      10,413         16,659       4,746       3,293
    Research and development                         32,149      22,328         23,165      20,029      21,605
    Marketing, General and
     Administrative                                  11,730       8,695          9,296       7,369       5,491
    Arbitration settlement                               --      39,666             --          --          --
    Purchase of in-process research
     and development                                     --          --             --          --       9,000
                                                    -------      ------        -------      ------      ------
       Total costs and expenses                      47,357      81,102         49,120      32,144      39,389
                                                    -------      ------        -------      ------      ------
  Loss from operations                              (35,702)    (51,600)       (12,917)    (13,138)    (18,119)
  Other income and expense                           (3,726)      1,140          1,865         296         759
                                                    -------      ------        -------      ------      ------

  Net loss                                         $(39,428)   $(50,460)      $(11,052)   $(12,842)    $(17,360)
                                                    -------      ------        -------      ------      ------
                                                    -------      ------        -------      ------      ------
  Basic and diluted net loss per share             $  (1.95)   $  (2.67)      $  (0.60)   $  (0.79)    $  (1.24)
                                                    -------      ------        -------      ------      ------
                                                    -------      ------        -------      ------      ------
     Shares used in computation of basic and
        diluted net loss per share                   20,226      18,928         18,544      16,265       13,947
                                                    -------      ------        -------      ------      ------
                                                    -------      ------        -------      ------      ------
</TABLE>

<TABLE>
<CAPTION>
                                                                       Year Ended December 31,
                                                    ---------------------------------------------------------
                                                    1998          1997         1996         1995         1994
                                                    ----          ----         ----         ----         ----
<S>                                                 <C>           <C>          <C>          <C>          <C>
                                                                             (In thousands)
CONSOLIDATED BALANCE SHEET DATA:
  Working capital                                  $ 11,542     $ 9,941       $ 36,386    $ 38,555    $ 18,041
  Total assets                                       43,454      49,277         68,798      57,854      38,116
  Long-term obligations                              60,220      33,234         13,437       8,331       7,398
  Accumulated deficit                              (175,955)   (136,527)       (86,067)   (75,015)     (62,174)
  Stockholders' equity (net capital deficiency)     (32,767)    (13,800)        31,213     38,252       18,117
</TABLE>
                                                            18

<PAGE>

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

     THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND 
UNCERTAINTIES RELATING TO THE FUTURE FINANCIAL PERFORMANCE OF CYGNUS, INC. 
("CYGNUS" OR THE "COMPANY), AND ACTUAL EVENTS OR RESULTS MAY DIFFER 
MATERIALLY. IN EVALUATING SUCH STATEMENTS, STOCKHOLDERS AND INVESTORS SHOULD 
SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED UNDER THE CAPTION "RISK 
FACTORS" CONTAINED IN THE MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL 
CONDITION AND RESULTS OF OPERATIONS WHICH COULD CAUSE ACTUAL RESULTS TO 
DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS. 
THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY RELEASE THE RESULTS OF ANY 
REVISIONS TO THESE FORWARD-LOOKING STATEMENTS WHICH MAY BE MADE TO REFLECT 
EVENTS OR CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCES 
OF UNANTICIPATED EVENTS.


GENERAL

     Cygnus is engaged in the development and manufacture of diagnostic and 
drug delivery systems, utilizing its proprietary technologies to satisfy 
unmet medical needs cost-effectively. The Company's current efforts are 
primarily focused on two core areas: a continuous and automatic glucose 
monitoring device (the GlucoWatch system) and transdermal drug delivery 
systems.

     The Company's product development efforts have been and are expected to 
continue to be either self-funded, funded by licensees or distributors, or 
both. In general, the Company's agreements provide that Cygnus will 
manufacture its products and receive manufacturing revenues from sales of 
these products to its licensees or distributors. Cygnus may also receive 
royalties based on certain of its licensees' or distributors' product sales. 
In certain circumstances, the Company may elect to license manufacturing 
rights for a product to its licensee in exchange for a technology transfer 
fee and/or a higher royalty rate.

     Cygnus' licensees and distributors generally have the right to abandon a 
product development effort at any time for any reason without significant 
penalty. Such cancellations may result in delays, suspension or abandonment 
of clinical testing, the preparation and processing of regulatory filings and 
product development and commercialization efforts. Licensees have exercised 
this right in the past, and there can be no assurance that current and future 
licensees or distributors will not exercise this right in the future. If a 
licensee or distributor were to cease funding one of the Company's products, 
Cygnus would either self-fund development efforts, identify and enter into an 
agreement with an alternative licensee or distributor or suspend further 
development work on the product. There can be no assurance that, if 
necessary, the Company would be able to negotiate an agreement with an 
alternative licensee or distributor on acceptable terms. Since all payments 
to the Company under its agreements following their execution are contingent 
on the occurrence of future events or sales levels, and the agreements are 
terminable by the licensee or distributor, no assurance can be given as to 
whether the Company will receive any particular payment thereunder or as to 
the amount or timing of any such payment. The Company may choose to self-fund 
certain research and development projects in order to exploit its 
technologies. Any increase in Company-sponsored research and development 
activities will have an immediate adverse effect on the Company's results of 
operations. However, should such Company-sponsored research and development 
activities result in a commercial product, the long-term effect on the 
Company's results of operations could be favorable. In the past some of the 
Company's licensees, distributors and collaborators have approached the 
Company requesting modification of the terms of existing agreements. The 
Company is currently involved in discussions with several companies with 
regard to a collaboration for the marketing and distribution of the 
GlucoWatch monitor in the U.S. and Europe. There can be no assurance that the 
Company will be able to enter into new collaborative arrangements.

     For the Company to remain competitive, it will need to develop, 
in-license or acquire new diagnostic and drug delivery products. Furthermore, 
the Company's ability to develop and commercialize products in the future 
will depend on its ability to enter into collaborative arrangements with 
additional licensees on favorable terms. There can be no assurance that the 
Company will be able to enter into new collaborative arrangements on such 
terms, if at all.

     The Company's results of operations vary significantly from year to year 
and depend on, among other factors, the signing of new product development 
agreements and the timing of recognizing payment amounts specified 
thereunder, the timing of recognizing license or distribution fees and cost 
reimbursement payments made by pharmaceutical licensees, and the demand for 
its products. Up-front and interim milestone payments from contracts are 
generally earned and recognized based on the percentage of actual efforts 
expended compared to total expected efforts

                                     19

<PAGE>

during the development period for each contract. However, contract revenues 
are not always aligned with the timing of related expenses. To date, research 
and development expenses have generally exceeded contract revenue in any 
particular period and the Company expects the same situation to continue for 
the next few years. In addition, the level of revenues in any given period is 
not necessarily indicative of expected revenues in future periods. In 1998 
seventy six percent of revenues recognized by the Company were attributable 
to four customers. The Company has incurred net losses each year since its 
inception and does not believe it will achieve profitability in 1999. At 
December 31, 1998, the Company's accumulated deficit and net capital 
deficiency were approximately $175.9 million and $32.8 million, respectively.

RESULTS OF OPERATIONS:

COMPARISON FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997

     PRODUCT REVENUES for the year ended December 31, 1998 were $0.6 million 
compared to $4.2 million for the year ended December 31, 1997. Product 
revenue for the year ended December 31, 1998 resulted from the shipments of 
the FemPatch system. Included in product revenue for the year ended December 
31, 1997 are the initial shipments of the FemPatch system and the final 
shipments of the Nicotrol patch. The reduction in total product revenue is 
primarily due to the discontinuation of shipments of the FemPatch system.

     Due to the discontinuation of Nicotrol patch manufacturing and the 
termination of the FemPatch system supply agreement, the Company does not 
expect any further product revenues until new products are commercialized. 
The Company does, however, expect to continue to receive royalty revenues 
from the manufacture and sale of the Nicotrol patch by the Company's 
licensee. There can be no assurance that the Company will be successful in 
its efforts to commercialize any future products.

     Due to the above factors and the uncertainty regarding when and if 
additional products will obtain approval from the FDA and when and if 
licensees will sell and market such products, the Company believes that the 
level of product revenues experienced to date is not indicative of future 
results and may fluctuate from year to year. 
 
     CONTRACT REVENUES for the year ended December 31, 1998 were $10.2 
million compared to the $14.1 million for the year ended December 31, 1997. 
Contract revenues primarily reflect labor and material cost reimbursements 
associated with the development of certain transdermal delivery systems and 
the amortization of milestone payments relating to certain transdermal 
delivery systems and the glucose monitoring device. The decrease in contract 
revenues  is primarily due to a one-time payment of $1.0 million received 
from Pharmacia & Upjohn in June 1997 for the exercise of its option to 
purchase the U.S. manufacturing rights for the Nicotrol patch, a reduction in 
clinical billings related to one of the Company's hormone replacement 
products and reduced milestone amortization related to the GlucoWatch monitor.

     In February 1996, the Company entered into an agreement with Becton 
Dickinson & Company for the marketing and distribution of the GlucoWatch 
monitor, a continuous and automatic glucose monitoring device being developed 
by Cygnus. Under the terms of the agreement, Becton Dickinson had exclusive 
worldwide marketing and distribution rights, with the exception of Japan and 
Korea. The agreement was amended in June 1997 to grant Becton Dickinson 
worldwide marketing rights, with the exception of Japan and Korea, for the 
Company's second generation glucose monitor. Cygnus retained primary 
responsibility for completing product development, obtaining regulatory 
approvals and manufacturing. In the first half of 1996, Cygnus received an 
up-front, non-refundable payment from Becton Dickinson. On March 31, 1998, 
the Company announced that the agreement it had with Becton Dickinson had 
been terminated. Consequently, the Company will not receive any future 
milestone payments under the Becton Dickinson agreement and will not be 
obligated to share future revenue, if any, associated with commercialization 
of the GlucoWatch monitor. The Company is currently involved in discussions 
with several companies with regard to collaboration for the sales and 
distribution of the GlucoWatch monitor in the U.S. and Europe. There can be 
no assurance that the Company will be able to enter into new collaborative 
arrangements.
 
     In July 1996, the Company entered into an agreement with Tokyo-based 
Yamanouchi for the marketing and distribution of the GlucoWatch monitor. 
Under the terms of this agreement, Yamanouchi has exclusive marketing and 
distribution rights in Japan and Korea. Cygnus will have primary 
responsibility for completing product development and for manufacturing. In 
the third quarter of 1996, Cygnus received an up-front, non-refundable 
payment from
                                  20
<PAGE>

Yamanouchi and is eligible to receive milestone payments as well as a 
percentage of the product's future commercial sales. In July 1996, the 
Company also entered into a development and marketing agreement with 
Yamanouchi for a 7-day transdermal product to deliver a proprietary 
Yamanouchi compound. In July 1998, Yamanouchi discontinued the agreement 
related to the 7-day transdermal product.

     In 1998, the Company entered into an agreement with Undisclosed company, 
for the development, supply and commercialization of a nicotine transdermal 
system, a smoking cessation patch being developed by Cygnus. Under the terms 
of the agreement, the Undisclosed company has marketing and distribution 
rights in certain territories. Cygnus has exclusive manufacturing and supply 
rights. The Undisclosed company has primary responsibility for obtaining 
regulatory approval and commercialization. Cygnus has received payment for 
1998 manufacturing and development costs and will receive similar future 
payments. The Company is also eligible to receive future milestone payments 
as well as a percentage of the product's future commercial success.

     In December 1998, a NDA was submitted to the FDA and the European 
Dossier has been submitted to the European authorities for the Company's 
7-day estrogen patch. In July 1998, the Company was notified by AHP, the 
licensee for two of the Company's transdermal hormone replacement products, 
that AHP wanted to discuss the status of its agreement with the Company. 
Cygnus was notified by AHP that it intended to exercise its right under the 
agreement to seek a sublicensee for these products and is now actively 
involved in doing so. AHP and Cygnus have negotiated an amendment to the 
agreement that provides Cygnus immediate ownership of the regulatory filing 
packages for the two products and the right to co-promote the two products as 
well. The amendment also provides that if AHP is unable to sign an agreement 
with a sublicensee within six months, the rights to the two products will 
revert to Cygnus and AHP will be obligated  to continue development 
activities for the two products for an additional six months. There can be no 
assurance that AHP will find a sublicensee. Furthermore, if AHP is 
unsuccessful in finding a sublicensee, it is uncertain what course of action 
the Company will take with regard to these two products, although it is 
expected the Company will seek a new collaboration for the distribution and 
marketing of the products. 

     Contract revenues are expected to fluctuate from quarter to quarter and 
from year to year, and future contract revenues cannot be reasonably 
predicted. The contributing factors to achieving contract revenues include, 
but are not limited to, future successes in finalizing new collaborative 
agreements, timely achievement of milestones under current contracts, and 
strategic decisions on self-funding certain projects. The Company is unable 
to predict to what extent the termination of existing contracts by current 
partners, or new collaborative agreements, if any, will impact overall 
contract revenues in 1999 and subsequent future periods.

     ROYALTY AND OTHER REVENUES for the year ended December 31, 1998 were 
$0.9 million, compared to $11.2 million for the year ended December 31, 1997. 
The amounts include royalties from sales by Pharmacia of the Company's 
nicotine transdermal product in Europe and Canada, and by Pharmacia's 
marketing partner in the U.S. The net decrease in royalty and other revenues 
for the year ended December 31, 1998 compared to the year ended December 31, 
1997 is primarily due to the 1996 launch in the U.S. of the non-prescription 
Nicotrol patch. The year ended December 31, 1997 included the recognition of 
previously deferred royalty payments associated with this launch, and a 
reimbursement payment from Pharmacia relating to inventory and purchase 
commitments, whereas no such revenue was included in the period ended 
December 31, 1998.
 
     Royalty revenue will fluctuate from period to period, since it is 
primarily based upon sales by the Company's licensees. The level of royalty 
income for a product also depends on various external factors, including the 
size of the market for the product, product pricing levels and the ability of 
the Company's licensee to market the product. Therefore, the level of royalty 
revenue for any given period is not indicative of the expected royalty 
revenue for future periods. 

     COSTS OF PRODUCTS SOLD for the year ended December 31, 1998, were $3.5 
million compared to $10.4 million for the year ended December 31, 1997. Costs 
of products sold primarily include direct and indirect production, facility 
and personnel costs required to meet current and future anticipated 
production levels. Costs of products sold for the period ended December 31, 
1998 include shipments of the FemPatch system. The decrease in costs of 
products sold for the period ended December 31, 1998 is primarily due to the 
reduced shipments of the FemPatch system. The Company experienced negative 
product margins for the periods ended December 31, 1998 and December 31, 1997 
due to low production volumes that prevented the Company from absorbing all 
of its fixed manufacturing costs. Because

                                         21

<PAGE>

the Company is not currently manufacturing any commercial products, the 
Company expects that fixed manufacturing costs will continue to result in 
negative product margins for the foreseeable future.

     RESEARCH AND DEVELOPMENT EXPENSES for the year ended December 31, 1998 
were $32.1 million compared to $22.3 million for the year ended December 31, 
1997. The increase in research and development expenses for the year ended 
December 31, 1998 is primarily due to the increased costs associated with the 
GlucoWatch monitor and the Autosensor in the following areas: material, 
design and scale up for development efforts, and material and outside charges 
for the accelerated level of clinical activities. Research and development and 
clinical activities primarily include support and development for the glucose 
monitoring program, the Company's hormone replacement therapy products and a 
contraception product. Cygnus does not anticipate an increase in its overall 
research and development expenses in 1999.

     MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES for the year ended 
December 31, 1998 were $11.7 million, compared to $8.7 million for the year 
ended December 31, 1997. The increase is primarily due to increased sales 
and marketing expenses related to the GlucoWatch monitor, in particular 
marketing research expenses. The Company does not expect that marketing, 
general and administrative expenses will increase in 1999.

     ARBITRATION SETTLEMENT EXPENSE for the year ended December 31, 1997 of 
$39.7 million represents a non-recurring arbitration settlement expense with 
Sanofi. As of December 31, 1998, the Company had accrued liabilities related 
to the arbitration settlement of $24.2 million. Of the total accrued 
liability of $24.2 million, $24.1 million is long-term. Under the terms of 
the settlement, Cygnus (i) paid Sanofi $14.0 million in cash in January 1998, 
(ii) will make royalty payments of between 6.5% and 8.5% of any and all net 
sales on its two hormone replacement products, which are subject to minimum 
payments in an aggregate amount equal to $17.0 million, commencing in 2001 
and ending in 2005, whether or not any net sales of the two products have 
occurred, and (iii) issued, in December 1997, a convertible promissory note 
in the principal amount of $6.0 million, payable in full at the end of four 
years and bearing interest at 6.5% per annum. The note will be convertible 
into the Company's Common Stock at Sanofi's option, exercisable at any time 
during the four year term, at a conversion rate of $21.725 per share.

     INTEREST INCOME (EXPENSE), NET OF INTEREST AND OTHER EXPENSE for the 
year ended December 31, 1998, was ($3.7) million as compared to $1.1 million 
for the year ended December 31, 1997. The decrease is due primarily to the 
$4.2 million non-cash costs of the beneficial conversion feature associated 
with the October 1998 restructuring of the 4% Senior Subordinated Convertible 
Notes, the interest expense associated with the subordinated convertible 
debt, the amortization of the financing fees related to this debt and the 
interest related to the additional long-term debt incurred in the second 
quarter of 1998. These costs were offset by a net arbitration settlement with 
Pharmacia & Upjohn from which Cygnus received $2.7 million.

COMPARISON FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1996

     PRODUCT REVENUES for the year ended December 31, 1997 were $4.2 million 
compared to $17.2 million for the year ended December 31, 1996. Included in 
product revenue, for the year ended December 31, 1997, are initial shipments 
of the FemPatch system. The reduction in total product revenue resulted from 
the discontinuation of the Nicotrol patch manufacturing in the first quarter 
of 1997.

     CONTRACT REVENUES for the year ended December 31, 1997 were $14.1 
million compared to the $13.1 million for the year ended December 31, 1996. 
Contract revenues primarily reflect labor and material cost reimbursements 
associated with certain transdermal delivery systems and the amortization of 
milestone payments relating to certain transdermal delivery systems and the 
glucose monitoring device. The increase in contract revenues is primarily due 
to a one time $1.0 million payment from Pharmacia for the exercise of its 
option to purchase the U.S. manufacturing rights for the Nicotrol patch. 

     ROYALTY AND OTHER REVENUES for the year ended December 31, 1997 were 
$11.2 million, compared to $5.9 million for the year ended December 31, 1996. 
The amounts include royalties from sales by Pharmacia of the Company's 
nicotine transdermal product in Europe and Canada and by Pharmacia's 
marketing partner in the U.S. The net increase in royalty and other revenues 
is primarily due to the recognition of previously deferred royalty payments 
associated with the U.S. over-the-counter sales of the Nicotrol patch during 
the second half of 1996 and a $2.5 million reimbursement payment from 
Pharmacia relating to inventory and purchase commitments previously expensed 
by the Company in 1996.
                                      22
<PAGE>


     COSTS OF PRODUCTS SOLD for the year ended December 31, 1997 were $10.4 
million compared to $16.7 million for the year ended December 31, 1996. Costs 
of products sold primarily include direct and indirect production, facility 
and personnel costs required to meet the production levels. The decrease in 
costs of products sold largely reflects the reduction of direct expenses 
related to the Nicotrol patch production as a result of Pharmacia exercising 
its option to purchase the manufacturing rights of the Nicotrol patch. Cost 
of products sold for the year ended December 31, 1997 include the initial 
shipments of the FemPatch system, the Company's second commercialized 
product. The Company experienced negative product margins for the year ended 
December 31, 1997 due to low production volumes which prevented the Company 
from absorbing all of its fixed manufacturing costs.

     RESEARCH AND DEVELOPMENT EXPENSES for the year ended December 31, 1997 
were $22.3 million compared to $23.2 million for the year ended December 31, 
1996. Research and development and clinical activities primarily include the 
glucose monitoring development program, the support of the Company's hormone 
replacement therapy products and a contraception product. 

     MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES for the year ended 
December 31, 1997 were $8.7 million, compared to $9.3 million for the year 
ended December 31, 1996. The decrease resulted primarily from decreased 
professional fees associated with the Company's legal proceedings involving 
Sanofi.

     INTEREST  INCOME, NET OF INTEREST AND OTHER EXPENSE for the year ended 
December 31, 1997 was $1.1 million as compared to $1.9 million for the year 
ended December 31, 1996. The decrease is due primarily to higher interest 
expense associated with the Company's June 1996, $8.0 million bank loan 
agreement for short-term working capital. In addition, interest income earned 
has decreased in conjunction with the decrease in the cash and cash 
equivalents balance. 

LIQUIDITY AND CAPITAL RESOURCES

     Overall, the cash, cash equivalents and investment balances as of 
December 31, 1998 totaled $28.8 million, representing a decrease of $6.0 
million from the total as of December 31, 1997. At December 31, 1998, the 
Company had a negative net worth of $32.8 million.

     Through December 1997, the Company received net proceeds of 
approximately $82.1 million from public offerings of its Common Stock. In 
February 1998, the Company received net proceeds of approximately $13.3 
million (net of issuance costs of approximately $0.5 million) from a direct 
public offering of its Common Stock. 

     Through 1997, the Company financed approximately $9.7 million of 
manufacturing and research equipment under capital loan and lease 
arrangements. In the second quarter of 1998, the Company entered into a new 
loan agreement for $1.4 million to finance additional capital equipment. 
Borrowings under this agreement are secured by specific Company assets.

     In April of 1998, the Company consolidated its two outstanding bank 
loans into an expanded credit facility with the same bank. An additional $4.7 
million was borrowed, increasing the total outstanding under the new 
agreement to $10.0 million. In November of 1998, the April agreement was 
further amended to modify the covenants. This balance will be repaid through 
November 2001, with monthly interest-only payments through November 1998 and 
monthly principal-and-interest installments thereafter. As of December 31, 
1998 there is $9.8 million outstanding under this agreement. Borrowings under 
this agreement are secured by specific Company assets.

     In February 1998, the Company entered into Note Purchase Agreements with 
certain institutional investors to issue and sell approximately $43 million 
of 4% Senior Subordinated Convertible Notes due 2005 (the "Notes"). On 
October 28, 1998, the Company restructured the Notes. Key provisions in the 
restructured Notes include the October 1998 repayment of $18.5 million in 
principal (reducing the principal balance from $43 million to $24.5 million), 
a delay in the convertibility of the majority of the Notes to June 30, 1999, 
modification of conversion prices of the Notes, the ability of the Company to 
redeem at par at any time all or part of the new principal amount of the 
Notes, an increase in the interest rate to 5.5% paid annually on the new 
principal balance and the change in the final maturity of the Notes to 
October 1, 2000 (see "Senior Convertible Notes" Part 1, Item I). Through 
December 31, 1998, $1.9 million of the first tranche of $6.0 million was 
converted into equity. In January 1999, the remaining  balance of $4.1 
million of the original first tranche of $6.0 million was converted into 
equity. 

                                   23

<PAGE>

      In addition to the cash received from the public offerings, issuance of 
the Notes, equipment lease and short-term working capital financing, the 
Company has been financing its operations primarily through revenues and 
interest income.

     Net cash used in operating activities for the year ended December 31, 
1998 was $42.5 million, compared with net cash used of $14.6 million for year 
ended December 31, 1997. Cash used in operating activities during the year 
ended December 31, 1998 was primarily due to the Company's net loss of $39.4 
million and a $14.0 million cash payment made in January 1998 to Sanofi under 
the terms of the arbitration settlement, offset by the non-cash beneficial 
conversion costs of $4.2 million associated with the October 1998 
restructuring of the Notes, an increase in accounts payable and other accrued 
liabilities of $2.8 million, depreciation and amortization of $1.9 million 
and amortization of debt issuance cost of $1.6 million. Cash used in 
operating activities during the year ended December 31, 1997 was primarily 
due to the Company's net loss of $50.5 million, a decrease of $10.4 million 
in deferred revenue, a decrease of $2.1 million in accounts payable and other 
accrued liabilities and an increase of $3.2 million in prepaid expenses and 
other current assets. This was offset by the $39.2 million increase in Sanofi 
obligations, decrease of $5.7 million in accounts receivable, $2.7 million of 
depreciation and amortization and an increase of $1.5 million in deferred 
compensation and other long-term liabilities. 

     The current level of cash used in operating activities is not 
necessarily indicative of the level of future cash usage. The Company expects 
a decrease in operating cash usage for 1999 primarily because the $14.0 
million payment in 1998 of the Sanofi arbitration liability will not recur in 
1999. 

     Net cash used in investing activities of $7.6 million for the year ended 
December 31, 1998 resulted primarily from net purchases of  investments of 
$4.2 million and capital expenditures of $3.4 million. Net cash used in 
investing activities of $0.8 million for the year ended December 31, 1997 
resulted primarily from $3.1 million in capital expenditures, offset by $2.3 
million in net maturity and sales of investments. 

     Net cash provided by financing activities of $39.7 million for the year 
ended December 31, 1998 includes, as mentioned above, net proceeds of $40.4 
million and $13.3 million from the Company's February 1998 issuance of Senior 
Subordinated Convertible Notes and from a direct public offering of its 
Common Stock, respectively; additional stock proceeds of $0.9 million and 
$6.1 million from the issuance of long-term debt, offset by a subordinated 
debt principal repayment of $18.5 million; and long-term debt and capital 
lease repayments of $2.0 million and $0.5 million, respectively. Net cash 
provided by financing activities of $3.0 million for the year ended December 
31, 1997 included $2.5 million from the exercise of warrants to purchase 
common stock, $2.9 million of common stock issuance proceeds and $1.3 million 
received from the Company's capital equipment loan, offset by $3.8 million in 
long-term debt and capital lease repayments. 

     The Company's long-term capital expenditure requirements will depend 
upon numerous factors, including the progress of the Company's research and 
development programs; the time required to obtain regulatory approvals; the 
resources that the Company devotes to the development of self-funded 
products, proprietary manufacturing methods and advanced technologies; the 
ability of the Company to obtain additional licensing arrangements and to 
manufacture products under those arrangements; the additional expenditures to 
support the manufacture of new products, if and when approved; and possible 
acquisitions of products, technologies and companies. As the Company 
evaluates the progress of its development projects, in particular the 
GlucoWatch system, its commercialization plans and the lead time to set up 
manufacturing capabilities, Cygnus may commence long-term planning for 
another manufacturing site. Nevertheless, the Company believes that such 
long-term planning will not result in any material impact on cash flows and 
liquidity for 1999.

     Based upon current expectations for operating losses and projected 
short-term capital expenditures, the Company believes that its existing cash, 
cash equivalents and investments of $28.8 million as of December 31, 1998, 
when coupled with cash from revenues and earnings from investments, will be 
sufficient to meet its operating expenses and capital expenditure 
requirements at least through the end of 1999. However, there can be no 
assurance that the Company will not require additional financing, depending 
upon future business strategies, results of clinical trials and management 
decisions to accelerate certain research and development programs and other 
factors.
                                            24
<PAGE>

     INCOME TAXES. At December 31, 1998, the Company had federal net 
operating loss and research and development tax credit carryforwards of 
approximately $131.0 million and $2.4 million, respectively. The Company had 
state net operating loss and tax credit carryforwards of approximately $19.8 
million and $1.9 million, respectively. These carryforwards will expire at 
various dates beginning in 1999. Because of the "change in ownership" 
provisions of the Internal Revenue Code, a substantial portion of the 
Company's net operating loss and tax credit carryforwards may be subject to 
annual limitations. The annual limitations may result in the expiration of 
net operating losses and tax credits before utilization.

YEAR 2000 COMPLIANCE

     The Company is preparing for the impact of the arrival of the Year 2000 
("Y2K")on its business, as well as on the businesses of its customers, 
suppliers and business partners. The "Y2K Issue" is a term used to describe 
the problems created by systems that are unable to accurately interpret dates 
after December 31, 1999. These problems are derived predominantly from the 
fact that many software programs have historically categorized the "year" in 
a two-digit format. The Year 2000 Issue creates potential risks for the 
Company, including potential problems in the Company's products as well as in 
the Information Technology ("IT") and non-IT systems that the Company uses in 
its business operations. The Company may also be exposed to risks from third 
parties with whom the Company interacts who fail to adequately address their 
own Y2K Issues.

     The Company began its Y2K efforts early in 1998 by forming a Project 
office chaired by the Company's Senior Vice President of Finance. The Board 
of Directors is advised periodically on the status of the Company's Y2K 
compliance program.

     The project team developed a five phase approach to identifying and 
remediating Y2K Issues. These phases are:

     1. Awareness
     2. Inventory
     3. Assessment
     4. Correction and Testing
     5. Implementation

     The Company completed the awareness phase of the project in the third 
quarter of 1998. This phase consisted of meetings with company personnel 
educating them on the issues related to Y2K. The meetings focused on internal 
systems, both IT and non-IT, as well as external systems and relationships.

     The Company engaged the services of an outside Y2K consulting service to 
perform a comprehensive inventory of internal IT and non-IT systems and 
applications. The inventory was completed during the fourth quarter of 1998.

     Concurrent with the inventory, the Company's consultant performed an 
assessment of  the systems and applications documented  in the inventory. The 
result of this independent assessment showed that the majority of the 
Company's internal IT systems were compliant. This is due to the fact that 
the Company does not rely on in-house developed applications for its core 
business applications and therefore does not have legacy code to review and 
test. The Company's core business applications, Accounts Payable, Accounts 
Receivable, Sales Orders, and Inventory Control are supported by an 
application that has been  certified by the supplier to be fully Y2K 
compliant and the compliance has been tested by the company. The assessment 
did determine that the payroll application in use was non-compliant. This was 
upgraded to a compliant version in the first quarter of 1999.

     Due to the regulatory requirements placed on the pharmaceutical and 
medical device industry by the FDA, the Company has placed appropriate 
attention on the non-IT systems. For the Company, this specifically covers 
all areas governed by current Good Manufacturing Practice ("cGMP") guidelines 
and include but are not limited to environmental monitoring/control systems, 
laboratory instrumentation and their sub-systems, production equipment, and 
materials handling equipment.  The assessment identified several of these 
non-IT systems to be non-compliant.  The majority of these non-compliant 
systems are laboratory instrumentation and their sub-systems. These systems 
are assessed to be non-mission critical. The Company fully expects that these 
systems will be upgraded, replaced or have a contingency plan in place by 
January 1, 2000.

     Concurrent with the inventory and assessment of internal systems and 
applications, the Company identified several providers of products and 
services that are critical to its operations. The Company is working with 
these providers to ensure that these critical products and services are 
available for continued operations after January 1, 2000. At this time the 
Company is not aware of any issues relating to these providers.

     The correction and testing, as well as the implementation, phases of the 
Company's Y2K compliance program are currently under way and are expected to 
be completed prior to January 1, 2000.

     The total cost associated with the Company's Y2K remediation is not 
expected to be material to the Company's financial condition or results of 
operations. The estimated total cost of the Company's Year 2000 remediation 
is not expected to exceed $500,000. Through December, 1998, the Company has 
spent approximately $100,000 in connection with Y2K Issues. The cost of 
implementing the replacement for the Company's core business applications has 
not been included in this figure since the replacement of the previous 
applications was not accelerated due to Y2K Issues. All Y2K expenditures are 
made from the respective departments' budgets. 

     Although the Company assesses its Y2K issue to be moderate to low, there 
can be no assurance that the Company will be completely successful in its 
efforts to address Y2K Issues.

     Having reasonably determined that the Company's own hardware and 
software systems will be substantially Y2K compliant, management believes 
that the worst case scenarios would most likely involve simultaneous 
Y2K-related disruptions from the Company's key customers, suppliers, service 
providers and/or other business partners. For these worst case scenarios to 
have maximum adverse impact on the Company, the vendors in question would 
either need to be sole-source providers, or their peer companies, who would 
otherwise be potential second-source suppliers, would also need to undergo 
similar Y2K-related disruption. The Company believes that such simultaneous 
disruptions of the supply of basic goods and services due to Y2K-related 
issues are unlikely to occur.

     Although the Company has not yet developed a comprehensive contingency 
plan to address situations that may result if the Company or any of the third 
parties upon which the Company is dependent is unable to achieve Y2K 
readiness, the Company's Y2K compliance program is ongoing and its ultimate 
scope, as well as the consideration of contingency plans, will continue to be 
evaluated as new information becomes available.

     The foregoing Y2K discussion contains "forward-looking statements" 
within the meaning of the Private Securities Litigation Reform Act of 1995. 
Such statements, including without limitation, anticipated costs and the 
dates by which the Company expects to complete certain actions, are based on 
management's best current estimates, which were derived utilizing numerous 
assumptions about future events, including the continued availability of 
certain resources, representations received from third parties and other 
factors. However, there can be no guarantee that these estimates will be 
achieved, and actual results could differ materially from those anticipated. 
Specific factors that might cause such material differences include, but are 
not limited to, the ability to identify and remediate all relevant IT and 
non-IT systems, results of Year 2000 testing, adequate resolution of Y2K 
Issues by businesses and other third parties who are service providers, 
suppliers or customers of the Company, unanticipated system costs, the 
adequacy of and ability to develop and implement contingency plans and 
similar uncertainties. The "forward-looking statements" made in the foregoing 
Y2K discussion speak only as of the date on which such statements are made, 
and the Company undertakes no obligation to update any forward-looking 
statement to reflect events or circumstances after the date on which such 
statement is made or to reflect the occurrence of unanticipated events.

RISK FACTORS 

     Cygnus wishes to caution stockholders and investors that the following 
important factors, among others, in some cases have affected, and in the 
future could affect, Cygnus' actual results and could cause Cygnus' actual 
consolidated results for 1999, and beyond, to differ materially from those 
expressed in any forward-looking statements made by or on behalf of Cygnus.  
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.

HISTORY OF OPERATING LOSSES; FUTURE CAPITAL REQUIREMENTS

     The Company has a limited operating history upon which its prospects can 
be evaluated.  Such prospects must be considered in light of the substantial 
risks, expenses and difficulties encountered by entrants into the medical 
device and drug delivery industry. The Company reported a net loss of $14.6 
million for the fourth quarter of 1998 and has experienced annual operating 
losses since inception. The Company expects to continue to incur operating 
losses at least until significant sales, if any, of the GlucoWatch monitor or 
the contraceptive patch (which is in phase III clinical trails and is 
currently in development with Johnson & Johnson) commence. There can be no 
assurance that the Company will generate significant revenues or achieve 
profitability. The Company has, and expects to have, fluctuations in 
quarterly results based on recognition of collaborative and contract revenues 
and expenses.  Some of these fluctuations could be significant.

     To date the Company has generated limited revenues from product sales 
and does not have significant experience in manufacturing, marketing or 
selling its products. There can be no assurance that the Company's future 
development efforts will result in commercially viable products, that the 
Company will be successful in introducing its products, or that required 
regulatory clearances or approvals will be obtained in a timely manner, or at 
all. There can be no assurance that the Company's products will ever gain 
market acceptance or that the Company will continue to generate revenues or 
achieve profitability. 

     The Company's revenues to date have been derived primarily from product 
development and licensing fees related to its products under development, as 
well as from manufacturing and royalty revenues from the Nicotrol patch and 
the FemPatch system. The Company will no longer receive manufacturing revenue 
from the Nicotrol patch or the FemPatch system. The Company will, however, 
continue to receive royalty payments for the Nicotrol patch. The Company 
expects that a substantial portion of its future revenues will be derived, if 
regulatory approvals are obtained, from sales of the GlucoWatch monitor and 
other products currently under development.

     The continued development of the Company's products will require the 
commitment of substantial resources to conduct the research, preclinical 
development and clinical trials necessary to bring such products to market 
and to establish production and marketing capabilities. The Company may seek 
additional funding through public or private financings, including debt or 
equity financings, and through other arrangements, including collaborative 
arrangements. Any additional equity financings may be dilutive to 
stockholders and debt financing, if available, may involve restrictions on 
dividends and other restrictions on the Company. Adequate funds, whether 
through financial markets or collaborative or other arrangements with 
corporate partners or from other sources, may not be available when needed 
or, if available, on terms acceptable to the Company.  Lack of sufficient 
additional funds may require the Company to delay, scale back or eliminate 
some or all of its research and product development programs or to license 
others to commercialize products or technologies that the Company would 
otherwise seek to develop itself.
                                     25
<PAGE>

      The Company believes that its existing cash, cash equivalents and 
investments, when coupled with cash from revenues and earnings from 
investments, will be sufficient to meet its operating expenses, dept 
repayment and capital expenditure requirements at least through 1999. The 
amounts and timing of expenditures will depend on the progress of ongoing 
research and development, the results of preclinical testing and clinical 
trials, the rate at which operating losses are incurred, the execution of any 
development and licensing agreements with corporate partners, the Company's 
development of products, the FDA regulatory process and other factors, many 
of which are beyond the Company's control.

DEPENDENCE ON LICENSEES, DISTRIBUTORS AND COLLABORATIVE ARRANGEMENTS

     The Company's business strategy for the development, clinical testing, 
regulatory approval, manufacturing and commercialization of its products 
depends, in large part, upon the Company's ability to selectively enter into 
and maintain collaborative arrangements with licensees and distributors. If 
the GlucoWatch monitor is commercialized, the Company will be dependent upon 
Yamanouchi Pharmaceutical Co., Ltd. for marketing and distribution of the 
GlucoWatch monitor in Japan and Korea. The Company does not currently have 
any marketing or distribution agreements for the GlucoWatch monitor other 
than the Yamanouchi collaboration. However, the Company is currently involved 
in discussions with several companies with regard to the collaboration for 
the sales and distribution of the GlucoWatch monitor in the U.S. and Europe. 
The Company's licensees and distributors generally have the right to 
terminate a product development effort at any time prior to regulatory 
approval for any reason without significant penalty. Such cancellations may 
result in delays, suspension or abandonment of clinical testing, the 
preparation and processing of regulatory filings and product development and 
commercialization efforts. Licensees have exercised this right in the past, 
and there can be no assurance that current and future licensees or 
distributors will not exercise this right in the future. 

     Since all payments to the Company under its licensing and distribution 
agreements following their execution are contingent on the occurrence of 
future events or sales levels, and the agreements are terminable by the 
licensee or distributor, no assurance can be given as to whether the Company 
will receive any particular payment thereunder or as to the amount or timing 
of any such payment. In the past some of the Company's licensees, 
distributors and collaborators have approached the Company requesting 
modification of the terms of existing agreements.  If a licensee or 
distributor were to cease funding one of the Company's products, Cygnus would 
either self-fund development efforts, identify and enter into an agreement 
with an alternative licensee or distributor, or suspend further development 
work on the product. Additionally, the Company may choose to self-fund 
certain research and development projects in order to exploit its 
technologies. However, should such Company-sponsored research and development 
activities result in a commercial product, the long-term effect on the 
Company's results of operations could be favorable. There can be no assurance 
that, if necessary, the Company would be able to negotiate an agreement with 
an alternative licensee or distributor on acceptable terms. Any increase in 
Company-sponsored research and development or sales and marketing activities 
will have an immediate adverse effect on the Company's results of operations.

     Furthermore, the resources and attention a licensee or distributor 
devotes to a product are not within the Company's control.  As a result, 
there may be delays in clinical testing, the preparation and processing of 
regulatory filings and commercialization efforts conducted by the Company's 
licensees or distributors.  There can be no assurance that one or more of the 
Company's licensees or distributors will not, for competitive reasons, 
support, directly or indirectly, a company or product that competes with the 
Company's product that is the subject of its license or distributor agreement 
with the Company.  Furthermore, any dispute between the Company and one of 
its licensees or distributors might require the Company to initiate or defend 
against expensive litigation or arbitration proceedings.

     Any termination of any license or distributor arrangement by one of the 
Company's licensees or distributors, any inability of a licensee or 
distributor to fund or otherwise satisfy its obligations under its 
arrangements with the Company and any significant dispute with or breach of a 
contractual commitment by a licensee or distributor would likely require the 
Company to seek and reach agreement with another licensee or distributor or 
to assume, to the extent possible and at its own expense, all the 
responsibilities being undertaken by the licensee or distributor. There can 
be no assurance that the Company would be able to reach agreement with a 
replacement licensee or distributor. If the Company were not able to find a 
replacement licensee or distributor, there can be no assurance that the 
Company would be able to perform or fund the activities for which such 
licensee or distributor is currently responsible. Even if the Company were 
able to perform and fund these activities, the Company's capital requirements 
would increase substantially. In addition, the further development and the 
clinical testing, regulatory approval process, marketing,

                               26

<PAGE>

distribution and sale of the product covered by such licensee or distributor 
would be significantly delayed. (See "Risk Factors -- Limited Marketing and 
Sales Experience.")

     For the Company to be competitive, it will need to develop, in-license 
or acquire new diagnostic and drug delivery products. Furthermore, the 
Company's ability to develop and commercialize products in the future will 
depend, in part, on its ability to enter into collaborative arrangements with 
additional licensees on favorable terms. There can be no assurance that the 
Company will be able to enter into new collaborative arrangements on such 
terms, if at all. Additionally, there can be no assurance that existing or 
future collaborative arrangements will be successful.

     Any of the foregoing circumstances could have a material adverse effect 
upon the Company's business, financial condition, and results of operations.

DEPENDENCE ON LICENSED PATENT APPLICATIONS AND PROPRIETARY TECHNOLOGY

     The Company's success depends in large part on its ability to obtain 
patent protection for its products, preserve its trade secrets and operate 
without infringing the proprietary rights of others, both in the U.S. and in 
other countries. Patent applications in the U.S. are maintained in secrecy 
until patents are issued, and since publication of discoveries in the 
scientific or patent literature tends to lag behind actual discovery by 
several months, Cygnus cannot be certain that it was the first to file patent 
applications on such inventions or that it will not infringe third party 
patents once issued. No assurance can be made that patents will be issued 
with respect to any of the Company's patent applications or that any patents 
will provide competitive advantages for its products or will not be 
challenged or circumvented by competitors. Cygnus also relies on trade 
secrets and proprietary know-how that it seeks to protect, in part, by 
confidentiality agreements with its licensees, employees and consultants. 
There can be no assurance that these agreements will not be breached, that 
the Company would have adequate remedies for any breach or that the Company's 
trade secrets will not otherwise become known or be independently developed 
by its competitors.

     Any litigation, in the U.S. or abroad, as well as foreign opposition 
and/or domestic interference proceedings, could result in substantial expense 
to the Company and significant diversion of effort by the Company's technical 
and management personnel. Litigation may be necessary to enforce patents 
issued to the Company or to protect trade secrets or know-how owned by the 
Company as well at to defend against infringement charges. A negative 
determination in such proceedings in which the Company is a party could 
subject the Company to significant liabilities to third parties or require 
the Company to seek licenses from third parties. Although patent and 
intellectual property disputes in the pharmaceutical product area have often 
been settled through licensing or similar arrangements, costs associated with 
such arrangements may be substantial and could include ongoing royalties. 
Furthermore, there can be no assurance that necessary licenses would be 
available to the Company on satisfactory terms, if at all. Accordingly, an 
adverse determination in a judicial or administrative proceeding or failure 
to obtain necessary licenses could prevent the Company from manufacturing and 
selling certain of its products, which would have a material adverse effect 
on the Company.

HIGHLY LEVERAGED; ABILITY TO SERVICE DEBT

     As of December 31, 1998, the Company had indebtedness of $59.5 million, 
including a balance of $22.6 million remaining on its Notes. Through December 
31, 1998 $1.9 million of the first tranche of $6.0 million was converted into 
equity. In January 1999, the remaining  balance of $4.1 million of the 
original first tranche of $6.0 million was converted into equity. The degree 
to which the Company is leveraged could materially and adversely affect the 
Company's ability to obtain financing for working capital, acquisitions or 
other purposes and could make it more vulnerable to industry downturns and 
competitive pressures. The Company's ability to meet its debt service 
obligations will be dependent upon the Company's future performance, which 
will be subject to financial, business and other factors affecting the 
operations of the Company, many of which are beyond its control. Although the 
Company believes its cash flows will be adequate to meet its interest 
payments, there can be no assurance that the Company will continue to 
generate cash flows in the future sufficient to cover its fixed charges or to 
permit the Company to satisfy any redemption obligations pursuant to the 
Notes (see below). If the Company is unable to generate cash flows in the 
future sufficient to cover its fixed charges or to permit the Company to 
satisfy any redemption obligations pursuant to the Notes, and the Company is 
unable to borrow sufficient funds either under its credit facilities or from 
other sources, it may be required to refinance all or a portion of its 
existing debt, to sell all or a portion of its assets, or to sell equity

                                       27

<PAGE>


securities. There can be no assurance that a refinancing would be possible, 
nor can there be any assurance as to the timing of any asset sales or sales 
of equity securities or the proceeds which the Company could realize 
therefrom. 

     The Notes are subordinate in right of payment to all existing and future 
Senior Debt (as defined in the First Supplemental Indenture). By reason of 
such subordination of the Notes, in the event of insolvency, bankruptcy, 
liquidation, reorganization, dissolution or winding up of the business of the 
Company or upon default in payment with respect to any Senior Debt of the 
Company or an event of default with respect to such indebtedness resulting in 
the acceleration thereof, the assets of the Company will be available to pay 
the amounts due on the Notes only after all Senior Debt of the Company has 
been paid in full. Moreover, holders of Common Stock would only receive the 
assets remaining after payment of all indebtedness and preferred stock, if 
any.

     The Notes are obligations exclusively of the Company. Although the 
Company does not currently conduct operations through subsidiaries, it may 
elect to do so as products become commercialized. In such event, the cash 
flow and the consequent ability to service debt, including the Notes, of the 
Company, will be partially dependent upon the earnings of its subsidiaries 
and the distribution of those earnings to, or upon loans or other payments of 
funds by those subsidiaries to, the Company. The payment of dividends and the 
making of loans and advances to the Company by its subsidiaries would be 
subject to statutory or contractual restrictions, would be dependent upon the 
earnings of those subsidiaries and would be subject to various business 
considerations.  Any right of the Company to receive assets of any of its 
subsidiaries upon their liquidation or reorganization (and the consequent 
right of the holders of the Notes [the "Holder(s)"] to participate in those 
assets) would be effectively subordinated to the claims of that subsidiary's 
creditors (including trade creditors), except to the extent that the Company 
is itself recognized as a creditor of such subsidiary, in which case the 
claims of the Company would still be subordinate to any security interests in 
the assets of such subsidiary and any indebtedness of such subsidiary senior 
to that held by the Company. Under certain circumstances, including the 
delisting of the Company's securities from the Nasdaq National Market, each 
holder of Notes will have the right, at the Holder's option, to require the 
Company to repurchase all or a portion of such Holder's Notes at a purchase 
price equal to 110% of the principal amount thereof plus accrued interest 
thereon to the repurchase date. 

LIMITED MARKETING AND SALES EXPERIENCE

     The Company has limited experience in marketing or selling medical 
device products. In order to successfully market and sell the GlucoWatch 
monitor or the Company's other products under development, the Company must 
either develop a more extensive marketing and sales force or enter into 
arrangements with third parties to market and sell such products. There can 
be no assurance that the Company will be able to successfully develop a more 
extensive marketing and sales force or that it will be able to enter into 
marketing and sales agreements with third parties on acceptable terms, if at 
all. If the Company maintains its own marketing and sales capabilities, it 
will compete with other companies that have experienced and well-funded 
marketing and sales operations. If the Company enters into a marketing 
arrangement with a third party for the marketing and sales of the Company's 
products, any revenues to be received by the Company from such products will 
be dependent on the third party, and the Company will likely be required to a 
pay a sales commission or similar amount to such party.

PRODUCT LIABILITY

     The design, development, manufacture and use of the Company's products 
involve an inherent risk of product liability claims and associated adverse 
publicity. Producers of medical products may face substantial liability for 
damages in the event of product failure or if it is alleged that the product 
caused harm. The Company currently maintains product liability insurance. 
Such insurance is expensive and difficult to obtain and may not be available 
in the future on acceptable terms or at all. There can be no assurance that 
the Company will not be subject to product liability claims, that the 
Company's current insurance would cover such claims, or that adequate 
insurance will continue to be available on acceptable terms to the Company in 
the future. In the event the Company is held liable for damages in excess of 
the limits of its insurance coverage, or if any claim or product recall 
results in significant adverse publicity against the Company, the Company's 
business, financial condition and results of operations could be materially 
and adversely affected.

ATTRACTING AND RETAINING KEY EMPLOYEES

                                28

<PAGE>

     The Company's ability to operate successfully and manage its potential 
future growth depends in significant part upon the continued service of 
certain key scientific, technical, managerial and finance personnel, and its 
ability to attract and retain additional highly qualified scientific, 
technical, managerial and finance personnel. The Company faces intense 
competition for qualified personnel in these areas, many of whom are often 
subject to competing employment offers, and there can be no assurance that 
the Company will be able to attract and retain such personnel. The loss of 
key personnel or inability to hire and retain additional qualified personnel 
in the future could have a material adverse effect on the Company's business, 
financial condition and results of operations.

VOLATILITY OF STOCK PRICE

     The trading price of the Company's Common Stock is subject to 
substantial fluctuations in response to factors such as announcements by the 
Company or its competitors of results of regulatory approval filings or 
clinical trials or testing, developments or disputes governing proprietary 
rights, technological innovations or new commercial products, government 
regulatory action, general conditions in the medical technology industry, 
changes in securities analysts' recommendations, or other events or factors, 
many of which are beyond the Company's control. In addition, the stock market 
in general has experienced extreme price and volume fluctuations in recent 
years which have particularly affected the market prices of many medical 
technology companies and which have been unrelated to the operating 
performance of such companies.  Fluctuations or decreases in the trading 
price of the Company's Common Stock may adversely affect the market for the 
Company's Common Stock. In the past, following periods of volatility in the 
market price for a company's securities, securities class action litigation 
often has been instituted.  Such litigation could result in substantial costs 
and a diversion of management attention and resources, which could have a 
material adverse effect on the Company's business, financial condition and 
operating results.

ABSENCE OF DIVIDENDS

     The Company has never declared or paid cash dividends on its Common 
Stock. The Company's current bank term loan precludes it from paying 
dividends to stockholders. The Company currently intends to retain any 
earnings for use in its business and therefore does not anticipate paying any 
dividends in the future.

NO REVERSE STOCK SPLIT FOR THE COMPANY; NASDAQ CONTINUED LISTING REQUIREMENTS 
ACHIEVED

     On September 30, 1998, the Company received correspondence from Nasdaq 
stating that the Company was not in compliance with the minimum bid price 
requirement for continued listing on the Nasdaq National Market. The Company 
subsequently demonstrated compliance with the New Nasdaq Listing Requirements 
by maintaining a $5.00 minimum closing bid price for the required number of 
consecutive trading days. 

     In January 1999, the Company announced that there will be no reverse 
stock split of the Company's common stock. Nasdaq notified the Company on 
January 27, 1999 that it had been found to be in compliance with the bid 
price requirement as well as all other requirements necessary for continued 
listing on the Nasdaq National Market. The Company had received approval from 
shareholders, in December 1998, for a three-for-one reverse stock split as a 
solution if there was no other recourse in complying with the continued 
listing requirements for the Nasdaq National Market; however, the Company has 
no current plans to implement the stock split at this time.
 


                                       29
<PAGE>


ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

INTEREST RATE RISK

     The Company's exposure to market risk for changes in interest rates 
relates primarily to the Company's investment portfolio and long-term debt 
obligations. The Company does not use derivative financial instruments in its 
investment portfolio. The Company places its investments with high credit 
quality issuers and, by policy, limits the amount of credit exposure to any 
one issuer.  As stated in its policy, the Company is averse to principal loss 
and ensures the safety and preservation of its invested funds by limiting 
default risk, market risk and reinvestment risk.

     The Company mitigates 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.

     The Company has no cash flow exposure due to rate changes for its $22.6 
million Notes or for the $8.9 million of other liabilities with fixed rates. 
The Company also has no cash flow exposure due to the rate change for certain 
long-term portions of Company's arbitration obligations as such obligations 
are not interest bearing. The Company does have cash flow exposure on its 
$9.8 million bank term loan due to its variable pricing. The Company 
primarily enters into debt obligations to support general corporate purposes 
including capital expenditures and working capital needs.

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

<TABLE>
<CAPTION>
   (dollars in thousands)             1999        2000       2001       Total      Fair Value
                                      ----        ----       ----       -----      ----------
<S>                                  <C>          <C>        <C>        <C>        <C>
   ASSETS:

     Cash & Cash equivalents
      Fixed                        $  5,305       ---        ---       $  5,305     $  5,305
      Average rate                     4.49%      ---        ---           4.49%         ---
</TABLE>
                                               30
<PAGE>

<TABLE>
<S>                                  <C>          <C>        <C>        <C>        <C>

     Variable rate                 $  3,961       ---        ---       $  3,961     $  3,961
     Average rate                      4.92%      ---        ---           4.92%         ---

   Short-term investments
     Fixed                         $ 14,979       ---        ---       $ 14,979     $ 14,982
     Average rate                      5.44%      ---        ---           5.44%         ---

   Long-term investments
     Fixed                              ---   $ 3,613        ---       $  3,613     $  3,622
     Average rate                       ---       5.7%       ---            5.7%         ---

   Total investments
     Securities                    $ 24,245   $ 3,613        ---        $ 27,858    $ 27,870
     Average rate                      5.15%      5.7%       ---            5.63%        ---

LIABILITIES:

Total long-term debt, including
     current portion
   Senior Subordinated
     Convertible Notes                  ---   $ 22,563       ---         $ 22,563   $ 22,563
     Fixed                              ---        5.5%      ---              5.5%       ---

   Other
    Fixed                          $  1,357   $  1,183   $ 6,358         $  8,898   $  8,898
    Average rate                      11.05%     11.27%     6.77%            8.02%       ---

    Variable rate                  $  2,500   $  2,708   $  4,583        $  9,791   $  9,791
    Average rate                       8.75%      8.75%      8.75%           8.75%       ---
</TABLE>

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The consolidated financial statements for the years ended December 31, 
1998, 1997 and 1996 are incorporated herein by reference and submitted as a 
separate section of this Form 10-K. (See Item 14.)

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

     Not Applicable.



                                        31

<PAGE>


                                         PART III


ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     Cygnus incorporates by reference the information concerning its 
directors set forth under the heading "Proposal One -- Re-Election of 
Directors" in the Company's definitive Proxy Statement with respect to 
Cygnus' 1999 Annual Meeting of Stock Holders to be filed with the Securities 
and Exchange Commission within 120 days of December  31, 1998 (the "Proxy 
Statement").

     Information concerning Cygnus' executive officers appears at the end of 
Part I of this report.

ITEM 11.  EXECUTIVE COMPENSATION

     Cygnus incorporates by reference the information set forth under the 
heading  "Executive Compensation and Other Information" in the Company's 
definitive Proxy Statement to be filed pursuant to Regulation 14A for its 
1999 Annual Meeting of Stockholders.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     Cygnus incorporates by reference the information set forth under the 
heading  "Security Ownership of Certain Beneficial Owners and Management" in 
the Company's definitive Proxy Statement to be filed pursuant to Regulation 
14A for its 1999 Annual Meeting of Stockholders.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     Cygnus incorporates by reference the information set forth under the 
headings "Proposal One -- Re-Election of Directors" and "Executive 
Compensation and Other Information" in the Company's definitive Proxy 
Statement to be filed pursuant to Regulation 14A for its 1999 Annual Meeting 
of Stockholders.



                                       32

<PAGE>


                                      PART IV

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

<TABLE>
<CAPTION>
a.1)      FINANCIAL STATEMENTS AND REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS                          Page
                                                                                                              -----
<S>                                                                                                           <C>
          Report of Ernst & Young LLP, Independent Auditors .................................................  F-3
          Consolidated Balance Sheets as of December 31, 1998 and 1997 ......................................  F-4
          Consolidated Statements of Operations for the years ended 
                  December 31, 1998, 1997 and 1996 ..........................................................  F-5
          Consolidated Statement of Stockholders' Equity/(net capital deficiency) for the years ended
                  December 31, 1998, 1997 and 1996 ..........................................................  F-6
          Consolidated Statements of Cash Flows for the years ended
                  December 31, 1998, 1997 and 1996 ..........................................................  F-7
          Notes to Consolidated Financial Statements ........................................................  F-8

a.2)      FINANCIAL STATEMENT SCHEDULE

          II.  Valuation and Qualifying Accounts ............................................................  S-1
</TABLE>

          All other schedules have been omitted since the required information
          is not present or is not present in amounts sufficient to require 
          submission of the schedule, or because the information required is 
          included in the consolidated financial statements, including the notes
          thereto.

b)        REPORTS ON FORM 8-K

          The Company has recently filed three Current Reports on Form 8-K.

          On October 28, 1998, the Company filed a Current Report on Form 8-K 
          reporting under Item 5 that the Company publicly announced its
          earnings for the quarter ended September 30, 1998.

          On October 30, 1998, the Company filed a Current Report on Form 8-K 
          reporting under Item 5 the restructuring of the Company's 4% Senior 
          Subordinated Convertible Notes due 2005.

          On December 3, 1998, the Company filed a Current Report on Form 8-K 
          reporting under Item 5 that it is to receive $2.726 million from 
          arbitration proceedings against Pharmacia & Upjohn.

c)       EXHIBITS

         The following exhibits are filed herewith or incorporated by reference:

3.1      Bylaws of the Registrant, as amended, incorporated by reference to 
         Exhibit 3.3 of the Registrant's Registration Statement Form S-1 
         No. 33-38363.
3.2      Restated Articles of Incorporation of the Registrant, as amended to 
         date, incorporated by reference to Exhibit 3.4 of the Registrant's 
         Registration Statement Form S-1 No. 33-38363.
4.1      Specimen of Common Stock certificate of the Registrant, incorporated by
         reference to Exhibit 4.1 of the Registrant's Registration Statement 
         Form S-1 No. 33-38363.
4.2      Rights Agreement dated September 21, 1993 between the Company and 
         Chemical Trust Bank of California (the "Transfer Agent"), which 
         includes the Certificate of Determination for the Series A Junior 
         Participating Preferred Stock as Exhibit A, the form of Right 
         Certificate as Exhibit B and the Summary of Rights to purchase 
         Preferred Shares as Exhibit C, incorporated by reference to Exhibit I
         of the Registrant's Form 8-A filed on October 21, 1993, Registration 
         No. 0-18962.

                                          33

<PAGE>

4.3      Form of Senior Indenture incorporated herein by reference to 
         Exhibit 4.1 filed with the Company's Registration Statement on Form S-3
         (File No. 33-39275) declared effective by the Securities and Exchange
         Commission on November 12, 1997 (the "November 1997 Form S-3").
4.4      Form of Subordinated indenture incorporated herein by reference to 
         Exhibit 4.2 filed with the Company's November 1997 Form S-3.
4.5      Form of Senior Debt Security (included in Exhibit 4.1) incorporated 
         herein by reference to Exhibit 4.3 filed with the Company's November 
         1997 Form S-3.
4.6      Form of Subordinated Debt Security (included in Exhibit 4.2) 
         incorporated herein by reference to Exhibit 4.4 filed with the 
         Company's November 1997 Form S-3.
4.7      First Supplemental Indenture dated as of February 2, 1998 by and 
         between Cygnus, Inc. and State Street Bank and Trust Company of 
         California, N.A. Incorporated by reference to Exhibit 4.5 of the 
         Company's Form 8-K dated February 4, 1998.
4.8      Second Supplemental Indenture, dated as of October 28, 1998, by and
         between Cygnus, Inc. and State Street Bank and Trust Company of 
         California, N.A., to the Indenture dated as of February 3, 1998 and
         the First Supplemental Indenture dated as of February 3, 1998, 
         incorporated by reference to Exhibit 4.8 of the Company's Form 8-K 
         filed on October 30, 1998.
4.9      First Amendment to the Rights Agreement dated October 26, 1998 between
         the Company and ChaseMellon Shareholder Services, L.L.C. (the "Rights
         Agent" successor to Chemical Trust), incorporated by reference to 
         Exhibit 99.1 of the Registrant's Form 8-A/A filed on December 14, 1998,
         Registration No. 0-18962.
4.10     Amended and Restated Rights Agreement dated October 27, 1998 between
         the Company 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 Right 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 8A/A filed on 
         December 14, 1998, Registration No. 0-19962.
10.1     Warrant dated September 28, 1990 issued by the Registrant to Paine 
         Webber R&D Partners II, L.P., incorporated by reference to Exhibit 10.5
         of the Registrant's Registration Statement Form S-1 No. 33-38363.
10.2     Agreement dated October 1, 1992 between the Registrant and Kabi
         Pharmacia, incorporated by reference to Exhibit 19.1 of the 
         Registrant's Form 10-Q for the quarter ended September 30, 1992, 
         Registration No. 0-18962.
10.3     Amended August 29, 1986 Agreement dated as of May 30, 1988 between the
         Registrant and Sanofi S.A. ("Sanofi"), incorporated by reference to 
         Exhibit 10.9A of the Registrant's Registration Statement Form S-1 
         No. 33-38363.
10.4     Amendment No. 1 made as of May 4, 1990 to the Amended August 29, 1986 
         Agreement between the Registrant and Sanofi, incorporated by reference
         to Exhibit 10.9B of the Registrant's Form S-1 Registration Statement 
         No. 33-38363.
10.5     Amendment No. 2 made as of August 31, 1990 to the Amended August 29,
         1986 Agreement between the Registrant and Sanofi, incorporated by 
         reference to Exhibit 10.9C of the Registrant's Form S-1 Registration
         Statement No. 33-38363.
10.6     Supply Agreement dated September 28, 1990 between the Registrant and
         Warner-Lambert Company, incorporated by reference to Exhibit 10.12 of
         the Registrant's Form S-1 Registration Statement No. 33-38363.
10.7     Agreement dated November 29, 1990 between the Registrant and 
         Warner-Lambert Company, incorporated by reference to Exhibit 10.13 of
         the Registrant's Form S-1 Registration Statement No. 33-38363.
10.8     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 Registration Statement No. 33-38363.
10.9     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 Registration Statement No. 33-38363.
10.10    Sublease Agreement dated June 12, 1990 between the Registrant and M&T
         Publishing, Inc., incorporated by reference to Exhibit 10.28 of the 
         Registrant's Form S-1 Registration Statement No. 33-38363.
10.11    Letter Agreement dated December 18, 1991 between the Registrant and 
         Menlo Capital Corporation, incorporated by reference to Exhibit 10.33
         of the Registrant's Form S-1 Registration Statement No. 33-45180.

                                     34

<PAGE>

10.12    Lease Agreement dated as of October 15, 1991 between the Registrant 
         and Lincoln Menlo Associates Limited, a California Limited Partnership,
         incorporated by reference to Exhibit 10.34 of the Registrant's Form S-1
         Registration Statement No. 33-45180.
10.13    Services Agreement made as of April 6, 1990 between the Registrant and
         DepoMed Systems, Inc., incorporated by reference to Exhibit 10.35 of 
         the Registrant's Form S-1 Registration Statement No. 33-45180. 10.14
10.14    Loan and Security Agreement dated June 26, 1992 between the Registrant
         and AT&T Commercial Finance Corporation. Incorporated by reference to 
         Exhibit 10.30 of the Registrant's Form 10-K for the fiscal year ended 
         December 31, 1993.
*10.15   Distributorship Agreement dated as of February 9, 1996 between the 
         Registrant and Becton Dickinson. Incorporated by reference to 
         exhibit 10.1 of the Company's Form 10-Q for the quarter ended 
         March 31, 1996.
*10.16   Agreement dated November 11, 1993 between the Registrant and Kabi 
         Pharmacia (the "Kabi Agreement") Incorporated in reference to 
         exhibit 10.33 of the Company's Form 10-K for the fiscal year ended  
         December 31, 1993.
*10.17   Development, Supply and License Agreement dated December 28, 1993 
         between the Registrant and Wyeth-Ayerst, a division of American Home 
         Products (the "U.S. Agreement") Incorporated by reference to 
         exhibit 10.34 of the Company's Form 10-K for the fiscal year ended 
         December 31, 1993.
*10.18   Development, Supply and License Agreement dated December 28, 1993 
         between the Registrant and Wyeth-Ayerst, a division of American Home
         Products (the "International Agreement") Incorporated by reference to
         exhibit 10.35 of the Company's Form 10-K for the fiscal year ended 
         December 31, 1993.
*10.19   Loan and Security Agreement between the Registrant and Silicon Valley
         Bank entered into as of June 24, 1996. Incorporated by reference to 
         exhibit 10.1 of the Company's Form 10-Q for the quarter ended 
         June 30, 1996.
10.20    Product Development, Supply and License Agreement dated June 8, 1994 
         between the Registrant and Ortho Pharmaceutical Corporation, a division
         of Johnson & Johnson. Incorporated by reference to exhibit 10.35 of the
         Company's Form 10-Q for the quarter ended June 30, 1994.
10.21    Agreement dated November 22, 1994, between the Registrant and Kabi 
         Pharmacia (the "Kabi" Agreement). Incorporated by reference to  
         exhibit 10.39 of the Company's Form 10-K for the fiscal year ended 
         December 31, 1994.
10.22    Loan and Security Agreement between Silicon Valley Bank and Registrant
         entered into as of December 21, 1994. Incorporated by reference to 
         exhibit 10.40 of the Company's Form 10-K for the fiscal year ended 
         December 31, 1994.
10.23    GMS Technology Purchase Agreement dated December 30, 1994, between the
         Registrant and Paine Webber. Incorporated by reference to exhibit 10.41
         of the Company's Form 10-K for the fiscal year ended December 31, 1994.
10.24    Lease Agreement dated January 18, 1995, between the Registrant and 
         Comdisco for $4.5 million. Incorporated by reference to exhibit 10.42 
         of the Company's Form 10-K for the fiscal year ended December 31, 1994.
*10.25   Product Supply and Distribution Agreement between the Registrant and
         Yamanouchi Pharmaceutical Co., LTD. dated as of July 14, 1996. 
         Incorporated by reference to exhibit 10.1 of the Company's Form 10-Q 
         for the quarter ended June 30, 1996.
10.26    Loan and Security Agreement dated June 27, 1997 between Heller 
         Financing and Registrant.
10.27    Form of Note Purchase Agreement dated as of February 2, 1998 between 
         Cygnus, Inc. and certain institutional investors. Incorporated by 
         reference to Exhibit 10.28 of the Company's Form 8-K dated 
         February 4, 1998.
10.28    Form Common Stock Purchase Agreement dated February 2, 1998 between 
         Cygnus, Inc. and certain institutional investors. Incorporated by 
         reverence to exhibit 10.29 of the Company's Form 8-K dated 
         February 4, 1998.
10.29    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).
10.30    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).
*10.31   Amendment Agreement to Development, Supply and License Agreement dated
         November 17, 1998 between the Registrant and Wyeth-Ayerst, a division
         of American Home Products Corporation, a Delaware corporation.
*10.32   Supply and Development Agreement dated May 21, 1998 between the 
         Registrant and Undisclosed.
                                      35
<PAGE>

*10.33   Amendment No. 1 to Supply and Development Agreement dated August 21,
         1998 between the Registrant and Undisclosed
*10.34   Supply Agreement dated June 19, 1998 between the Registrant and E.I.
         du Pont de Nemours & Co., a Delaware corporation.
*10.35   Detection of Analytes Product Development and License Agreement dated
         June 19, 1998 between the Registrant and E.I. du Pont de Nemours & Co.,
         a Delaware corporation.
10.36    Amended and Restated Loan and Security Agreement between the Registrant
         and Silicon Valley Bank entered into as of April 30, 1998, incorporated
         by reference to exhibit 10.45 of the Company's Form 10-Q for the 
         quarter ended September 30, 1998.
10.37    Press Release, dated November 25, 1997, issued by Cygnus, Inc. 
         announcing the results of research clinical studies. Incorporated by 
         reference to exhibit 99.1 of the Company's Form 8-K dated December 25,
         1997.
10.38    Press Release, dated November 25, 1997, issued by Cygnus, Inc. 
         announcing a proposed public offering of convertible subordinated 
         notes. Incorporated by reference to exhibit 99.2 of the Company's 
         Form 8-K dated December 25, 1997.

         EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS

10.39   1994 Stock Option / Award Plan, incorporated by reference to 
        Exhibit 99.1 of the Registrant's Form S-8 Registration Statement 
        No. 333-18357, filed December 20, 1996.
10.40   Amended 1991 Employee Stock Purchase Plan incorporated by reference
        to Exhibit 99.2 of the Registrant's Form S-8 Registration Statement 
        No. 333-18357, filed December 20, 1996.
10.41   Form of Indemnification Agreement for Directors and Officers, 
        incorporated by reference to Exhibit 10.29 of the Registrant's 
        Form S-1 Registration Statement No. 33-38363.
10.42   1991 Bonus Plan for Director-Level Employees and Officers incorporated
        by reference to Exhibit 10.36 of the Registrant's Form S-1 
        Registration Statement No. 33-45180.
10.43   Amended and Restated Employment Agreement dated January 29, 1996 
        between the Registrant and Gregory B. Lawless. Incorporated by 
        reference to exhibit 10.30 of the Company's Form 10-K for the fiscal 
        year ended December 31, 1996.
10.44   Form of Agreement with Executive Officers relating to change in 
        control . incorporated by reference to exhibit 10.31 of the Company's
        Form 10-K for the fiscal year ended December 31, 1996.
10.45   Employment Agreement dated May 30, 1992 between the Registrant and 
        Alan F. Russell.
10.46   1994 Stock Option/Award Plan (As Amended and Restated as of February 24,
        1998), incorporated by reference to Exhibit 99.1 o the Company's 
        Form S-8 Registration Statement No. 333-67331, filed November 16, 1998.
10.47   Amended 1991 Employee Stock Purchase Plan (As Amended and Restated as of
        February 24, 1998), incorporated by reference to Exhibit 99.6 of the 
        Company's Form S-8 Registration Statement No. 333-67331, filed 
        November 16.1998.
10.48   Plan Amendment Cygnus, Inc. 1994 Stock Option/Award Plan, Incorporated
        by reference to Exhibit 99.2 of the Company's Form S-8 Registration 
        Statement No. 333-67331, filed November 16.1998.
10.49   Form of Special Addendum to Stock Option Agreement (Change in Control),
        incorporated by reference to Exhibit 99.3 of the Company's Form S-8 
        Registration Statement No. 333-67331, filed November 16.1998.
10.50   Form of Special Addendum to Stock Option Agreement (Termination of 
        Employment Without Cause -- Officers), incorporated by reference to 
        Exhibit 99.4 of the Company's Form S-8 Registration Statement 
        No. 333-67331, filed November 16.1998.
10.51   Form of Special Addendum to Stock Option Agreement (Termination of 
        Employment Without Cause -- Key Employee), incorporated by reference to
        Exhibit 99.5 of the Company's Form S-8 Registration Statement 
        No. 333-67331, filed November 16.1998.
10.52   Written Compensation Agreement between Registrar and Mr. Marion, 
        incorporated by reference to Exhibit 99.7 of the Company's Form S-8 
        Registration Statement No. 333-67331, filed November 16.1998.
10.53   Stock Option Agreement between Registrant and Mr. Marion, incorporated
        by reference to Exhibit 99.8 of the Company's Form S-8 Registration 
        Statement No. 333-67331, filed November 16.1998.
10.54   Form of Agreement dated August 28, 1998 between the Company and each of
        the Executive officers with respect to post-employment benefits 
        incorporated by reference to Exhibit 10.46 of the Company's form 10-Q
        for the period ended September 30, 1998.

                                      36

<PAGE>

10.55   Form of Agreement between the Company and each of the Executive 
        officers with respect to post-employment benefits relating to change 
        of control incorporated by reference to Exhibit 10.46 of the Company's
        Form 10-Q for the period ended September 30, 1998.

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

        23.1  Consent of Ernst & Young LLP, Independent Auditors (see page 40)
        25.1  Power of Attorney (see page 39)
        27.0  Financial Data Schedule

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

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



                                        37

<PAGE>

                                     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 30th day of 
March, 1999.


                                     CYGNUS, INC.



                                     By: /s/ JOHN C. HODGMAN
                                         -------------------------------------
                                                   John C. Hodgman
                                         President and Chief Executive Officer
                                              (Principal Executive Officer)













                                            38

<PAGE>

                                 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/her 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.

<TABLE>
<CAPTION>
         Signature                        Title                                     Date
         <S>                              <C>                                        <C>

/s/ GARY W. CLEARY, Ph.D.        Chairman of the Board of Directors and Chief       March 30, 1999
------------------------------   Technical Officer
Gary W. Cleary, Ph.D.


/s/ JOHN C. HODGMAN              President and Chief Executive Officer              March 30, 1999
------------------------------   (Principal Executive Officer)              
John C. Hodgman                  


/s/ CRAIG W. CARLSON             Chief Financial Officer and Senior Vice            March 30, 1999
------------------------------   President, Finance (Principal Accounting 
Craig W. Carlson                 Officer)


/s/ FRANK T. CARY                Director                                           March 30, 1999
------------------------------
Frank T. Cary


/s/ ANDRE F. MARION              Vice Chairman of the Board of Directors            March 30, 1999
------------------------------ 
Andre F. Marion


/s/ RICHARD G. ROGERS            Director                                           March 30, 1999
------------------------------   
Richard G. Rogers


/s/ WALTER B. WRISTON            Director                                           March 30, 1999
------------------------------  
Walter B. Wriston
</TABLE>





                                               39



<PAGE>


                                EXHIBIT 23.1

             CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

     We consent to the use of our report dated January 19, 1999, except for 
the Note 14, as to which the date is February 23, 1999 in this Annual Report 
(Form 10-K) of Cygnus, Inc.

     We consent to the incorporation by reference in the Registration 
Statements (Form S-8 Nos. 33-41502, 33-43710, 33-59774, 33-86038 and 
333-18357) pertaining to the Amended 1986 Stock Option Plan, the 1991 Amended 
Employee Stock Purchase Plan, the Amended 1986 Incentive Stock Plan and the 
1994 Stock Option/Award Plan of Cygnus, Inc. of our report dated January 19, 
1999, except for the Note 14, as to which the date is February 23, 1999 with 
respect to the consolidated financial statements and schedule of Cygnus, Inc. 
included  in the Annual Report (Form 10-K) for the year ended December 31, 
1998.

 




Palo Alto, California                                      /s/ ERNST & YOUNG LLP
March 30,  1999













                                       40


<PAGE>

                                    Cygnus, Inc.


                          Consolidated Financial Statements





                  For the Years ended December 31, 1998, 1997 and 1996


                                        with


                            Report of Independent Auditors

















                                         F-1



<PAGE>


                                     Cygnus, Inc.


                           CONSOLIDATED FINANCIAL STATEMENTS

                  For the Years ended December 31, 1998, 1997 and 1996


                                       Contents
<TABLE>
<S>                                                                                      <C>
Report of Ernst & Young LLP, Independent Auditors ....................................... F-3

Audited Consolidated Financial Statements:

Consolidated Balance Sheets ............................................................. F-4
Consolidated Statements of Operations ................................................... F-5
Consolidated Statement of Shareholders' Equity/(net capital deficiency) ................. F-6
Consolidated Statements of Cash Flows ................................................... F-7
Notes to Consolidated Financial Statements .............................................. F-8
</TABLE>


















                                           F-2



<PAGE>



REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS



The Board of Directors and Stockholders
Cygnus, Inc.


     We have audited the accompanying consolidated balance sheets of Cygnus, 
Inc. as of December 31, 1998 and 1997, 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, 1998. 
Our audits also included the financial statement schedule listed in the Index 
at Item 14(a). These financial statements and schedule are the responsibility 
of the Company's management. Our responsibility is to express an opinion on 
these financial statements and schedule based on our audits.

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

     In our opinion, the financial statements referred to above present 
fairly, in all material respects, the consolidated financial position of 
Cygnus, Inc. at December 31, 1998 and 1997, and the consolidated results of 
its operations and its cash flows for each of the three years in the period 
ended December 31, 1998, in conformity with generally accepted accounting 
principles. Also, in our opinion, the related financial statement schedule, 
when considered in relation to the basic financial statements taken as a 
whole, presents fairly in all material respects the information set forth 
therein.

Palo Alto, California January 19, 1999, except for the Note 14, as to which 
the date is February 23, 1999



                                                          /s/ Ernst & Young LLP


                                      F-3

<PAGE>
                                        Cygnus, Inc.
                                  CONSOLIDATED BALANCE SHEETS
                                        (In thousands)
<TABLE>
<CAPTION>
                                                                              DECEMBER 31,
                                                                     1998                   1997
                                                                 -------------------------------------
<S>                                                              <C>                     <C>
ASSETS:
CURRENT ASSETS:
  Cash and cash equivalents                                      $  10,219               $  20,669
  Short-term investments                                            14,982                  14,163
  Trade accounts receivable, net of allowance  (1998 -- $123;
    1997 -- $123)                                                      876                   2,040
  Inventories                                                          771                     924
  Prepaid expenses and other current assets                            510                   1,834
  Current portion of employee notes receivable                         185                     154
                                                                 -------------------------------------
                Total current assets            
                                                                    27,543                  39,784
EQUIPMENT AND IMPROVEMENTS:
  Office and laboratory equipment                                   18,237                  14,856
  Leasehold improvements                                             1,304                     885
                                                                 -------------------------------------
                                                                    19,541                  15,741
  Less accumulated depreciation and amortization                   (13,077)                (11,145)
                                                                 -------------------------------------
              Net equipment and improvements                         6,464                   4,596

  Long-term investments                                              3,622                   --
  Long-term portion of employee notes receivable                       286                     301
  Deferred compensation and other assets                             4,451                   4,596
  Unamortized portion of the issuance costs of the Senior
    Subordinated Convertible Notes                                   1,088                   --
                                                                 -------------------------------------
              Total Assets                                        $ 43,454                $ 49,277
                                                                 -------------------------------------
                                                                 -------------------------------------
LIABILITIES AND NET CAPITAL DEFICIENCY:
CURRENT LIABILITIES:
  Accounts payable                                                $  2,585                $  1,070
  Amounts payable to related parties                                 1,043                     224
  Accrued clinical trials                                              831                   --
  Accrued compensation                                               4,593                   3,298
  Accrued professional services                                        729                     842
  Other accrued liabilities                                            943                   1,263
  Customer advances                                                    207                     624
  Current portion of arbitration obligation                             60                  16,223
  Current portion of deferred revenue                                1,153                   1,846
  Current portion of long-term debt                                  3,415                   3,767
  Current portion of capital lease obligations                         442                     686
                                                                 -------------------------------------
              Total current liabilities                             16,001                  29,843

Long-term portion of arbitration obligation                         24,158                  23,000
Long-term portion of deferred revenue                               --                       1,188
Long-term portion of debt                                            8,252                   3,812
Long-term portion of capital lease obligations                         581                     390
Senior Subordinated Convertible Notes                               22,563                    --
Deferred compensation and other long-term liabilities                4,666                   4,844

STOCKHOLDERS' NET CAPITAL DEFICIENCY:
  Preferred stock, $0.001 par value:  5,000 shares authorized;
     no shares issued and outstanding                               --                        --
  Common stock, $0.001 par value:  40,000 shares authorized;      
     issued and outstanding: 20,886 and 19,273 shares at
     December 31, 1998 and 1997, respectively                           21                      19
  Additional paid-in-capital                                       143,155                 122,709
  Accumulated deficit                                             (175,955)               (136,527)
  Accumulated other comprehensive income / (loss)                       12                      (1)
                                                                 -------------------------------------
   Net capital deficiency                                          (32,767)                (13,800)
                                                                 -------------------------------------
    Total liabilities and stockholders' net capital deficiency   $  43,454                $ 49,277
                                                                 -------------------------------------
                                                                 -------------------------------------
</TABLE>
SEE ACCOMPANYING NOTES.
                                            F-4
<PAGE>

                                           Cygnus, Inc.

                                CONSOLIDATED STATEMENTS OF OPERATIONS
                                (In thousands, except per share data)
<TABLE>
<CAPTION>
                                                                       YEARS ENDED DECEMBER 31,
                                                                 1998             1997            1996
                                                                 -------------------------------------
<S>                                                              <C>              <C>             <C>
REVENUES:

  Product revenues                                               $    587       $   4,212    $   17,211
  Contract revenues                                                10,178          14,106        13,085
  Royalty and other revenues                                          890          11,184         5,907
                                                                 --------------------------------------
    TOTAL REVENUES                                                 11,655          29,502        36,203

COSTS AND EXPENSES:

  Costs of products sold                                            3,478          10,413        16,659
  Research and development                                         32,149          22,328        23,165
  Marketing, general and administrative                            11,730           8,695         9,296
  Arbitration settlement                                              ---          39,666           ---
                                                                 --------------------------------------
    TOTAL COSTS AND EXPENSES                                       47,357          81,102        49,120

Loss from operations                                              (35,702)        (51,600)      (12,917)

Interest and other income                                           6,009           2,989         2,851
Interest and other expense                                         (9,735)         (1,849)         (986)
                                                                 --------------------------------------
NET LOSS                                                         $(39,428)       $(50,460)     $(11,052)
                                                                 --------------------------------------
                                                                 --------------------------------------
BASIC AND DILUTED NET LOSS PER SHARE                             $  (1.95)       $  (2.67)     $  (0.60)
                                                                 --------------------------------------
                                                                 --------------------------------------
Shares used in computation of basic and diluted
  net loss per share                                               20,226          18,928        18,544
                                                                 --------------------------------------
                                                                 --------------------------------------
</TABLE>
SEE ACCOMPANYING NOTES.

                                              F-5

<PAGE>

                                 Cygnus, Inc.

        CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY/(NET CAPTIAL DEFICIENCY)
                For the Years Ended December 31, 1998, 1997 and 1996
                                 (In thousands)

<TABLE>
<CAPTION>
                                                                                            Accumulated           Total
                                                                                               Other          Stockholders'
                                                            Additional                        Compre-          Equity (net
                                                 Common     paid-in-      Accumulated         hensive            capital
                                                 Stock      capital         Deficit        Income/(loss)        deficiency)
                                                 ---------------------------------------------------------------------------
<S>                                              <C>        <C>           <C>              <C>                  <C>

BALANCE, DECEMBER 31, 1995                       $    18    $  113,248    $  (75,015)        $      1              38,252
Issuance of  333  shares of common stock              --         2,749            --               --               2,749
Issuance of  90 shares of common stock under
    the Employee Stock Purchase Plan                  --           823            --               --                 823
Issuance of 45 shares of common stock
    through exercise of warrant                       --           446            --               --                 446
Change in unrealized loss on investments              --            --            --               (5)                 (5)
Net loss                                              --            --       (11,052)              --             (11,052)
                                                 ---------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1996                       $    18    $  117,266    $  (86,067)         $    (4)          $  31,213
                                                 ---------------------------------------------------------------------------
                                                 ---------------------------------------------------------------------------
Issuance of 258 shares of common stock                 1         2,211            --               --               2,212
Issuance of 64 shares of common stock under
    the Employee Stock Purchase Plan                 --            707            --               --                 707
Issuance of  255 shares of common stock
    through exercise of warrant                      --          2,525            --               --               2,525
Change in unrealized loss on investments             --             --            --                3                   3
Net loss                                             --             --       (50,460)              --             (50,460)
                                                 ---------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1997                       $   19     $  122,709    $ (136,527)         $    (1)          $ (13,800)
                                                 ---------------------------------------------------------------------------
                                                 ---------------------------------------------------------------------------
Issuance of  3 shares of common stock                --             20            --               --                  20
Issuance of 141 shares of common stock under
    the Employee Stock  Purchase Plan                --            872            --               --                 872
Issuance of 906 shares of common stock in
    fourth public offering, net of issuance
    costs of $486                                     1         13,326            --               --              13,327
Issuance of 565 shares arising from the
    conversion of the Senior Subordinated 
    Note                                              1          1,998            --               --               1,999
Additional paid-in capital arising from the
    beneficial conversion feature of the 
    restructure of the Senior Subordinated
    Notes                                           --           4,230            --               --               4,230
Change in unrealized gain / (loss) on
    investments                                     --              --            --               13                  13
Net loss                                            --              --       (39,428)              --             (39,428)
                                                 ---------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1998                       $  21      $  143,155    $ (175,955)             $12            $(32,767)
                                                 ---------------------------------------------------------------------------
                                                 ---------------------------------------------------------------------------
</TABLE>

SEE ACCOMPANYING NOTES

                                               F-6

<PAGE>

                                         Cygnus, Inc.

                            CONSOLIDATED STATEMENTS OF CASH FLOWS
                       Increase/(Decrease) in Cash and Cash Equivalents
                                        (In thousands)

<TABLE>
<CAPTION>
                                                                            YEARS ENDED DECEMBER 31,

                                                                          1998          1997         1996
                                                                       ------------------------------------
                                                                       <C>          <C>          <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss                                                               $ (39,428)   $ (50,460)   $ (11,052)
Adjustments to reconcile net loss to net cash (used in)/provided by
   operating activities:
  Depreciation                                                             1,684        1,971        1,861
  Amortization                                                               256          768          941
  (Gain)/loss on write-down and disposals of equipment                       (19)       1,350           --
  Beneficial conversion feature of restructured Notes                      4,230           --           --
  Amortization of debt issuance costs                                      1,561
  Other                                                                     (125)        (133)        (280)
(Increase)/decrease in assets:
  Trade accounts receivables                                               1,163        5,719       (5,449)
  Inventories                                                                153        1,407       (1,953)
  Prepaid expenses and other assets                                        1,454       (3,201)      (1,888)
Increase/(decrease) in liabilities:
  Accounts payable and other accrued liabilities                           2,848       (2,061)       2,325
  Accrued compensation                                                     1,295          121          986
  Accrued professional services                                             (114)         151          (35)
  Customer advances                                                         (418)        (522)         300
  Deferred revenue                                                        (1,881)     (10,445)       6,646
  Arbitration liability                                                  (15,005)      39,223           --
  Deferred compensation and other liabilities                               (178)       1,494        1,261
                                                                       ---------    ---------    ----------
      Net cash used in operating activities                              (42,524)     (14,618)      (6,337)
                                                                       ---------    ---------    ----------

CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures                                                      (3,365)      (3,095)      (1,515)
Purchases of investments                                                 (48,314)     (30,148)     (31,565)
Maturity and sale of investments                                          44,073       32,408       31,602
                                                                       ---------    ---------    ----------
      Net cash used in investing activities                               (7,606)        (835)      (1,478)
                                                                       ---------    ---------    ----------

CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from sale and leaseback of assets                                    --           --          464
Issuance of common stock                                                  14,219        5,444        4,018
Net proceeds from the issuance of Senior Subordinated Convertible Notes   40,351
Proceeds from issuance of long-term debt                                   6,110        1,331        8,000
Principal payments of Senior Subordinated Convertible Notes              (18,500)
Principal payments of long-term debt                                      (2,023)      (2,486)        (490)
Payment of capital lease obligations                                        (477)      (1,315)      (1,474)
                                                                       ---------    ---------    ----------
      Net cash provided by financing activities                           39,680        2,974       10,518
                                                                       ---------    ---------    ----------

Net increase/(decrease) in cash and cash equivalents                     (10,450)     (12,479)       2,703
Cash and cash equivalents at beginning of year                            20,669       33,148       30,445
                                                                       ---------    ---------    ----------
Cash and cash equivalents at end of year                                 $10,219      $20,669      $33,148
                                                                       ---------    ---------    ----------
                                                                       ---------    ---------    ----------
</TABLE>

SEE ACCOMPANYING NOTES.

                                      F-7

<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                      FOR THE YEAR ENDED DECEMBER 31, 1998
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 1:  BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

DESCRIPTION OF BUSINESS

    The Company was incorporated in California in 1985 and was merged into a 
Delaware corporation in September 1995. The Company is engaged in the 
development and manufacture of diagnostic and drug delivery systems, 
utilizing proprietary technologies to satisfy unmet medical needs cost 
effectively. The Company's current efforts are primarily focused on two core 
areas: an automatic and continuous glucose monitoring device (the GlucoWatch 
monitor) and transdermal drug delivery systems.

CONSOLIDATION

    The consolidated financial statements include the accounts of the Company 
and its wholly-owned subsidiaries after elimination of all material 
inter-company balances and transactions.  Cygnus' subsidiaries were inactive 
in 1998, 1997 and 1996.

USE OF ESTIMATES

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

REVENUE RECOGNITION

    Product sales are recorded when FemPatch or Nicotrol products are 
shipped. Nicotrol product shipments were discontinued in the first quarter of 
1997 upon Pharmacia's exercise of its option to purchase the U.S. 
manufacturing rights for the Nicotrol patch from Cygnus. FemPatch product 
shipments were discontinued in the second quarter of 1998 and in November 
1998 the agreement between Warner-Lambert and Sanofi was terminated, which 
also terminated the supply agreement between the Company and Warner-Lambert. 
Up-front and interim milestone payments from feasibility and development 
contracts are generally earned and recognized based on percentage of actual 
efforts expended compared to total expected efforts during the development 
period for each contract.  The total expected efforts under each contract are 
estimated by management and updated periodically in light of the current 
conditions and expected development timeline. Milestone payments received at 
the end of the development period of an agreement are generally recognized 
upon receipt. Deferred revenue includes the portion of up-front and interim 
milestone payments received on research, development and distribution 
agreements which have been deferred and will be recognized over the related 
development period in relation to efforts expended under the agreement.
 
    Two customers provided 60% and 40% of the 1998 product sales and royalty 
and other income. In 1997, these two customers provided 84% and 16% of this 
revenue, and in 1995 and 1996 one of these customers provided 100% of product 
sales and royalty and other income. 
 
    Five customers provided 47%, 17%, 11%, 9% and 6% of the 1998 contract 
revenues. In 1997, four of these customers provided 33%, 14%, 10% and 10% of 
this revenue, and in 1996, three of these customers provided 28%, 25% and 5% 
of this revenue. 

COSTS OF PRODUCTS SOLD

    Direct and indirect costs associated with manufacturing FemPatch and 
Nicotrol products are included in costs of products sold. 

RESEARCH AND DEVELOPMENT

The Company has entered into license, collaboration and distribution agreements 
with certain companies.  In general, these agreements provide that Cygnus will 
create and/or manufacture the drug delivery or diagnostic system and receive 


                                      F-8

<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 1:  BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
         (CONTINUED)

reimbursements for costs incurred, payment for product shipped to licensees 
or distributors and royalties based on product sales by its licensees and 
distributors. Additionally, under such agreements, Cygnus may receive one or 
more up-front payments and milestone payments (which are made upon the 
occurrence of certain events, such as the filing of the NDA or an ANDA for a 
product), as well as reimbursements of certain research and development 
expenses. Research and development expenses consist of process development 
costs, costs associated with work performed under development agreements and 
self-funded research, and costs incurred in clinical studies and 
regulatory/scientific affairs. Research and development expenses covered 
under contracts partially funded by the Company's licensees and distributors 
for the years ended December 31, 1998, 1997 and 1996 were approximately 
$24,374, $19,242 and $17,657, respectively.  Revenues recorded under 
arrangements amounted to $10,178, $11,206 and $10,827, respectively. Cygnus' 
pharmaceutical company licensees and distributors generally have the right to 
abandon the rights to a product and the obligation to make related payments.  
Since all payments to the Company under these agreements are contingent on 
the occurrence of future events or sales levels, and the agreements are 
terminable by the licensee or distributor, no assurance can be given as to 
whether the Company will receive any particular payment thereunder or as to 
the amount or timing  of any such payment.

INVENTORIES

    Inventories are stated at the lower of cost (first-in, first-out method) or 
market, after appropriate consideration was given to obsolescence and 
inventories in excess of anticipated future demand.  Net inventories consist of 
the following:

<TABLE>
<CAPTION>

                                    DECEMBER 31,
                                    1998    1997
                                    ------------
<S>                                 <C>     <C>
    Raw materials                   $771    $787
    Work in process                 ----      86
    Finished goods                  ----      51
                                    ------------
                                    $771    $924
                                    ------------
                                    ------------
</TABLE>

Inventories at December 31, 1998 and 1997 relate to the Company's estrogen 
(FemPatch) transdermal product.


                                      F-9

<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 1:  BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
         (CONTINUED)

EQUIPMENT AND IMPROVEMENTS 

    Equipment and improvements are recorded at the lower of cost or net 
realizable value. Depreciation of equipment is computed on a straight-line 
basis over the estimated useful lives of eighteen months to sixty 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.  In 1997, the Company incurred 
charges of $1.3 million to write down the cost of Nicotrol patch equipment to 
its net realizable value. This write-down was due to the termination of 
Nicotrol patch manufacturing by the Company.

DEFERRED COMPENSATION 

    In 1995, the Company adopted a non-qualified deferred compensation plan.  
The Plan was intended to be unfunded and was maintained by the Company 
primarily for the purpose of providing deferred compensation for a select 
group of management.  As of December 31, 1998 and 1997, the Company recorded 
$4.3 million and $4.4 million, respectively, as other long-term assets and as 
other long-term liabilities related to the plan which included both 
contributions and net investment earnings. These investments were directed by 
the participants.  In January 1999, the Company terminated the plan and the 
plan assets will be distributed to participants in the first quarter of 1999.

NET LOSS PER SHARE 

    Basic and diluted net loss per share is computed using the weighted 
average number of shares of Common Stock outstanding. Shares issuable from 
stock options and warrants outstanding are excluded from the diluted earnings 
per share computation, as their effect is anti-dilutive. 

ACCOUNTING FOR STOCK-BASED COMPENSATION

    Under Statement 123, "Accounting for Stock-Based Compensation," 
stock-based compensation expense to employees is measured using either the 
intrinsic value method as prescribed by Accounting Principle Board Opinion 
No. 25, "Accounting for Stock Issued to Employees" (APB 25), or the 
fair-value method described in FAS 123. Cygnus has elected to follow APB 25 
and related interpretations in accounting for  its employee stock options and 
disclose only the pro-forma impact of the fair-value method on net income and 
earnings per share. (See Note 4 "Stockholders' Equity.") 

NEW ACCOUNTING PRONOUNCEMENTS 

    Effective January 1, 1998 the Company adopted the Financial Accounting 
Standard Board's Statements of Financial Accounting Standards No. 130, 
Reporting Comprehensive Income ("FAS 130") and Financial Accounting Standard 
No. 131, Disclosure about Segment of an Enterprise and Related Information 
("FAS 131") and restated prior years' financial statements to conform to the 
above reporting standards.

    FAS 130 establishes standards for reporting and displaying comprehensive 
income and its components in a full set of general purpose financial 
statements. Comprehensive income includes all changes in stockholders' equity 
during a period except those resulting from investments by owners and 
distributions to owners. The adoption of FAS 130 resulted in revised and 
additional disclosure but had no effect on the financial position, results of 
operations or liquidity of the Company.

    FAS 131 establishes standards for the way that public business 
enterprises report information about operating segments in annual financial 
statements and requires that those enterprises report selected information 
about operating segments in interim financial reports. It also establishes 
standards for related disclosures about products and services, geographic 
areas, and major customers. Effective December 31, 1998, the Company adopted 
FAS 131. On this basis, the Company has two principal businesses and, 
therefore, two reportable business segments: diagnostics and drug delivery. 
Segment results are presented on this basis in 1998, as well as retroactively 
(see Note 7, "Business Segments"). This new pronouncement does not alter 
reported net income.

                                      F-10

<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 1:  BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
         (CONTINUED)

    In June 1998, the Financial Accounting Standards Board issued Statement 
of Financial Accounting Standard No. 133, Accounting for Derivative 
Instruments and Hedging Activities ("FAS 133"). FAS 133 requires all 
derivatives to be recorded on the balance sheet at fair value and establishes 
special accounting rules for different types of hedges. Adoption of this 
statement is required in the year ending December 31, 2000 and is not 
expected to have a material impact on Company's results of operations or 
financial condition.

SECURITIES AVAILABLE-FOR-SALE

    Securities available-for-sale are carried at fair value, based on quoted 
market prices, and the unrealized gains and losses have been combined with 
the accumulated deficit due to immateriality.  Realized gains and losses and 
declines in value judged to be other-than-temporary on available-for-sale 
securities are included in investment income. 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 investment income.

    The Company considers all highly liquid investments with a maturity from 
the date of purchase of three months or less to be cash equivalents. The 
Company invests its excess (to current demands) cash in high credit quality, 
highly liquid instruments. These investments have included, but are not 
limited to, Treasury Notes, Federal Agency Securities, Auction Rate 
Certificates, Auction Rate Preferred Stock, and Commercial Paper. 

                                      F-11

<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 2:  FAIR VALUE OF FINANCIAL INSTRUMENTS 

    For the years ended December 31, 1998 and 1997 the net realized gains and 
losses on available-for-sale securities were immaterial. 

    As of December 31, 1998 and 1997 all debt securities are classified as 
available-for-sale. The following is a summary of available-for-sale 
securities as of December 31, 1998 and 1997:

<TABLE>
<CAPTION>
                                                        AVAILABLE-FOR-SALE SECURITIES
                                              --------------------------------------------
                                                         GROSS        GROSS      ESTIMATED
                                                      UNREALIZED    UNREALIZED     FAIR
                                                COST     GAINS       LOSSES        VALUE
                                              --------------------------------------------
<S>                                           <C>     <C>           <C>          <C>
AS OF DECEMBER 31, 1998:

Cash Equivalents:
  Money Market Fund                           $ 3,961    $ --        $ --        $ 3,961
  Certificate of Deposit                        4,000      --          --          4,000
  Federal Agency Security, due in less
    than ninety days                            1,305      --          --          1,305
                                              -------    ----        ----        -------
      Total Cash Equivalents                  $ 9,266    $ --        $ --        $ 9,266
                                              -------    ----        ----        -------
                                              -------    ----        ----        -------
Short-Term Investments:
  Federal Agency Securities                     2,290       3          --          2,293
  Auction Rate Certificates                    11,049      --          --         11,049
  Corporate Notes                               1,640      --          --          1,640
                                              -------    ----        ----        -------
      Total Short-Term Investments            $14,979    $  3        $ --        $14,982
                                              -------    ----        ----        -------
                                              -------    ----        ----        -------
Long-Term Investments:
  Federal Agency Securities                     3,613      11          (2)         3,622
                                              -------    ----        ----        -------
      Total Long-Term Investments             $ 3,613    $ 11        $ (2)       $ 3,622
                                              -------    ----        ----        -------
                                              -------    ----        ----        -------
AS OF DECEMBER 31, 1997:

Cash Equivalents:
  Money Market Fund                           $18,925    $ --        $ --        $18,925
                                              -------    ----        ----        -------
      Total  Cash Equivalents                 $18,925    $ --        $ --        $18,925
                                              -------    ----        ----        -------
                                              -------    ----        ----        -------
Short-Term Investments:
  Treasury Bills                              $ 1,900    $  1        $ --        $ 1,901
  Federal Agency Securities                     3,023      --          --          3,023
  Auction Rate Certificates                     6,216      --          --          6,216
  Auction Rate Preferred                        1,012      --          --          1,012
  Corporate Notes                               2,013      --          (2)         2,011
                                              -------    ----        ----        -------
     Total Short-Term Investments             $14,164    $  1        $ (2)       $14,163
                                              -------    ----        ----        -------
                                              -------    ----        ----        -------
</TABLE>

All cash equivalents and investments as of  December 31, 1998 and 1997 have 
maturity dates of less than twenty-one months and one year, respectively. 

                                      F-12

<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 3:  CREDIT LINE AND LEASES 

    In December 1994, the Company borrowed $1.7 million under a bank line of 
credit to finance the purchase of manufacturing and research equipment. In 
June of 1996, the Company received $8.0 million under a bank loan agreement 
for short-term working capital. In April of 1998, the Company consolidated 
its two outstanding bank loans into an expanded credit facility with the same 
bank. An additional $4.7 million was borrowed, increasing the total 
outstanding under the new agreement to $10.0 million. In November of 1998, 
the April agreement was further amended to modify the covenants. This balance 
will be repaid through November 2001, with monthly interest-only payments 
through November 1998, and monthly principal-and-interest installments 
thereafter. As of December 31, 1998 there is $9.8 million outstanding under 
this agreement. The line bears interest at one percentage point above the 
prime rate (8.75% in total as of December 31, 1998). In June 1997, the 
Company entered into a loan agreement for $1.3 million to finance additional 
capital equipment. The line bears interest at a fixed rate of 9.39% per year. 
Borrowings under this agreement are secured by specific Company assets.  This 
loan is being repaid monthly through June 2000.  As of December 31, 1998, 
there was $0.7 million outstanding.  In the second quarter of 1998, the 
Company entered into a new loan agreement for $1.4 million to finance 
additional capital equipment. Borrowings under this agreement are also 
secured by specific Company assets. As of December 31, 1998, there was $1.2 
million outstanding. All loan agreements are subject to certain financial 
covenants, including minimum cash balances and tangible net worth. If certain 
of these covenants are not met, the lenders may require collateral of the 
amounts outstanding.  In the event of default, the lenders may, at their 
option, exercise their rights to remedies specified in the loan agreements 
which include, among other things, the acceleration of amounts due under the 
agreements.

    Assets leased under capital leases are included in equipment with a cost 
of $5,490 and $5,065 on December 31, 1998 and 1997, respectively, with 
related accumulated amortization of approximately $4,806 and $4,275 on 
December 31, 1998 and 1997, respectively.  Upon the expiration of the lease, 
the Company has purchase options for the leased equipment at market value. As 
of December 31, 1998, there was $1,023 outstanding. This lease agreement has 
certain financial covenants, including minimum cash balance. If certain of 
these covenants are not met, the leasing company may require collateral of 
the amounts outstanding.  In the event of default, the leasing company can 
accelerate all amounts due.

    The future aggregate principal payments of long-term debt and minimum 
lease payments under capital leases, together with the present value of the 
net minimum lease payments as of December 31, 1998, are as follows:

<TABLE>
<CAPTION>
                                                            LONG-TERM DEBT             CAPITAL LEASES
                                                            --------------             --------------
<S>                                                         <C>                         <C>
Years ending December 31,
  1999                                                          $ 3,415                   $  555
  2000                                                            3,450                      495
  2001                                                            4,802                      145
                                                                -------                   ------
Total principal and minimum lease payments, respectively        $11,667                    1,195
                                                                -------
                                                                -------
Less amount representing interest                                                            172
                                                                                          ------
Present value of net minimum lease payments                                                1,023
Current portion                                                                              442
                                                                                          ------
Amounts due after one year                                                                $  581
                                                                                          ------
                                                                                          ------
</TABLE>

    The fair market value of the long-term debt approximates its carrying 
value of $11,667.

    The Company leases its facilities under a non-cancelable operating lease 
for three of its four buildings expiring in 2003.  The terms of the lease 
provide for rental payments on a graduated scale.  The Company is recognizing 
rent expense on a straight-line method over the lease period and therefore 
has accrued for the rent expense incurred but not paid. Additionally, the 
Company leases an off-site warehouse with a three-year lease term ending in 
October 1999.


                                      F-13

<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 3:  CREDIT LINE AND LEASES (CONTINUED)

    Minimum future rental commitments under the operating leases on December 
31, 1998 amount to $1,941 in 1999, $1,904 in 2000, $1,954 in 2001, $2,015 in 
2002, and $2,078 in 2003.  Rent expense amounted to $1,064, $1,020, and 
$1,013, for the years ended December 31, 1998, 1997, and 1996, respectively.

NOTE 4:   STOCKHOLDERS' EQUITY

PREFERRED SHARE PURCHASE RIGHTS PLAN

    Pursuant to the Company's Stockholder Rights Plan, the Board declared a 
dividend distribution of one Preferred Share Purchase Right ("Right") for 
each outstanding share of Common Stock, issuable on October 18, 1993 to 
stockholders of record on that date.  These rights will remain outstanding 
until September 21, 2003. 

WARRANTS 

    In September 1990, in connection with the PaineWebber product development 
program, a warrant to purchase 300 shares of common stock at $9.90 per share 
was issued to the development partner. All warrants have been exercised as of 
December 31, 1997. 

EMPLOYEE STOCK PURCHASE PLAN

    As part of an employee retention program, the Company established the 
1991 Employee Stock Purchase Plan, as Amended and Restated as of February 24, 
1998 (the "Stock Purchase Plan") to provide employees with an opportunity to 
purchase Common Stock of the Company through payroll deductions. A total of 
925 shares of Common Stock were reserved for issuance to eligible employees 
under the amended Stock Purchase Plan. The amended Stock Purchase Plan will 
terminate in 2023 unless sooner terminated by the Board of Directors.  Under 
this Stock Purchase Plan, the Company's employees, subject to certain 
restrictions, may purchase shares of Common Stock at 85 percent of the lesser 
of the fair market value at either the date of enrollment or the date of 
purchase. During 1998 and 1997, 116 and 64 shares, respectively, were issued 
under the Stock Purchase Plan, and at December 31, 1998, 362 shares were 
available for issuance.

STOCK OPTION PLAN

    The Company has elected to follow Accounting Principles Board Opinion 
No.25, "Accounting for Stock Issued to Employees" (APB 25), and related 
Interpretations in accounting for its employee stock options because, as 
discussed below, the alternative fair value accounting provided for under 
FASB Statement No. 123, "Accounting for Stock-Based Compensation," requires 
use of option valuation models that were not developed for use in valuing 
employee stock options. Under APB 25, because the exercise price of the 
Company's employee stock options equals the market price of the underlying 
stock on the date of grant, no compensation expense is recognized.

    The Company has a 1994 Stock Option/Award Plan, as Amended and Restated 
as of February 24, 1998 (the "Stock Plan") which authorizes the Board of 
Directors to grant incentive stock options, nonstatutory stock options, stock 
purchase rights and stock bonuses to employees and consultants.  The Stock 
Plan, as amended, authorizes the issuance of up to 7,916 Common Shares, of 
which 1,402 are available for grant at December 31, 1998. Under the Stock 
Plan, incentive stock options must be granted at fair market value at the 
date of grant as determined by the Board of Directors or committee thereof. 
Options generally vest over a four-year period and are exercisable for a term 
of ten years after issuance, unless otherwise determined by the Board of 
Directors or committee thereof. 

    Pro forma information regarding net income and earnings per share is 
required by Statement 123, which also requires that the information be 
determined as if the Company has accounted for its employee stock options 
granted subsequent to December 31, 1994 under the fair value method of that 
Statement. The fair value for these options and the fair value for the stocks 
issued under the Stock Purchase Plan were estimated at the date of grant 
using a Black-Scholes option pricing model with the following 
weighted-average assumptions for 1998, 1997 and 1996: risk-free interest rate 
of 4.25%, 5.41% and 6.125%, respectively; a dividend yield of 0.0%; 
volatility factors of the expected market price of the Company's common stock 
of .78, .66, and .68, respectively; and a weighted-average expected life of 
the option of 5 years.

                                      F-14

<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 4:   STOCKHOLDERS' EQUITY (CONTINUED)

    The Black-Scholes option valuation model was developed for use in 
estimating the fair value of traded options which 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 the Company's 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 its 
employee stock options.

    For purposes of pro forma disclosures, the estimated fair value of the 
options issued under the Stock Plan is amortized to expense over the options' 
vesting period.  The estimated fair value of the compensation benefit 
received under the Stock Purchase Plan is expensed in the year of purchase.  
The Company's pro forma information follows:

<TABLE>
<CAPTION>
                                            1998         1997       1996
                                            ----         ----       ----
<S>                                      <C>          <C>         <C>
Pro forma net loss                       $(44,898)    $(54,691)   $(13,653)
Pro forma loss per share                 $  (2.22)    $  (2.89)   $  (0.74)
</TABLE>

    The effects on pro forma disclosures of applying FAS 123 are not likely 
to be representative of effects on pro forma disclosures of future years 
because FAS123 is applicable only to options granted subsequent to 
December 31, 1994.

                                      F-15

<PAGE>
                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 4:   STOCKHOLDERS' EQUITY (CONTINUED)

 A summary of the Company's stock option activity, including the number, 
weighted-average exercise price, and weighted-average remaining contractual 
life for options outstanding and the number and weighted-average exercise 
price of options exercisable for the year ended December 31, 1998, is as 
follows:

<TABLE>
<CAPTION>
                               OPTIONS OUTSTANDING                       EXERCISABLE
-----------------    -------------------------------------       -------------------------
                       Number        Weighted     Weighted           Number      Weighted 
                     Outstanding     Average       Average       Exercisable     Average 
Range of Exercise    at Year-end    Remaining     Exercise       at Year-end     Exercise 
     Prices            (000)       Contractual      Price             (000)      Price
                                      Life
-----------------    -------------------------------------       -------------------------
<S>                  <C>           <C>            <C>            <C>             <C>
$ 3.25 -   $ 3.25       881          6.31            $3.25             0                0  
$ 4.25 -   $ 7.000      588          6.11            $6.7695         539         $ 6.8934  
$ 7.25   - $10.75       606          5.53            $9.1055         541         $ 9.0473  
$11.00   - $14.375      442          8.04           $13.8119         229         $14.1384  
$14.500  - $14.500      594          8.44           $14.5000         338         $14.5000  
$14.750  - $15.625      454          4.27           $15.5668         428         $15.5940  
$15.84   - $18.000      449          7.74           $16.9533         168         $16.4855  
$18.1250 - $22.625      413          7.56           $20.4436         269         $20.7817  
                      -------                                      -------
$ 3.25   - $22.625    4,427          6.69           $11.3393       2,512         $12.6510  
</TABLE>

<TABLE>
<CAPTION>
                                         OPTION ACTIVITY SUMMARY FOR THE YEAR ENDED DECEMBER 31:
                                  ---------------------------------------------------------------------
                                         1998                     1997                  1996
                                  ---------------------   ----------------------  ---------------------
                                             Weighted -               Weighted -             Weighted -
                                              Average                  Average                Average
                                  Options    Exercise      Options    Exercise    Options    Exercise 
                                  (000)       Price         (000)      Price       (000)      Price
                                  ---------------------   ----------------------  ---------------------
<S>                               <C>        <C>          <C>         <C>         <C>        <C>
Outstanding-beginning of year      3,277       $13.2569     2,432       $11.81      2,372      $ 9.66
Granted                            1,458       $ 7.717      1,346       $14.96        486      $19.78
Granted outside Plan                  20       $ 3.25        ----         ----       ----        ----
Exercised                            (25)      $ 8.5055      (258)      $ 8.35       (333)     $ 8.41
Forfeited                           (303)      $14.356       (243)      $13.24        (93)     $10.75
                                   -----                    -----                   -----
Outstanding at end of year         4,427       $11.3393     3,277       $13.27      2,432      $11.81
                                   -----       --------     -----       ------      -----      ------
                                   -----       --------     -----       ------      -----      ------

Exercisable at end of year         2,512       $12.6510     1,627       $11.89      1,350      $10.90
                                   -----       --------     -----       ------      -----      ------
                                   -----       --------     -----       ------      -----      ------

Weighted-average fair value of

Options granted during the year   $7.717                    $7.13                   $9.54
</TABLE>

Under the Stock Plan, stock may be sold and stock bonuses or rights to 
purchase common stock may be granted by the Board of Directors or a committee 
thereof  (the "Board") for past services at the fair market value at the date 
of grant.  The Board may impose certain repurchase rights, in favor of the 
Company, in the event that an employee is terminated prior to certain 
predetermined vesting dates.  As of December 31, 1998, 1997 and 1996, no 
shares were subject to repurchase.

                                      F-16
<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 4:   STOCKHOLDERS' EQUITY (CONTINUED)

COMMON STOCK RESERVED FOR FUTURE ISSUANCE

    At December 31, 1998, the total number of shares of Common Stock reserved 
for issuance under all stock plans was 6,190.

                                      F-17

<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 5:  INCOME TAXES

    An income tax benefit has not been accrued on net losses due to the 
uncertainty regarding the Company's future profitability.
 
    Significant components of the Company's deferred tax assets for federal 
and state income taxes as of December 31, 1998 and 1997 are as follows:

                                                YEAR ENDED DECEMBER 31,
                                                  1998          1997
                                                  ----          ----
Net operating loss carryforwards               $ 46,000     $  25,900
Research and development credits                  3,600         2,400
Reserves and accruals                             4,500         4,100
Capitalized R&D                                   7,900         5,700
Arbitration obligation                           10,000        15,800
Other -- net                                      2,700         3,400
                                               ----------------------
  Total deferred tax assets                    $ 74,700      $ 57,300
  Valuation allowance for deferred tax assets   (74,700)      (57,300)
                                               ----------------------
Net deferred tax assets                        $      0      $      0
                                               ----------------------
                                               ----------------------

    The valuation allowance for the deferred tax assets increased by $17.4 
million and $19.8 million during the years ended December 31, 1998 and 
December 31, 1997, respectively. Approximately $3.2 million of the valuation 
allowance results from tax deductions under the stock option plans and will 
be credited to Common Stock when recognized.

    At December 31, 1998, the Company had federal net operating loss and 
research and development tax credit carryforwards of approximately $131 
million and $2.4 million, respectively. The Company had state net operating 
loss and tax credit carryforwards of approximately $19.8 million and $1.9 
million, respectively. These carryforwards will expire at various dates 
beginning in 1999.

    Because of the "change in ownership" provisions of the Internal Revenue 
Code, a substantial portion of the Company's 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 6:  STATEMENTS OF CASH FLOWS DATA

<TABLE>
<CAPTION>
                                                           1998        1997       1996
                                                       --------------------------------
<S>                                                    <C>         <C>          <C>
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS INFORMATION
Interest paid                                          $   2,834   $   1,631    $   844

SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND
  FINANCING ACTIVITIES
Equipment purchased under capital leases               $     ---   $     ---    $   464
Unrealized gain/(loss) on investments                  $      12   $       3    $    (5)
</TABLE>


                                      F-18

<PAGE>
                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 7: BUSINESS SEGMENTS

    The Company operates in two business segments: diagnostics and drug 
delivery. Both segments are engaged in development and manufacture, utilizing 
proprietary technologies to satisfy unmet medical needs cost effectively. The 
segments are strategic business units managed separately based on the 
differences in the technologies of their respective product lines.
 
    The diagnostics division's efforts are primarily focused on an automatic 
and continuous glucose monitoring device, the GlucoWatch automatic glucose 
monitor. The GlucoWatch monitor is designed to take frequent measurements, 
thus providing an abundance of glucose data to potentially better control 
fluctuating glucose levels. The Company believes its proprietary extraction 
and sensing technologies provide the potential to develop unique products for 
glucose monitoring which could lead to improved treatment for people with 
diabetes. 

    The drug delivery division's efforts are focused primarily on transdermal 
drug delivery systems, which provide for the controlled release of drugs 
directly into the bloodstream through intact skin. Cygnus' transdermal 
technology is based on the objective of making transdermal products less 
irritating, more comfortable and longer to wear for the patient. The Company 
has received FDA approval for two products and has a number of others in 
late-stage development, including two hormone replacement therapy products 
and a contraceptive product.

    The accounting policies of the business segments are the same as those 
describe in the summary of significant accounting policies. The Company does 
not currently have a measure of interest income or interest expense by 
business segment. There are no reconciling items between total segment 
revenues and profit and (loss) and consolidated results. The Company utilizes 
the following information for the purpose of making decisions and assessing 
segments' performance.

<TABLE>
<CAPTION>
                                                         BUSINESS SEGMENTS
                                             ---------------------------------------------
          1998                                DIAGNOSTICS   DRUG DELIVERY   CORPORATE TOTAL
          ----                                -----------   -------------   ---------------
     <S>                                      <C>           <C>             <C>            
     Revenue                                    $     457     $    11,198     $      11,655
     Profit/(loss)                                (40,030)            602           (39,428)
     Depreciation and  amortization                   969             971             1,940
     Other significant items:                                                              
        Beneficial conversion costs                 4,230            ----             4,230
                                                                                           
     Identifiable assets                           39,130           4,324            43,454
     Expenditure for long lived assets          $   2,834     $       531     $       3,365
                                                                                           
          1997                                                                             
          ----                                                                             
                                                                                           
     Revenue                                    $   2,146     $    27,356     $      29,502
     Profit/(loss)                                (15,083)        (35,377)         (50,460)
     Depreciation and  amortization                 1,230           1,509            2,739 
     Other significant items:                                                              
       Arbitration settlement                        ----         (39,666)         (39,666)
       Writedown of assets                             15           1,275            1,290 
     Identifiable assets                           42,955           6,322           49,277 
     Expenditure for long lived assets          $   2,577     $       518     $      3,095 
                                                                                           
          1996                                                                             
          ----                                                                             
                                                                                           
     Revenue                                    $   2,712     $    33,491     $     36,203 
     Profit/(loss)                                 (8,405)         (2,647)         (11,052)
     Depreciation and  amortization                   757           2,045            2,802 
     Identifiable assets                           53,750          15,048           68,798 
     Expenditure for long lived assets          $     791     $       724     $      1,515 
</TABLE>
                                      F-19
<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 7: BUSINESS SEGMENTS (CONTINUED)

    All segmental revenues have been generated in the U.S. and the Company 
currently does not have any long lived assets outside the U.S.  

NOTE 8:  SENIOR CONVERTIBLE NOTES

    In February 1998, the Company entered into Note Purchase Agreements with 
certain institutional investors to issue and sell approximately $43 million 
of 4% Senior Subordinated Convertible Notes due 2005 (the "Notes"). On 
October 28, 1998, the Company restructured the Notes. Key provisions in the 
restructured Notes include the October 1998 repayment of $18.5 million in 
principal (reducing the principal balance from $43 million to $24.5 million), 
a delay in the convertibility of the majority of the Notes to June 30, 1999 
or after, modification of conversion prices of the Notes, the ability of the 
Company to redeem at par at any time all or part of the new principal amount 
of the Notes, an increase in the interest rate to 5.5% paid annually on the 
new principal balance and the change in the final maturity of the Notes to 
October 1, 2000. 

    Under the terms of the restructured Notes, all of the remaining $24.5 
million principal amount of the Notes are redeemable by the Company at par 
including accrued interest. $18.5 million of the Notes will not be  
convertible into Common Stock by the Note Holders until June 30, 1999. The 
restructured Notes are divided into three tranches. The first tranche had a 
original principal amount of  $6 million and was convertible in whole or in 
part into Common Stock at any time, at a price that was fixed until June 30, 
1999 ($3.54), and was subject to a potential upward adjustment on February 1, 
1999 based on certain market formulas. As of December 31, 1998, $1.9 million 
of the first tranche had been converted into Common Stock. The balance of the 
first tranche was fully converted in January 1999. The second tranche also 
has an original principal amount of $6 million and cannot be converted into 
Common Stock until June 30, 1999, at which time it becomes convertible in 
whole or in part. On June 30, 1999, the conversion price of the second 
tranche will be $6.89, which was established on February 1, 1999,  based on 
the average of closing bid prices using a fifteen trading days look-back from 
February 1, 1999. Subsequent to June 30, 1999, the conversion price of the 
second tranche will be determined based on other market formulas containing 
certain look-back provisions. The third tranche of the restructured notes has 
an original principal amount of $12.5 million and cannot be converted into 
Common Stock until July 1, 1999 at a conversion price that will be determined 
based on market based pricing formulas which contain look-back provisions.  
Beginning July 1, 1999, no more than 15% of the second and third  tranches  
may  be converted  per calendar  month  at conversion prices which reflect 
market based formulas. Such formulas  contain components based on various 
averages of closing bid prices and low trading prices during fifteen or ten, 
as the case may be, trading days look-back periods from various dates.  Any 
portions of the 15% monthly amounts of the second and third tranches that are 
not converted in the relevant month may be rolled over for conversion in 
future months. If the Company calls the second tranche of Notes  ($6 million) 
for redemption before February 1, 1999, the Note Holders will be entitled to 
convert not more than 50% of such notes called before the redemption occurs.  
No such call was made by the Company prior to February 1, 1999. If the 
Company calls the third tranche of Notes ($12.5 million) for redemption 
before July 1, 1999, the Note Holders will not be entitled to convert any 
portion of such tranche so called. The Note Holders will otherwise be 
entitled to convert Notes called for redemption before the redemption occurs, 
at conversion prices based on market formulas. 

    The terms of the restructured Notes contained beneficial conversion 
features relative to the first tranche which resulted in a non-cash charge to 
earnings of $4.2 million. Future tranches of the restructured Notes may also 
have similar beneficial conversion features. Such beneficial features, if 
any, are contingent upon future events including timing of conversion and 
market prices at the time of conversion and accordingly the Company is not 
able to estimate any potential charges at this time. 

                                      F-20

<PAGE>

                                   CYGNUS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

NOTE 9: RELATED PARTY TRANSACTIONS

    The Company currently does business with two companies that are 
principally owned by a non-officer Vice President of the Company. These 
companies are primarily engaged to design and build manufacturing equipment 
for the GlucoWatch system, and to manufacture components of the GlucoWatch 
system. The Company spent approximately $4.0 million with these companies in 
1998, and this amount is expected to increase in 1999. As of December 31, 
1998, $1.0 million was payable to these companies, and the Company had 
outstanding purchase commitments to one of these companies totaling $0.9 
million.

NOTE 10: COMMITMENTS 

    As of December 31, 1998, the Company had non-cancelable purchase orders 
totaling $0.9 million with a single vendor for the construction of 
manufacturing equipment to be used to produce components of the GlucoWatch 
system.

NOTE 11: CONCENTRATION OF CREDIT RISK

    The Company maintains its cash, cash equivalents and investments 
primarily with a bank and two brokerage houses. This practice is consistent 
with the Company's policy to maintain high liquidity and ensure safety of 
principal.

    As of December 31, 1998, approximately 97% of the trade accounts 
receivable are due from three customers. The remaining balance of the trade 
accounts receivable are due from two customers, all of which are large 
pharmaceutical companies. As of December 31, 1997, approximately 90% of the 
trade accounts receivable were due from two customers.  The remaining balance 
of the trade accounts receivable were due from four customers, all of which 
were large pharmaceutical companies. Generally, the Company does not require 
any collateral on receivable balances.

NOTE 12:  EMPLOYEE BENEFIT PLAN

    The Company has a defined contribution benefit plan (the "Plan") covering 
substantially all employees. The Plan provides for employee contributions up 
to 15 percent of their annual pre-tax compensation or to a maximum of 17 
percent of the combined pre-tax and after-tax compensation, as defined in the 
Plan. The Plan provides for the Company to match a portion of the 
contributions. For the years ended December 31, 1998 and 1997, the Company 
incurred defined contribution expense of $0.1 million and $0.08 million, 
respectively.

NOTE 13:  LEGAL PROCEEDINGS
 
    On November 20, 1998, the American Arbitration Association issued the 
final award on the arbitration proceedings between Cygnus and Pharmacia & 
Upjohn ("Pharmacia") relating to the Nicotrol patch, Cygnus' smoking 
cessation patch. Pursuant to the findings from the arbitration proceedings, 
Cygnus was awarded $4.3 million for prevailing in some of its claims and 
Pharmacia was awarded $1.6 million for prevailing in some of its claims. 
Accordingly, Cygnus realized a net amount of $2.7 million. By way of 
background, Cygnus initiated these proceedings in May 1997 based on the 
agreement between Cygnus and Pharmacia, which provided that Pharmacia would 
be obligated to pay Cygnus for, among other things, existing inventory costs 
and certain purchase order commitments.  Pharmacia disputed their obligations 
regarding certain of the inventory costs and certain purchase order 
commitments. In March 1998, Pharmacia added a counterclaim against Cygnus in 
the arbitration, seeking approximately $1.5 million in reimbursement for an 
alleged overpayment in royalties for Nicotrol units shipped in 1996 and 1997. 
Cygnus' claim and Pharmacia's counterclaim commenced on June 15, 1998 before 
a panel of the American Arbitration Association. This final and unappealable 
decision settles all claims and counterclaims submitted to this Arbitration 
by the Parties.

NOTE 14: SUBSEQUENT EVENTS

    On February 23, 1999 a warrant to purchase 120 shares of Common Stock was 
issued to Petkevich and Partners, LLC for services rendered in providing 
financing advice. Sixty (60) shares can be purchased at $0.01 (one cent) per 
share prior to March 2, 1999 by Petkevich and Partners, LLC and 60 shares at 
$3.25 per share prior to November 1, 1999. The warrant and shares have not 
been registered under the Securities Act of 1933. On February 26, 1999, 
Petkevich and Partners, LLC exercised the warrant to purchase 60 shares at 
the exercise price of $0.01 (one cent) per share of the outstanding warrant.

                                      F-21

<PAGE>

                                                                     SCHEDULE II


                                 CYGNUS, INC.

                       VALUATION AND QUALIFYING ACCOUNTS
                YEARS ENDED DECEMBER 31, 1998,  1997, AND 1996
                           (DOLLARS IN THOUSANDS)


<TABLE>
<CAPTION>
                                        BALANCE AT     CHARGED TO      CHARGED TO
                                       BEGINNING OF    COSTS AND          OTHER                     BALANCE AT
                                           YEAR          EXPENSES        ACCOUNTS    DEDUCTIONS    END OF YEAR
                                       -------------------------------------------------------------------------
<S>                                    <C>             <C>             <C>           <C>           <C>
Year ended December 31, 1998:
   Deducted from asset accounts:
   Allowance for doubtful accounts     $  123           $  --           $  --         $    --        $   123
   Warranty reserve                       435              --              --              --            435
                                       ---------------------------------------------------------------------
                                       $  558           $  --           $  --         $    --        $   558
                                       ---------------------------------------------------------------------
                                       ---------------------------------------------------------------------

Year ended December 31, 1997:
   Deducted from asset accounts:
   Allowance for doubtful accounts     $1,137           $ --            $ --          $(1,014)       $   123
   Warranty reserve                       435             --              --               --            435
                                       ---------------------------------------------------------------------
                                       $1,572           $ --            $ --          $(1,014)       $   558
                                       ---------------------------------------------------------------------
                                       ---------------------------------------------------------------------

Year ended December 31, 1996:
   Deducted from asset accounts:
   Allowance for doubtful accounts     $1,137           $ --            $ --          $    --        $ 1,137
   Warranty reserve                       435             --              --               --            435
                                       ---------------------------------------------------------------------
                                       $1,572           $ --            $ --          $    --        $ 1,572
                                       ---------------------------------------------------------------------
                                       ---------------------------------------------------------------------
</TABLE>


                                      S-1