<PAGE>
 
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                   FORM 10-K
(Mark One)
[X]     Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934

                  For the Fiscal Year Ended December 31, 1998

[_]     Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the Period From _________ to __________.

                        Commission File Number:  0-27188
                                                 -------
                               PHARMACOPEIA, INC.
             (Exact name of Registrant as specified in its charter)

          DELAWARE                                33-0557266
(State or other jurisdiction of      (I.R.S. employer identification number)
 incorporation or organization)

                   CN 5350, PRINCETON, NEW JERSEY  08543-5350
             (Address of principal executive offices and zip code)

                                 (609) 452-3600
              (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 $.0001
                                                             -------------------
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 periods as 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 approximate aggregate market value of voting stock held by
nonaffiliates of the Registrant was $172,672,671 based on the last sale price of
Common Stock reported on The Nasdaq National Market on January 31, 1999.
3,472,804 shares of Common Stock held by  officers, directors, and holders of 5%
or more of the outstanding Common Stock have been excluded in that such persons
may be deemed to be affiliates.  This determination of affiliate status is not
necessarily a conclusive determination for other purposes.

     As of January 31, 1999, the number of outstanding shares of the
Registrant's Common Stock was 19,259,298.

                      DOCUMENTS INCORPORATED BY REFERENCE

     Certain information required by Part III of Form 10-K is incorporated by
reference from the Registrant's Proxy Statement for the Annual Stockholders
Meeting to be held May 4, 1999 (the "Proxy Statement), which will be filed with
the Securities and Exchange Commission within 120 days after the close of the
Registrant's fiscal year ended December 31, 1998.
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES

                                 1998 FORM 10-K

                               TABLE OF CONTENTS

                                                                            Page
                                                                            ----

PART I........................................................................ 2

      ITEM 1.  BUSINESS....................................................... 2
      ITEM 2.  PROPERTIES.....................................................28
      ITEM 3.  LEGAL PROCEEDINGS..............................................28
      ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............28

PART II.......................................................................30

      ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
               STOCKHOLDER MATTERS............................................30
      ITEM 6.  SELECTED FINANCIAL DATA........................................31
      ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
               CONDITION AND RESULTS OF OPERATIONS............................31
      ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
               RISK...........................................................35
      ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................35
      ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
               ACCOUNTING AND FINANCIAL DISCLOSURE............................35

PART III......................................................................35

      ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.............35
      ITEM 11. EXECUTIVE COMPENSATION.........................................36
      ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
               MANAGEMENT.....................................................36
      ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................36

PART IV.......................................................................36

      ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
               FORM 8-K.......................................................36

SIGNATURES....................................................................41

REPORT OF INDEPENDENT AUDITORS...............................................F-1
<PAGE>
 
                                     PART I
                                        
ITEM 1.  BUSINESS

      Pharmacopeia, Inc. ("Pharmacopeia" or the "Company") offers products and 
services to accelerate drug discovery and chemicals development integrating 
three platform technologies: small molecule combinatorial chemistry, 
high-throughput screening, and simulations software. The Company's small
molecule combinatorial chemistry and high-throughput screening operations are
focused primarily on drug discovery and are conducted by its Laboratory Services
segment ("Pharmacopeia Labs"). Through its wholly-owned subsidiary, Molecular
Simulations Incorporated ("MSI"), which the Company acquired in 1998,
Pharmacopeia's software segment develops and commercializes molecular modeling,
simulation, and informatics software and services for both life science and
materials science customers.

      When used in this Report, the words "expects", "believes", "anticipates",
"estimates" and similar expressions are intended to identify forward-looking
statements.  Such statements are subject to risks and uncertainties, including
those set forth under the caption "Business --Important Factors Regarding
Forward Looking Statements" and elsewhere in this Report, that could cause
actual results to differ materially from those projected.  These forward-looking
statements speak only as of the date of this Report and the Company disclaims
any undertaking to publicly update or revise any forward-looking statements
contained herein to reflect any change in the Company's expectations with regard
thereto or any change in events, conditions or circumstances on which any such
statement is based.

                         OVERVIEW OF PHARMACOPEIA LABS

      Since its inception in March 1993, the Company has focused its research
efforts in developing novel, proprietary technologies for accelerating the pace
of drug discovery for its pharmaceutical and biotechnology customers.
Pharmacopeia Labs' Encoded Combinatorial Library on Polymeric Support
("ECLiPS"TM) technology addresses a key challenge in the drug discovery process:
generating and evaluating large numbers of diverse and readily identifiable
small molecule compounds to find new, orally active drugs. ECLiPS enables
Pharmacopeia Labs to generate hundreds of thousands of small molecule compounds
at a fraction of the cost of traditional chemical synthesis methods.
Pharmacopeia Labs focuses on drug discovery, and seeks customers to develop,
manufacture, market and sell resulting drugs. To date, Pharmacopeia Labs has
signed contracts with several pharmaceutical customers for collaborations using
ECLiPS, including Schering Corporation and Schering-Plough Ltd. (collectively
"Schering-Plough"), Berlex Laboratories, Inc. ("Berlex"), Novartis Corporation
("Novartis"), Bayer Corporation ("Bayer"), Daiichi Pharmaceutical Co., Ltd.
("Daiichi"), N.V. Organon ("Organon"), Bristol-Myers Squibb Company ("BMS"),
Pharmacia & Upjohn Inc. ("Pharmacia Upjohn") and Zeneca Limited ("Zeneca") and
with a number of biotechnology customers.

      Pharmacopeia Labs' technology supports its pharmaceutical and
biotechnology customers in improving their drug discovery productivity.
Pharmacopeia Labs uses "Direct Divide" combinatorial chemistry to build
collections, or libraries, of 10,000 to 500,000 or more small molecule compounds
by performing only 50 to 200 individual chemical reactions. Pharmacopeia Labs'
ECLiPS technology offers substantial productivity improvements as compared to
the 10,000 to 500,000 or more reactions that would be required to prepare
similarly sized chemical libraries by synthesizing each compound individually.
The ECLiPS productivity advantage results from the synthesis of compounds on
tiny plastic beads in large mixtures. After each solid phase synthesis step,
proprietary tag sets are attached to the beads to indicate the chemical building
block and reaction conditions used in that step. These stable, easily detectable
tag sets enable the rapid identification from the mixture of any compound that
is active 

                                      -2-
<PAGE>
 
in a biological screening assay. This tagging technology is licensed exclusively
from Columbia University ("Columbia") and Cold Spring Harbor Laboratory ("Cold
Spring").

      Pharmacopeia Labs' objective is to be among the industry leaders in the
discovery and optimization of novel drug candidates.  Pharmacopeia Labs'
commercialization strategy is to pursue collaborations with pharmaceutical and
biotechnology companies. Pursuant to collaborative agreements, Pharmacopeia Labs
licenses its libraries for screening by customers, forms drug discovery
collaborations with its customers and plans to license internally developed
compounds. Pharmacopeia Labs' technology strategy is to enhance productivity
through cost reductions and increased throughput, to increase the size and
quality of its library compound collection and its high throughput screening
capabilities, and to build its knowledge base of the relationships between
chemical structures and biological targets for use in future drug discovery
programs.

DRUG DISCOVERY TECHNOLOGIES USED AT PHARMACOPEIA LABS

      A major bottleneck in the drug discovery process is the limited number and
diversity of available chemical compounds. Using traditional manual chemical
synthesis techniques, a chemist is usually able to synthesize only 25 to 50
compounds per year. The low productivity of manual synthesis severely constrains
the number of compounds available for screening in order to identify active
compounds and provide the basis for initial structure-activity relationships
("SAR") analysis. Manual synthesis also slows the optimization process by
limiting the number of analogs synthesized and tested.

      Numerous technologies have been developed to accelerate the synthesis of
chemical compounds. Several early methods were based on either automated or
combinatorial chemical synthesis of oligonucleotides and peptides, which are not
generally useful as oral drugs. Combinatorial chemistry involves the synthesis
of large numbers of different chemical compounds by creating all possible
combinations of a set of chemical components, or building blocks. More recent
methods include robotic synthesis and various combinatorial chemistry approaches
to synthesizing libraries of small molecules, which are generally preferred by
pharmaceutical companies as drug development candidates.

      Pharmacopeia Labs believes that its drug discovery technology offers a
unique solution to the bottleneck that constrains the drug discovery process.
Pharmacopeia Labs' combinatorial chemistry technology generates large, diverse
libraries of the small molecules favored by pharmaceutical companies for
development. Most importantly, Pharmacopeia Labs' technology uses solid phase
synthesis and an encoding system to permit rapid identification of compounds
synthesized in combinatorial mixtures.

      The ECLiPS technology uses a patented "Direct Divide" approach to
combinatorial chemistry to build collections, or libraries, of 10,000 to 500,000
or more small molecule compounds by performing only 50 to 200 individual
chemical reactions.  This "Direct Divide" approach yields a more controlled
distribution of final compounds than does the "pool and split" method currently
used by certain other companies in drug discovery and previously practiced by
Pharmacopeia Labs. Pharmacopeia Labs is able to synthesize a large number of
widely diverse libraries of small molecule compounds because its chemists can
combine a nearly unlimited set of chemical building blocks using a wide variety
of reactions.  Although large libraries of peptides, oligonucleotides and other
oligomers can be generated, their diversity is constrained by the limited number
of building blocks and the fewer reactions available to combine them.

                                      -3-
<PAGE>
 
      Pharmacopeia Labs uses ECLiPS to build libraries of small, low molecular
weight (less than 700 Daltons) compounds, predominantly heterocycles. These low
molecular weight compounds are preferred by pharmaceutical companies because
they are more likely to be orally active (effective as drugs in tablet or
capsule form), tend to have longer duration of action and are less expensive to
manufacture. In contrast, natural peptide and oligonucleotide drugs are usually
degraded by human digestive system enzymes and generally must be administered by
injection. In addition, peptide and oligonucleotide drugs are often quickly
eliminated from the body, which limits their duration of action.

      The ECLiPS technology allows Pharmacopoeia Labs to quickly identify the
chemical structure of individual small compounds synthesized in combinatorial
mixtures. This identification is made possible through the use of Pharmacopeia
Labs' encoded solid phase synthesis technology. Solid phase synthesis generally
refers to the synthesis of compounds on tiny plastic beads. Encoding refers to
the tag sets that Pharmacopeia Labs attaches to each bead as a compound is
synthesized. These tag sets allow Pharmacopeia Labs to rapidly identify the
chemical structure of each compound.

      Pharmacopeia Labs' drug discovery approach encompasses its ECLiPS
technology, assay technology, production automation, information systems and
quality assurance programs, as more fully described below.

ECLiPS Technology

      The ECLiPS technology is the central component of Pharmacopeia Labs' drug
discovery approach. ECLiPS includes solid phase synthesis, combinatorial
chemistry and sets of encoding molecules.

      Solid Phase Synthesis.  Pharmacopeia Labs has developed proprietary
methods and procedures for performing a variety of small molecule chemical
reactions on tiny plastic beads. In this approach to chemical synthesis, known
as solid phase synthesis, compounds are bound to these tiny plastic beads using
special linkers. This approach offers several advantages over solution phase
synthesis.  Solid phase synthesis can often result in higher yields because the
beads can be repeatedly re-exposed to reactants until the desired reaction
product has reached a satisfactorily high yield. Solid phase synthesis also
facilitates the isolation of individual compounds. Beads can be washed with
solvents to remove byproducts, and an individual compound can then be isolated
from a mixture by removing a single bead and breaking the linkage to detach the
compound from the bead.

      Pharmacopeia Labs believes that its experience in solid phase synthesis of
diverse, heterocyclic, small compounds is a key competitive advantage. Large,
diverse libraries of these small molecules are more difficult to synthesize than
libraries of oligonucleotides or peptides. The great diversity of chemical
building blocks and the variety of chemical reactions that must be used in
synthesizing these small molecules require a wide range of reaction conditions,
including temperature, pH, solvents, catalysts and other variables. Each
chemical reaction must be optimized to achieve high yields of the desired
compound.

      Combinatorial Chemistry. Pharmacopeia Labs' ECLiPS technology employs
"Direct Divide" combinatorial chemistry. For example, a chemist using a five
step reaction sequence and ten building blocks per step can synthesize a mixture
of 100,000 different chemicals by performing only 50 chemical reactions. Using
larger numbers of building blocks or steps can create larger libraries. This
technology offers substantial productivity improvement in comparison to parallel
synthesis and other techniques currently employed to generate chemical
libraries. Parallel synthesis is the performance of a series of 

                                      -4-
<PAGE>
 
individual chemical reactions, usually several dozen simultaneously, typically
using robotics. In parallel synthesis, 111,110 individual chemical reactions
would be required to synthesize the same 100,000 compounds that Pharmacopeia
Labs' technology can accomplish in 50 reactions. Parallel synthesis requires
extensive labor and time and a significant capital investment in robotics. The
labor and time disadvantage increases exponentially with library size.

      Sets of encoding molecules.  Pharmacopeia Labs overcomes the challenge of
identifying active compounds from combinatorial mixtures through its use of a
proprietary collection of chemically stable small molecules, or tag sets, to
encode each bead used in solid phase synthesis. This enables Pharmacopeia Labs
to quickly identify the structure of an active compound prepared using the
"Direct Divide" technique without resorting to deconvolution, a process in which
an active compound must be "reverse engineered" by resynthesizing and testing
various component combinations until the structure of the active compound is
deduced. During each step of Pharmacopeia Labs' solid phase synthesis process,
specific tag sets are attached to the beads to indicate the chemical reagent and
reaction conditions used in that step. By the end of the synthesis process, each
bead has collected tag sets that represent all of the building blocks used to
create the compound on that bead. When an active compound is found in an assay,
the bead from which the active compound was extracted is analyzed. The tag sets
are detached from the bead using specific chemical reactions that break the
linkage between the tag sets and the bead. The detached tag sets are read using
conventional gas chromatography techniques. The results, which resemble a bar
code, are captured in a database that identifies and stores data regarding the
active compound.

      Pharmacopeia Labs' proprietary tag sets have the following important
characteristics:

      Stability.  Pharmacopeia Labs' proprietary tag sets are relatively
unreactive.  For this reason the tag sets do not break or decompose as a result
of heat, vigorous shaking or other harsh reaction conditions. Thus, the tag sets
rarely interfere with or limit the solid phase chemical reactions used to create
potential new drug compounds. By contrast, the oligonucleotides and peptides
used as tags by some companies are more fragile because they are more reactive.
These large molecule tags may therefore interfere with chemical reactions or may
be decomposed or altered chemically during compound synthesis. These factors
constrain the range of chemicals that can be synthesized in solid phase when
oligonucleotide or peptide tags are used.

      Size and Detectability.  In contrast to the relatively large size of
oligonucleotide and peptide tags, Pharmacopeia Labs' tag sets are small and easy
to attach to and detach from the beads. The highly sensitive detection methods
available for these tag sets allow Pharmacopeia Labs to use them in extremely
small quantities. Pharmacopeia Labs' tag sets do not occupy a significant
portion of the beads' capacity and do not interfere with the extraction or
testing of detached compounds.

      Thus, using its proprietary ECLiPS technology, Pharmacopeia Labs can
synthesize a large combinatorial mixture of compounds and rapidly identify the
specific structure of individual active compounds found in the library. As of
December 31, 1998, Pharmacopeia Labs has used its ECLiPS technology to
synthesize libraries containing an aggregate of more than 4.8 million unique
chemical compounds. Many of these libraries have initially been licensed to
customers for their exclusive use for varying periods of time.

      ECLiPS also assists Pharmacopeia Labs in protecting its intellectual
property.  When a customer licenses Pharmacopeia Labs' libraries, Pharmacopeia
Labs ships microtiter plates containing library compounds detached from the
beads for screening in the customer's laboratories. The beads containing 

                                      -5-
<PAGE>
 
the tag sets never leave Pharmacopeia Labs' facility. When the customer finds an
active compound in an assay, the customer asks Pharmacopeia Labs to decode the
compound. This process notifies Pharmacopeia Labs of active compounds identified
by its customers.

Assay Technology

      The second component of Pharmacopeia Labs' drug discovery approach is its
proprietary assay technology. Pharmacopeia Labs employs 96-well and 384-well
microtiter plate solution phase assays, a standard format in the pharmaceutical
and biotechnology industry, to evaluate the biological activity of compounds in
Pharmacopeia Labs' libraries. The adoption of this format facilitates the use of
its libraries in assays performed by its customers.

      Pharmacopeia Labs has improved the 96-well and 384-well microtiter plate
assays it performs for its collaborators and its internal drug discovery
programs. These improvements include increasing the sensitivity of detection,
increasing the number of assays that can be run daily, reducing labor and
materials required to execute assays and allowing simultaneous collection of
information on the activity of a single compound against multiple targets.

      During 1998 Pharmacopeia Labs completed more than 30 million tests of its
library compounds for activity against biological targets such as receptors or
enzymes.  For primary screening, Pharmacopeia Labs' often includes 10-20
compounds per well to perform a quick survey of a library's activity.  If assay
results suggest that some compounds in that library are active, then compounds
from that library are tested individually.

      Pharmacopeia Labs has also been developing an integrated set of
technologies to increase throughput and reduce compound and reagent consumption.
Pharmacopeia Labs' Ultra High Throughput Screen (UHTS) system is based on a
1,536-well plate.  Each screening well in this plate accommodates a 1 microtiter
volume for conducting the assay.  This compares with a 100 microtiter volume
required in each well of a  96-well plate.  Thus, compound and reagent
consumption are reduced by 99%.  In addition, each plate represents 1,536 tests
rather than 96.

      Pharmacopeia Labs has been developing this 1,536-well system internally
and through contractors, vendors and collaborators since 1996.  Pharmacopeia
Labs expects to begin screening of its library collection using this technology
in selected assays during 1999.

Production Automation

      Production automation technology is the third component of Pharmacopeia
Labs' integrated drug discovery approach. Pharmacopeia Labs has developed
proprietary instruments and methods for quickly and cost effectively
manipulating large numbers of small plastic beads and the compounds that are
detached from these beads. Pharmacopeia Labs' proprietary technology includes
bead washing and synthesis vessels that support the synthesis process. The
production automation technology also includes proprietary engineering methods
and automated systems for placing individual compounds in 96 to 1,536-well
microtiter plates and processing these plates in preparation for screening.
Screening a single 50,000 compound library against 20 or more targets can
require the loading, processing and testing of thousands of 96-well microtiter
plates.

                                      -6-
<PAGE>
 
Information Systems

      Pharmacopeia Labs has developed proprietary software to support its drug
discovery activities. Pharmacopeia Labs' information systems assist Pharmacopeia
Labs' scientists in managing the extensive data generated during library
production and testing. First, the software tracks the chemical building blocks,
reaction steps and tag sets used to create each library. Pharmacopeia Labs'
systems then track the thousands of bar-coded microtiter plates filled and
processed as libraries are screened. As active compounds are identified and
decoded, Pharmacopeia Labs' software integrates the tag set decoding results
with the original library design database to quickly provide Pharmacopeia Labs'
scientists with the specific chemical structure and synthesis steps for the
active compound.

      Pharmacopeia Labs' information systems also include analytical and
database tools. Databases of available chemical building blocks and reactions
are used as reference sources in the library design process. Molecular modeling,
structure analysis and statistical programs are available for designing
optimization libraries. In addition, analytical and database software is used to
collect and analyze the results of individual assays.  In 1998, the Company
acquired MSI, thereby significantly enhancing its ability to use informatics in
the drug discovery process.  See "Overview of MSI."

      As Pharmacopeia Labs continues to build its chemical libraries and
accelerates its high-throughput screening activities an enormous amount of SAR
information is emerging from these activities, which is being stored in
Pharmacopeia Labs' information systems.  Pharmacopeia Labs has the ability to
provide existing and new customers access to this data warehouse of SAR
information to assist in the search for candidate molecules that interact with
specific targets.  No assurance can be given as to if or when such access will
be provided.

      For information regarding year 2000 compliance see "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."

Quality Assurance

      Pharmacopeia Labs' drug discovery approach includes an extensive quality
assurance program. As libraries are synthesized, representative compounds are
analyzed at each reaction step to assure that yields are high and compounds are
sufficiently pure. During library production, samples are tested at each
reaction step to assure that the tag sets have been satisfactorily attached and
can be decoded. Representative compounds are also tested to identify optimal
solvents and detachment conditions for removing compounds from beads to perform
screening assays. Production plates containing compounds for screening include
control samples to further assure that plates to be screened in assays have been
prepared appropriately.

PHARMACOPEIA LABS' DRUG DISCOVERY PROGRAMS

      Pharmacopeia Labs has several active drug discovery programs underway
using its drug discovery technology. Pharmacopeia Labs is presently conducting
ten programs pursuant to collaborative agreements with six of its customers.
Pharmacopeia Labs is also using its drug discovery technology for internal
programs. These targets include receptors and enzymes in therapeutic areas,
including inflammation, cancer, certain neurological disorders, and metabolic
and cardiovascular diseases. In an effort to identify lead compounds,
Pharmacopeia Labs has commenced the screening of its combinatorial libraries
against these targets and has identified several active compounds in these
assays. Activities are currently being extended to include the optimization of
lead compounds and the determination of 

                                      -7-
<PAGE>
 
bioavailability. Future activities may include preclinical animal efficacy and
toxicity studies. Pharmacopeia Labs will continue to seek financial support from
pharmaceutical companies for the optimization of lead compounds identified by
internal screening. In return for such support, Pharmacopeia Labs would offer
the funding pharmaceutical company an option to license the resulting drug
development candidate for commercialization. Pharmacopeia Labs may also invest
its own funds to optimize these lead compounds into development candidates for
outlicensing to pharmaceutical companies.

PHARMACOPEIA LABS' BUSINESS STRATEGY

      Pharmacopeia Labs' objective is to be the industry leader in the discovery
and optimization of novel drug candidates on an out-sourced basis. Pharmacopeia
Labs seeks to minimize its financing requirements and shorten its time to
profitability by pursuing drug discovery collaborations with multiple
pharmaceutical and biotechnology companies. Pharmacopeia Labs does not currently
plan to develop, manufacture and sell its own pharmaceutical products.
Pharmacopeia Labs' business strategy exploits the emerging trend in the
pharmaceutical industry to outsource certain products and services that can be
more efficiently provided by third parties. Pharmacopeia Labs' commercialization
and technology strategy has several components.

Commercialization Strategy

      Pharmacopeia Labs' commercialization strategy is to provide collections of
compounds and drug development candidates to multiple pharmaceutical and
biotechnology customers. Under these arrangements, Pharmacopeia Labs' customers
are responsible for the clinical development and eventual manufacture and sale
of resulting drugs. Customers compensate Pharmacopeia Labs through (i) funding
or fees during or upon completion of its research and (ii) milestone payments
and royalties on drugs based on Pharmacopeia Labs' technology and developed by
Pharmacopeia Labs' customers. Each collaboration is tailored to the individual
customer's needs but is developed within three broad frameworks:

      Form Drug Discovery Collaborations.  Pharmacopeia Labs synthesizes
targeted and optimization libraries of compounds and, using its high throughput
screening technology, screens these libraries and Pharmacopeia Labs' internal
libraries to identify active compounds.  In several collaborations, Pharmacopeia
Labs performs optimization services to identify drug development candidates.

      License Libraries.  Pharmacopeia Labs creates and licenses large libraries
of compounds to customers who screen these compounds using their own assays and
facilities. This increases the potential value of Pharmacopeia Labs' libraries
by having them screened in drug discovery assays against many biological
targets.  These libraries are most often licensed on an exclusive basis and
become non-exclusive after the expiration of defined time frames.

      Outlicense Compounds from Internal Discovery Programs.  Pharmacopeia Labs
will seek to license to third parties drug development candidates identified by
Pharmacopeia Labs. Pharmacopeia Labs may also seek pharmaceutical sponsors for
various internal development programs, giving the sponsor an option to license
any resulting drug development candidates.

                                      -8-
<PAGE>
 
Technology Strategy

      Pharmacopeia Labs' technology strategy is to enhance productivity through
cost reductions and increased throughput and to build Pharmacopeia Labs' library
collection and its knowledge base of the relationships between chemical
structures and biological targets for use in future drug discovery programs.

      Enhance Productivity.  Pharmacopeia Labs seeks to leverage its existing
technology by increasing productivity through cost reductions and significant
increases in throughput. Pharmacopeia Labs' internal research and development
efforts focus on: (i) advances in Pharmacopeia Labs' automated systems; (ii) the
development of enhanced software; (iii) the development of new materials and
reactions for solid phase synthesis; (iv) new high throughput screening formats;
and (v) the discovery and optimization of lead compounds for Pharmacopeia Labs'
internal programs.

      Develop Collection of Libraries and Knowledge Base.  Pharmacopeia Labs is
building sets of libraries that will eventually aggregate millions of compounds
available for future screening programs. This collection of compounds will
increase as new libraries are created and as outlicensed libraries are returned
to Pharmacopeia Labs upon the expiration of customers' exclusivity periods.
Pharmacopeia Labs believes that this growing library collection will provide a
valuable source of leads for future drug discovery programs. Pharmacopeia Labs
also intends to build a knowledge base of the relationships between classes of
chemical structures and classes of biological targets. This knowledge base will
grow as Pharmacopeia Labs designs, synthesizes and screens large numbers of
compounds against a growing number of targets. Pharmacopeia Labs believes that
this knowledge base will provide a future competitive advantage by enabling
Pharmacopeia Labs to identify more quickly active compounds for newly identified
targets.

PHARMACOPEIA LABS' CUSTOMERS

      Pharmacopeia Labs has signed collaborative agreements for services
provided by Pharmacopeia Labs with Schering-Plough, Berlex, Novartis, Bayer,
Daiichi, Organon, BMS, Pharmacia Upjohn and Zeneca.  The loss of one or more of
such customers may have a material adverse affect on Pharmacopeia Labs.

PHARMACOPEIA LABS' COMPETITORS

      Many organizations are actively attempting to identify and optimize
compounds for potential pharmaceutical development. Pharmacopeia Labs competes
with the research departments of pharmaceutical companies, biotechnology
companies, other combinatorial chemistry companies and research and academic
institutions.

      Many of these competitors have greater financial and human resources, and
more experience in research and development, than Pharmacopeia Labs.
Historically, pharmaceutical companies have maintained close control over their
research activities, including the synthesis, screening and optimization of
chemical compounds. Many of these companies, which represent the greatest
potential market for Pharmacopeia Labs' products and services, are developing
combinatorial chemistry and other methodologies to improve productivity,
including major investments in robotics technology to permit the automated
parallel synthesis of compounds. In addition, these companies may already have
large collections of compounds previously synthesized or ordered from chemical
supply catalogs or other sources against which they may screen new targets.
Other sources of compounds include compounds 

                                      -9-
<PAGE>
 
extracted from natural products such as plants and microorganisms and compounds
created using rational drug design. Academic institutions, governmental agencies
and other research organizations are also conducting research in areas in which
Pharmacopeia Labs is working, either on their own or through collaborative
efforts.

      Pharmacopeia Labs competes with several alternative technologies in the
design and synthesis of new chemical libraries for drug discovery programs.
Combinatorial chemistry libraries of oligonucleotides and peptides can be
synthesized in extremely large numbers. These molecules are also sequenceable,
making it easy to identify the structure of an individual oligonucleotide or
peptide found to be active in an assay. However, oligonucleotides and peptides
are not usually effective as oral drugs because they are usually not
bioavailable. These molecules are also usually quickly metabolized in the human
bloodstream. Other, unnatural oligomer libraries have also been prepared, but
these are less easily sequenceable than peptides and oligonucleotides. In
addition, unnatural oligomer libraries lack the diversity of structures of the
small molecule libraries prepared by Pharmacopeia Labs.

      Libraries of small molecule compounds, which are preferred as drug
candidates due to their increased potential for oral bioavailability and long
duration of action, have recently been developed using competitive techniques.
Three such techniques are based on "pool and split" solid phase combinatorial
chemistry. The first uses oligonucleotide or peptide tags on each bead to
identify each synthesis step. These large molecule tags are relatively fragile,
which limits the nature of reaction conditions (temperature, pressure, etc.) and
reagents (acids, bases, etc.) that can be used to build compounds. In addition,
these large molecule tags complicate the synthesis of compounds or beads.
Pharmacopeia Labs' proprietary tag sets, in comparison, are durable, simple to
attach and detach, and allow Pharmacopeia Labs to make larger and more diverse
libraries of small compounds. The second "pool and split" combinatorial
chemistry technique uses deconvolution to identify the chemical structure of
compounds found active in assays. Deconvolution is a slow, labor-intensive
process, and may require several weeks of scientists' time to determine the
structure of a single active compound. Pharmacopeia Labs' tag sets permit
hundreds of structures to be determined each day. The third "pool and split"
combinatorial chemistry technique uses what are referred to as "hard tags" and
is proprietary to a specific large pharmaceutical company.

      A fourth competitive approach is to perform a series of individual
chemical reactions, typically using a robotic system. The result of robotic
synthesis is compounds in individually labeled vessels. Robotic synthesis also
yields larger quantities of each compound than are usually achieved in
combinatorial mixtures such as Pharmacopeia Labs'. Using robotic synthesis,
however, requires extensive labor and time when compared with Direct Divide
combinatorial chemistry. This labor and time disadvantage increases
exponentially with library size.

EXCLUSIVE LICENSE WITH COLUMBIA UNIVERSITY AND COLD SPRING HARBOR LABORATORY

      In 1993, the Company entered into an exclusive license agreement with
Columbia and Cold Spring (jointly, the "Licensors") covering technology related
to tagged combinatorial chemical libraries and methods of preparing and
utilizing such libraries. The licensed technology includes patents and patent
applications filed by Columbia and Cold Spring covering the use of encoding tag
sets to implement the drug discovery process using combinatorial chemistry
libraries. The Company is obligated to pay a minimum annual license fee of
$100,000. The term of the agreement is the later of (i) 20 years or (ii) the
expiration of the last patent relating to the technology, at which time the
Company has a fully paid license to the technology. The Company is also
obligated to pay royalties to the Licensors based on net sales of pharmaceutical
products developed by the Company as well as a percentage of all 

                                     -10-
<PAGE>
 
other payments and royalties received by the Company from customers where the
Company has utilized the technology licensed from the Licensors.

PATENTS AND PROPRIETARY INFORMATION

      The Company and its licensors currently have nineteen issued U.S. patents
and a number of pending U.S. and foreign patent applications relating to various
aspects of the Company's technology, including its molecular tags, certain
screening technologies and its libraries or compounds contained therein. These
patents and patent applications are either owned by the Company or rights under
them are licensed to the Company.  Of particular note, the Company is the
exclusive licensee of U.S. patents issued on October 15, 1996, February 24, 1998
and August 4, 1998 which provide broad protection to the Company's use of
encoded combinatorial libraries.  The Company's success will depend in large
part on its ability, and the ability of its licensees and its licensors, to
obtain patents for its technologies and the compounds and other products, if
any, resulting from the application of such technologies, defend patents once
obtained, maintain trade secrets and operate without infringing upon the
proprietary rights of others, both in the United States and in foreign
countries.

      The patent positions of pharmaceutical and biotechnology companies,
including the Company, are uncertain and involve complex legal and factual
questions for which important legal questions are largely unresolved.  Certain
patent applications, relating to encoded combinatorial libraries, have been
filed by others prior to the Company's patent applications. In February of 1997,
the European Patent Office granted to Affymax Technologies, N.V., a subsidiary
of Glaxo, certain patent claims which, if valid, would cover the synthesis of
encoded small molecule libraries of the type developed by the Company. On
November 12, 1997, the Company filed an Opposition to these patent claims
challenging their validity. If these claims are found valid and are enforceable,
the Company's ability to practice its ECLiPS technology in Europe would be
restricted unless the Company obtains appropriate licenses from the owner of
such patents. Although the Company has business relationships with a number of
European customers, the Company does not currently practice its technology in
Europe. On January 13, 1998, a U.S. patent was issued to Affymax that contains
certain claims covering a method of preparing an encoded library of chemical
compounds. In a press release issued by Affymax on January 13, 1998, Affymax
stated that these patent claims provide it with "a dominant proprietary position
in the area of tagged chemical libraries." The Company's scientific staff has
reviewed these patent claims and believes that such claims do not cover the
ECLiPS technology. If it is ultimately determined that these claims are valid
and enforceable and that the Company's ECLiPS technology infringes such claims,
then the Company's ability to use its ECLiPS technology in the United States may
be restricted unless the Company obtains appropriate licenses from the owner of
such patent and the Company may be subject to a claim for monetary damages.
However, if any such licenses were required from Affymax, there can be no
assurance that such licenses would be available to the Company or would be
available upon terms reasonably acceptable to the Company. The Company does not
know of any patent applications by others that would preclude the Company from
obtaining patent protection in the United States or elsewhere for its ECLiPS
technology. However, disputes may arise between the Company and other patent
holders as to claims of infringement, which could involve protracted periods of
litigation. Some of the Company's competitors have, or are affiliated with
companies having, substantially greater resources than the Company, and such
competitors may be able to sustain the costs of complex patent litigation to a
greater degree and for longer periods of time than the Company. Uncertainties
resulting from the initiation and continuation of any patent or related
litigation could have a material adverse effect on the Company's ability to
compete in the marketplace pending resolution of the disputed matters.

                                     -11-
<PAGE>
 
      There can be no assurance that patents will issue as a result of any
pending applications or that, if issued, such patents will be sufficiently broad
to afford protection against competitors with similar technology. Moreover,
there can be no assurance that the Company or its customers will be able to
obtain patent protection for lead compounds or pharmaceutical products based
upon the Company's technology. There can be no assurance that any patents issued
to the Company or its collaborative partners, or for which the Company has
license rights, will not be challenged, invalidated or circumvented, or that the
rights granted thereunder will provide competitive advantages to the Company.
Litigation, which could result in substantial cost to the Company, may be
necessary to enforce the Company's patent and license rights or to determine the
scope and validity of others' proprietary rights. Further, U.S. patents do not
provide any remedies for infringement that occurred before the patent is
granted.

      The commercial success of the Company will also depend upon avoiding the
infringement of patents issued to competitors and upon maintaining the
technology licenses upon which certain of the Company's current products are, or
any future products under development might be, based. If competitors of the
Company prepare and file patent applications in the United States that claim
technology also claimed by the Company, the Company may have to participate in
interference proceedings declared by the U.S. Patent and Trademark Office
("PTO") to determine the priority of invention, which could result in
substantial cost to the Company, even if the outcome is favorable to the
Company. An adverse outcome could subject the Company to significant liabilities
to third parties and require the Company to license disputed rights from third
parties or cease using the technology. A U.S. patent application is maintained
under conditions of confidentiality while the application is pending in the PTO,
so that the Company cannot determine the inventions being claimed in pending
patent applications filed by its competitors in the PTO.

      The Company currently has certain licenses from third parties and in the
future may require additional licenses from other parties to develop,
manufacture and market commercially viable products effectively. There can be no
assurance that such licenses will be obtainable on commercially reasonable
terms, if at all, that the patents underlying such licenses will be valid and
enforceable or that the proprietary nature of the patented technology underlying
such licenses will remain proprietary.

      The Company relies substantially on certain technologies which are not
patentable or proprietary and are therefore available to the Company's
competitors. The Company also relies on certain proprietary trade secrets and
know-how, which are not patentable. Although the Company has taken steps to
protect its unpatented trade secrets and know-how, in part through the use of
confidentiality agreements with its employees, consultants and certain of its
contractors, 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 or discovered by competitors.

GOVERNMENT REGULATION OF PHARMACOPEIA LABS

      Regulation by governmental entities in the United States and other
countries will be a significant factor in the production and marketing of any
pharmaceutical products that may be developed by a customer of Pharmacopeia Labs
or, in the event Pharmacopeia Labs decides to develop a drug beyond the
preclinical phase, by Pharmacopeia Labs. The nature and the extent to which such
regulation may apply to Pharmacopeia Labs' customers will vary depending on the
nature of any such pharmaceutical products. Virtually all pharmaceutical
products developed by Pharmacopeia Labs' customers will require regulatory
approval by governmental agencies prior to commercialization. In particular,
human pharmaceutical therapeutic products are subject to rigorous preclinical
and clinical testing and other 

                                     -12-
<PAGE>
 
approval procedures by the U.S. Food and Drug Administration ("FDA") and by
foreign regulatory authorities. Various federal and, in some cases, state
statutes and regulations also govern or influence the manufacturing, safety,
labeling, storage, record keeping and marketing of such pharmaceutical products.
The process of obtaining these approvals and the subsequent compliance with
appropriate federal and foreign statutes and regulations are time consuming and
require the expenditure of substantial resources.

      Generally, in order to gain FDA approval, a company must conduct
preclinical studies in the laboratory and in animal models to gain preliminary
information on a compound's efficacy and to identify any safety problems. The
results of these studies are submitted as a part of an Investigational New Drug
application ("IND") that the FDA must review before human clinical trials of an
investigational drug can start. In order to commercialize any products,
Pharmacopeia Labs or its customer will be required to sponsor and file an IND
and will be responsible for initiating and overseeing the clinical studies to
demonstrate the safety and efficacy that are necessary to obtain FDA approval of
any such products. Clinical trials are normally done in three phases and
generally take two to five years, but may take longer, to complete. After
completion of clinical trials of a new product, FDA and foreign regulatory
authority marketing approval must be obtained. If the product is classified as a
new drug, Pharmacopeia Labs or its customer will be required to file a New Drug
Application ("NDA") and receive approval before commercial marketing of the
drug. The testing and approval processes require substantial time and effort and
there can be no assurance that any approval will be granted on a timely basis,
if at all. NDAs submitted to the FDA can take, on average, two to five years to
obtain approval. If questions arise during the FDA review process, approval can
take more than five years. Even if FDA regulatory clearances are obtained, a
marketed product is subject to continual review, and later discovery of
previously unknown problems or failure to comply with the applicable regulatory
requirements may result in restrictions on the marketing of a product or
withdrawal of the product from the market as well as possible civil or criminal
sanctions. For marketing outside the United States, Pharmacopeia Labs will also
be subject to foreign regulatory requirements governing human clinical trials
and marketing approval for pharmaceutical products. The requirements governing
the conduct of clinical trials, product licensing, pricing and reimbursement
vary widely from country to country. The research and development processes of
Pharmacopeia Labs involve the controlled use of hazardous materials.
Pharmacopeia Labs is subject to federal, state and local laws and regulations
governing the use, manufacture, storage, handling and disposal of such materials
and certain waste products. Although Pharmacopeia Labs believes that its
activities currently comply with the standards prescribed by such laws and
regulations, the risk of accidental contamination or injury from these materials
cannot be eliminated. In the event of such an accident, Pharmacopeia Labs could
be held liable for any damages that result and any liability could exceed the
resources of Pharmacopeia Labs. In addition, there can be no assurance that
Pharmacopeia Labs will not be required to incur significant costs to comply with
environmental laws and regulations in the future.

PHARMACOPEIA LABS' SOURCES OF SUPPLY

      Pharmacopeia Labs currently relies on one supplier to provide plastic
filter bottom microtiter plates that are used in the assay plate preparation
process.  Should Pharmacopeia Labs be unable to obtain an adequate supply of
these or comparable filter bottom plates at commercially reasonable rates, its
ability to continue to prepare assay plates would be materially and adversely
affected.

PHARMACOPEIA LABS' PHARMACEUTICAL MANUFACTURING AND MARKETING

      Pharmacopeia Labs does not expect to directly manufacture or market any
pharmaceutical products that may be developed under its collaborative
arrangements. However, Pharmacopeia Labs 

                                     -13-
<PAGE>
 
may, in the future, consider undertaking such activities if it believes they are
appropriate under the circumstances. Pharmacopeia Labs has no experience in
developing pharmaceutical products or in manufacturing or marketing products on
a commercial scale. Pharmacopeia Labs may not have the resources to develop or
to manufacture or market by itself on a commercial scale any products identified
by it. In the event Pharmacopeia Labs decides to establish a manufacturing
facility, Pharmacopeia Labs will require substantial additional funds, and will
be required to hire and train significant additional personnel and comply with
the extensive FDA "good manufacturing practice" regulations applicable to such a
facility.

                                OVERVIEW OF MSI
                                        
      MSI is a leading provider of molecular modeling and simulation software.
MSI designs, develops, markets and supports software that facilitates the
discovery and development of new products and processes in the pharmaceutical,
biotechnology, chemical, petrochemical and materials industries. Using MSI's
software products, researchers are able to increase the speed and efficiency of
the research and development cycle, thereby reducing product development costs
and shortening the time to market for new product introductions and process
improvements. MSI's customers comprise leading commercial, governmental and
academic organizations, including many of the largest pharmaceutical,
biotechnology, chemical, petroleum and semiconductor companies worldwide.

      MSI has a comprehensive product suite consisting of over 100 application
modules based on proprietary technologies that employ fundamental scientific
principles, advanced computer visualization, molecular modeling techniques and
computational chemistry. MSI's application products allow scientists to perform
molecular level computations of chemical, biological and physical properties, to
simulate, visualize and analyze chemical and biological systems, and to
communicate the results to other scientists. MSI's products are based upon
advanced software architectures that facilitate the development, integration and
deployment of new software products. MSI also offers open access to its core
software development environment, within which customers and third-party
licensees can develop, integrate and distribute their own software applications
for computational chemistry, biology and materials research. MSI markets its
products and services worldwide, principally through its direct sales force
based in the United States and Europe and through its distribution network in
the Asia/Pacific region.

      MSI plans to continue enhancing its product and service offerings for
simulation specialists, who are the principal users of MSI's products. In
addition, MSI plans to broaden significantly its user base to include the much
larger population of experimentalists--laboratory scientists and engineers that
engage in experimental activities. MSI has packaged its core simulation
technologies into solutions-oriented applications known as computational
instruments. These products are easier to use than traditional simulation
products and perform specific functions analogous to typical laboratory
procedures. Recently, MSI has developed its WebLab family of products, which are
computational instruments accessible over corporate intranets. These instruments
create a "virtual laboratory" of computational instruments and other products
for use on desktop computers by a broad range of scientists to perform
computational chemistry, biology and materials experiments.

MSI INDUSTRY BACKGROUND

      For companies in the pharmaceutical, chemical and materials industries,
innovation in the discovery and development of new products and the rapid, cost-
effective commercialization of these products is crucial to success. To keep
pace with scientific advancement, companies in these industries 

                                     -14-
<PAGE>
 
invest considerable resources in technologies designed to help discover, develop
and commercialize new products and processes. The pace of technical progress has
resulted in the increased use of computation to simulate processes, predict the
outcome of product designs and decrease the time to market.

      Many factors that affect a product's performance, including activity,
bioavailability, toxicity, shelf life and environmental impact, are governed by
fundamental, atomic level properties such as molecular shape, structure and
reactivity. Molecular simulation was developed to predict these molecular
properties and help researchers discover new products, sharpen the focus of
experimental activities and improve ultimate product performance. Beginning in
the late 1970's, major pharmaceutical and chemical companies began to use
molecular simulation in their research and development activities.

      Increased academic and commercial investment in the 1980's improved the
utility of these new simulation technologies. As researchers began to migrate
from mainframe and minicomputer-based systems to high performance UNIX
workstations, companies emerged to provide commercial quality molecular
visualization and computational chemistry software products.

THE MSI SOLUTION

      MSI offers a broad suite of software products and services designed to
enable MSI customers to shorten product lead times, reduce research and
development costs, improve product and process performance, collect and compute
otherwise inaccessible information, and communicate more effectively both inside
and outside an organization. MSI's products and services incorporate the
following attributes:

o     Validated Core Technology. MSI's core technology consists of a number of
      fundamental, scientifically proven methods for conducting predictive
      computer modeling of chemical, biological and materials phenomena at the
      atomic and molecular scale. This core technology is validated by over a
      decade of industrial use and by the publication of more than 400
      presentations, papers and articles citing applications of this technology.

o     Broad Applicability. MSI's validated core technology enables MSI to offer
      a wide range of products and services to a variety of industries,
      including the pharmaceutical, biotechnology, chemical, petrochemical,
      electronics, food, paper, agrochemical, aerospace, plastics, paint and
      natural gas industries. MSI's products simulate and analyze both small
      molecules that may be candidates for new drugs and more complex molecular
      structures such as DNA or the polymers found in plastics and rubber. These
      products are used in research applications as diverse as drug discovery,
      protein design and structure determination, crystallization and
      formulation, polymer property prediction, catalysis and development of
      electronic materials.

o     Open Architecture. MSI's products are based upon an open architecture that
      allows customers, collaborators and third parties to develop software
      applications in the same development environment used internally by MSI.
      MSI's core molecular modeling functions are included in this open
      environment, which permits developers to focus on their particular
      scientific interests and increase the power and utility of their programs
      by integrating them with MSI's products.

o     Ease of Use. MSI develops software products that are integrated, modular,
      focused on specific research areas or techniques, and accessible by an
      intuitive graphical user interface ("GUI"). MSI's GUI enables
      experimentalists to use molecular simulation in a manner consistent with
      established analytical and laboratory techniques, in a user-friendly
      computational environment.

                                     -15-
<PAGE>
 
o     Increased Access. MSI is developing a Web-based product line that targets
      a broader group of users, including experimentalists and engineers. Web
      browsers and other software products are used increasingly by scientific
      researchers on desktop computers to search for, analyze and communicate
      scientific data, particularly within corporate intranets. MSI's Web-based
      products use familiar Web browser technology and are built upon MSI's open
      architecture and validated core technology.

MSI'S BUSINESS STRATEGY

      MSI's objective is to strengthen its position as a leading provider of
molecular simulation products and services worldwide by providing a set of
productivity tools that are integral to the research and development activities
of its customers. The key elements of MSI's strategy to achieve this objective
include:

o     Expand User Base. MSI plans to increase its number of sales personnel in
      order to increase sales to its key accounts and pursue new customers
      within existing markets. In addition, MSI's products have been designed to
      expand use of its software to include not only a growing number of
      simulation specialists, but also the much larger group of
      experimentalists. MSI believes it can leverage its strong relationships
      with simulation specialists to help promote use of MSI products by other
      scientists working in the same organization as the specialists.

o     Leverage Core Technology and Maintain Technology Leadership. MSI believes
      its core technology has helped position MSI at the forefront of simulation
      technology providers. MSI intends to continue to make significant
      investments in research and development in order to improve the efficiency
      and predictive accuracy of its core technology and to maintain its
      technology leadership. Further, MSI's strategy for WebLab is to create a
      "virtual laboratory" that allows access to MSI's validated core technology
      from desktop computers operating within corporate intranets.

o     Become the Industry Standard. MSI has created a development product, the
      Cerius2 Software Developer's Kit ("Cerius2 SDK"), that allows customers
      and third-party licensees to use MSI's open architecture to create their
      own applications for internal use or for distribution. MSI is extending
      this development product to include the WebLab SDK for applications
      development within MSI's WebLab environment. The open architecture
      facilitates communication within and between companies and institutions
      that use MSI's products. MSI intends to continue to promote its
      development environment as the industry standard for use and development
      of molecular simulation and related applications.

o     Promote Strategic Technology Relationships. MSI strengthens its internal
      scientific and technical expertise through MSI's consortia and through
      joint development projects with leading academic, governmental and
      industrial researchers. MSI will continue to pursue strategic
      relationships with third parties in order to provide it with early access
      to new technologies, facilitate market acceptance of new products and
      reduce internal research and development investment.

                                     -16-
<PAGE>
 
MSI'S TECHNOLOGY

     MSI's core technology delivers predictive models of chemical, biological
and materials phenomena within MSI's open environment. This technology simulates
interatomic and intermolecular interactions, and a wide range of corresponding
properties, including molecular structure, activity, diversity, stability,
morphology, solubility, adhesion, adsorption, diffusion, color, analytical
spectra, and optical, electrical and mechanical properties. The benefits of
MSI's technology have been validated by more than 400 published presentations,
papers and articles citing MSI's technology.

Methods

     There are four primary classes of molecular simulation methods, all of
which are employed by MSI in its products:

     Quantum Methods. Quantum methods, the most fundamental of MSI's methods,
compute interatomic interactions at the level of electrons and nuclei.  These
methods make the least number of assumptions about the nature of relevant
interactions and require little or no parameterization. These methods are
capable of simulating which combinations of elements are stable, how chemical
reactions occur, and other electronic structural properties such as reactivity,
color and magnetism. These methods are the most computationally demanding and
are applied to small, carefully selected models.

     Molecular Methods. Molecular methods probe molecular conformations and the
interactions between molecules based on simplified analytical expressions. These
methods include automated procedures for probing how a drug molecule binds to an
active site, what conformations a polymer chain may adopt, what similarities
exist between a new amino acid sequence and protein sequences for which tertiary
structures are known, and they also include tools used to determine structure
based on X-ray diffraction or NMR data.

     Correlative Methods. Correlative methods identify interrelationships
between structure and properties that can be used predictively. In many cases,
macroscopic properties are known to be determined by molecular-level behavior,
but the analytical details of these relationships are not known.  The
quantitative structure activity relationship methods ("QSAR") provide a
framework in which to correlate molecular attributes and macroscopic properties.
The framework can predict, to a reasonable degree of confidence, the properties
of molecules that are comparable with a control set for which properties have
been measured.

     Statistical Methods. Statistical methods are needed when many different
configurations must be sampled or when macroscopic properties reflect an
averaging over many different states. These include methods for modeling complex
polymer structures, computing thermodynamic parameters and conducting
statistical analyses of real and virtual molecular libraries.

Open Architecture

     MSI has pioneered an open molecular simulation software architecture,
Cerius2, which includes an efficient data model; libraries of mathematical,
chemical and graphical utilities; and a client/server data and communications
management layer. Cerius2, a modular, object-oriented system, is written
principally in C++ and uses industry-standard protocols such as MOTIF and
TCP/IP. This modular architecture is designed to provide streamlined access to
the various methods, allowing their use in discrete, combined and packaged ways.
The Cerius2 application programming interfaces ("APIs") are 

                                     -17-
<PAGE>
 
used by MSI's internal developers to create products. The same APIs are made
available through the Cerius2 SDK to customers and third-party licensees. Using
the Cerius2 open architecture and its validated methods, MSI has created its
computational instruments. In each of these computational instruments, a
particular application of one or more methods is precalibrated, parameters and
protocols are predefined and results are delivered in an easily interpretable
fashion. These computational instruments are designed for and used by
experimentalists, such as synthetic, analytical and formulation chemists.

      WebLab is a Web-enabling extension of the Cerius2 open architecture, and
is the medium by which MSI can deliver desktop products for experimentalists.
Accessed from a Web browser operating as a client, these products make use of
both the Cerius2 architecture and MSI's methods running on a server machine. The
server is a UNIX workstation accessed through a corporate intranet. The client
browser application is created using industry-standard languages and protocols.
The WebLab Viewer, a helper application, provides improved performance in the
display and manipulation of molecular structures. Versions of the WebLab Viewer
have been released for PCs running under Windows 95 and Windows NT.

      MSI's Cerius2 architecture, graphics and interface subsystems are
supported on Silicon Graphics and IBM UNIX workstations. Certain of the methods
are also supported on vector supercomputers and on shared and distributed memory
parallel architectures. Existing and planned WebLab products will run on major
platforms that support standard browser technology.

MSI'S PRODUCTS AND SERVICES

      Based upon the technology described above, MSI provides an extensive suite
of software products used throughout the research and development cycle. MSI
believes that offering a "single-shop," integrated molecular simulation solution
is a significant benefit to its customers. MSI's product family consists of over
100 application modules.

      MSI's methods products are powerful, full-featured simulation engines used
primarily by simulation specialists. MSI's application packages are targeted,
solutions-oriented modules usually built upon MSI's methods. These application
packages are also used by simulation specialists and, in the case of
computational instruments, by experimentalists. The Cerius2 Visualizer has a
flexible card-stack layout and is designed to be user-friendly for the
experimentalist as well as the simulations specialist. MSI's WebLab products are
simple-to-use, desktop products designed for specific research tasks of
experimental chemists, biologists and engineers. MSI's methods products,
applications packages, graphical modeling systems and WebLab Viewer are used
throughout the pharmaceutical, biotechnology, chemical and materials industries.

      MSI's individual software modules are priced from $2,500 to $75,000 for an
industrial customer on a UNIX workstation with a single processor. A typical
commercial product installation for a new user in one application area costs
approximately $50,000. Larger installations might include software modules for
several different application areas and for multiple processors or workstations.
MSI's WebLab products have individual user prices of less than $5,000; the
WebLab ViewerLite is provided at no charge on a compact disc or may be
downloaded from MSI's Web site.

                                     -18-
<PAGE>
 
MSI's Customer Applications

     MSI's products are used in a variety of research areas within a number of
industries. The principal research and development areas in which MSI products
are used include the following:

     Protein Design. The pharmaceutical, biotechnology, cosmetics and
agrochemical industries use MSI's software to understand the relationship
between protein structure and function and to analyze, modify and tailor
proteins and peptides. MSI's protein modeling products integrate capabilities in
structure generation, molecular simulation, protein database search and
analysis, molecular visualization and presentation.  Products used in protein
design include Cerius2 and Insight II modules, QUANTA, Discover and CHARMm.

     Macromolecular Structure Determination. Protein structure determination is
a prerequisite for a structure-based route to drug discovery in the
pharmaceutical and biotechnology industries. MSI provides complete software
systems that streamline the process of protein structure determination from X-
ray and NMR data.  These systems include products for data processing and
reduction, rapid model building, structure refinement, model evaluation,
analysis and graphical display. Products used in protein structure determination
include X-PLOR, Insight II application modules, QUANTA, Discover, CHARMm and
Felix.

     Rational Drug Design. MSI's rational drug design products are used in the
pharmaceutical and biotechnology industries. These products allow the design and
optimization of small, organic therapeutics, based on a protein active site
model or on activity data for a set of compounds. Related techniques are used to
design and assess combinatorial molecular libraries.  Products used in drug
design include Catalyst, Cerius2 and Insight II application modules, QSAR and
Discover.

     Polymer Modeling. Polymer modeling products are used by researchers in the
chemical, plastics, rubber, adhesives, petrochemical, aerospace and automotive
industrial sectors. Polymer researchers seek to analyze and predict polymer
properties and establish the link between these properties and the molecular-
level structure of the material. MSI's polymer software products allow these
researchers to construct and characterize models of polymers and predict key
properties, such as blend compatibility, mechanical behavior, cohesion and
adhesion to surfaces. MSI's polymer products include Cerius2 and Insight II
application modules, QSAR and Discover.

     Crystallization. Crystallization phenomena are important to development and
formulation departments in companies in the pharmaceutical, paint and pigment,
petrochemical and chemical industrial sectors. MSI offers products to predict
crystal structure, polymorphism and crystal shapes, and to design additives to
control or inhibit crystal growth. MSI's crystallization products include
Cerius2 and Insight II application modules, Discover, DMol, CASTEP and QSAR.

     Electronics Research. The trend toward microminiaturization of electronic
devices has created a need for improved processes and materials. MSI's software
products are used by semiconductor and electronics companies to understand
surface chemistry, defects, thin oxide layers, magnetic properties and the
performance of new packaging materials. These products include Cerius2 and
Insight II application modules, Discover, DMol and CASTEP.

     Chemical Reactions. Understanding, controlling and improving chemical
conversions is a key research and development objective of petrochemical,
chemical and pharmaceutical companies. MSI 

                                     -19-
<PAGE>
 
offers a range of quantum methods products for simulating chemical reactivity,
conversions and thermochemical data, including Cerius2 and Insight II
application modules, DMol and CASTEP.

     Catalysis and Sorption. MSI's catalysis and sorption products are used by
companies in the chemical, petrochemical, natural gas and plastics industries
and by catalyst manufacturers to characterize catalysts and sorbent materials
and to simulate thermodynamic and reactivity data. MSI's products are used to
characterize and design metallocene catalysts, zeolites and other molecular
sieves, and metal oxides. MSI's catalysis and sorption products include Cerius2
and Insight II application modules, Discover, DMol and CASTEP.

     Analytical Simulation. MSI's analytical products are used by companies in
each of the markets served by MSI to display and interpret diffraction, electron
microscopy, infra-red and other analytical data. MSI's analytical products
include Cerius2 and Insight II application modules, and Felix.

MSI's Other Products and Services

      Integration Products. The Cerius2 SDK offers customers and third-party
licensees a standard simulation environment in which to develop and integrate
their own applications. The Cerius2 SDK provides an external developer with
access to the full set of Cerius2 APIs used by MSI's own internal development
staff. With the Cerius2 SDK a developer can employ any of the functions,
subsystems or methods embodied in or accessible through Cerius2 to integrate an
external program or to create additional application functionality, with a
corresponding Cerius2 GUI. MSI is extending Cerius2 SDK to include the WebLab
SDK for applications development within MSI's WebLab environment.

      Databases. Databases are a close adjunct to MSI's software products. MSI
resells a number of scientific databases for use with its product modules,
including Derwent's World Drug Index, MDL Information Systems' Available
Chemical Directory, and the Brookhaven Protein Databank.

      Accelerated Research Services. MSI offers consulting, contract research,
custom development and systems integration services. MSI's accelerated research
services allow its customers to benefit from MSI's facilities and the expertise
of MSI's staff in outsourcing these types of specialist functions. In certain
contract research projects, MSI may receive some future compensation in the form
of a royalty payment on sales of products or processes that result from the
project. MSI intends to continue to apply its technology and the expertise of
its staff to design new products and processes, both internally and through
collaborative activity, and to benefit from such projects when possible through
future royalty payments.

      Computer Hardware. As a convenience to its customers, MSI acts as a value-
added reseller of computer hardware in order to deliver a complete turn-key
molecular simulation system. MSI purchases substantially all of its hardware for
resale from Silicon Graphics, Inc. ("SGI"). MSI's agreement with SGI obligates
MSI to meet an annual minimum purchase volume. Under the agreement, SGI provides
installation, support and maintenance with respect to the computer hardware.

MSI'S CUSTOMERS

      MSI's customer base consists of leading commercial, governmental and
academic organizations.  No MSI customer accounted for more than 10% of the
Company's revenues during the fiscal year ended December 31, 1998.

                                     -20-
<PAGE>
 
      Industrial Customers. MSI industrial customers include many of the largest
pharmaceutical, biotechnology, chemical, petroleum and semiconductor companies
worldwide. In each of the past three fiscal years, a significant portion of
MSI's total revenue has been derived from pharmaceutical, biotechnology and
chemical companies.

      Governmental Customers. Many major governmental institutions in the United
States, Canada, Europe and the Asia/Pacific region use MSI's products.

      Academic Customers. Many of the world's leading universities in the United
States, Europe and the Asia/Pacific region use MSI's products. This use
historically has been for purposes of academic research, but MSI believes its
products increasingly may be used as a part of formal university teaching
curricula.

MSI'S STRATEGIC AND ACADEMIC ALLIANCES

      MSI has entered into a number of strategic alliances relating to product
development, product distribution and joint marketing. MSI plans to continue to
cultivate relationships with academic, governmental and commercial research
organizations for purposes of identifying and licensing new technology for MSI
to use in product development. In addition, MSI plans to maintain and expand its
alliances focused on compatibility of MSI's products with databases and database
management systems, other computational chemistry and molecular simulation
products, and products in related markets such as laboratory instrumentation.
MSI also intends to continue to enter into porting and joint marketing
arrangements with hardware vendors on whose systems MSI's products operate.

MSI'S CONSORTIA

      Since 1986, MSI has formed a number of consortia with outside parties,
commonly for purposes of market expansion. MSI believes the formation and
management of these consortia helps MSI focus on topical industrial needs and
establishes the consortia members as an initial customer base for its products.
MSI believes its consortia help MSI establish valuable working relationships
with leaders in its target markets.

      These consortia bring together groups of industrial researchers, academic
experts and MSI scientists that focus on developing, validating and applying
simulation to the target industrial research area. Typically, MSI consortia
participants provide funds and a liaison to MSI. Each consortium generally has a
three-year term and has a defined set of objectives and milestones that are
updated and re-prioritized annually by the consortium's members. Some of the
consortia have been extended beyond their initial terms in order to continue the
benefits of the collaborative activities.

      MSI has four active consortia in the following research areas: Polymers,
Catalysis and Sorption, Combinatorial Chemistry and Pharmaceutical Development.
Consortia agreements are generally one to three years in length and require the
consortium participant to pay MSI an annual fee. In return, consortium members
obtain rights to participate in meetings, vote on product development priorities
and non-exclusive licenses to use software products developed as a result of the
consortium activities.

MSI SALES AND MARKETING

      MSI markets its products and services worldwide. In the United States and
Europe, MSI has direct sales forces, consisting of field sales and telesales
representatives. In Japan and other Asia/Pacific 

                                     -21-
<PAGE>
 
countries, MSI distributes its products and services through TMSI, which manages
a network of subdistributors in this region. MSI and Teijin each own 50% of
TMSI.

      North and South America; Europe. MSI employs direct sales representatives
and telesales representatives to market and sell MSI's products and services.
Certain of the telesales representatives focus exclusively on sales to academic
researchers. The direct sales representatives and remaining telesales
representatives work in teams selling to commercial and governmental accounts in
assigned geographic territories and focus on either life science industries or
material sciences industries. The direct sales representatives typically focus
on larger accounts and account transactions greater than $50,000 and work
closely with MSI's pre-sales support scientists in order to demonstrate MSI's
products and their applicability to various research and development efforts.

      Japan and the Asia/Pacific region. MSI has a distribution agreement with
TMSI under which TMSI serves as the exclusive distributor of MSI's products and
services in Japan, South Korea, Taiwan, Hong Kong, China, India, Singapore,
Malaysia, Australia and New Zealand. TMSI has been MSI's exclusive distributor
in Japan since April 1, 1992 and in the other Asia/Pacific countries since April
1, 1994. TMSI's Japanese office has sales, marketing and administrative
personnel who manage and support four subdistributors in Japan. TMSI also
maintains an office in Korea with sales, marketing and administrative personnel
who manage and support subdistributors and conduct direct sales activities in
the other Asian countries. TMSI's subdistributor agreements generally renew
automatically each year but may be terminated if either party gives notice 90
days prior to expiration of the then current term.

      In support of its sales activities, MSI participates in industry trade
shows, publishes its own magazine, places advertisements in other industry
publications, publishes articles in industrial and scientific publications,
conducts direct mail campaigns, sponsors industry conferences and seminars, and
maintains a World Wide Web home page that contains information about MSI and its
product and service offerings.

MSI PRODUCT DEVELOPMENT

      MSI's development efforts are focused on expanding its simulation software
product line, designing enhancements to MSI's core technology and integrating
existing and new products into MSI's principal software architectures. MSI
intends to offer regular updates to its products and to expand its existing
product suite. A key component of MSI's product development activities is the
extension of its core UNIX-based software architecture to accommodate access to
MSI's products from Web browser technology operating on desktop computers.

      MSI licenses products or otherwise has acquired products from corporate,
governmental and academic institutions including BASF AG, Bayer AG, Bristol-
Myers Squibb, DuPont, California Institute of Technology, the University of
Cambridge and Harvard University. These arrangements sometimes involve joint
development efforts and frequently require the payment of royalties by MSI. The
development and royalty obligations, scope of distribution rights, duration and
other terms of these arrangements vary depending on the product, the market,
resource requirements, the other parties with whom MSI contracts and other
factors. MSI has also developed products with funding and direction from
customers through MSI's consortia activities. See "-- Consortia." MSI intends to
continue to license or otherwise acquire technology or products from third
parties in the future and to develop products as part of its consortia
arrangements with customers.

                                     -22-
<PAGE>
 
MSI CUSTOMER SERVICES AND SUPPORT

      MSI is committed to providing customers with superior support including
telephone, electronic mail, fax and Internet-based technical support services;
training; user group conferences; and targeted contract and consulting services
involving application of MSI's technology and scientific expertise to particular
research needs of customers. MSI believes that a high level of customer service,
support and training is critical to the adoption and successful utilization of
its products.

      Purchases of multi-year licenses to use MSI's software products include
one year of maintenance services, consisting of technical support and software
upgrades. Thereafter, MSI offers renewals of maintenance services on an annual
basis for an annual fee. Annual licenses to use MSI's software products
generally include all maintenance services. Most of MSI's customers contract for
maintenance and support services. These give customers access to new releases,
technical notes, documentation addenda and other support required to utilize
MSI's products effectively, including access to MSI's technical and scientific
support personnel during extended business hours. Through its distribution
channels, MSI offers training conducted by staff knowledgeable in both the
theory and application of molecular simulation. Technical newsletters and
bulletins and advance notification about future software releases are sent to
customers to keep them informed and to help them with resource allocation and
scheduling. To maintain an ongoing understanding of customer requirements, MSI
sponsors scientific symposia and user group meetings throughout the year.

MSI'S COMPETITORS

      The market for MSI's products is intensely competitive, subject to rapid
change and significantly affected by new product introductions and other market
activities of industry participants. MSI's competitors offer a variety of
products and services to address this market. MSI believes that the principal
competitive factors in this market are product quality, flexibility, ease-of-
use, scientific validation and performance, functionality and features, open
architecture, quality of support and service, reputation and price. Competition
currently comes from the following principal sources: other molecular simulation
software packages and software for analysis of chemical and biological data;
desktop software applications, including chemical drawing, molecular modeling
and analytical data simulation applications; consulting and outsourcing
services; other types of simulation software provided to engineers; and firms
supplying databases, such as chemical or genomic information databases, database
management systems and information technology. In addition, certain of MSI's
licenses grant the right to sublicense MSI's software. As a result, MSI's
customers and third-party licensees could develop specific simulation
applications using the Cerius2 SDK and compete with MSI by distributing such
programs to potential customers of MSI. Customers or licensees could also
develop their own simulation technology and cease using MSI's products and
services. Further, they may choose to sublicense such technology, in which case
MSI may receive royalty payments.

      Certain of MSI's competitors and potential competitors have longer
operating histories than MSI and have greater financial, technical, marketing
and other resources. Further, many of MSI's competitors offer products and
services directed at more specific markets than those targeted by MSI, enabling
these competitors to focus a greater proportion of their efforts on such
markets. Certain offerings that are competitive with MSI's products and services
are developed and made available by governmental organizations and academic
institutions, and these entities may be able to devote substantial resources to
product development and also offer their products to users for little or no
charge. There can be no assurance that MSI's current or potential competitors
will not develop products, services or technologies that are comparable to,
superior to, or render obsolete, the products, services and technologies offered
by 

                                     -23-
<PAGE>
 
MSI. There can be no assurance that MSI's competitors will not adapt more
quickly than MSI to technological advances and customer demands, thereby
increasing such competitors' market share relative to that of MSI. Any material
decrease in demand for MSI's technologies or services may have a material
adverse effect on the business, financial condition and results of operations of
MSI.

MSI'S SOURCES OF SUPPLY

      MSI purchases substantially all hardware products that it resells to its
licensees from a single vendor.  Management believes that other vendors could be
identified who could provide MSI and its licensees with similar hardware
products at comparable terms.  However, any disruption of supply could cause a
temporary adverse effect in MSI's revenues during any period requiring porting
of MSI software products to alternative hardware platforms or negotiation of
alternative supply and distribution agreements.

INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS

      MSI relies primarily on a combination of copyright, trademark and trade
secret laws, confidentiality procedures and contractual provisions to protect
its proprietary rights. MSI also has two United States patents. MSI believes
that factors such as the technological and creative skills of its personnel, new
product development, frequent product enhancements, name recognition and
reliable product maintenance are essential to establishing and maintaining a
technical leadership position. MSI seeks to protect its software, documentation
and other written materials under trade secret and copyright laws, which afford
only limited protection. Further, there can be no assurance that MSI's patents
will offer any protection or that they will not be challenged, invalidated or
circumvented. Furthermore, there can be no assurance that others will not
develop technologies that are similar or superior to MSI's technology. Despite
MSI's efforts to protect its proprietary rights, unauthorized parties may
attempt to copy aspects of MSI's products or to obtain and use information that
MSI regards as proprietary. In limited instances, MSI has licensed source codes
of certain products to customers or collaborators. For these reasons, policing
unauthorized use of MSI's products therefore may be difficult. In addition, the
laws of some foreign countries do not protect proprietary rights as fully as do
the laws of the United States.

      There can be no assurance that MSI's means of protecting its proprietary
rights in the United States or abroad will be adequate.

      There can be no assurance that third parties will not claim infringement
by MSI of their intellectual property rights. From time to time MSI receives
letters from third parties claiming or suggesting that its products may infringe
patents or other intellectual property rights. In particular, MSI has received
letters from Tripos, Inc. and Immunex Corporation stating that MSI's products
may be relevant to patents held by them. MSI has investigated these matters and
believes that they are immaterial to the operations of MSI. There can be no
assurance, however, that MSI's products do not infringe upon the patent or other
intellectual property rights of these or other third parties, that MSI will not
be required to seek licenses for or otherwise acquire rights to technology as a
result of claims of infringement or that these or other companies will not bring
infringement suits against MSI. MSI expects in general that simulation software
product developers will increasingly be subject to infringement claims as the
number of products and competitors in MSI's industry segments grows and the
functionality of products in different industry segments overlaps. Any such
claims, with or without merit, could be time consuming to defend, result in
costly litigation, divert management's attention and resources, cause product
shipment delays or require MSI to enter into royalty or licensing agreements.

                                     -24-
<PAGE>
 
Such royalty or licensing agreements, if required, may not be available on terms
acceptable to MSI, if at all. In the event of a successful claim of product
infringement against MSI, the failure or inability of MSI to license or design
around the infringed technology would have a material adverse effect on MSI's
business, financial condition and results of operations.

                         INTEGRATED BUSINESS ACTIVITIES

      Although the Company currently operates Pharmacopeia Labs and MSI
primarily as two separate businesses as described in the previous sections of
this document, the Company is exploring ways in which the businesses might be
further improved through the integration of certain business functions.  For
example, the Company has formed the Center for Informatics and Drug Discovery
(CIDD) wherein a dedicated staff of research employees are investigating ways in
which the Pharmacopeia Labs technology and the MSI software technology might be
integrated.  Initially, the CIDD will use Pharmacopeia Labs' database of
chemical and biological interactions to test and validate computational
approaches to drug discovery, with the goal of enhancing the quality and
predictive utility of MSI's software.  The CIDD will also seek to "mine" the
millions of data points of information generated by Pharmacopeia Labs through
its drug discovery efforts for use in future drug discovery programs.  The
Company believes that the integration of the laboratory knowledge accumulated at
Pharmacopeia Labs with the simulation knowledge accumulated at MSI could create
combined informatics product offerings as well as improved laboratory services
and simulations software.  The Company is also exploring ways in which the MSI
direct sales force could assist Pharmacopeia Labs in its sales and marketing
endeavors.

          RISKS ASSOCIATED WITH CONSOLIDATED INTERNATIONAL OPERATIONS

      In 1998, approximately 57% of the Company's consolidated revenue was
derived from customers outside the United States both through international
subsidiaries and on an export basis.  Approximately 38% of the Company's revenue
was derived from customers in Europe and approximately 19% was derived from
customers in the Asia/Pacific region.  The Company anticipates that
international revenue will continue to account for a significant percentage of
revenue in the future.  The Company's international operations are subject to
risks inherent in the conduct of international business, including unexpected
changes in regulatory requirements, longer payment cycles, exchange rate
fluctuations, export license requirements, tariffs and other barriers, political
and economic instability, limited intellectual property protection, difficulties
in collecting trade receivables, difficulties in managing distributors or
representatives, difficulties in staffing and managing foreign subsidiary or
joint venture operations, and potentially adverse tax consequences.  Certain
East Asian countries are currently experiencing severe economic turmoil,
represented by depressed business conditions and volatility in local currencies.
Such conditions may adversely impact the Company's financial results as a result
of customers altering their spending plans and by subjecting the Company to
greater foreign exchange exposure.  There can be no assurance that the Company
will be able to sustain or increase international revenue and there can be no
assurance that any of the foregoing factors will not have a material adverse
effect on the Company's international operations and therefore its business,
financial condition and results of operations.  The Company's direct
international sales generally are denominated in local currencies.
Fluctuations in the value of currencies in which the Company conducts business
relative to the United States dollar result in currency transaction gains and
losses, and the impact of future exchange rate fluctuations cannot be accurately
predicted.  There can be no assurance that future fluctuations in currency
exchange rates will not have a material adverse impact on revenue from
international sales, and thus the Company's business, financial condition and
results of operations.  When deemed appropriate, the Company engages in currency
exchange rate hedging transactions in an 

                                     -25-
<PAGE>
 
attempt to mitigate the impact of adverse exchange rate fluctuations. There can
be no assurance that any currency hedging policies will be successful, or that
they will not increase the negative impact of exchange rate fluctuations.

                     CONSOLIDATED RESEARCH AND DEVELOPMENT

      Pharmacopeia's consolidated expenses for research and development
activities were as follows:

<TABLE>
<CAPTION>
                        Year Ended December 31 (in thousands)
                -----------------------------------------------------
<S>               <C>                 <C>               <C>
                      1996              1997              1998
                -----------------   ---------------   ---------------
 
Collaborative        $13,129           $16,931           $20,307
Proprietary           20,945            25,251            28,656
</TABLE>

  These increased amounts primarily reflect additional costs incurred with the
expansion of Pharmacopeia Labs' chemical library production and screening
efforts for collaborations and for its own use, and additional costs incurred at
MSI related primarily to Weblab.

                             CONSOLIDATED EMPLOYEES
                                        
  As of December 31, 1998, the Company had 546 regular employees, 344 of whom
were in research and development, including 182 chemists, biologists and
engineers holding doctorate degrees.  None of the Company's employees is covered
by collective bargaining agreements. Management considers its relations with its
employees to be good.

                 IMPORTANT RISK FACTORS REGARDING CONSOLIDATED
                           FORWARD LOOKING STATEMENTS
                                        
  Certain discussions set forth above regarding the Company's strategy for the
development and commercialization of its products and services as well as its
ability to achieve profitability in the near term are forward-looking
statements.  This strategy depends upon the acceptance by potential customers of
combinatorial chemistry and analysis of compounds provided by the Company as an
effective tool in new drug discovery and the Company's ability to maintain the
arrangements it currently has in place. Historically, pharmaceutical companies
have conducted lead compound identification and optimization within their own
research departments, due to the highly proprietary nature of the activities
being conducted, the central importance of these activities to their drug
discovery and development efforts, and the desire to obtain maximum patent and
other proprietary protection on the results of their internal programs. In order
to achieve its business objectives, the Company must convince these companies
that the Company's technology and expertise justify the outsourcing of these
programs to the Company. There can be no assurance that the Company will be able
to attract customers on acceptable terms for its products and services or
develop a sustainable profitable business. Moreover, the pricing and nature of
the Company's combinatorial libraries is such that there may only be a limited
number of pharmaceutical companies that are potential customers for such
libraries. There can be no assurance that the Company will be able to establish
additional collaborative or licensing arrangements, that any such arrangements
or licenses will be on terms favorable to the Company, or that current or future
collaborative or licensing arrangements will ultimately be successful.

                                     -26-
<PAGE>
 
  Further, the Company's receipt of revenues from collaborative arrangements is
affected by the timing of efforts expended by the Company and the timing of lead
compound identification.  The Company's products and services will only result
in commercialized pharmaceutical products generating milestone payments and
royalties upon significant preclinical and clinical development, requisite
regulatory approvals, the establishment of manufacturing capabilities and
successful marketing. The Company does not currently intend to perform any of
these activities, other than in some instances preclinical work. Therefore, the
Company will be dependent upon the expertise and dedication of sufficient
resources by third parties to develop and commercialize products based on
library compounds produced and lead compounds discovered by the Company. Should
a collaborative partner fail to develop or commercialize a compound or product
to which it has rights from the Company, the Company may not receive any future
milestone payments or royalties associated with such compound or product. The
Company's contractual arrangements with its customers do not obligate the
customers to develop or commercialize lead compounds discovered by the Company.
In addition, there can be no assurance that any such development or
commercialization would be successful. The compound basis for drugs developed by
a customer may be a derivative or optimized version of the lead compound
provided to the customer by the Company. While the Company's existing
collaborative agreements provide that the Company will receive milestone
payments and royalties with respect to certain products developed from certain
derivative compounds, there can be no assurance that disputes will not arise
over the application of payment provisions to such products. There can be no
assurance that current or future collaborative partners will not pursue
alternative technologies, or develop alternative products either on their own or
in collaboration with others, including the Company's competitors, as a means
for developing treatments based on the targets which are the subject of the
collaborative arrangements with the Company.

  The Company's success is also dependent on the results of operations of its
wholly-owned subsidiary, MSI.  The ability of MSI to increase revenue from the
license of its products is dependent upon increased market acceptance of MSI's
software products and services.  MSI's products are used primarily by simulation
specialists.  MSI's strategy is to expand usage of its products and services by
marketing and distributing its software, in part through its Web-based products,
to experimentalists.  If MSI cannot expand its customer base to include
experimentalists, or if MSI otherwise cannot successfully market and sell its
Web-based products and related services, MSI may not be able to increase its
revenue, or its revenue may decline.  In general, increased market acceptance
and greater market penetration of MSI's products depend upon several factors,
including the overall product performance, ease of implementation and use,
accuracy of simulation, breadth and integration of product offerings and the
extent to which users achieve the intended research and development benefits
from their use of MSI's products and services.  There can be no assurance that
MSI's products and services will achieve increased market acceptance or
penetration in MSI's target industries or other industries.  Failure to increase
market acceptance or penetration would restrict substantially the future growth
of MSI and may have a material adverse effect on the Company.

  The Company's success will also depend upon certain issues arising in
connection with the Company's patents and proprietary technology. See "Business
-- Patents and Proprietary Information."

                        CONSOLIDATED SEGMENT INFORMATION

  The information in Note 9 of the Notes to Financial Statements is incorporated
herein by reference.

                                     -27-
<PAGE>
 
ITEM 2.  PROPERTIES

  Pharmacopeia Labs currently leases and occupies approximately 144,000 square
feet in or near Princeton, New Jersey.  These leases expire at various dates
through 2005. MSI's principal administrative, sales, support, marketing and
product development facilities and the MSI corporate headquarters are located in
San Diego, California, where MSI has leased 76,635 square feet through December
2006. MSI's European headquarters, along with administrative, sales, support,
marketing and product development functions, are located in Cambridge, England,
where MSI has leased 6,545 square feet through December 31, 2008 and has
subleased an additional 4,952 square feet in the same building through February
1, 2007. MSI leases additional offices in the United States, Europe and Asia.

ITEM 3.  LEGAL PROCEEDINGS

     The Company is not a party to any material legal proceedings.

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

     Not applicable.

     EXECUTIVE OFFICERS OF THE REGISTRANT

     The executive officers of the Company are as follows:

<TABLE>
<CAPTION>
             NAME                  AGE                      POSITION
             ----                  ---                      --------
<S>                             <C>    <C>
Joseph A. Mollica, Ph.D.           58    Chairman of the Board, President and Chief Executive
                                         Officer
 
John J. Baldwin, Ph.D.             64    Chief Science and Technology Officer
 
Lewis J. Shuster                   43    President and Chief Operating Officer, Pharmacopeia
                                         Laboratories

Saiid Zarrabian                    46    President and Chief Operating Officer, MSI
 
Stephen A. Spearman, Ph.D.         49    Executive Vice President, Discovery Technology
 
Nolan H. Sigal, M.D., Ph.D.        49    Senior Vice President, Drug Discovery
 
Bruce C. Myers                     43    Senior Vice President of Finance, Administration and
                                         Strategic Planning, MSI
 
Richard J. Walsh                   55    Senior Vice President, Marketing and Business Development
 
Kenneth P. McCarthy                42    Vice President, Human Resources
</TABLE>
  Dr. Mollica has served as the Chairman of the Board and Chief Executive
Officer of Pharmacopeia since February 1994 and was appointed President in
August 1996. From 1987 to December 1993, Dr. Mollica was employed initially by
the DuPont Company and then by The DuPont Merck Pharmaceutical Company, most
recently as President and Chief Executive Officer. Dr. Mollica is 

                                     -28-
<PAGE>
 
a director of USP, Inc., ImPath, Inc. and Neurocrine BioSciences, Inc. Dr.
Mollica received a Ph.D. from the University of Wisconsin, and a Doctor of
Science, h.c., from the University of Rhode Island.

     Dr. Baldwin has served as Vice President of Chemistry since July 1993, was
appointed Senior Vice President of Chemistry in August 1996 and was appointed
Chief Science and Technology Officer in June 1998. For a period of thirty years,
prior to joining the Company, Dr. Baldwin held a variety of scientific and
management positions with Merck Sharp & Dohme Research Laboratories, most
recently as Distinguished Senior Scientist. Dr. Baldwin holds more than 140 U.S.
patents and is the inventor of Trusopt, a drug for preventing glaucoma. Dr.
Baldwin received a Ph.D. in Organic Chemistry from the University of Minnesota.

     Mr. Shuster has served as Chief Financial Officer since November 1994, was
appointed Executive Vice President, Corporate Development and Chief Financial
Officer in August 1996 and  was appointed President and Chief Operating Officer
of Pharmacopeia Laboratories in February 1999.  Mr. Shuster served as Executive
Vice President, Operations and Finance for Human Genome Sciences, Inc., a
biotechnology company, from September 1992 to November 1994. From 1986 to June
1992, Mr. Shuster was with Microbiological Associates, Inc., a biological safety
testing services company, most recently as President and Chief Executive
Officer. Mr. Shuster received a M.B.A. from Stanford University Graduate School
of Business.

  Mr. Zarrabian has served as Chief Operations Officer of MSI since October 1994
and was appointed President and Chief Operating Officer, MSI in February 1999.
From 1988 to October 1994, Mr. Zarrabian was Vice President and Director of
Symbolics Inc. which declared Chapter 11 bankruptcy in January 1993.  From 1978
to 1988, Mr. Zarrabian was Director of Mechanical Applications Development at
Computervision Corporation.

  Dr. Spearman has served as Executive Vice President, Operations since August
1996 and was appointed Executive Vice President, Discovery Technology in June
1998.  From 1975 to August 1996, Dr. Spearman held several positions at CIBA-
GEIGY Corporation, most recently as Project Leader.  Dr. Spearman received his
Ph.D. and M.S. from Emory University.  Dr. Spearman also holds a M.B.A. in
Finance from Bryant College.

     Dr. Sigal has served as Vice President of Biology since January 1994 and
was appointed Senior Vice President, Drug Discovery in August 1996.  From 1983
to December 1993, Dr. Sigal held several positions at Merck Research
Laboratories, most recently as Executive Director of the Department of
Immunology Research. Dr. Sigal received a M.D. and Ph.D. from the University of
Pennsylvania.

     Mr. Myers has served as Senior Vice President of Finance, Administration
and Strategic Planning, MSI since December 1998. Mr. Myers served as Chief
Financial Officer and Secretary to the Board for GTI Corporation from January
1997 to December 1998. From June 1989 to December 1996, Mr. Myers was with
Photomatrix, Inc. and served as Chief Financial Officer, Chief Operating Officer
and Secretary to the Board. Prior to joining Photomatrix, Mr. Myers spent eleven
years with Arthur Andersen & Company. Mr. Myers holds a B.S. in Commerce from
the University of Virginia and is a Certified Public Accountant.

     Mr. Walsh has served as Senior Vice President, Marketing and Business
Development since February 1998.  Mr. Walsh served as Vice President, Corporate
Development for Cytogen Corporation from 1994 to 1998.  From 1992 to 1994 Mr.
Walsh served as Vice President, Biotechnology Acquisition for the Medical and
Agricultural groups at American Cyanamid Company.  Prior to joining American

                                     -29-
<PAGE>
 
Cyanamid Company, Mr. Walsh spent twenty-five years at Parke Davis and its
parent, the Warner Lambert Company.  Mr. Walsh holds a B.S. degree in Pharmacy
from the University of Cincinnati.

     Mr. McCarthy has served as Vice President, Human Resources since September
1996.  Mr. McCarthy served as Vice President, Human Resources and Corporate
Services for Genelabs Technologies, Inc. from 1990 to 1996.  From 1981 to 1990,
Mr. McCarthy was with Schlumberger, Inc. and held various personnel management
positions.  Mr. McCarthy received his B.S. degree in Industrial and Labor
Relations from the New York State School of Industrial and Labor Relations of
Cornell University.

                                    PART II

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

MARKET FOR COMMON STOCK

     The Company's Common Stock has traded on The Nasdaq Stock Market(R) under
the symbol PCOP since the Company's initial public offering on December 5, 1995.
The following table sets forth for the periods indicated the high and low sale
prices of the Common Stock.

<TABLE>
<CAPTION>
                                            -----------------------------  -----------------------------
                                                        1998                            1997
                                            -----------------------------  -----------------------------
                                                High            Low             High            Low
                                            -------------  --------------  --------------  -------------
<S>                                         <C>            <C>             <C>             <C>
First Quarter                                  $22.13          $15.00          $22.63         $16.50
Second Quarter                                  20.38           11.63           17.38          12.88
Third Quarter                                   14.00            9.73           22.75          12.75
Fourth Quarter                                  10.63            8.00           23.13          16.00
</TABLE>

HOLDERS OF RECORD

     As of January 31, 1999, there were approximately 461 holders of record.

     The Company has never paid cash dividends on its capital stock.  The
Company currently expects that it will retain its future earnings for use in the
operation and expansion of its business and does not anticipate paying any cash
dividends in the foreseeable future.

                                     -30-
<PAGE>
 
ITEM 6.    SELECTED FINANCIAL DATA
        (in thousands, except per share data)
<TABLE>
<CAPTION>
                                                     Year Ended
                                                     December 31,
---------------------------------------------------------------------------------------
                                 1994       1995       1996       1997         1998
                               ---------  ---------  ---------  ---------  ------------
Statements of Operations Data:
<S>                            <C>        <C>        <C>        <C>        <C>         
Total revenue................  $ 15,372   $ 35,271   $ 62,060   $ 81,197       $ 92,211
Operating loss (2) (3).......   (11,171)   (21,300)    (8,358)    (3,024)       (13,456)
Net loss  (2) (3)............   (11,277)   (20,836)    (7,386)    (1,728)       (10,163)
Basic and diluted net loss
  per share..................     (2.61)     (2.79)      (.42)      (.09)          (.54)
Weighted average number of 
  common shares outstanding,
  basic and diluted..........     4,321      7,458     17,736     18,445         18,916
Cash dividends declared per 
  common share...............         -          -          -          -              -
</TABLE> 
<TABLE> 
<CAPTION> 
 
                                                  As of December 31,
                                -----------------------------------------------------
                                 1994       1995       1996       1997        1998
                                --------   --------   --------   --------    --------
<S>                            <C>        <C>        <C>         <C>        <C> 
Balance Sheet Data:            
Cash, cash equivalents, and    
 marketable securities.......  $ 19,345   $ 71,271   $ 95,991    $ 97,640   $ 81,098
Total assets.................    30,428     99,693    131,644     140,051    127,865
Notes payable, and deferred    
 revenue, long-term portion       
 and    other long-term        
 liabilities.................     3,028      4,085      6,433       6,194      3,332
Accumulated deficit..........   (32,707)   (53,543)   (60,929)    (62,657)   (72,820)
Total stockholders'               
 equity......................    17,792     59,450     75,501      80,596     72,217
</TABLE>

 (1) The financial information set forth above excludes financial information
     for Biosym Technologies, Inc. ("Biosym") prior to August 16, 1995, the
     effective date of MSI's acquisition of Biosym.
 (2) The 1995 amount includes a $6.5 million write-off of acquired in-process
     research and development, $4.5 million in restructuring costs and a $1.1
     million write-off of capitalized software, all in connection with the
     acquisition of Biosym.
 (3) The 1998 amount includes $8.0 million of merger related expenses.
 (4) Selected financial data for all periods presented has been restated to
     include the operations of MSI. The MSI merger was completed on June 12,
     1998 and was accounted for as a pooling-of-interests.


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

     The following discussion of the financial condition and results of
operations of Pharmacopeia should be read in conjunction with the consolidated
financial statements and the related notes thereto included elsewhere is this
document. The discussion in this document contains forward looking statements
that involve risks and uncertainties. Pharmacopeia's actual results may differ
materially from the results discussed in the forward looking statements. Factors
that could cause or contribute to such differences include those discussed in
this section as well as those discussed elsewhere in this document.

                                     -31-
<PAGE>
 
     The Company's consolidated financial statements for all periods presented
have been restated to include the operations of MSI.  The MSI merger was
completed June 12, 1998 and was accounted for as a pooling-of-interests.

RESULTS OF OPERATIONS

Years Ended December 31, 1998 and 1997

     Total revenues for the year ended December 31, 1998 rose 14% to $92.2
million compared to $81.2 million reported for the same period last year.  In
1998 contract revenues increased to $29.7 million compared to $24.5 million a
year ago.  The year to year increase of $5.2 million or 21%, primarily reflects
expanded efforts in the Schering-Plough, Bristol-Myers Squibb and Zeneca
collaborations.  1998 software license, service, hardware and other revenues
increased to $62.5 million compared to $56.7 million a year ago.  The year to
year increase of $5.8 million or 10%, is primarily the result of consolidating,
in 1998, the operating results of TMSI as a result of MSI becoming the
controlling partner in this joint venture.

     Research and development expenses increased $6.8 million to $49.0 million
during 1998; a 16% increase over 1997 levels. These increased amounts primarily
reflect increased personnel costs, facilities expenses, equipment depreciation,
leasehold amortization and laboratory supplies and reagents as the Company
expands its efforts to support its existing collaborations along with making
investments in software development, chemical library production, proprietary
drug discovery, and high throughput screening.

     Sales, general and administrative expenses were $38.2 million and $31.8
million in the years ended December 31, 1998 and 1997, respectively.  The
increase of $6.4 million or 20%, is primarily attributable to consolidating, in
1998, the operating results of TMSI along with increased payroll and personnel
expenses as the Company continued to hire additional sales, marketing and
administrative personnel.

     Merger related costs of $8.0 million were recorded during 1998 in
connection with the MSI merger.  Such charges consist of transaction costs,
principally investment banking and professional fees which were expensed under
the pooling-of-interests method of accounting.

     The Company had net interest and other income of $4.2 million and $4.3
million for the twelve months ended December 31, 1998 and 1997, respectively.
The decrease of $0.1 million, resulted primarily from a decrease in the average
balance of cash, cash equivalents and marketable securities.

     The Company recorded a provision for income taxes of $0.9 million for 1998
compared to a provision for income taxes of $3.0 million for 1997.  The year to
year favorable tax variances are primarily the result of the combined companies'
ability to offset MSI's taxable income with Pharmacopeia's losses during the
period following the completion of the merger.

YEARS ENDED DECEMBER 31, 1997 AND 1996

     Revenues increased to $81.2 million in 1997, compared to $62.1 million in
1996.  The increase of $19.1 million or 31% primarily reflects contract revenue
increases from the new collaboration with BMS and the Company's expanded efforts
in the drug discovery collaborations with Bayer, Daiichi, and Organon along with
increased software license, service, hardware and other revenue resulting from
increased customer sites and additional sales to existing customers.

                                     -32-
<PAGE>
 
     Research and development expense increased to $42.2 million in 1997
compared to $34.1 million in 1996. These increased amounts primarily reflect
increased personnel costs, facilities expenses, equipment depreciation,
leasehold amortization and laboratory supplies and reagents as the Company
expands its efforts to support its existing collaborations along with making
investments in software development, chemical library production, proprietary
drug discovery, and high throughput screening.

     Sales, general and administrative expenses were $31.8 million and $28.6
million in the years ended December 31, 1997 and 1996, respectively.  The
increase is largely attributable to increased expenses associated with the
Company's sales force and increased customer support requirements along with
increased payroll and personnel expenses as the Company continued to hire
additional management and administrative personnel.

     The Company had net interest and other income of $4.3 million and $4.0
million for the twelve months ended December 31, 1997 and 1996, respectively.
The increase of $0.3 million resulted primarily from an increase in the average
balance of cash, cash equivalents and marketable securities.

     The Company's provision for income tax consists primarily of foreign income
taxes withheld from foreign revenue associated with the Company's wholly owned
subsidiary MSI.  The tax provision for 1996 reflects the impact of foreign
income taxes withheld on revenue as well as MSI's inability to completely offset
its operating income with loss carryforwards because of minimum tax
requirements.  MSI was able in 1997 to offset a substantial portion of its
income with net operating loss carryforwards.

LIQUIDITY AND CAPITAL RESOURCES

     As of December 31, 1998, the Company had working capital of $57.3 million.
The Company has funded its activities through December 31, 1998 primarily
through the sale of equity securities, funding under collaborative arrangements
and sales of software licenses and hardware.

     The Company's funds are currently invested in U.S. Treasury and government
agency obligations, investment grade commercial paper and other short-term money
market instruments.  The Company may also invest such proceeds in investment
grade, interest-bearing securities having a maximum maturity of two years.  As
of December 31, 1998, the Company's cash, cash equivalents and marketable
securities totaled $81.1 million.

     In connection with the Company's agreement with the Trustees of Columbia
University and Cold Spring Harbor Laboratory, the Company is required to pay
annual license fees.  The Company is also required to pay to Columbia University
certain royalties.

     The Company's primary investing activities have consisted of capitalized
software development costs, leasehold improvements and purchases of equipment
and software rights.  The Company anticipates that its capital requirements will
continue at approximately the same level over the next two years as the Company
continues to invest in capital assets, capitalized software development and
research and development activities to support its growth.

     As of December 31, 1998, MSI had a note outstanding to Teijin in the amount
of $0.7 million, which is due within the next twelve months.

     As of December 31, 1998, the Company had federal net operating loss
carryforwards of approximately $45.8 million.  These federal net operating loss
carryforwards, which are fully reserved, will begin to expire in 2008 through
2018.  Utilization of the net operating loss carryforwards will be subject to
limitation under Section 382 of the Internal Revenue Code.

                                     -33-
<PAGE>
 
     The Company anticipates that its existing capital resources will be
adequate to fund the Company's operations at least through 2000.  There can be
no assurance that changes will not occur that would consume available capital
resources before such time.  The Company's capital requirements depend on
numerous factors, including the ability of the Company to extend existing
collaborations and enter into additional collaborative arrangements, competing
technological and market developments, changes in the Company's existing
collaborative relationships, the cost of filing, prosecuting, defending and
enforcing patent claims and other intellectual property rights and the outcome
of related litigation, the purchase of additional capital equipment,
acquisitions of other businesses or technologies, the progress of the Company's
drug discovery programs and the progress of the customer activities that could
produce milestone and royalty payments to the Company.  There can be no
assurance that additional funding, if necessary, will be available on favorable
terms, if at all.

YEAR 2000

     The year 2000 presents concerns for business computing because the use of
certain two digit date formats could cause date sensitive software to recognize
"00" as the year 1900 rather than the year 2000. The problem exists for many
kinds of software and hardware, including mainframes, mini-computers, PC's, and
embedded systems. The year 2000 issue could affect the Company's software
products, its internal systems, and the systems used by its distributors,
customers and vendors.

     The Company is continuing to test its MSI software products and to classify
its tested products as "compliant," "compliant with minor issues," and "not
compliant."  To date, all major MSI product lines have been tested and none have
been classified as "not compliant."  Of the more than 100 application modules
comprising MSI's product lines, only one module has been identified as "not
compliant," and a minor correction has been identified to make this module
"compliant."  The Company is also developing software updates to address those
products that have been classified as "compliant with minor issues."  None of
these corrections or updates is expected to require a substantial resource
commitment or to disrupt the Company's ongoing business activities.
Pharmacopeia's policy is to make its commercially offered software products year
2000 "compliant."

     Pharmacopeia is also testing the readiness of its internal systems,
including information technology (IT) and non-IT systems, for handling the year
2000, and has started the remediation and certification process. The Company is
also reviewing its facilities and infrastructures. Contingency plans will be
developed, where appropriate, in parallel with the testing and remediation
efforts.

     Pharmacopeia is evaluating its third-party distribution and supply chain to
understand their ability to continue providing services and products through the
change to the year 2000. The Company is monitoring and working directly with key
vendors, service providers, hardware manufacturers and distributors to avoid any
business interruption in the year 2000. If critical third parties are identified
to have issues, contingency plans will be developed.

     While year 2000 issues present a potential risk to Pharmacopeia's internal
systems, distribution and supply chain, and facilities, the Company is
minimizing risk with a worldwide effort. Pharmacopeia is performing an extensive
assessment and is in the process of testing and remediating mission critical
components. The current plan is to have all of these components resolved by
September 1999. Management currently believes that all critical systems will be
ready by the year 2000 and that the cost to address all issues will not exceed
$.7 million.

                                     -34-
<PAGE>
 
ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

      The Company's international operations are subject to risks inherent with
exchange rate fluctuations.  During 1998, approximately 57% of the Company's
consolidated revenue was derived from customers outside the United States.
Approximately 38% of the Company's revenue was derived from customers in Europe
and approximately 19% was derived from customers in the Asia/Pacific region.
The Company's exchange rate risk is greatest for dollar/euro and dollar/yen
fluctuations.  The Company's direct international sales generally are
denominated in local currencies.  Fluctuations in the value of currencies in
which the Company conducts business relative to the United States dollar results
in currency transaction gains and losses.  When deemed appropriate, the Company
engages in currency exchange rate hedging transactions in an attempt to mitigate
the impact of adverse exchange rate fluctuations.  The Company does not
currently have any hedging arrangements in place.

     The Company does not use derivative financial instruments in its operations
or investment portfolio.  However, the Company regularly invests excess
operating cash in overnight repurchase agreements that are subject to changes in
short-term interest rates.  Accordingly, the Company believes that the market
risk arising from its holding of these financial instruments is minimal.

     The Company does not have exposure to market risks associated with changes
in interest rates as it has no variable interest rate debt outstanding.  The
Company does not believe it has any other material exposure to market risks
associated with interest rates.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

      The Company's consolidated financial statements and notes thereto and the
independent auditors' report appear beginning on page F-1 of this Report.

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

      Not applicable.

                                    PART III
                                        
ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

      (a)  The information required by this Item concerning the Company's
directors is incorporated by reference from the section captioned "Election of
Directors" in the Company's Proxy Statement related to the 1999 Annual Meeting
of Stockholders to be held on May 4, 1999 (the "Proxy Statement").

      (b)  The information required by this Item concerning the Company's
executive officers is set forth in Part I of this Form 10-K.

      (c) On the basis of reports and representations submitted by or on behalf
of the directors, executive officers and ten percent stockholders of the
Company, all Forms 3, 4 and 5 showing ownership of and change of ownership in
the Company's equity securities during 1998 were timely filed with the
Securities and Exchange Commission as required by Section 16 (a) of the Exchange
Act, except that a Form 4 was not filed until March of 1999 to reflect the
conversion of MSI options held by Dr. Bartlett to Pharmacopeia options, and a
Form 3 in respect of each of the Company's executive officers Richard J. Walsh,

                                     -35-
<PAGE>
 
Kenneth P. McCarthy and  Ronald Goldstein that was due by June 22, 1998 was not
filed until August 6, 1998.

ITEM 11.  EXECUTIVE COMPENSATION.

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

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

      The information required by this Item is incorporated by reference from
the section captioned "Stock Ownership of Principal Stockholders and Management"
in the Proxy Statement.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

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

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

(a)(1)  Financial Statements

        The following Consolidated Financial Statements are included:
        Report of  Independent Auditors
        Consolidated Balance Sheets as of December 31, 1997 and 1998
        Consolidated Statements of Operations for the years ended December 31,
          1996, 1997 and 1998
        Consolidated Statements of Stockholders' Equity for the years ended
          December 31, 1996, 1997 and 1998
        Consolidated Statements of Cash Flows for the years ended December 31,
          1996, 1997 and 1998
        Notes to Consolidated Financial Statements

(a)(2)  Financial Statement Schedules

        All financial statement schedules are omitted because they are not
        applicable, or not required, or because the required information is
        included in the financial statements or notes thereto.

<TABLE> 
<CAPTION> 
 
(a)(3)    Exhibits:
<S>                                <C> 
          3.1******                Restated Certificate of Incorporation of the Registrant.
          3.3******                Bylaws of the Registrant, as amended.
          3.3(a)********           Amendment to Bylaws of Pharmacopeia dated July 31, 1997.
          4.3*                     Stockholders Rights Agreement, dated February 15, 1995.
          10.1*                    Series A and Series B Preferred Stock Purchase Agreement, dated July 21,
                                   1993.
</TABLE> 

                                     -36-
<PAGE>
 
<TABLE> 
<CAPTION> 
<S>                                <C> 
          10.2*                    Series B Preferred Stock Purchase Agreement, dated March 11, 1994.
          10.3*                    Series C Preferred Stock Purchase Agreement, dated December 22, 1994.
          10.4*                    Series D Preferred Stock Purchase Agreement, dated February 15, 1995.
          10.5**#                  Amended 1994 Incentive Stock Plan.
          10.5(a)*******#          Amendment No. 3 to the 1994 Incentive Stock Plan dated May 9, 1997.
          10.6*#                   1995 Employee Stock Purchase Plan.
          10.7*#                   1995 Director Option Plan.
          10.8*+                   Library Collection Agreement, dated as of October 1, 1995, between
                                   Pharmacopeia and Novartis Corporation.
          10.9*+                   Research, License, and Royalty Agreement, dated as of February 15, 1995,
                                   between Pharmacopeia and Berlex Laboratories, Inc.
          10.9(a)*******+          Amendment No. 1 to Research, License and Royalty Agreement between the
                                   Company and Berlex Laboratories, Inc. dated November 27, 1996.
          10.9(b)*******+          Amendment No. 2 to Research, License and Royalty Agreement between the
                                   Company and Berlex Laboratories, Inc. dated June 30, 1997.
          10.9(c)*********+        Amendment No.3 to Research, License and Royalty Agreement between the
                                   Company and Berlex Laboratories, Inc. dated November 21, 1997.
          10.10*+                  License Agreement, dated as of October 6, 1995, among Pharmacopeia, the
                                   Trustees of Columbia University in the City of New York and Cold Spring
                                   Harbor Laboratory.
          10.11*+                  Collaboration Agreement, dated as of December 22, 1994, between
                                   Pharmacopeia and Schering Corporation and Schering-Plough, Ltd.
          10.11(b)*******+         Amendment No. 2 to Collaboration Agreement and Random Library Agreement
                                   between the Company and Schering Corporation and Schering-Plough, Ltd.
                                   dated as of April 22, 1996.
          10.11(c)*******+         Amendment No. 3 to Collaboration Agreement and Random Library Agreement
                                   between the Company and Schering Corporation and Schering-Plough, Ltd.
                                   dated as of April 21, 1997.
          10.12*+                  Random Library Agreement, dated as of December 22, 1994, between
                                   Pharmacopeia and Schering Corporation and Schering-Plough, Ltd.
          10.13*                   Lease Agreement between Pharmacopeia and Eastpark at 8A.
          10.13(a)**               Amendment dated as of January 22, 1996 to Lease Agreement between
                                   Pharmacopeia and Eastpark at 8A.
          10.13(b)****             Third Amendment to Lease Agreement dated March 31, 1996 between
                                   Pharmacopeia and Eastpark at 8A.
          10.14*                   Sublease, dated as of December 7, 1994, between Pharmacopeia and Enichem
                                   Americas, Inc.
          10.15*                   Lease, dated as of May 2, 1994, between Pharmacopeia and College Road
                                   Associates Limited, as amended.
          10.15(a)**               Lease dated as of December 1, 1995 between Pharmacopeia and College Road
                                   Associates, as amended.
          10.15(b)****             Third Execution and Modification of lease dated June 7, 1996, between
                                   Pharmacopeia and College Road Associates Limited.
          10.17*#                  Employment Agreement, dated October 4, 1994, between the Company and Lewis
                                   J. Shuster.
</TABLE> 

                                     -37-
<PAGE>
 
<TABLE> 
<S>                                <C> 
          10.18*********#          Employment Agreement effective November 1, 1997 between the Company and
                                   Joseph A. Mollica, Ph.D.
          10.19************#       Employment Agreement, dated January 30, 1998, between the Company and
                                   Richard Walsh
          10.20*#                  Employment Agreement, dated June 3, 1993, between the Company and John J.
                                   Baldwin, Ph.D.
          10.21*#                  Employment Agreement, dated December 2, 1993, between the Company and
                                   Nolan H.
                                   Sigal, M.D., Ph.D.
          10.22*#                  Consulting Agreement, dated April 30, 1993, between the Company and W.
                                   Clark Still, Ph.D.
          10.23*                   Warrant to purchase Common Stock issued to Columbia University.
          10.24*                   Warrant to purchase Common Stock issued to Cold Spring Harbor Laboratory.
          10.25**+                 Collaboration Agreement effective as of December 31, 1995 between
                                   Pharmacopeia and Bayer.
          10.26**+                 Random Library Agreement effective as of December 31, 1995 between
                                   Pharmacopeia and Bayer.
          10.27***********#        Employment Agreement effective November 30, 1995 between Molecular
                                   Simulations Incorporated and Michael J. Savage
          10.27(a)************#    Amendment No. 1 to Employment Agreement between Molecular Simulations
                                   Incorporated and Michael J. Savage dated as of October 1, 1997
          10.28***********#        Employment Agreement effective November 30, 1995 between Molecular
                                   Simulations Incorporated and Saiid Zarrabian
          10.28(a)************#    Amendment No. 1 to Employment Agreement between Molecular Simulations
                                   Incorporated and Saiid Zarrabian dated as of October 1, 1997
          10.30***+                Collaborative Agreement dated as of March 29, 1996 with Daiichi
                                   Pharmaceutical Co., Ltd.
          10.30(a)*******+         Amendment No. 1 to Collaboration Agreement between the  Company and Daiichi
                                   Pharmaceutical Co., Ltd. dated April 14, 1997.
          10.31****+               Research Agreement, between Pharmacopeia, Inc. and N.V. Organon dated May
                                   31, 1996.
          10.32*****#              Employment Agreement, dated June 20, 1996, between the Company and Stephen
                                   A. Spearman, Ph.D.
          10.33*****               Lease Agreement, dated June 21, 1996, between Pharmacopeia and South
                                   Brunswick Rental I, Ltd.
          10.34**********+         Collaboration and License Agreement between Pharmacopeia, Inc. and
                                   Bristol-Myers Squibb Company dated November 26, 1997.
          10.35************+       Joint Venture Agreement dated February 14, 1992 between Polygen Corporation
                                   and Teijin Limited.
          10.36************        Amendment No. 1 to Joint Venture Agreement dated March 30, 1998 between
                                   Teijin Limited and Molecular Simulations Incorporated.
          10.37************+       Distributorship Agreement dated April 1, 1992 between Polygen 
</TABLE> 

                                     -38-
<PAGE>
 
<TABLE> 
<S>                                <C> 
                                   Corporation and Teijin Molecular Simulations Incorporated
          10.38************        Amendment to Distributorship Agreement dated October 17, 1994 between
                                   Molecular Simulations Incorporated and Teijin Molecular Simulations
                                   Incorporated.
          10.39************+       Amendment No. 2 to Distributorship Agreement dated September 30, 1996
                                   between Molecular Simulations Incorporated and Teijin Molecular Simulations
                                   Incorporated.
          10.40*************+      Amended and Restated Distributorship Agreement, dated March 1, 1998,
                                   between Molecular Simulations Incorporated and Teijin Molecular Simulations
                                   Incorporated
          10.41*************       Indemnity Agreement, dated March 1, 1998, between Molecular Simulations
                                   Incorporated and Teijin Molecular Simulations Incorporated
          10.42*************       Lease Agreement, dated February 26, 1987, as amended, between Sorrento Tech
                                   Limited and Biosym Technologies, Inc.
          10.43++                  Collaboration and License Agreement, dated as of October 29, 1998, between
                                   Pharmacopeia, Inc. and Schering-Plough Ltd.
          10.44++                  Collaboration and License Agreement, dated as of October 29, 1998, between
                                   Pharmacopeia, Inc. and Schering Corporation.
          10.45                    Guarantee, dated as of October 29, 1998, between Pharmacopeia, Inc. and
                                   Schering-Plough Corporation
          10.46#                   Employment Agreement, dated December 17, 1998, between the Company and
                                   Lewis Shuster
          10.47                    Lease dated November 12, 1998 between Molecular Simulations Inc. and San
                                   Diego Tech Center, LLC
          10.48#                   Indemnity Agreement dated July 21, 1997 between Molecular Simulations Inc.
                                   and C. Peter W. Booth
          11.1*                    Statement re Computation of Per Share Earnings.
          21.0                     Subsidiaries of Pharmacopeia, Inc.
          23.1                     Consent of Ernst & Young LLP.
          23.2                     Consent of Arthur Andersen LLP.
          24.1                     Powers of Attorney (See signature page)
          27.1                     Financial Data Schedule
          27.2*************        Restated Financial Data Schedule as of June 30, 1997
</TABLE>



* Incorporated by reference to the same numbered exhibit filed with the
Company's Registration Statement on Form S-1 No. 33-93460.
** Incorporated by reference to the same numbered exhibit filed with the
Company's Form 10-K for the year ended December 31, 1995.
*** Incorporated by reference to the same numbered exhibit filed with the
Company's Form 10-Q for the quarter ended March 31, 1996.
**** Incorporated by reference to the same numbered exhibit filed with the
Company's Form 10-Q for the quarter ended June 30, 1996.
***** Incorporated by reference to the same numbered exhibit filed with the

                                     -39-
<PAGE>
 
Company's Form 10-Q for the quarter ended September 30, 1996.
****** Incorporated by reference to the same numbered exhibit filed with the
Company's Form 10-K for the year ended December 31, 1996.
******* Incorporated by reference to the same numbered exhibit filed with the
Company's Form 10-Q for the quarter ended June 30, 1997.
******** Incorporated by reference to the same numbered exhibit filed with the
Company's form 10-Q for the quarter ended September 30, 1997.
********* Incorporated by reference to the same numbered exhibit filed with the
Company's Form 10-K for the year ended December 31, 1997.
********** Incorporated by reference to the same numbered exhibit filed with the
Company's Form 10-K/A-2 for the year ended December 31, 1997.
*********** Incorporated by reference to Exhibit 10.15 and 10.16 to Molecular
Simulations Incorporated's Registration Statement on Form S-1 (Registration No.
333-21427) listed on February 10, 1997.
************ Incorporated by reference to the same numbered exhibit filed with
the Company's Form 10-Q for the quarter ended June 30, 1998.
*************Incorporated by reference to the same numbered exhibit filed with
the Company's Form 10-Q for the quarter ended September 30, 1998.
+ Confidential treatment granted.
++ Confidential treatment requested.
# Represents a management contract or compensatory plan or arrangement.

(b)  Reports on Form 8-K

     There were no reports on Form 8-K required to be filed for the quarter
     ended December 31, 1998.

(c)  Exhibits

     See Item 14 (a)(3) above.

(d)  Financial Statement Schedule

See Item 14(a)(2) above.

                                     -40-
<PAGE>
 
                                   SIGNATURES

      Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                               PHARMACOPEIA, INC.
 
 
                               By:  /s/ Lewis J. Shuster
                                  --------------------------------
                                    Lewis J. Shuster
                                    President and
                                    Chief Operating Officer - Pharmacopeia Labs
                                    (Principal Accounting Officer)
 
                               Date:  March 29, 1999


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                                     -41-
<PAGE>
 
                               POWER OF ATTORNEY

      KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Lewis J. Shuster and Joseph A. Mollica,
Ph.D., jointly and severally, as his attorney-in-fact, each with full power of
substitution, for him or her, in any and all capacities, to sign each amendment
to this Report on Form 10-K, and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said attorneys-in-
fact or his or her substitute or substitutes may lawfully do or cause to be done
by virtue hereof.

      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>
Signatures                               Title                                   Date
----------                               -----                                   ----
<S>                                      <C>                                     <C>
 
/s/ Joseph A. Mollica, Ph.D.             Chairman of the Board, President and    March 29, 1999
---------------------------------------  Chief Executive Officer (Principal
  Joseph A. Mollica, Ph.D.               Executive Officer)
 
/s/ Lewis J. Shuster                     President and Chief Operating Officer   March 29, 1999
---------------------------------------  - Pharmacopeia Labs (Principal
   Lewis J. Shuster                      Financial and Accounting Officer)
 
/s/ Gary E. Costley, Ph.D.               Director                                March 29, 1999
---------------------------------------
   Gary E. Costley, Ph.D.

/s/ C. Peter W. Booth                    Director                                March 29, 1999
---------------------------------------
   C. Peter W. Booth
                                         Director                                March 29, 1999
---------------------------------------
   Frank Baldino, Jr., Ph.D.
                                         Director                                March 29, 1999
---------------------------------------
   Edith W. Martin, Ph.D.

/s/ Charles A. Sanders, M.D.             Director                                March 29, 1999
---------------------------------------
   Charles A. Sanders, M.D.
                                         Director                                March 29, 1999
/s/ Paul A. Bartlett, Ph.D.
---------------------------------------
   Paul A. Bartlett, Ph.D.
</TABLE>

                                     -42-
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
                                        



                                    CONTENTS
 
 
Report of Independent Auditors ..........................................  F-1
Report of Independent Public Accountants.................................  F-2
Consolidated Balance Sheets .............................................  F-3
Consolidated Statements of Operations ...................................  F-4
Consolidated Statements of Stockholders' Equity .........................  F-5
Consolidated Statements of Cash Flows ...................................  F-6
Notes to Consolidated Financial Statements ..............................  F-7
<PAGE>
 
                         Report of Independent Auditors
                                        

The Board of Directors and Stockholders
Pharmacopeia, Inc.

We have audited the accompanying consolidated balance sheet of Pharmacopeia,
Inc. and subsidiaries as of December 31, 1998, and the related consolidated
statements of operations, stockholders' equity and cash flows for the year then
ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free from
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 Pharmacopeia, Inc.
and subsidiaries at December 31, 1998 and the consolidated results of their
operations and their cash flows for the year then ended in conformity with
generally accepted accounting principles.

We previously audited and reported on the balance sheet as of December 31, 1997
and the related statements of operations, stockholders' equity, and cash flows
of Pharmacopeia, Inc. for the years ended December 31, 1996 and 1997, prior to
their restatement for the 1998 pooling of interests as described in Note 3. The
contribution of Pharmacopeia, Inc. to total assets represented 68.3% as of
December 31, 1997 and its contribution to revenues represented 23.8% and 30.2%
of the restated totals for 1996 and 1997, respectively.  Financial statements of
the other pooled company included in the 1996 and 1997 restated consolidated
statements were audited and reported on separately by other auditors.  We also
have audited, as to combination only, the accompanying consolidated balance
sheet as of December 31, 1997 and the related consolidated statements of
operations, stockholders' equity, and cash flows for the years ended December
31, 1996 and 1997, after restatement for the 1998 pooling of interests; in our
opinion, such consolidated financial statements have been properly combined on
the basis described in Note 3 to the consolidated financial statements.



                                              Ernst & Young LLP

Princeton, New Jersey
January 28, 1999
<PAGE>
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
                                        

To Molecular Simulations Incorporated:

      We have audited the consolidated balance sheet of Molecular Simulations
Incorporated (a Delaware Corporation) and subsidiaries as of December 31, 1997
and the related consolidated statements of income, stockholders' equity and cash
flows for the years ended December 31, 1996 and 1997.  These consolidated
financial statements are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

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

      In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Molecular
Simulations Incorporated and subsidiaries as of December 31, 1997 and the
results of their operations and their cash flows for the years ended December
31, 1996 and 1997, in conformity with generally accepted accounting principles.


Arthur Andersen LLP


San Diego, California
February 4, 1998
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                          Consolidated Balance Sheets
                   (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
                                                                              December 31,
                                                                 -----------------------------------
                                                                         1997              1998
                                                                 -----------------------------------
<S>                                                                <C>               <C>
ASSETS
Current assets:
   Cash and cash equivalents                                              $ 24,609          $ 36,863
   Marketable securities                                                    60,166            44,235
   Trade receivables, net of allowance for doubtful accounts of             
    $466 and $609, respectively                                             19,424            22,771
   Prepaid expenses and other current assets                                 4,671             5,774
                                                                 -----------------------------------
Total current assets                                                       108,870           109,643
                                                                 -----------------------------------
 
Non-current investments in marketable securities                            12,865                 -
Property and equipment, net                                                 13,141            13,700
Software development costs, net of accumulated amortization of                   
    $5,813 and $2,725, respectively                                          3,437             3,492
Other assets                                                                 1,738             1,030
                                                                 -----------------------------------
                                                                          $140,051          $127,865
                                                                 ===================================
 
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
    Accounts payable                                                      $  4,232          $  5,158
    Accrued liabilities                                                     18,118            21,427
    Notes payable, current portion                                           1,566             1,316
    Deferred revenue, current portion                                       29,345            24,415
                                                                 -----------------------------------
 
Total current liabilities                                                   53,261            52,316
 
Notes payable, long-term portion                                             1,852               328
Deferred revenue, long-term portion                                          4,342             1,764
Other long-term liabilities                                                      -             1,240
 
Commitments and contingencies                                                    -                 -
 
Stockholders' equity:
    Preferred stock, $.0001 par value, 2,000,000 shares                          -                 -
       authorized; none issued and outstanding
    Common stock, $.0001 par value, 40,000,000 shares authorized;
       18,804,780 and 19,120,604 shares issued and outstanding
       at December 31, 1997 and 1998, respectively                               1                 1
    Additional paid-in capital                                             144,440           145,499
    Accumulated deficit                                                    (62,657)          (72,820)
    Accumulated other comprehensive loss                                    (1,188)             (463)
                                                                 -----------------------------------
Total stockholders' equity                                                  80,596            72,217
                                                                 -----------------------------------
                                                                          $140,051          $127,865
                                                                 ===================================
</TABLE>
       See accompanying notes to these consolidated financial statements.

                                      F-3
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                        
<TABLE>
<CAPTION>
                                                                 Year Ended December 31,
                                                       1996                1997                1998
                                              -----------------------------------------------------------
<S>                                             <C>                 <C>                 <C>
Revenue:
 Contract                                             $14,799             $24,523             $29,677
 Software license, service and other                   41,083              49,108              54,420
 Hardware                                               6,178               7,566               8,114
                                              -----------------------------------------------------------
Total revenue                                          62,060              81,197              92,211
 
Cost and Expense:
 Software, license and other                            2,517               3,512               3,476
 Hardware                                               5,242               6,720               7,061
 Research and development:
  Collaborative                                        13,129              16,931              20,307
  Proprietary                                          20,945              25,251              28,656
 Sales, general and administrative                     28,585              31,807              38,169
 Merger related costs                                       -                   -               7,998
                                              -----------------------------------------------------------
Total cost and expenses                                70,418              84,221             105,667
                                              -----------------------------------------------------------
 
Operating loss                                         (8,358)             (3,024)            (13,456)
 
Interest and other income, net                          4,043               4,292               4,202
                                              ----------------------------------------------------------- 
Income (loss) before provision for income                                                             
 taxes                                                 (4,315)              1,268              (9,254)
Provision for income taxes                              3,071               2,996                 909
                                              -----------------------------------------------------------
Net loss                                              $(7,386)            $(1,728)           $(10,163)
                                              ===========================================================
 
Basic net loss per share                                $(.42)              $(.09)              $(.54)
Diluted net loss per share                              $(.42)              $(.09)              $(.54)
Weighted average shares of common stock
 outstanding-basic                                     17,736              18,445              18,916
Weighted average shares of common stock
 outstanding-diluted                                   17,736              18,445              18,916
</TABLE>

       See accompanying notes to these consolidated financial statements.

                                      F-4
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                STATEMENTS OF CONSOLIDATED STOCKHOLDERS' EQUITY
                   (Dollars in thousands, except share data)
                                        
<TABLE>
<CAPTION>
                                                    COMMON STOCK                        TREASURY STOCK
                                             ---------------------------              --------------------               
                                                                         ADDITIONAL                                    
                                              NUMBER OF SHARES             PAID-IN    NUMBER OF            ACCUMULATED 
                                                                 AMOUNT    CAPITAL      Shares    AMOUNT     DEFICIT   
                                           ----------------------------------------------------------------------------
<S>                                          <C>                 <C>     <C>          <C>         <C>      <C>         
Balance at December 31, 1995                      17,204,635         $1    $113,025           -   $   -       $(53,543)
Acquisition of treasury stock                                                             7,594       (2)              
Retirement of treasury stock                          (7,594)                    (2)     (7,594)       2               
Issuance of common stock in  private                                                                                   
 placements                                          973,206                 23,641                                    
Issuance of common stock for exercise                                                                                  
 of options                                           66,112                    153                                    
Issuance of common stock in employee                                                                                   
 stock purchase plan                                   7,171                    111                                    
Translation adjustment                                                                                                 
Net loss                                                                                                        (7,386)
                                           ----------------------------------------------------------------------------
Balance at December 31, 1996                      18,243,530          1     136,928           -        -       (60,929)
Acquisition of  treasury stock                                                            1,646       (1)              
Retirement of treasury stock                          (1,646)                    (1)     (1,646)       1               
Issuance of common stock in  private                                                                                   
 placements, net                                     438,323                  6,861                                    
Issuance of common stock for exercise of                                                                               
 options                                              93,477                    201                                    
Issuance of common stock in employee                                                                                   
 stock purchase plan                                  18,488                    235                                    
Issuance of common stock for 401k                                                                                      
 matching                                             12,608                    216                                    
Translation adjustment                                                                                                 
Net loss                                                                                                        (1,728)
                                           ----------------------------------------------------------------------------
Balance at December 31, 1997                      18,804,780          1     144,440           -        -       (62,657)
Acquisition of treasury stock                                                             3,584       (1)              
Retirement of treasury stock                          (3,584)                    (1)     (3,584)       1               
Issuance of common stock for exercise                                                                                  
 of options                                          263,481                    502                                    
Issuance of common stock in employee                                                                                   
 stock purchase plan                                  32,264                    298                                    
Issuance of common stock for 401k                                                                                      
 matching                                             23,663                    260                                    
Translation adjustment                                                                                                 
Net loss                                                                                                       (10,163)
                                           ----------------------------------------------------------------------------
Balance at December 31, 1998                      19,120,604         $1    $145,499           -   $    -      $(72,820)
                                           ============================================================================
</TABLE>

<TABLE> 
<CAPTION> 
                                              ACCUMULATED OTHER       TOTAL    
                                               COMPREHENSIVE     STOCKHOLDERS'
                                               INCOME (LOSS)         EQUITY   
                                             -----------------------------------
<S>                                          <C>                 <C>          
Balance at December 31, 1995                           $   (33)       $ 59,450
Acquisition of treasury stock                                               (2)
Retirement of treasury stock                                                  
Issuance of common stock in  private                                          
 placements                                                             23,641      
Issuance of common stock for exercise                                         
 of options                                                                153   
Issuance of common stock in employee                                          
 stock purchase plan                                                       111   
Translation adjustment                                    (466)           (466)
Net loss                                                                (7,386)
                                           -----------------------------------
Balance at December 31, 1996                              (499)         75,501
Acquisition of  treasury stock                                              (1)
Retirement of treasury stock                                                  
Issuance of common stock in  private                                          
 placements, net                                                         6,861     
Issuance of common stock for exercise of                                      
 options                                                                   201   
Issuance of common stock in employee                                       
 stock purchase plan                                                       235   
Issuance of common stock for 401k                                             
 matching                                                                  216
Translation adjustment                                    (689)           (689)
Net loss                                                                (1,728)
                                           -----------------------------------
Balance at December 31, 1997                            (1,188)         80,596
Acquisition of treasury stock                                               (1)
Retirement of treasury stock                                                  
Issuance of common stock for exercise                                         
 of options                                                                502 
Issuance of common stock in employee                                          
 stock purchase plan                                                       298   
Issuance of common stock for 401k                                             
 matching                                                                  260    
Translation adjustment                                     725             725
Net loss                                                               (10,163)
                                           -----------------------------------
Balance at December 31, 1998                             $(463)       $ 72,217
                                           =================================== 
</TABLE> 

       See accompanying notes to these consolidated financial statements.

                                      F-5
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                             (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
                                                                          Year Ended December 31,
                                                              1996                1997                 1998
                                                       ----------------------------------------------------------
<S>                                                      <C>              <C>                   <C>
Cash flows from operating activities
Net loss                                                       $ (7,386)             $ (1,728)           $(10,163)
Adjustments to reconcile net loss to net cash provided
   by (used in) operating activities:
  Depreciation                                                    2,833                 3,599               4,110
  Amortization                                                    1,205                 2,162               1,881
  Changes in operating assets and liabilities:
   Accounts receivable                                           (1,347)               (3,246)             (3,347)
   Prepaid expenses and other current assets                       (682)                 (258)             (1,103)
   Other assets                                                    (159)                  353                 708
   Accounts payable                                                (599)                1,856                 926
   Accrued liabilities                                            3,440                 3,316               3,309
   Deferred revenue                                              13,395                  (314)             (7,508)
   Other                                                            (84)                   37               1,227
                                                       ----------------------------------------------------------
Net cash provided by (used in) operating activities              10,616                 5,777             (10.960)
 
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures                                             (7,590)               (7,549)             (5,283)
Increase in capitalized software development costs               (1,520)               (1,923)             (1,322)
Effect of TMSI consolidation                                          -                     -              (1,113)
Purchases of held to maturity securities                        (95,750)              (90,373)            (26,756)
Purchases of available for sale securities                            -                     -             (36,231)
Proceeds from sales of held to maturity securities               63,615                81,765              35,758
Proceeds from sales of available for sale securities                  -                     -              56,025
                                                       ----------------------------------------------------------
Net cash provided by (used in) investing activities             (41,245)              (18,080)             21,078
 
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from issuance of common stock                       23,905                 7,477               1,059
Payments on note payable                                         (1,196)               (1,313)             (1,590)
Additions to capital lease obligations                            1,344                     -                   -
Principal payments on capital leases                               (373)                 (193)               (184)
                                                       ----------------------------------------------------------
Net cash provided by financing activities                        23,680                 5,971                (715)
Exchange rate effect on cash                                       (466)                 (627)                725
                                                       ----------------------------------------------------------
Net increase (decrease) in cash and cash equivalents             (7,415)               (6,959)             10,128
Cash and cash equivalents beginning of period 
  (including TMSI in 1998)                                       38,983                31,568              24,609
                                                       ----------------------------------------------------------
Cash and cash equivalents at end of period                     $ 31,568              $ 24,609            $ 36,863
                                                       ==========================================================
 
 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for:
 Interest                                                      $    307              $    379            $    333
 Income taxes                                                  $    817              $  1,555            $  1,277
</TABLE>
       See accompanying notes to these consolidated financial statements.

                                      F-6
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                               DECEMBER 31, 1998
                                        
1.  ORGANIZATION AND DESCRIPTION OF BUSINESS

Pharmacopeia, Inc., ("Pharmacopeia") develops combinatorial chemistry libraries
and uses these libraries alone and through collaborations to discover new, low
molecular weight compounds principally for use as pharmaceuticals.
Pharmacopeia's wholly-owned subsidiary, Molecular Simulations Incorporated and
its subsidiaries ("MSI"), which was acquired on June 12, 1998 (see Note 3)
designs, develops, markets and supports software that facilitates the discovery
and development of new products and processes in the pharmaceutical,
biotechnology, chemical, petrochemical and materials industries and also offers
consulting, training and maintenance services in support of its customers' use
of its software products.  Pharmacopeia and MSI are collectively referred to
herein as the "Company".

2.  SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION

These consolidated financial statements include the accounts of Pharmacopeia,
its wholly-owned subsidiaries and, beginning in 1998, its 50% owned joint
venture (see Note 10).  All significant intercompany balances and transactions
have been eliminated in consolidation.

USE OF ESTIMATES

The preparation of the 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.

CASH EQUIVALENTS

The Company considers all highly liquid investments with an original maturity of
three months or less to be cash equivalents.  The Company invests its cash in
deposits with major financial institutions, money market funds, U.S. Treasury
securities and other investment grade securities such as prime rated commercial
paper.

MARKETABLE SECURITIES

Marketable securities consist of fixed income investments with a maturity of
greater than three months such as United States treasury securities, obligations
of United States government agencies, other investment grade securities such as
prime rated commercial paper and corporate bonds.  As a result of the Company's
strategic acquisition intentions, initiated with the merger of MSI (see Note 3),
the Company as of June 30, 1998, transferred the classification of its
marketable securities of $64,029 from held-to-maturity to available-for-sale.
Available-for-sale securities are carried at market which approximates cost as
of December 31, 1998.

Property and Equipment

Property and equipment is stated at cost.  Depreciation is provided over the
estimated useful lives of the related assets, which range from three to ten
years using the straight-line method. Assets under capital leases are amortized
over the lesser of the useful life of the assets or the applicable lease terms,
whichever is shorter, which approximates 5 years.

                                      F-7
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   Notes to Consolidated Financial Statements
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                               DECEMBER 31, 1998
                                        
2.  SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

SOFTWARE DEVELOPMENT COSTS

Development costs incurred in the research and development of new software
products and enhancements to existing software products are expensed as incurred
until technological feasibility has been established. Thereafter, the Company
capitalizes software development costs in accordance with Statement of Financial
Accounting Standards No. 86 (SFAS 86), "Accounting for the Cost of Computer
Software to be Sold, Leased or Otherwise Marketed".  The Company amortizes such
capitalized costs over the estimated product life, not to exceed three years
from the date on which the product is available for general release.  The
Company capitalized approximately $1,520, $1,923 and $1,394 in 1996, 1997 and
1998, respectively.  Included in the accompanying consolidated statements of
operations for 1996, 1997 and 1998, respectively, is approximately $902, $1,585,
and $1,339 of amortization expense related to capitalized software.

REALIZATION OF ASSETS

The Company periodically re-evaluates the original assumptions and rationale
utilized in the establishment of the carrying value and estimated life of its
assets.  The criteria used for these evaluations include management's estimates
of the assets continuing ability to generate income from operations and positive
cash flow in future periods, as well as the strategic significance of its assets
to the Company's business objectives.

FOREIGN CURRENCY TRANSLATION

The Company translates certain of its accounts and the financial statements of
its foreign operations in accordance with Statement of Financial Accounting
Standards No. 52 (SFAS No. 52), "Foreign Currency Translation".  Assets and
liabilities are translated into U.S. dollars at the rate of exchange at the end
of the period.  Resulting translation adjustments are reflected as a cumulative
translation adjustment which is included in accumulated other comprehensive
income (loss) within stockholders' equity.  Revenue and expense accounts are
translated using the weighted average exchange rate for the period.  Transaction
gains and losses are reflected in the results of operations.

CONCENTRATIONS OF RISK

The Company purchases substantially all hardware products that it resells to its
licensees from a single vendor.  Management believes that other vendors could be
identified who could provide the Company and its licensees with similar hardware
products at comparable terms.  However, any disruption of supply could cause a
temporary adverse effect in the Company's revenues during any period requiring
porting of the Company's software products to alternative hardware platforms or
negotiation of alternative supply and distribution agreements.

The Company licenses its products primarily to corporations, including value
added resellers and academic institutions, serving a wide variety of domestic
and foreign markets.  The Company extends credit to its licensees based on its
evaluation of the customer's financial condition, generally without requiring a
deposit or collateral.  Exposure to losses on receivables is principally
dependent on each customer's financial condition.  The Company monitors its
exposure for credit losses and maintains allowances for estimated losses.

                                      F-8
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                               DECEMBER 31, 1998

                                        
2.  SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

The Company's international sales are generally denominated in foreign
currencies.  Losses on the conversion of foreign-denominated receivables into
U.S. dollars could have a material adverse effect on the Company's financial
statements.  The Company conducts business in the Asia/Pacific region primarily
in Japan. Any significant decline in the Japanese economy or the value of its
currency could have a material adverse impact on the Company.

REVENUE RECOGNITION

Contract revenue from collaborative agreements relates to research and
development work and is recognized primarily using the percentage of completion
method.  The application of this revenue recognition method is dependent on the
contractual arrangement of each agreement.  Accordingly, revenue is recognized
as research and development labor (based on a contractually agreed upon dollar
amount per person) is expended against a total research and development plan
(based on a total amount of labor as defined in each agreement).  Payments
received under these agreements prior to the completion of the related work are
recorded as deferred revenue.  Non-refundable milestone payments and up-front
fees are recognized as contract revenue when received as the Company has no
other performance obligations.

The Company recognizes revenue from licenses of computer software provided that
the customer has signed a non-cancelable license agreement, the software and
related documentation has been shipped, no material uncertainties regarding
customer acceptance exist, collection of the resulting receivable is deemed
probable and no other significant obligations by the Company exist.  Prepaid
post contract support and maintenance ("PCS") revenue bundled with software
license agreements is unbundled using objective, vendor specific evidence.  PCS
revenue is recognized pro-rata over the related license period, which is
generally one year.  Revenue generated from consulting, training and software
customization sold separately from license agreements are recognized as the
services are performed.

The Company earns revenue under product development and consortia agreements
wherein several unrelated parties enter into a joint product development
agreement with the Company.  The Company's product development and consortia
agreements are generally one to three years in length, require an annual fee and
contain progressive milestones.  In exchange for a consortia fee, customers
receive consortia membership, a software library of certain Company products and
related software maintenance support.  The portion of consortia fees associated
with the initial software library is recognized by the Company in the first
month of membership, while consortia fees associated with consortia membership
and software maintenance are recognized by the Company on a straight-line basis
over the term of the agreement.  The Company is not required to deliver
specified products under the agreements and the consortia fees are non-
refundable.  If the Company is successful in developing products under the
product development and consortia agreements described above, a non-transferable
license is typically awarded to the consortia members.

                                      F-9
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                               DECEMBER 31, 1998
                                        
2.    SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Under certain circumstances, the Company sells computer hardware to a licensee
of the Company's software products.  In these instances, the Company typically
orders the hardware from an unrelated vendor and records revenue upon shipment
of the hardware to the licensee by the vendor.

RESEARCH AND DEVELOPMENT

All research and development costs are charged to operations as incurred.

STOCK BASED COMPENSATION

As permitted by FASB Statement No. 123, "Accounting for Stock-Based
Compensation" (FASB 123), the Company has elected to follow Accounting Principal
Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and
related interpretations in accounting for its employee stock option plans.
Under APB 25, no compensation expense is recognized at the time of option grant
because the exercise price of the Company's employee stock option equals the
fair market value of the underlying common stock on the date of grant.

EARNINGS PER SHARE

Basic and diluted earnings per share is calculated in accordance with FASB 
Statement No. 128, earnings per share. All earnings per share amounts for all 
periods have been presented, and where appropriate, restated to conform to the 
requirements of Statement 128.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

As of January 1, 1998, the Company adopted SFAS No. 130, Reporting Comprehensive
Income   ("SFAS No. 130").  SFAS No. 130 establishes new rules for the reporting
and display of comprehensive income (loss) and its components; however, the
adoption of this Statement had no impact on the Company's net loss or
stockholders' equity. SFAS No. 130 requires that foreign currency translation
adjustments, which prior to adoption were reported separately in stockholders'
equity, be included in accumulated other comprehensive income.  Prior year
financial statements have been reclassified to conform to the requirements of
SFAS No. 130.  All of the Company's amounts in accumulated other comprehensive
income (loss) are attributable to translation adjustments.

In June 1997, the FASB issued SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information, which is effective for years beginning after
December 15, 1997.  SFAS No. 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.  The Company adopted the new requirements
retroactively in 1998.

                                     F-10
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                               DECEMBER 31, 1998
                                        
2.  SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

In March 1998, the AICPA issued SOP 98-1, Accounting For the Costs of Computer
Software Developed For or Obtained for Internal use.  The Company is required to
adopt the SOP effective January 1, 1999.  The SOP will require the
capitalization of certain costs incurred after the date of adoption in
connection with developing or obtaining software for internal use.  The Company
currently expenses such costs as incurred.  The Company has determined the
historical impact of adopting this SOP to be immaterial.

3.  ACQUISITION

On June 12, 1998 Pharmacopeia completed its merger with MSI through the issuance
of approximately 7.1 million shares of Pharmacopeia common stock for all of the
issued and outstanding MSI Common Stock, MSI Class B Common Stock and MSI Series
A Convertible Preferred Stock.  The merger has been accounted for as a pooling
of interests and accordingly, the financial statements for the periods prior to
the merger have been restated to include MSI.  In connection with the merger,
the Company recorded merger-related charges of approximately $8.0 million.  Such
charges consist of transaction costs, principally investment banking and
professional fees.

The following table summarizes 1998 information on a separate company basis for
Pharmacopeia and MSI prior to the completion of the merger:

<TABLE>
<CAPTION>
                                                 PERIOD FROM
                                             JANUARY 1, 1998 TO
                                                JUNE 12, 1998
                                         ------------------------
Total revenue:
<S>                                        <C>
     Pharmacopeia                                  $12,322
     MSI                                            20,437
                                                          
Net income (loss):                                        
     Pharmacopeia                                  $(3,588)
     MSI                                            (1,483)
</TABLE>                                                       
                                                               
4.    MARKETABLE SECURITIES                                    
                                                               
      Marketable securities consist of the following as of
      December 31,

<TABLE>
<CAPTION>
                                                                1997                     1998
                                                  --------------------------------  --------------
                                                      CURRENT         NONCURRENT       Current
                                                  ----------------  --------------  --------------
<S>                                               <C>               <C>             <C>
U.S. treasury securities and obligations of
 U.S. government agencies                              $31,732         $ 8,501         $36,245
                                                       
U.S. corporate debt securities                          28,434           4,364           7,990
                                                       -------         -------         -------
                                                       $60,166         $12,865         $44,235
                                                       =======         =======         =======
</TABLE>

At December 31, 1997 and 1998 the fair value of the Company's marketable
securities approximated cost and therefore, there were no unrealizable gains or
losses.

                                     F-11

<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                               DECEMBER 31, 1998
                                        
5.  PROPERTY AND EQUIPMENT

Property and equipment consist of the following:
<TABLE>
<CAPTION>
                                                                            DECEMBER 31,
                                                                       1997              1998
                                                               -----------------------------------
<S>                                                              <C>               <C>
Laboratory equipment                                                  $ 7,388          $  8,477
Furniture, fixtures and equipment                                       4,076             4,553
Computers and software                                                  5,633             8,287
Leasehold improvements                                                  4,213             5,780
Other                                                                     954               453
                                                               -----------------------------------
                                                                       22,264            27,550
Accumulated depreciation and amortization                              (9,123)          (13,850)
                                                               -----------------------------------
Property and equipment, net                                           $13,141          $ 13,700
                                                               ===================================
</TABLE>

6.  ACCRUED LIABILITIES

Accrued liabilities consist of the following:
<TABLE>
<CAPTION>
                                                                            DECEMBER 31,
                                                                       1997              1998
                                                               -----------------------------------
<S>                                                                 <C>            <C>
Accrued payroll and other compensation                                $ 7,796           $ 8,529
Royalties                                                               1,041               946
Merger related costs                                                        -             3,867
Accrued taxes                                                           4,975             5,108
Other                                                                   4,306             2,977
                                                               -----------------------------------
                                                                      $18,118           $21,427
                                                              ====================================
</TABLE>

7.  INCOME TAXES

The Company accounts for income taxes under Statement of Financial Accounting
Standards ("SFAS") No. 109, "Accounting for Income Taxes" which requires the
asset and liability method of accounting for income taxes.  Under the asset and
liability method, deferred income taxes are recognized for the tax consequences
of "temporary differences" by applying enacted statutory tax rates applicable to
future years to differences between the financial carrying amounts and the tax
basis of existing assets and liabilities.


                                     F-12
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                               DECEMBER 31, 1998
 
7.  Income Taxes    (continued)

Significant components of the Company's deferred tax assets and liabilities as
of December 31 are as follows:

<TABLE>
<CAPTION>
                                                                 1997               1998
                                                         -----------------------------------
Deferred tax assets:
<S>                                                        <C>                <C>
Net operating loss carryforwards                               $ 16,541             $ 17,873
Unused tax credits                                                2,134                2,261
Accruals and reserves                                             2,203                2,628
Other                                                                 -                  258
                                                         --------------     ----------------
Gross deferred tax asset                                         20,878               23,020
 
Deferred tax liabilities:
  Fixed assets and intangibles                                      825                  948
                                                         --------------     ----------------
 
Net asset before valuation allowance                             20,053               22,072
Valuation allowance                                             (20,053)             (22,072)
                                                         --------------     ----------------
 
Net deferred tax asset (liability)                         $         -        $        -
                                                         ==============     ================
</TABLE>

Under SFAS No. 109, a valuation allowance is established, if based on the weight
of available evidence, it is more likely than not that a portion of the deferred
tax asset will not be realized.  Accordingly, a full valuation allowance has
been provided to offset the Company's net deferred tax assets.

The provision for income taxes consists of the following for the years ended
December 31,:

<TABLE>
<CAPTION>
                                   1996        1997        1998
                                 ---------  ----------  ----------
<S>                              <C>        <C>         <C>
Current:
 
  Federal                         $   47      $1,603       $   -
  State                               59         480         310
  Foreign                          1,365         913         599
 
Deferred:
 
  Federal                          1,600           -           -
  State                                -           -           -
  Foreign                              -           -           -
                                 ---------------------------------
Total                             $3,071      $2,996       $ 909
                               ===================================
</TABLE>

                                     F-13
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                               DECEMBER 31, 1998

7.  Income Taxes   (continued)

The reconciliation of income taxes computed at the U.S. statutory federal tax
rate to income tax expense for the years ended December 31 are:
<TABLE>
<CAPTION>
                                                   1996              1997               1998
                                             -------------     -------------     ---------------
<S>                                            <C>               <C>               <C>
Tax expense (benefit) at U.S.
  statutory rate                                 $(1,467)           $  431             $(3,146)
State income taxes, net of
  federal income tax benefit                          39               317                 205
Nondeductible merger costs                             -                 -               1,788
Change in valuation allowance                      2,941             1,537               1,986
Foreign Taxes                                      1,534               975              (   12)
Other  Items                                          24              (264)                 88
                                             -------------     -------------     ---------------
 
Income tax expense                               $ 3,071            $2,996             $   909
                                             =============     =============     ===============
</TABLE>

Pretax income (loss) before extraordinary item from the Company's domestic
operations totaled approximately ($3,800), $1,400 and ($10,900) for the years
ended December 31, 1996, 1997 and 1998, respectively. Pretax income (loss) from
the Company's foreign operations totaled approximately ($500), ($200) and
$1,800 for the years ended December 31, 1996, 1997 and 1998, respectively.

As of December 31, 1998, the Company has federal net operating loss
carryforwards of approximately $45.8 million. The federal net operating losses
and credits begin to expire in 2008 through 2018, if not fully utilized.
Realization is dependent on generating sufficient taxable income prior to
expiration of the loss carryforwards.

As a result of certain transactions involving the Company's stock, the Company
believes an ownership change, as defined in Section 382 of the Internal Revenue
Code, has occurred.  Consequently, future utilization of the Company's federal
net operating loss carryforwards may be subject to limitations.

8.  STOCK PLANS

The Company has three Stock Plans, the 1994 Incentive Stock Plan, the 1995
Employee Stock Purchase Plan and the 1995 Director Option Plan.

In accordance with the 1994 Incentive Stock Plan (the "Plan"), the Company may
grant up to 2,750,000 shares of both incentive or non-qualified stock options or
stock purchase rights to officers, directors, employees, sales representatives
and consultants of the Company. The term of each incentive and non-qualified
stock option and stock purchase right is ten years or ten years and one day from
the date of grant. Vesting generally occurs over a period of not greater than
five years.

                                     F-14
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                               DECEMBER 31, 1998

                                        
8.  STOCK PLANS   (CONTINUED)

Under the 1994 Incentive Stock Plan, 1,819,408 outstanding options and stock
purchase rights were exercisable at December 31, 1998 and there were 409,324
shares available for future grants.  In addition,1,181,484 of the outstanding
options issued and exercisable were from various former MSI plans.  All stock
purchase rights which are not vested are subject to repurchase by the Company.

In 1995, the Company adopted the 1995 Employee Stock Purchase Plan ("ESPP")
under Section 423 of the Internal Revenue Code.  An aggregate of 250,000 shares
of common stock are reserved for offering under the ESPP.  In 1998, 32,204
shares of common stock were purchased at prices ranging from $7.01 to $12.54 per
share, as determined by the ESPP.  At December 31, 1998, there were 192,077
shares available for future purchase.

In accordance with the 1995 Directors Option Plan, the Company may grant up to
150,000 options to purchase shares of common stock to non-employee members of
the Board.  The exercise price of the stock options shall be equal to the fair
market value per share of common stock on the option grant date.  Each option
has a term of ten years from the option grant date and shall become exercisable
in a series of three equal and successive annual installments.  In 1998 45,000
options were granted at an exercise price of $17.125. At December 31, 1998,
33,336 of the outstanding options were exercisable and there were 45,000 shares
available for future grants.

FASB 123 requires pro forma information regarding net income and earnings per
share as if the Company has accounted for its employee stock options and
warrants granted subsequent to December 31, 1994 and shares of common stock
purchased by employees in connection with the ESPP ("equity awards") under the
fair value method of FASB 123.  The fair value of these equity awards was
estimated at the date of grant using a Black-Scholes option pricing model with
the following weighted average assumptions for 1996, 1997 and 1998,
respectively: risk-free interest rates of 6.17%, 5.44% and 4.49%; expected
volatility of 59.70, 47.00 and 81.00; expected option life of 5.6, 5.8 and 5.9
years from vesting and an expected dividend yield of 0.0%.

For purposes of pro forma disclosures, the estimated fair value of the equity
awards is amortized to expense over the options' vesting period.  The Company's
pro forma information is as follows:

<TABLE>
<CAPTION>
                                                         1996             1997             1998
                                                   -------------    -------------    -------------
<S>                                                 <C>              <C>              <C>
Pro forma net loss.................................    $(9,014)         $(5,224)        $(17,209)
Pro forma basic net loss per share.................    $  (.51)         $  (.28)        $   (.91)
</TABLE>

                                     F-15
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                               DECEMBER 31, 1998

                                        
8.  STOCK PLANS   (CONTINUED)

     A summary of the Company's stock option activity, and related information
for the years ended December 31, 1996, 1997, and 1998 follows:

<TABLE>
<CAPTION>
                                -------------------------------     ------------------------------    ------------------------------
                                             1996                                1997                              1998
                                -------------------------------     ------------------------------    ------------------------------

                                                    Weighted                          Weighted                          Weighted
                                  Common Stock      Average             Common        Average         Common Stock      Average
                                     Options        Exercise            Stock         Exercise           Options        Exercise
                                                     Price             Options         Price                             Price
                                                                                                                   
                                --------------  --------------     -------------  --------------    --------------  --------------
<S>                               <C>             <C>                <C>            <C>               <C>             <C>
Outstanding at beginning of year     2,152,343          $ 1.91         2,650,397          $ 6.41         3,164,229          $ 8.19
  Granted.......................       722,906           19.22           778,524           13.94         1,217,504           12.45
  Exercised.....................       (81,700)           2.91          (109,169)           3.32          (295,578)           2.42
  Forfeited.....................      (143,152)           2.26          (155,523)           9.01          (361,133)          13.01
                                --------------                     -------------                    -------------- 
                                                                                                                   
Outstanding at end of year           2,650,397            6.41         3,164,229            8.19         3,725,022            9.54
                                ==============                     =============                    ============== 
                                                                                                                   
Exercisable at end of year             843,258                         1,450,000                         1,852,744 
                                ==============                     =============                    ============== 
Weighted average fair value of                                                                                     
 options granted during the year                          8.03                             10.58                              6.52
 
</TABLE>

     Stock options outstanding at December 31, 1998 are summarized as follows:

<TABLE>
<CAPTION>
                                                                                       Weighted Average
                               Outstanding                 Weighted Average                Exercise
     Range of                   Options at                     Remaining                     Price
  Exercise Prices           December 31, 1998              Contractual Life
-------------------    --------------------------    ---------------------------    ---------------------
<S>                     <C>                           <C>                            <C>
    $           .48                68,991                            5.9                   $  .46
    $ 1.24 - $19.00             3,331,049                            6.5                     8.66
    $19.38 - $26.75               324,982                            7.7                    21.81
                       --------------------------
    $  .48 - $26.75             3,725,022                            6.6                     9.66
                       --------------------------
</TABLE>

                                     F-16
<PAGE>
 
                      Pharmacopeia, Inc. and Subsidiaries
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATE)
                               DECEMBER 31, 1998
9.   Segment information

Pharmacopeia operates in two business segments.  The Company's Laboratory
Services segment develops combinatorial chemistry libraries and uses these
libraries alone and through funded collaborations to discover new, low molecular
weight compounds principally for use as pharmaceuticals.  The Company's Software
segment designs, develops, markets and supports software that facilitates the
discovery and development of new products and processes in the pharmaceutical,
biotechnology, chemical petrochemical and materials industries.  Summarized
financial information concerning the industry segments and geographic areas in
which the Company operated at December 31, 1996, 1997 and 1998 and for each of
the years then ended is presented in the following tables:

<TABLE>
<CAPTION>

BUSINESS SEGMENTS                                          1996                                           1997                    
                                      --------------------------------------------     -------------------------------------------- 

                                                        Laboratory                                    Laboratory                  
                                        SOFTWARE         Services           TOTAL      SOFTWARE        Services           TOTAL   
                                                                                                                                  
                                      --------------------------------------------------------------------------------------------
<S>                                     <C>         <C>                   <C>          <C>         <C>                  <C>       
Revenue:                                                                                                                          
  Contract                               $    -             $  14,799     $ 14,799     $      -           $  24,523     $ 24,523  
  Software licenses, service and                                                                                                  
     Other                                41,083                    -       41,083       49,108                   -       49,108  
  Hardware                                 6,178                    -        6,178        7,566                   -        7,566  
                                      --------------------------------------------------------------------------------------------- 
Total Revenue                            $47,261            $  14,799     $ 62,060      $56,674           $  24,523     $ 81,197  
                                      ============================================================================================
                                                                                                                                  
Operating income (loss)                  $ 3,700             ($12,058)     ($8,358)     $ 7,820            ($10,844)     ($3,024) 
                                      ============================================================================================
                                                                                                                                  
Total Assets                             $39,665            $  91,979     $131,644      $44,364           $  95,687     $140,051  
                                      ============================================================================================
                                                                                                                                  
GEOGRAPHIC INFORMATION                                                                                                            
Revenues (2)(3):                                                                                                                  
  U.S.                                                                    $ 48,910                                      $ 62,444  
  Europe                                                                    13,150                                        18,753  
                                                                     -------------                                 -------------
  Asia-Pacific                                                                   -                                             -  
Total:                                                                    $ 62,060                                      $ 81,197  
                                                                     =============                                 =============  
</TABLE>
<TABLE> 
<CAPTION> 

BUSINESS SEGMENTS                                             1998                     
                                      -------------------------------------------------
                                                         Laboratory                    
                                         SOFTWARE         Services             Total   
                                      -------------------------------------------------
<S>                                      <C>         <C>                   <C>         
Revenue:                                                                               
  Contract                               $      -            $  29,677     $     29,677
  Software licenses, service and                                                       
     Other                                 54,420                    -           54,420     
  Hardware                                  8,114                    -            8,114
                                      -------------------------------------------------
Total Revenue                             $62,534            $  29,677     $     92,211
                                      =================================================
                                                                                       
Operating income (loss)                   $ 1,090             ($14,546)     (1)($13,456)
                                      =================================================
                                                                                       
Total Assets                              $52,889            $  74,976     $    127,865
                                      =================================================
                                                                                       
GEOGRAPHIC INFORMATION                                                                 
Revenues (2)(3):                                                                       
  U.S.                                                                     $     58,601
  Europe                                                                         22,739
  Asia-Pacific                                                                   10,871
                                                                      -----------------
Total:                                                                     $     92,211
                                                                      ================= 
</TABLE> 
(1)  Includes $8.0 million of merger related costs.
(2)  Revenue in the U.S. category for 1996 and 1997 includes export sales
     primarily to TMSI, the Company's sales and distribution entity for Asia
     Pacific region. TMSI was accounted for under the equity method during 1996
     and 1997, and was consolidated in 1998.
(3)  Export sales totaled $28,944, $21,811 and $18,489 in 1996, 1997 and 1998,
     respectively.

                                     F-17
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATE)
                               DECEMBER 31, 1998

10.   Joint Venture Agreement

The Company owns a 50% interest in Teijin Molecular Simulations Incorporated
(TMSI), a Japan corporation formed for the purpose of marketing, distribution,
licensing, selling and supporting the Company's products in Asia.  For periods
through December 31, 1997 the Company used the equity method of accounting for
the joint venture.  The Company had product sales to TMSI of approximately
$5,924 and $8,478 in 1996 and 1997, respectively.  The products are typically
shipped directly to the end user by the Company.

Condensed financial information of TMSI as of and for the years ended December
31, 1996 and 1997 is as follows:
<TABLE>
<CAPTION>
                                                            1996                 1997
                                                      -----------------     ---------------
                                                          (unaudited)        (unaudited) 
<S>                                                   <C>                   <C>
Current assets......................................         $5,425             $ 4,790
Non-current assets..................................            642                 583
Current liabilities.................................          4,028               3,353
Stockholders' Equity................................          2,039               2,020
Revenue.............................................          6,490              11,067
Operating income....................................            267                 848
Net income..........................................            110                 343
</TABLE>

As a result of certain changes to the joint venture agreement related to the
management and control of the joint venture, in 1998 the Company began to
consolidate its interest in TMSI.

As of December 31, 1998 the Company has a remaining obligation to Teijin Limited
of $700 which will be paid in 1999.

11.   COMMITMENTS AND CONTINGENCIES

OPERATING LEASES

The Company has several operating leases or sub-leases for office and laboratory
space, which expire at various dates through February 28, 2007.

     The future minimum lease commitments at December 31, 1998 are as follows:

<TABLE>
                   <S>                     <C>
                        1999                    $ 4,361
                        2000                      4,370
                        2001                      4,359
                        2002                      4,322
                        2003                      4,365
                        Thereafter               11,339
</TABLE>

Rent expense for the years ended December 31, 1996, 1997 and 1998 was $2,846,
$3,793 and $4,435, respectively.

                                     F-18
<PAGE>
 
                      PHARMACOPEIA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
            (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATE)
                               DECEMBER 31, 1998


11.   Commitments and Contingencies (continued)

ROYALTIES

The Company pays royalties to approximately forty-five partners for the
worldwide licenses to enhance and market certain software developed at
universities, corporations and other institutions.  A majority of the royalty
agreements are long term or perpetual in nature and the royalty obligations
thereunder are generally based on a percentage of revenues derived from certain
software licenses plus associated revenues from post contract support and
maintenance. The royalty agreements require quarterly payments and generally do
not limit the maximum royalty amount under the agreement.  Certain agreements
contain provisions for quarterly and annual minimum royalties of approximately
$457.  The Company paid royalties under these agreements of approximately $606,
$1,333 and $2,110 in 1996, 1997 and 1998, respectively.  Approximately $701,
$1,304 and  $1,623 of royalty expense related to royalty agreements is included
in license cost of revenue for the year ended December 31, 1996, 1997 and 1998,
respectively.  Based on existing royalty agreements the Company expects to incur
significant future royalty obligations.

On July 16, 1993, the Company entered into a license agreement with the Trustees
of Columbia University and Cold Spring Harbor Laboratory.  The agreement grants
to the Company an exclusive, worldwide license to certain technology for making
and using combinatorial chemical libraries.  The agreement includes annual
license fees and certain royalties to be made by the Company.  In October 1995,
the Company amended this license agreement and issued warrants to purchase
100,000 shares of common stock at $10.00 per share, exercisable through October
5, 2000 or earlier as defined in the warrants the years ended December 31, 1996,
1997, and 1998 the Company paid royalties and license fees to Columbia
University of  $590, $550 and $514, respectively.

Litigation

In the ordinary course of business, the Company is subject to claims and, from
time to time, is named in various legal proceedings. In the opinion of
management, the amount of ultimate liability, if any, with respect to any
pending actions will not materially affect the financial position or results of
operations of the Company.

                                     F-19
<PAGE>
 
                      Pharmacopeia, Inc. and Subsidiaries
                          Report on Form 10-K for the
                          Year ended December 31, 1998

                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
 
 
Exhibit                                                                                 Sequentially 
Number                          Exhibit Name                                              Numbered      
                                                                                            Page     
<S>         <C>
10.43++     Collaboration and License Agreement, dated as of October 29, 1998,
            between Pharmacopeia, Inc. and Schering-Plough Ltd.
            
10.44++     Collaboration and License Agreement, dated as of October 29, 1998,
            between Pharmacopeia, Inc. and Schering Corporation
            
10.45       Guarantee, dated as of October 29, 1998, between Pharmacopeia, Inc.
            and Schering-Plough Corporation
            
10.46#      Employment Agreement, dated December 17, 1998, between the Company
            and Lewis Shuster
            
10.47       Lease dated November 12, 1998 between Molecular Simulations Inc. and
            San Diego Tech Center, LLC
            
10.48#      Indemnity Agreement dated July 21, 1997 between Molecular
            Simulations Inc. and C. Peter W. Booth
            
21.0        Subsidiaries of Pharmacopeia, Inc.
 
23.1        Consent of Ernst & Young LLP
 
23.2        Consent of Arthur Andersen LLP
 
24.1        Powers of Attorney (see signature page)
 
27.1        Financial Data Schedule (filed electronically with the SEC only)
 
++     Confidential treatment requested
 
 
#      Represents a management contract or compensatory plan or arrangement
</TABLE>

                                     F-20