<PAGE>
 
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                      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, 1997

          [_]  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
 incorporation or organization)                           number)


                  101 College Road East, Princeton, NJ 08540
             (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. [X]

     The approximate aggregate market value of voting stock held by
nonaffiliates of the Registrant was $161,963,477 based on the last sale price of
Common Stock reported on The Nasdaq National Market on January 31, 1998.
2,053,322 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, 1998, the number of outstanding shares of the
Registrant's Common Stock was 11,795,486.


                      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 1998 Annual Meeting of
Stockholders forming a part of the Registration Statement on Form S-4 (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, 1997.

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<PAGE>
 
                              PHARMACOPEIA, INC.

 
                                1997 Form 10-K
 
                               Table of Contents
                                                                          Page
                                                                          ----
 
PART I....................................................................   3
 
     ITEM 1.     BUSINESS.................................................   3
     ITEM 2.     PROPERTIES...............................................  17
     ITEM 3.     LEGAL PROCEEDINGS........................................  17
     ITEM 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS......  17
 
PART II...................................................................  19
 
     ITEM 5.     MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED 
                 STOCKHOLDER MATTERS......................................  19
     ITEM 6.     SELECTED FINANCIAL DATA..................................  19
     ITEM 7.     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL 
                 CONDITION AND RESULTS OF OPERATIONS......................  20
     ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
                 RISK.....................................................  23
     ITEM 8.     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA..............  23
     ITEM 9.     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON 
                 ACCOUNTING AND FINANCIAL DISCLOSURE......................  23
 
PART III..................................................................  24
     ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.......  24
     ITEM 11.    EXECUTIVE COMPENSATION...................................  24
     ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND 
                 MANAGEMENT...............................................  24
     ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS...........  24
 
PART IV...................................................................  25
 
     ITEM 14.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON 
                 FORM 8-K.................................................  25
 
SIGNATURES................................................................  28

REPORT OF INDEPENDENT AUDITORS............................................ F-1

                                      -2-
<PAGE>
 
                                    PART I


ITEM 1.  BUSINESS

Overview

     Since its inception in March 1993, Pharmacopeia, Inc. ("Pharmacopeia" or
the "Company"), a Delaware corporation, has focused its research efforts in
developing a novel, proprietary technology for accelerating the pace of drug
discovery for its pharmaceutical and biotechnology customers. The Company's
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 the Company to
generate hundreds of thousands of small molecule compounds at a fraction of the
cost of traditional chemical synthesis methods. The Company focuses on drug
discovery, and seeks customers to develop, manufacture, market and sell
resulting drugs. To date, the Company has signed contracts with several
pharmaceutical customers, 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"), and Bristol-
Myers Squibb Company ("BMS"), and with a number of biotechnology customers.

     The Company's technology supports its pharmaceutical and biotechnology
customers in improving their drug discovery productivity. The Company 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. The Company's 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 Company's 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 Company to rapidly identify from the mixture any compound that is
active in a biological screening assay. The Company's tagging technology is
licensed exclusively from Columbia University ("Columbia") and Cold Spring
Harbor Laboratory ("Cold Spring").

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

     When used in this Report, the words "expects", "believes", "anticipates",
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"estimates" and similar expressions are intended to identify forward-looking
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statements.  Such statements are subject to risks and uncertainties, including
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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
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any undertaking to publicly update or revise any forward-looking statements
---------------------------------------------------------------------------
contained herein to 
-------------------

                                      -3-
<PAGE>
 
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.
------
 
Pharmacopeia's Drug Discovery Technology

     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.

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

     Pharmacopeia's 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 at
Pharmacopeia. The Company 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.

     The Company 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.

     Pharmacopeia's ECLiPS technology allows the Company to quickly identify the
chemical structure of individual small compounds synthesized in combinatorial
mixtures. This identification is made possible through the use of the Company's
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 the Company attaches to each bead as a compound is synthesized. These
tag sets allow the Company to rapidly identify the chemical structure of each
compound.

                                      -4-
<PAGE>
 
Description of Pharmacopeia's Drug Discovery Technology

     The Company's drug discovery approach encompasses its ECLiPS technology,
assay technology, production automation, information systems and quality
assurance programs.

ECLiPS Technology

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

     Solid Phase Synthesis.  The Company 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.

     The Company 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. The Company's 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 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's 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.  The Company 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 the Company 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 the Company's 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 

                                      -5-
<PAGE>
 
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.

     The Company's proprietary tag sets have the following important
characteristics:

     Stability.  The Company's 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, the Company's 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 the Company to use them in extremely small
quantities. The Company's 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, the Company can synthesize a
large combinatorial mixture of compounds and rapidly identify the specific
structure of individual active compounds found in the library. To date, the
Company has used its ECLiPS technology to synthesize libraries containing an
aggregate of more than 3.8 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 the Company in protecting its intellectual property.
When a customer licenses the Company's libraries, the Company ships microtiter
plates containing library compounds detached from the beads for screening in the
customer's laboratories. The beads containing the tag sets never leave the
Company's facility. When the customer finds an active compound in an assay, the
customer asks the Company to decode the compound. This process notifies the
Company of active compounds identified by its customers.

Assay Technology

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

     The Company has improved the 96-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.

                                      -6-
<PAGE>
 
     The Company has also been developing an integrated set of workstations to
provide a complete front-end for miniaturization within a conventional high-
throughput screening environment. Using this technology will enable existing
compound collections or combinatorial libraries to be reformatted from current
96-well microtiter formats into 1536-well high-density plates designed for high-
throughput screening applications, and to be screened in this new format.

Production Automation

     Production automation technology is the third component of the Company's
integrated drug discovery approach. The Company 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. The Company's 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-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.

Information Systems

     The Company has developed proprietary software to support its drug
discovery activities. Pharmacopeia's information systems assist the Company's
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. The Company's systems then track
the thousands of bar-coded microtiter plates filled and processed as libraries
are screened. As active compounds are identified and decoded, the Company's
software integrates the tag set decoding results with the original library
design database to quickly provide the Company's scientists with the specific
chemical structure and synthesis steps for the active compound.

     The Company's 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.

     As the Company continues to build its chemical libraries and accelerates it
high-throughput screening activities an enormous amount of SAR information is
emerging from these activities, which is being stored in the Company's
information systems.  The Company 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

     The Company's 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 

                                      -7-
<PAGE>
 
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's Drug Discovery Programs

     Pharmacopeia has several active drug discovery programs underway using its
drug discovery technology. The Company is presently conducting ten programs
pursuant to collaborative agreements with six of its customers. The Company is
also using its drug discovery technology for internal programs. As of December
31, 1997, the Company was performing high throughput assays for eighteen
biological targets selected by the Company for its 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, the Company
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 bioavailability.  Future activities may include preclinical
animal efficacy and toxicity studies. The Company will continue to seek
financial support from pharmaceutical companies for the optimization of lead
compounds identified by internal screening. In return for such support, the
Company would offer the funding pharmaceutical company an option to license the
resulting drug development candidate for commercialization. The Company may also
invest its own funds to optimize these lead compounds into development
candidates for outlicensing to pharmaceutical companies.

Proposed Merger

     On February 4, 1998, Pharmacopeia, Micro Acquisition Corporation, a wholly-
owned subsidiary of Pharmacopeia ("MAC") and Molecular Simulations Incorporated
("MSI") executed a definitive merger agreement pursuant to which Pharmacopeia
will acquire MSI in a tax-free, stock-for-stock transaction.  MSI is a 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.  The closing of the merger is subject to
the satisfaction of a number of conditions and approvals and there can be no
assurance that the merger will be consummated.  See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Proposed Merger".

Business Strategy

     Pharmacopeia's objective is to be the industry leader in the discovery and
optimization of novel drug candidates. The Company seeks to minimize its
financing requirements and shorten its time to profitability by pursuing drug
discovery collaborations with multiple pharmaceutical and biotechnology
companies. The Company does not currently plan to develop, manufacture and sell
its own pharmaceutical products. The Company's 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's
commercialization and technology strategy has several components.

Commercialization Strategy

     The Company's commercialization strategy is to provide collections of
compounds and drug development candidates to multiple pharmaceutical and
biotechnology customers. Under these arrangements, the Company's customers are
responsible for the clinical development and eventual manufacture and sale of
resulting drugs. Customers compensate the Company through (i) funding or fees
during or upon completion of its research and (ii) milestone payments and
royalties on drugs based on the Company's technology and 

                                      -8-
<PAGE>
 
developed by the Company's customers. Each collaboration is tailored to the
individual customer's needs but is developed within three broad frameworks:

     Form Drug Discovery Collaborations.  The Company synthesizes targeted and
optimization libraries of compounds and, using its high throughput screening
technology, screens these libraries and the Company's internal libraries to
identify drug development candidates.

     License Libraries.  Pharmacopeia 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 the Company's 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.  The Company will
seek to license to third parties drug development candidates identified by the
Company. The Company may also seek pharmaceutical sponsors for various internal
development programs, giving the sponsor an option to license any resulting drug
development candidates.

Technology Strategy

     The Company's technology strategy is to enhance productivity through cost
reductions and increased throughput and to build the Company's 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 seeks to leverage its existing
technology by increasing productivity through cost reductions and significant
increases in throughput. The Company's internal research and development efforts
focus on: (i) advances in the Company's 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 the Company's internal
programs.

     Develop Collection of Libraries and Knowledge Base.  The Company 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 the Company upon the expiration of customers' exclusivity periods. The
Company believes that this growing library collection will provide a valuable
source of leads for future drug discovery programs. The Company 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
the Company designs, synthesizes and screens large numbers of compounds against
a growing number of targets. The Company believes that this knowledge base will
provide a future competitive advantage by enabling the Company to identify more
quickly active compounds for newly identified targets.

Collaborative Arrangements

     The Company has signed collaborative agreements with Schering-Plough,
Berlex, Novartis, Bayer, Daiichi, Organon, and BMS as described below.

     Schering-Plough.  In December 1994, the Company and Schering-Plough signed
a collaborative agreement for (i) the optimization of lead compounds that
interact with a specific molecular target in the field of cancer and (ii) the
identification and optimization of lead compounds that interact with specific
molecular 

                                      -9-
<PAGE>
 
targets in the field of asthma. The Company and Schering-Plough also signed an
agreement under which the Company provided Schering-Plough with combinatorial
libraries for screening by Schering-Plough in a wide range of Schering-Plough's
internal drug screening assays. Schering-Plough has paid the Company $13.5
million under the research program to be performed through the fourth year of
the Collaboration Agreement. The term of the research program as amended extends
until December 1998 and is subject to further extension by agreement of both
parties, although no assurance can be given that such extension will occur or
regarding the terms and conditions of such extension. The agreements provide
Schering-Plough with exclusive worldwide rights to develop and commercialize
lead compounds discovered by the Company that are active against the specified
molecular targets or discovered by Schering-Plough to be active in its assays.
Compounds contained in libraries created by the Company for Schering-Plough will
be exclusive to Schering-Plough for various time periods. These exclusivity
periods can be extended upon payment of additional fees. In the event Schering-
Plough successfully identifies, develops and obtains regulatory approval for
drugs based upon the Company's compounds, Schering-Plough will make additional
milestone payments to the Company. During 1996 and 1997, Schering-Plough made
milestone payments to the Company. Schering-Plough will also be obligated to pay
to the Company royalties on the sale of any drugs that result from this
relationship. In connection with the collaboration, Schering-Plough has made
investments totaling $20 million in the Company.

     Berlex.  In February 1995, Pharmacopeia and Berlex signed a collaborative
agreement for the identification and optimization of lead compounds which
interact with a specific molecular target that may have applications in the
treatment of multiple sclerosis. Under the terms of this agreement, Berlex paid
the Company an aggregate of $5.5 million over the first two years of the
agreement for library synthesis and screening conducted by the Company.  The
term of the research program as amended expired in February 1998. The parties
are currently negotiating a further extension of such program, although no
assurance can be given that such extension will occur or regarding the terms and
conditions of such extension. Berlex is also obligated to make additional
payments upon the achievement of certain milestones and to pay royalties on
sales of drugs that may result from the relationship. During 1997 Berlex made
its first milestone payment. The agreement provides Berlex with exclusive
worldwide rights to develop and commercialize compounds active against the
specified molecular target. The agreement also provides for an exclusivity
period on the compounds provided to Berlex.  In connection with the
collaboration, an affiliate of Berlex made a $3.5 million equity investment in
the Company and purchased an additional $2.5 million of the Common Stock sold in
the Company's initial public offering.

     Novartis.  Effective October 1, 1995, the Company entered into an agreement
with Novartis to create libraries in collaboration with Novartis for screening
by Novartis. Under this agreement, the Company is obligated to provide certain
numbers of compounds during each of the five years of the research program. The
agreement grants Novartis an exclusivity period on the libraries, which may be
extended for a fee. Under the terms of this agreement, Novartis has paid the
Company $6 million and is obligated to pay an additional $2 million during each
subsequent year of the research program. The agreement provides Novartis with
exclusive worldwide rights to develop and commercialize certain products based
on active compounds discovered using these libraries. In the event Novartis
successfully identifies and develops drugs based on the Company's compounds,
Novartis will make milestone payments to the Company. Novartis will also be
obligated to pay to the Company royalties on the sale of any drugs that result
from the relationship.

     Bayer.  Effective December 31, 1995, the Company entered into (i) a
collaborative agreement with Bayer for the identification and optimization of
lead compounds that interact with specific molecular target(s) selected by
Bayer, and (ii) an agreement under which the Company is to provide Bayer with
combinatorial libraries for screening by Bayer in Bayer's internal screening
assays.  Bayer has paid the Company $4 million through the second year of the
agreement for library creation.  Bayer is also obligated to fund research
conducted by the Company during the period from July 1, 1996 through February
15, 1999 in 

                                      -10-
<PAGE>
 
the amount of $5.5 million. A minimum of an additional $2.75 million of research
funding is due if Bayer exercises an option to extend the term of the research
program for an additional year. Bayer has paid the Company $5.5 million for
research to be performed through the first two years of the agreement. The
agreements provide Bayer with exclusive worldwide rights to develop and
commercialize lead compounds discovered by the Company that are active against
the specified molecular targets or discovered by Bayer to be active in its
assays. Compounds contained in libraries created by the Company for Bayer will
be exclusive to Bayer for various time periods. These exclusivity periods can be
extended upon payment of additional fees. In the event Bayer successfully
identifies, develops and obtains regulatory approval for drugs based upon the
Company's compounds, Bayer will make milestone payments to the Company. Bayer
will also be obligated to pay to the Company royalties on the sale of any
products that result from this relationship. In connection with the
collaboration, Bayer made a $10 million equity investment in the Company in
February 1996.

     Daiichi.  Effective March 29, 1996, Pharmacopeia and Daiichi signed a
collaborative agreement for the identification and optimization of lead
compounds which interact with a specific molecular target(s) selected by
Daiichi.  Over the first three years of the agreement, Daiichi is obligated to
pay the Company approximately $14 million in research and development funding
and license fees, of which, Daiichi has paid the Company $9.7 million.  The
agreement provides Daiichi with exclusive worldwide rights to develop and
commercialize compounds active against the specified molecular targets or
discovered by Daiichi to be active in its assays.  In the event Daiichi
successfully identifies, develops and obtains regulatory approval for drugs
based upon the Company's compounds, Daiichi will make milestone payments to the
Company. Daiichi will also be obligated to pay to the Company royalties on the
sale of any products that result from this relationship.  In connection with the
collaboration, Daiichi has made a $5 million equity investment in the Company in
March 1996.  Daiichi made an additional $3.0 million equity investment in
December 1997 as a result of the Company's meeting a specific milestone.

     Organon. Effective May 31, 1996, the Company entered into a collaborative
agreement with Organon for the identification and optimization of lead compounds
that interact with specific molecular target(s) selected by Organon.  Under the
terms of the agreement, Organon is required to pay the Company a total of $10.7
million in research and development funding and license fees, over the initial
three year term, of which, $6.9 million has been paid.  Organon is also
obligated to make additional payments upon the achievement of certain milestones
and to pay royalties on sales of drugs that may result from the relationship.
The agreement provides Organon with exclusive worldwide rights to develop and
commercialize lead compounds active against the specified molecular targets or
discovered by Organon to be active in its assays.  In the event Organon
successfully identifies, develops and obtains regulatory approval for drugs
based upon the Company's compounds, Organon will make milestone payments to the
Company.  Organon will also be obligated to pay to the Company royalties on the
sale on any products that result from the relationship.  In connection with the
collaboration, Organon made a $4.2 million equity investment in the Company in
May 1996 and an additional $4.2 million equity investment in May 1997.

     BMS. Effective December 11, 1997, the Company entered into a collaboration
and license agreement with BMS for the identification and optimization of lead
compounds that interact with specific molecular target(s) selected by BMS.
Under the terms of the agreement, BMS is required to pay the Company a total of
$10.4 million in research and development funding and license fees, over the
initial three year term, of which, $3.4 million has been paid.  BMS is also
obligated to make additional payments upon the achievement of certain milestones
and to pay royalties on sales of drugs that may result from the relationship.
The agreement provides BMS with exclusive worldwide rights to develop and
commercialize lead compounds active against the specified molecular targets or
discovered by BMS to be active in its assays.  In the event BMS successfully
identifies, develops and obtains regulatory approval for drugs based upon the
Company's compounds, BMS will make milestone payments to the Company.

                                      -11-
<PAGE>
 
Customers

     During 1997, the Company recognized $24.5 million in contract revenue
primarily from its significant customers.  See Note 10 of Notes to Financial
Statements and "Collaborative Arrangements" above.

Research and Development Funding

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

<TABLE>
<CAPTION>
                           Year ended December 31 (in thousands)
                             1995          1996          1997
                          ----------    ----------    ----------
<S>                        <C>          <C>           <C>
Collaborative              $5,563         $13,129       $16,931
Proprietary                 5,468           8,111        12,588
</TABLE>

These increased amounts primarily reflect additional costs incurred with the
expansion of the Company's chemical library production and screening efforts for
collaborations and for its own use.

Competition

     Many organizations are actively attempting to identify and optimize
compounds for potential pharmaceutical development. Pharmacopeia 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 the Company. 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's 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 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 the Company is working, either on their
own or through collaborative efforts.

     The Company 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 the Company.

     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

                                      -12-
<PAGE>
 
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. The
Company's proprietary tag sets, in comparison, are durable, simple to attach and
detach, and allow the Company 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. The Company's 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 the Company's. 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 a patent 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 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 six 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 and February 24,
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 

                                      -13-
<PAGE>
 
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 has reviewed
these patent claims and, in reliance upon an opinion of patent counsel, believes
that the patent claims are invalid and, in any event, not infringed. 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.

     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.

                                     -14-
<PAGE>
 
     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

     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 the Company or,
in the event the Company decides to develop a drug beyond the preclinical phase,
by the Company. The nature and the extent to which such regulation may apply to
the Company's customers will vary depending on the nature of any such
pharmaceutical products. Virtually all pharmaceutical products developed by the
Company's 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
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, the
Company 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, the
Company 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, the Company will also be subject to foreign
regulatory requirements governing human clinical trials and marketing approval
for 

                                      -15-
<PAGE>
 
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 the Company involve the
controlled use of hazardous materials. The Company 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 the Company
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, the
Company could be held liable for any damages that result and any liability could
exceed the resources of the Company. In addition, there can be no assurance that
the Company will not be required to incur significant costs to comply with
environmental laws and regulations in the future.

Sources of Supply

     The Company currently relies on two suppliers to provide the majority of
plastic beads used in the solid phase chemical synthesis of its compounds. The
Company has built a significant multi-year inventory of these beads. In
addition, the Company has determined that other commercially available beads can
be used as an alternative to those indicated above.  Should the Company be
unable to obtain an adequate supply of these or comparable beads at commercially
reasonable rates, its ability to continue to identify and optimize lead
compounds and development candidates would be materially and adversely affected.

Pharmaceutical Manufacturing and Marketing

     The Company does not expect to directly manufacture or market
pharmaceutical products. However, the Company may, in the future, consider
undertaking such activities if it believes they are appropriate under the
circumstances. The Company has no experience in developing pharmaceutical
products or in manufacturing or marketing products on a commercial scale. The
Company 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 the
Company decides to establish a manufacturing facility, the Company 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.

Employees

     As of December 31, 1997, the Company had 197 regular employees, 168 of whom
were in research and development, including 71 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 Factors Regarding 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 

                                      -16-
<PAGE>
 
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.

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

ITEM 2.  PROPERTIES

     The Company currently leases and occupies approximately 137,000 square feet
of laboratory and office space in three buildings in or near Princeton, New
Jersey. This includes approximately 120,000 square feet of laboratory space and
approximately 17,000 square feet of administrative office space. These leases
expire at various dates between 1998 and 2005.

ITEM 3.  LEGAL PROCEEDINGS

     The Company is not a party to any legal proceedings.

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

     Not applicable.

                                      -17-
<PAGE>
 
                     EXECUTIVE OFFICERS OF THE REGISTRANT

     The executive officers of the Company are as follows:

             Name               Age                   Position
             ----               ---                   --------

Joseph A. Mollica, Ph.D.         57    Chairman of the Board, President and 
                                       Chief Executive Officer
 
Stephen A. Spearman, Ph.D.       48    Executive Vice President of Operations
 
Lewis J. Shuster                 42    Executive Vice President, Corporate 
                                       Development and Chief Financial Officer
 
Nolan H. Sigal, M.D., Ph.D.      48    Senior Vice President of Drug Discovery


John J. Baldwin, Ph.D.           63    Senior Vice President of Chemistry


     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 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. Spearman has served as Executive Vice President, Operations since
August 1996.  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 an M.B.A. in
Finance from Bryant College.

     Mr. Shuster has served as Chief Financial Officer since November 1994 and
was appointed Executive Vice President, Corporate Development and Chief
Financial Officer in August 1996. 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 an M.B.A. from Stanford University Graduate School
of Business.

     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 an M.D. and Ph.D. from the University of
Pennsylvania.

     Dr. Baldwin has served as Vice President of Chemistry since July 1993 and
was appointed Senior Vice President of Chemistry in August 1996. 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.

                                     -18-
<PAGE>
 
                                    PART II

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

Market for Common Stock

     The Company's Common Stock trades on the Nasdaq National Market tier of The
Nasdaq Stock Market 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.
 
                                              1997            1996
                                          High    Low     High    Low          
                                         ------  ------  ------  ------        
           First Quarter                 $22.63  $16.50  $31.50  $23.38        
           Second Quarter                 17.38   12.88   28.50   19.38        
           Third Quarter                  22.75   12.75   22.88   12.13        
           Fourth Quarter                 23.13   16.00   25.25   15.88        

Holders of Record

     As of January 31, 1998, there were approximately 240 holders of record.

Dividends

     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.

Recent Sales of Unregistered Securities

<TABLE>
<CAPTION>
                          Transaction                        Number of           Aggregate
                             Date           Securities     Securities (1)     Offering Price
                      -----------------    ------------    --------------     --------------
<S>                   <C>                  <C>             <C>                <C>
Daiichi               December 29, 1997    Common Stock       161,616            $3,000,000
</TABLE>

(1) Transaction exempt from the registration requirements of Section 5 of the
Securities Act of 1933, as amended, by virtue of the exemption contained in
Section 4(2) of such act.
 
ITEM 6.  SELECTED FINANCIAL DATA
         (in thousands, except share and per share data)

<TABLE>
<CAPTION>
                                      Period From
                                    March 26, 1993
                                    (inception) to                Year Ended
                                     December 31,                 December 31,
                                    ----------------------------------------------------------------------
                                         1993            1994          1995          1996          1997
                                         ----            ----          ----          ----          ----   
<S>                                 <C>                <C>          <C>          <C>           <C>
Statements of Operations Data:
Total revenue.....................      $       --     $       --   $    5,151   $    14,799   $    24,523
Operating loss....................          (2,134)        (8,472)      (9,661)      (12,058)      (10,844)
Net loss..........................          (2,107)        (8,349)      (8,956)       (8,383)       (6,678)
Basic net loss per share..........           (1.24)         (3.15)       (2.77)         (.77)         (.58)
Weighted average number of common
  shares outstanding/(1)/.........       1,701,022      2,648,268    3,231,102    10,833,980    11,453,743
Cash dividends declared per       
 common share.....................              --             --           --            --            --
</TABLE> 

                                     -19-
<PAGE>
 
<TABLE> 
<CAPTION> 

                                                   As of December 31,
                                    ----------------------------------------------------------------------
                                         1993            1994          1995          1996          1997
                                         ----            ----          ----          ----          ----   
<S>                                 <C>               <C>           <C>           <C>           <C>
Balance Sheet Data:
Cash, cash equivalents, and
 marketable securities............      $ 1,658       $ 13,490      $ 60,900      $ 81,482      $ 82,621
Total assets......................        2,299         15,512        65,541        91,979        95,687
Notes payable, and deferred                            
 revenue, long-term portion.......           78            254           969         3,451         3,987
Accumulated deficit...............       (2,107)       (10,456)      (19,412)      (27,795)      (34,473)
Total stockholders' equity........        1,916         10,980        54,334        69,748        70,437
</TABLE>

---------------------------
(1) Computed on the basis described for basic net loss per share in Note 2 of
Notes to Financial Statements.

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS
Overview
        
     The following Management's Discussion and Analysis is based on historical
financial results of Pharmacopeia, Inc. ("Pharmacopeia" or the "Company") and
includes certain forward-looking statements that do not specifically reflect the
impact that the proposed merger described below under the caption "Proposed
Merger" may have on future financial performance of the post-merger company.
Such performance may not follow the same historical trends as those presented in
the following discussion.

     Pharmacopeia was incorporated in March 1993 and is engaged in research and
development and chemical library production for collaborations and for its own
use. The Company's research and development has focused on efficient, cost
effective, high throughput systems for synthesizing and screening large
libraries of chemicals for new drug discovery and optimization.  The Company has
incurred losses since inception and, as of December 31, 1997 had an accumulated
deficit of $34.5 million.  The Company anticipates incurring additional losses
over at least the next several years as it expands its research and development
and chemical library production efforts.  The Company expects that its losses
will fluctuate from quarter to quarter and that such variations may be
substantial.

Results of Operations

     The Company expects that its revenue sources for at least the next several
years will be limited to future drug discovery collaboration payments from
Schering-Plough, Berlex, Novartis, Bayer, Daiichi, Organon, Zeneca and BMS and
from other customers under existing arrangements and others that may be entered
into in the future.  The timing and amounts of such revenues, if any, will
likely fluctuate. Historical results should not be viewed as indicative of
future operating results.  The Company will be required to conduct significant
research, development and production activities during the next several years to
fulfill its obligations under its drug discovery collaborative agreements and to
develop other collaborations and technologies.  The Company does not anticipate
having net income in the next several years.

Years Ended December 31, 1997 and 1996

     Revenues increased to $24.5 million in 1997, compared to $14.8 million in
1996.  The increase of $9.7 million in 1997 revenues is primarily the result of
the Company's new collaboration with BMS and its expanded efforts in the drug
discovery collaborations with Bayer, Daiichi, and Organon. The Company's source
of revenues for the next several years will be interest income, payments under
its current collaborations and payments from other customers, to the extent that
the Company enters into any additional arrangements.

                                     -20-
<PAGE>
 
     Research and development expenses increased to $29.5 million compared to
$21.2 million in 1996. These increased amounts primarily reflect increased
salaries, personnel and facilities lease expenses as the Company continued to
hire additional research and development personnel, equipment depreciation,
leasehold amortization, and laboratory supplies purchased in connection with the
expansion of the Company's chemical library production and screening efforts for
drug discovery collaborations and for internal discovery programs. Research and
development expenses are expected to continue to increase as the Company further
expands its activities and incurs, among other things, expenses related to
additional staff increases, increased rent for expanded facilities, and
increased equipment and reagent purchases.

    General and administrative expenses were $5.8 million and $5.6 million in
the years ended December 31, 1997 and 1996, respectively. The increase is
primarily attributable to increased payroll and personnel expenses as the
Company continued to hire additional management and administrative personnel,
along with increased patent legal fees.

     The Company had interest income of $4.4 million  in 1997 compared to $3.9
million in 1996.  The increase in interest income resulted from higher average
balances of cash, cash equivalents and marketable securities. Interest expense
for both periods is a result of interest incurred on notes payable.

Years Ended December 31, 1996 and 1995

     Revenues increased to $14.8 million in 1996, compared to $5.2 million in
1995. The increase of $9.6 million primarily reflected expanded efforts in the
Company's collaborations with Schering-Plough, Berlex, Novartis, Bayer, Daiichi
and NV Organon. The 1995 revenues were attributable entirely to the Schering-
Plough and Berlex collaborations.

     The Company incurred research and development expenses of $21.2 million and
$11.0 million in the years ended December 31, 1996 and 1995, respectively.
These increased amounts primarily reflected increased salaries and personnel
expenses as the Company continued to hire additional research and development
personnel, equipment depreciation and facilities expenses and laboratory
supplies purchased in connection with the expansion of the Company's chemical
library production and screening efforts for collaborations and for its own use.

     General and administrative expenses were $5.6 million and $3.8 million in
the years ended December 31, 1996 and 1995, respectively. The increase was
primarily attributable to increased payroll and personnel expenses as the
Company hired additional management and administrative personnel and incurred
additional legal, insurance and other professional fees in connection with the
overall scale-up of the Company's operations.

Liquidity and Capital Resources

     As of December 31, 1997, the Company had working capital of $50.4 million.
The Company has funded its activities through December 31, 1997 primarily
through the sale of equity securities and funding under collaborative
arrangements.  From inception through December 31, 1997, the Company received
$104.9 million in net proceeds from equity financing and received $59.9 million
in research and development, license fees and milestone payments under
collaborative agreements.

     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 

                                     -21-
<PAGE>
 
years. As of December 31, 1997, the Company's cash and cash equivalents totaled
$9.6 million. In addition, the Company had marketable securities of $73.0
million. See Note 2 to Financial Statements.

     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.

     In addition, as of December 31, 1997, the Company had outstanding
commitments for construction and equipment purchases totaling $0.2 million.  The
Company anticipates that its capital requirements will continue at approximately
the same level over the next two years as the Company expands its research and
development activities.  In connection with such expansion, the Company expects
to incur substantial expenditures for hiring additional management, scientific
and administrative personnel and for planned expansion and upgrading of its
facilities, including acquisition of additional equipment.

     As of December 31, 1997, the Company had federal net operating loss
carryforwards of $34.7 million. These carryforwards will expire beginning in the
year 2008. Utilization of the net operating loss carryforwards will be subject
to limitation under Section 382 of the Internal Revenue Code. See Note 7 of
Notes to Financial Statements.

     The Company anticipates that its existing capital resources will be
adequate to fund the Company's operations at least through 1999.  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 Company's customers' milestone
and royalty producing activities.  There can be no assurance that additional
funding, if necessary, will be available on favorable terms, if at all.  The
Company's forecasts of the period of time through which its financial resources
will be adequate to support its operations is forward looking information, and
actual results could vary.  The factors described earlier in this paragraph will
impact the Company's future capital requirements and the adequacy of its
available funds.

     Based on preliminary reviews, the Company believes that its significant
internal computer information systems are year 2000 compliant.  All other
internal systems are currently being assessed and a further review of all
systems is currently planned.  Given the information known at this time, the
Company does not believe that changes to its systems to make them year 2000
compliant will require significant resources or material costs.  No assurance
can be given, however, that all of the Company's systems will be year 2000
compliant on a timely basis or that actual compliance costs or the impact of the
Company's failure to achieve substantial year 2000 compliance will not have a
material adverse effect on the Company.

     The Company intends to contact its significant suppliers and large
customers to determine the extent to which the Company is vulnerable to those
third parties' failure to remediate their own year 2000 issue.  To date, the
Company is unaware of any situations of noncompliance that would adversely
affect its operations.  However, there can be no assurance that the systems of
other companies on which the Company's systems rely will be timely converted or
that a failure to convert by another company would not have a material adverse
effect on the Company.

                                     -22-
<PAGE>
 
Proposed Merger

     On February 4, 1998, Pharmacopeia, Micro Acquisition Corporation, a wholly-
owned subsidiary of Pharmacopeia ("MAC") and Molecular Simulations Incorporated
("MSI") executed a definitive merger agreement (the "Merger Agreement") pursuant
to which Pharmacopeia will acquire MSI in a tax-free, stock-for-stock
transaction, which Pharmacopeia expects will qualify for accounting treatment on
a "pooling-of-interests" basis.

     Pursuant to the Merger Agreement, MAC will be merged into MSI with MSI as
the surviving corporation.  Assuming that outstanding options to purchase shares
of common stock of MSI are not exercised before the effective time of the
merger, Pharmacopeia will (a) acquire all of the outstanding capital stock of
MSI in exchange for approximately 7.0 million newly-issued shares of
Pharmacopeia Common Stock and (b) assume the outstanding MSI options, which will
then be exercisable for shares of Pharmacopeia Common Stock, potentially
resulting in the issuance of up to an additional 1.7 million newly-issued shares
of Pharmacopeia Common Stock.

     The transaction is subject to certain conditions, including stockholder
approvals, the effectiveness of a registration statement under federal
securities laws relating to the Pharmacopeia Common Stock to be issued in the
merger, the listing of such Pharmacopeia Common Stock on the Nasdaq National
Market and the expiration of applicable waiting periods under pre-merger
notification regulations.

     As of December 31, 1997 MSI had total assets of $46.5 million and for the
year ended December 31, 1997 MSI had total revenue of $56.7 million and net
income of $5.4 million.

     After the closing of the merger, Pharmacopeia will file, as part of a
current Report on Form 8-K, unaudited pro forma combined condensed financial
statements that give effect to the merger.

 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Not applicable.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The Company's financial statements and notes thereto and the independent
auditors' report appear on pages F-1 through F-16 of this Report.

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

     Not applicable.

                                      -23-
<PAGE>
 
                                    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 1998 Annual Meeting
of Stockholders forming a part of the Registration Statement on Form S-4, to be
filed with the Securities and Exchange Commission within 120 days after the
Company's fiscal year end.  Two of the Company's Directors, Ms. More and Mr.
Colella, are not included in the Proxy Statement because they have advised the
Company of their decision not to stand for re-election at the Company's 1998
Annual Meeting of Stockholders.  Information concerning both Ms. More and Mr.
Colella is set forth below.
 
       Ms. More, age 52, has served as a director of the Company since June
1994.  Ms. More has been a managing member of Oak Investment Partners, a venture
capital firm, since 1980.  Ms. More is currently a director of Alexion
Pharmaceuticals, Inc. and several closely held companies.

       Mr. Colella, age 57, has served as a director of the Company since July
1993.  Mr. Colella has been a general partner of Institutional Venture Partners,
a venture capital firm, since 1984.  Mr. Colella is currently a director of CV
Therapeutics, Inc., Integrated Medical Resources, Onyx Pharmaceuticals, Inc.,
and several closely held companies.

     (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) The information required by this Item concerning compliance with
Section 16(a) of the Exchange Act is incorporated by reference from the section
captioned "Section 16(a) Beneficial Ownership Reporting Compliance" contained in
the Proxy Statement.

ITEM 11.  EXECUTIVE COMPENSATION

     The information required by this Item is incorporated by reference from the
section captioned "Executive Compensation" in the Company's 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 Company's Proxy Statement.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information required by this Item is incorporated by reference from the
sections captioned "Certain Transactions" in the Company's Proxy Statement.

                                      -24-
<PAGE>
 
                                  PART IV

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

(a)(1)  Financial Statements

        The following Financial Statements are included:
        Report of Independent Auditors
        Balance Sheets as of December 31, 1996 and 1997
        Statements of Operations for the years ended December 31, 1995, 1996 and
        1997
        Statements of Stockholders' Equity for the years ended December 31,
        1995, 1996 and 1997
        Statements of Cash Flows for the years ended December 31, 1995, 1996 and
        1997
        Notes to 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.

 
(a)(3)    Exhibits:


<TABLE>
<C>              <S>
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.
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.
</TABLE> 

                                      -25-
<PAGE>
 
<TABLE> 
<C>              <S> 
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.
10.18#            Employment Agreement effective November 1, 1997 between the
                  Company and Joseph A. Mollica, Ph.D.
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.
10.30***+         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.
</TABLE> 

                                      -26-
<PAGE>
 
<TABLE>
<C>               <S>
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.
11.1*             Statement re Computation of Per Share Earnings.
21.0              Subsidiaries of Pharmacopeia, Inc.
23.1              Consent of Ernst & Young LLP
24.1              Powers of Attorney (see signature page)
27.1              Financial Data Schedule
</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
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.

+  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, 1997.

(c)  Exhibits

     See Item 14(a)(3) above.

(d)  Financial Statement Schedules

     See Item 14(a)(2) above.

                                      -27-
<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
                                         Executive Vice President, Corporate
                                         Development and Chief Financial Officer
                                         (Principal Accounting Officer)

                                    Date:  February 25, 1998
                                  


                    [Rest of page intentionally left blank]

                                      -28-
<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>
 
 
Signature                                     Title              Date
---------                                     -----              ----                 
<S>                              <C>                               <C>
 
                                                                                     
/s/ JOSEPH A. MOLLICA, Ph.D.     Chairman of the Board and Chief   February 25, 1998 
----------------------------     Executive Officer (Principal                        
(Joseph A. Mollica, Ph.D.)       Executive Officer)                                  
                                                                                     
                                                                                     
                                                                                     
/s/ LEWIS J. SHUSTER             Executive Vice President,         February 25, 1998 
--------------------             Corporate Development and Chief                     
(Lewis J. Shuster)               Financial Officer (Principal                        
                                 Financial and Accounting                            
                                 Officer)                                            
                                                                                     
                                                                                     
                                                                                     
                                                                                     
/s/ FRANK BALDINO, Jr., Ph.D.    Director                          February 25, 1998 
-----------------------------                                                        
(Frank Baldino, Jr., Ph.D.)                                                          
                                                                                     
/s/ PAUL A. BARTLETT, Ph.D.      Director                          February 25, 1998 
---------------------------                                                          
(Paul A. Bartlett, Ph.D.)                                                            
                                                                                     
/s/ SAMUEL D. COLELLA            Director                          February 25, 1998 
---------------------
(Samuel D. Colella)
                                                                                     
/s/ GARY E. COSTLEY, Ph.D.       Director                          February 25, 1998 
--------------------------                                                           
(Gary E. Costley, Ph.D.)                                                             
                                                                                     
/s/ EDITH W. MARTIN, Ph.D.       Director                          February 25, 1998 
--------------------------                                                           
(Edith W. Martin, Ph.D.)                                                             
                                                                                     
/s/ EILEEN M. MORE               Director                          February 25, 1998 
------------------                                                                   
(Eileen M. More)                                                                     
                                                                                     
/s/ CHARLES A. SANDERS, M.D.     Director                          February 25, 1998 
----------------------------
(Charles A. Sanders, M.D.)
</TABLE>

                                      -29-
<PAGE>
 
                              Pharmacopeia, Inc.

                         Index To Financial Statements



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


The Board of Directors and Stockholders
Pharmacopeia, Inc.


We have audited the accompanying balance sheets of Pharmacopeia, Inc. as of
December 31, 1996 and 1997, and the related statements of operations,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1997.  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 financial position of Pharmacopeia, Inc. at December
31, 1996 and 1997 and the results of its operations and its cash flows for each
of the three years in the period ended December 31, 1997 in conformity with
generally accepted accounting principles.


                                                       ERNST & YOUNG LLP


Princeton, New Jersey
January 27, 1998, except for
 Note 13 as to which the date is February 4, 1998

                                      F-1
<PAGE>
 
                              Pharmacopeia, Inc.

                                Balance Sheets
                   (Dollars in thousands, except share data)

<TABLE>
<CAPTION>
                                                                       December 31
                                                                     1996       1997
                                                                  -------------------
<S>                                                               <C>        <C> 
Assets
Current assets:
 Cash and cash equivalents                                        $ 17,059   $  9,590
 Marketable securities                                              64,423     60,166
 Prepaid expenses and other current assets                           1,525      1,890
                                                                  ------------------- 
Total current assets                                                83,007     71,646
                                                                  ------------------- 
 
Non-current investments in marketable securities                               12,865
Property and equipment, net                                          8,295     10,874
Other assets                                                           677        302
                                                                  -------------------
                                                                  $ 91,979   $ 95,687
                                                                  ===================
Liabilities and stockholders' equity
Current liabilities:
 Accounts payable                                                 $    742   $  1,756
 Accrued liabilities                                                 2,240      2,726
 Notes payable, current portion                                        710        690
 Deferred revenue                                                   15,088     16,091
                                                                  ------------------- 
Total current liabilities                                           18,780     21,263
 
Notes payable, long-term portion                                     1,405        712
Deferred revenue, long-term                                          2,046      3,275
 
Commitments
 
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;
  11,267,499 and 11,786,941 shares issued and outstanding at
  December 31, 1996 and 1997, respectively                               1          1
 Additional paid-in capital                                         97,542    104,909
 Accumulated deficit                                               (27,795)   (34,473)
                                                                  -------------------
Total stockholders' equity                                          69,748     70,437
                                                                  -------------------
                                                                  $ 91,979   $ 95,687
                                                                  ===================
</TABLE>

See accompanying notes.

                                      F-2
<PAGE>
 
                               Pharmacopeia, Inc.

                            Statements of Operations
                 (Dollars in thousands, except per share data)

<TABLE>
<CAPTION>

                                                    Year ended December 31
                                                  1995       1996       1997
                                                -----------------------------
<S>                                             <C>       <C>        <C>
Contract revenue                                $ 5,151   $ 14,799   $ 24,523
 
Operating expenses:
 Research and development:
  Collaborative                                   5,563     13,129     16,931
  Proprietary                                     5,468      8,111     12,588
 General and administrative                       3,781      5,617      5,848
                                                -----------------------------
Operating loss                                   (9,661)   (12,058)   (10,844)
 
Interest income                                     798      3,938      4,397
Interest expense                                    (93)      (263)      (231)
                                                -----------------------------
Net loss                                        $(8,956)  $ (8,383)  $ (6,678)
                                                =============================
 
Basic net loss per share                        $ (2.77)  $   (.77)  $   (.58)
                                                =============================
</TABLE>

See accompanying notes.

                                      F-3
<PAGE>
 
                               Pharmacopeia, Inc.

                       Statements of Stockholders' Equity
                    (Dollars in thousands, except share data)


<TABLE> 
<CAPTION> 
                                                   Convertible
                                                 Preferred Stock        Common Stock                   
                                              ---------------------------------------------   Additional   
                                               Number of             Number of                 Paid-in     
                                                 Shares    Amount     Shares      Amount       Capital     
                                              -----------------------------------------------------------
<S>                                           <C>         <C>       <C>           <C>        <C> 
Balance at December 31, 1994                    8,400,880 $      1   2,672,750     $              21,444 
 Sale of Convertible Series D preferred stock     350,000                                          3,500 
 Sales of common stock                                                   1,094                         1 
 Acquisition of treasury stock                                                                           
 Retirement of treasury stock                                          (64,521)                      (11)
 Mandatory conversion of Convertible
    preferred stock to common stock            (8,750,880)      (1)  4,375,446        1                  
 Common stock issued based on anti-dilution
    provisions                                                          43,750                           
 Exercise of warrant                                                    15,750                           
 Issuance of common stock in initial public
    offering, net of expenses                                        2,990,000                    43,808 
 Issuance of common stock for exercise of
    options                                                              5,700                         3 
 Issuance of common stock in private placement                         232,558                     5,000
 Net loss                                                                                                
                                              -----------------------------------------------------------
Balance at December 31, 1995                            -        -  10,272,527        1           73,745 
 Acquisition of  treasury stock                                                                          
 Retirement of treasury stock                                           (7,594)                       (2)
 Issuance of common stock in private
    placements                                                         973,206                    23,641 
 Issuance of common stock for exercise of
    options                                                             22,189                        47 
 Issuance of common stock in employee stock
    purchase plan                                                        7,171                       111 
 Net loss                                                                                                
                                              -----------------------------------------------------------
 Balance at December 31, 1996                           -        -  11,267,499        1           97,542 
 Acquisition of treasury stock                                                                           
 Retirement of treasury stock                                           (1,646)                       (1)
 Issuance of common stock in private
    placements, net                                                    438,323                     6,861 
 Issuance of common stock for exercise
    of options                                                          51,669                        56 
 Issuance of common stock in employee stock
    purchase plan                                                       18,488                       235 
 Issuance of common stock for 401K
    matching                                                            12,608                       216 
 Net loss                                                                                                
                                              -----------------------------------------------------------
 Balance at December 31, 1997                           - $      -  11,786,941    $    1        $104,909    
=========================================================================================================

<CAPTION> 

                                              
                                                 Treasury Stock                           
                                              -----------------------                        Total
                                               Number of                   Accumulated   Stockholders'
                                                Shares       Amount          Deficit         Equity
                                              --------------------------------------------------------
<S>                                           <C>          <C>          <C>            <C> 
Balance at December 31, 1994                     45,000    $     (9)    $    (10,456)   $    10,980
 Sale of Convertible Series D preferred stock                                                 3,500
 Sales of common stock                                                                            1
 Acquisition of treasury stock                   19,521          (2)                             (2)
 Retirement of treasury stock                   (64,521)         11                               -
 Mandatory conversion of Convertible
    preferred stock to common stock                                                               -
 Common stock issued based on anti-dilution
    provisions                                                                                    -
 Exercise of warrant                                                                              -
 Issuance of common stock in initial public
    offering, net of expenses                                                                43,808
 Issuance of common stock for exercise of
    options                                                                                       3
 Issuance of common stock in private placement                                                5,000
 Net loss                                                                     (8,956)        (8,956)
                                              --------------------------------------------------------
Balance at December 31, 1995                          -           -          (19,412)        54,334
 Acquisition of  treasury stock                   7,594          (2)                             (2)
 Retirement of treasury stock                    (7,594)          2
 Issuance of common stock in private
    placements                                                                               23,641
 Issuance of common stock for exercise of
    options                                                                                      47
 Issuance of common stock in employee stock
    purchase plan                                                                               111
 Net loss                                                                     (8,383)        (8,383)
                                              --------------------------------------------------------
 Balance at December 31, 1996                          -          -          (27,795)        69,748
 Acquisition of treasury stock                     1,646         (1)                             (1)
 Retirement of treasury stock                     (1,646)         1
 Issuance of common stock in private
    placements, net                                                                           6,861
 Issuance of common stock for exercise
    of options                                                                                   56
 Issuance of common stock in employee stock
    purchase plan                                                                               235
 Issuance of common stock for 401K
    matching                                                                                    216
 Net loss                                                                     (6,678)        (6,678)
                                              --------------------------------------------------------
 Balance at December 31, 1997                      -           $  -     $    (34,473)      $ 70,437
======================================================================================================
</TABLE> 

                                      F-4
<PAGE>
 
                               Pharmacopeia, Inc.

                            Statements of Cash Flow
                             (Dollars in thousands)



<TABLE>
<CAPTION>
                                                           Year ended December 31
                                                         1995       1996       1997
                                                     --------------------------------
<S>                                                    <C>        <C>        <C> 
Cash flows from operating activities
Net loss                                               $ (8,956)  $ (8,383)  $ (6,678)
Adjustments to reconcile net loss to net cash used
 in operating activities:
  Depreciation                                              554      1,467      2,754
  Amortization                                               40         40         22
  Changes in operating assets and liabilities:
   (Increase) in prepaid expenses and other current        (691)      (370)      (365)
   assets
  (Increase) decrease in other assets                      (238)      (159)       353
  Increase in accounts payable                               26        241      1,014
  Increase in accrued liabilities                         1,046        499        486
  Increase in deferred revenue                            4,599      9,536      2,232
                                                     --------------------------------
Net cash provided by (used in) operating activities      (3,620)     2,871       (182)
 
Cash flows from investing activities
Capital expenditures                                     (2,410)    (6,834)    (5,333)
Purchases of marketable securities                      (41,391)   (95,750)   (90,373)
Proceeds from sales of marketable securities             13,108     63,615     81,765
(Increase) decrease in segregated cash                      125
                                                     --------------------------------
Net cash used in investing activities                   (30,568)   (38,969)   (13,941)
 
Cash flows from financing activities
Net proceeds from issuance of common stock               48,810     23,797      7,367
Net proceeds from issuance of convertible preferred       3,500
 stock
Increase in notes payable                                 1,233      1,344
Repayments of note payable                                 (228)      (596)      (713)
                                                     --------------------------------
Net cash provided by financing activities                53,315     24,545      6,654
                                                     --------------------------------
  
Increase (decrease) in cash and cash equivalents         19,127    (11,553)    (7,469)
Cash and cash equivalents at beginning of period          9,485     28,612     17,059
                                                     --------------------------------
Cash and cash equivalents at end of period             $ 28,612   $ 17,059   $  9,590
                                                     ================================
 
Interest paid                                          $     93   $    263   $    231
                                                     ================================
</TABLE>

See accompanying notes.

                                      F-5
<PAGE>
 
                              Pharmacopeia, Inc.

                         Notes to Financial Statements
            (Dollars in thousands, except share and per share data)
                               December 31, 1997


1.  Organization and Description of Business

Pharmacopeia, Inc. (the "Company"), which was incorporated in Delaware in March
1993, develops combinatorial chemical libraries and uses these libraries alone,
and through collaborations, to discover new, low molecular weight compounds
principally for use as pharmaceuticals.

Through December 1994, the Company was in the development stage.  Beginning in
January 1995, the Company started receiving and expects to continue to receive
revenue from collaboration agreements (see Note 10).  As a result, the Company
is no longer considered to be in the development stage.  Included in accumulated
deficit is $10,456  accumulated during the development stage.

The Company's approach to drug discovery represents a newly created business for
which there is little precedent.  The Company's expansion of its operations and
enhancements to its drug discovery technology will result in significant
expenses over the next several years that may not be offset by significant
revenues.  The Company expects that any revenues for the foreseeable future and
the Company's ability to achieve profitability will be dependent upon the
ability of the Company to enter into additional collaborative arrangements with
customers.

2.  Significant Accounting Policies

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 which can be readily purchased or sold using
established markets.  Such securities are carried at market which approximates
cost.

                                      F-6
<PAGE>
 
                              Pharmacopeia, Inc.

                         Notes to Financial Statements
            (Dollars in thousands, except share and per share data)
                               December 31, 1997



2.  Significant Accounting Policies (continued)

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.

Intangible Assets

Intangible assets are included in other assets and consist primarily of licensed
technology which represents the initial payment for certain exclusive licenses
granted to the Company as of the date of incorporation and are being amortized
over four years.  Accumulated amortization at December 31, 1996 and 1997 was
$142 and $164, respectively.

Revenue Recognition

Research and development contract revenue is recognized as the services are
performed on a percentage of completion basis.  Amounts received in advance of
services to be performed are recorded as deferred revenue.

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.

                                      F-7
<PAGE>
 
                              Pharmacopeia, Inc.

                         Notes to Financial Statements
            (Dollars in thousands, except share and per share data)
                               December 31, 1997



2.  Significant Accounting Policies (continued)

Basic Net Loss Per Share

In 1997, the Financial Accounting Standards Board issued Statement No. 128,
Earnings per Share. Statement 128 replaced the calculation of primary and fully
diluted earnings per share with basic and diluted earnings per share.  Unlike
primary earnings per share, basic earnings per share excludes any dilutive
effects of options, warrants and convertible securities.  Diluted earnings per
share is very similar to the previously reported fully diluted earnings per
share. The effect of adoption of Statement 128 had no financial impact and
accordingly, no restatement of loss per share for prior years was necessary.

The basic net loss per share is based on net loss for the year, divided by the
weighted average number of common shares outstanding during the year.  Common
stock equivalents such as convertible preferred stock, stock options and
warrants are not included as their effect is anti-dilutive. Shares used in
computing basic net loss per share were 3,231,102, 10,833,980 and 11,453,743 for
the years ended December 31, 1995, 1996 and 1997 respectively.

Impact of Recently Issued Accounting Standards

In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income"
("SFAS No. 130").  SFAS No. 130 establishes standards for the reporting and
display of comprehensive income and its components and is applied to all
enterprises.  SFAS No. 130 is effective for financial statements for fiscal
years beginning after December 15, 1997.  The adoption of SFAS No. 130 will have
no impact on the Company's consolidated results of operations, financial
position or cash flows.

In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS No. 131").  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 issued to stockholders.  It also establishes standards for
related disclosures about products and services, geographic areas, and major
customers.  SFAS No. 131 is effective for financial statements for fiscal years
beginning after December 15, 1997, and therefore, the Company will adopt the new
requirements retroactively in 1998.  The adoption of SFAS No. 131 will have no
significant impact on the Company's financial reporting.

                                      F-8
<PAGE>
 
                              Pharmacopeia, Inc.

                         Notes to Financial Statements
            (Dollars in thousands, except share and per share data)
                               December 31, 1997
                                        


3.  Property and Equipment

Property and equipment consist of the following:

                                                            December 31      
                                                            1996      1997   
                                                       -------------------   
Laboratory equipment                                     $ 4,904   $ 7,388   
Furniture, fixtures and equipment                          1,227     1,828   
Computers and software                                     1,649     2,559   
Leasehold improvements                                     2,716     3,629   
Construction in progress                                      15       440   
                                                       -------------------
                                                          10,511    15,844   
Less accumulated depreciation and amortization            (2,216)   (4,970)  
                                                       -------------------   
Property and equipment, net                              $ 8,295   $10,874   
                                                       ===================   

4.  Leases

The Company has a total of three operating leases or sub-leases for office and
laboratory space which expire at various dates through November 30, 2005.

The future minimum lease commitments at December 31, 1997 are as follows:


                     1998                              $2,911
                     1999                               2,761
                     2000                               1,471
                     2001                               1,041
                     2002                               1,041
                     Thereafter                         3,037


Rent expense for the years ended December 31, 1995, 1996 and 1997 was $1,255,
$1,783 and $2,828, respectively.


                                      F-9
<PAGE>
 
                              Pharmacopeia, Inc.

                         Notes to Financial Statements
            (Dollars in thousands, except share and per share data)
                               December 31, 1997



5.  Accrued Liabilities

Accrued liabilities consist of the following:

                                                                   1996     1997
                                                              ------------------
Accrued bonus                                                    $  623   $1,005
Accrued vacation                                                    208      322
Accrued relocation                                                  573      219
Accrued licensing costs - related party (Note 12)                   300      377
Other                                                               536      803
                                                              ------------------
                                                                 $2,240   $2,726
                                                              ==================

6.  Notes Payable

The Company has entered into Equipment Financing Agreements primarily for the
purchase of certain laboratory and research related equipment. Under the terms
of these agreements, the Company may finance up to $2,850 of equipment and
leasehold improvements.  At December 31, 1997, the Company had sixteen separate
secured notes payable under these agreements. The notes payable expire at
various dates through June 2000.

The following is a schedule, by year, of the future principal payments under
equipment financing agreements as of December 31, 1997:

1998                                                                $  690
1999                                                                   481
2000                                                                   231
                                                                  --------
Total principal payments                                            $1,402
                                                                  ========


7.  Income Taxes

The Company utilizes the liability method to account for income taxes. Deferred
income taxes reflect the net effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
the amounts used for income tax purposes.  Significant components of the
Company's net deferred tax asset, which is considered noncurrent, are as
follows:

                                      F-10
<PAGE>
 
                              Pharmacopeia, Inc.

                         Notes to Financial Statements
            (Dollars in thousands, except share and per share data)
                               December 31, 1997



7.  Income Taxes (continued)

<TABLE> 
<CAPTION> 

                                                                    December 31
                                                                  1996       1997
                                                               ---------------------
<S>                                                              <C>        <C> 
Deferred tax assets
Net operating loss carryforward                                  $ 11,218   $ 13,900
Research credit                                                       722      1,334
Deferred tax asset valuation reserve                              (11,940)   (15,234)
                                                               ---------------------
Net deferred tax asset                                           $    -     $     -
                                                               =====================
</TABLE>

In 1995, 1996 and 1997, the Company recorded valuation reserves of $8,145,
$11,940, and $15,234, respectively, principally to offset the benefits of net
operating loss carryforwards at the end of those years.

At December 31, 1997, the Company has federal net operating loss (NOL)
carryforwards of approximately $34,700 which expire in 2008 ($2,131), 2009
($8,475), 2010 ($9,100), 2011 ($8,294) and 2012 ($6,700).  An ownership change
pursuant to Section 382 of the Internal Revenue Code occurred in December 1995
as a result of the public offering of the Company's common stock.  The effect of
the ownership change is that use of approximately $11,800 of the NOL
carryforward is restricted to approximately $6,700 per year.  The Company has
state NOL carryforwards $34,700 at December 31, 1997, which expire in 2000
($2,100), 2001 ($8,500), 2002 ($9,100), 2003 ($8,300) and 2004 ($6,700).

The Company has federal research tax credit carryforwards of approximately $936
at December 31, 1997 which expire from 2008 through 2012. Approximately $476 of
the carryforwards are subject to limitation pursuant to Section 382.  In
addition, the Company has a state research tax credit carryforward of
approximately $466 which expires from 2002 to 2004.

8.  Stockholders' Equity

Common Stock

During 1996 the Company received a total of $25,165 in proceeds from the sale to
four corporate partners of 973,206 newly issued shares of Pharmacopeia common
stock.  Of the total proceeds, $23,641 was recognized as equity.  The balance of
$1,524 was initially recorded on the balance sheet as deferred revenue and is
being recognized as revenue over the balance of the term of the associated
corporate collaboration agreements.

During 1997 the Company received a total of $7,165 in proceeds from the sale to
two corporate partners of newly issued shares of Pharmacopeia common stock.  Of
the total proceeds, $6,791 was recognized as equity.  The balance of $374 is
currently included in the balance sheet as deferred revenue and will be
recognized as revenue over the balance of the term of the associated corporate
collaboration agreement.

                                      F-11
<PAGE>
 
                              Pharmacopeia, Inc.

                         Notes to Financial Statements
            (Dollars in thousands, except share and per share data)
                               December 31, 1997

9.  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 1,750,000 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.

At December 31, 1997, 387,544 of the outstanding options and stock purchase
rights were exercisable and there were 303,586 shares available for future
grants.  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 1997, 18,488
shares of common stock were purchased at  prices ranging from $12.54 to $12.96
per share, as determined by the ESPP. At December 31, 1997, there were 224,341
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.  During 1997
50,000 options were granted at exercise prices ranging from $14.13 to $16.00 per
share.  At December 31, 1997, 11,664 of the outstanding options were exercisable
and there were 78,334 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 1995, 1996, and 1997,
respectively: risk-free interest rates of 6.06%, 6.17%, and 5.44%; expected
volatility of 59.70, 59.70, and 47.00; expected option life of 5.6, 5.6, and 5.8
years from vesting and an expected dividend yield of 0.0%.
                                        

                                      F-12
<PAGE>
 
                              Pharmacopeia, Inc.

                         Notes to Financial Statements
            (Dollars in thousands, except share and per share data)
                               December 31, 1997



9. Stock Plans (continued)

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:

                                                     1995       1996      1997
                                                     ----       ----      ----

     Pro forma net loss............................$(9,565)   $(9,474)  $(9,395)
     Pro forma basic net loss per share............$(2.96)    $(.87)    $(.82)


A summary of the Company's stock option activity, and related information for
the years ended December 31, 1995, 1996, and 1997 follows:

<TABLE>
<CAPTION>
                                      1995                             1996                             1997
                            ----------------------------      -------------------------      ---------------------------       
                                               Weighted                        Weighted                        Weighted
                              Common           Average         Common          Average          Common         Average
                               Stock           Exercise         Stock          Exercise          Stock         Exercise
                              Options            Price         Options           Price          Options           Price
                            ---------          ---------      ---------         -------      -----------        --------
<S>                         <C>                <C>            <C>               <C>          <C>                <C> 
Outstanding at                
beginning of year.......      120,000             $ .48        363,575           $ 2.10         921,271           $14.19 
Granted.................      250,900              2.83        598,220            20.90         517,680            16.22
Exercised...............       (6,794)              .49        (22,189)            2.76         (36,669)            1.06
Forfeited...............         (531)              .84        (18,335)            7.83         (46,583)           18.14
                            ---------                         --------                       ----------                     
 
Outstanding at end of   
year                          363,575              2.10        921,271            14.19       1,355,699            15.17
                            =========                         ========                       ==========                      

Exercisable at end of         
year                           36,959                          132,715                          387,544
                            =========                         ========                       ==========                      
 
Weighted average fair
value of options        
granted during the year                            2.81                           13.03                             8.51
 
</TABLE>
 
     Stock options outstanding at December 31, 1997 are summarized as follows:


                                                                      Weighted
                              Outstanding       Weighted Average      Average
       Range of                Options at           Remaining         Exercise
    Exercise Prices         December 31, 1997    Contractual Life       Price 
    ---------------         -----------------    ----------------     --------  
    $  .48                        96,402                 6.9          $   .48
    $ 1.24 - $19.00              971,147                 8.7            14.48
    $19.38 - $26.75              288,150                 8.6            22.38
                            -----------------
    $  .48 - $26.75            1,355,699                 8.6            15.17
                            =================

                                      F-13
<PAGE>
 
                              Pharmacopeia, Inc.

                         Notes to Financial Statements
            (Dollars in thousands, except share and per share data)
                               December 31, 1997


10. Collaborative Agreements

On December 22, 1994, the Company entered into a Collaboration Agreement and
Random Library Agreement with Schering Corporation and Schering-Plough Ltd.
(collectively "Schering-Plough") which provides for research funding, product
development milestone payments and royalties on net product sales. The term of
these agreements as amended extend into 1998 and are subject to further
extension by agreement of both parties.

On February 15, 1995, the Company entered into a Collaboration Agreement with
Berlex Laboratories, Inc. ("Berlex").  The term of the Collaboration Agreement
as amended extends into 1998 and is subject to further extension by agreement of
both parties.  Berlex has agreed to pay the Company research funding, product
development milestone payments, and royalties on net product sales.

On October 1, 1995, the Company entered into an agreement with Novartis
Corporation ("Novartis") to create libraries in collaboration with Novartis for
screening by Novartis.  Under this agreement, the Company is obligated to
provide certain numbers of compounds during each of the five years of the
program.  In return, Novartis is obligated to pay the Company research funding
during each year of the agreement.  Novartis has also agreed to pay the Company
milestone payments and royalties on the sale of any drugs that result from the
relationship.

During 1996 the Company signed new agreements with Bayer, Daiichi, and NV
Organon. The effective date of the Bayer agreement was December 31, 1995. Under
these agreements each of these companies has committed to fund certain licensing
and research and development ("R&D") programs at Pharmacopeia.  The R&D programs
expire at various dates through May 1999 and are subject to extension by
agreement of both parties.  These firms also agreed to pay the Company milestone
payments and royalties on the sale of drugs that result from the relationships.

During 1997 the Company signed new agreements with Zeneca Limited and Bristol-
Myers Squibb Company. The R&D programs expire at various dates through December
2000 and are subject to extension by agreement of both parties.  These firms
have also agreed to pay the Company milestone payments and royalties on the sale
of any products generated by the collaboration.

Revenue from customers representing 10% or more of total contract revenue for
the years ended December 31, 1995, 1996 and 1997 is as follows:



                                      F-14
<PAGE>
 
                              Pharmacopeia, Inc.

                        Notes to Financial Statements
           (Dollars in thousands, except share and per share data)
                              December 31, 1997


10.  Collaborative Agreements (continued) 


       Customer                     1995             1996             1997
-------------------------     --------------    --------------   -------------
           A                         58%              36%              21%
           B                          -               16%              21%
           C                          -               14%              15%
           D                          -                -               13%
           E                          -                -               13%
           F                         42%              19%              11%


11.    Employee Tax-Deferred Savings Plan

The Company maintains a 401(k) defined contribution plan (the "Plan") covering
all full time employees.  Employees are eligible to participate on the first day
of the month following their date of hire.  The Plan provides for voluntary
employee contributions from 1% to 20% of annual compensation, subject to a
maximum limit allowed by Internal Revenue Service guidelines.  Matching
contributions in either cash or Company stock may be made at the discretion of
the Company.  Employer contributions vest to participants at a rate of  33 1/3%
per year of service, provided that after three years of service all past and
subsequent employer contributions are 100% vested.  $216 of contributions were
charged to operations for the year ended December 31, 1997.

12.  Commitments

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 its license agreement with the Trustees of Columbia
University and Cold Spring Harbor Laboratories.  In connection with this
amendment, the Company 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.  During the years ended December 31, 1995, 1996, and
1997 the Company paid royalties and license fees to Columbia University of
$419, $590, and $500 respectively.

In addition, the Company had commitments for construction and equipment of
approximately $172 at December 31, 1997.


                                      F-15
<PAGE>
 
                              Pharmacopeia, Inc.

                         Notes to Financial Statements
            (Dollars in thousands, except share and per share data)
                               December 31, 1997


13. Subsequent Event

On February 4, 1998, the Company and Molecular Simulations Incorporated ("MSI")
announced the execution of a definitive merger agreement under which the Company
will acquire MSI in a tax-free, stock-for-stock transaction to be accounted for
on a pooling basis. The Company will acquire all of the outstanding stock of MSI
and will assume the outstanding MSI options, which will then be exercisable for
shares of the Company's Common Stock. MSI is a 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. As of December 31, 1997 MSI had total assets of $46,500 and for the
year ended December 31, 1997 MSI had total revenue of $56,700 and net income of
$5,400.


                                     F-16
<PAGE>
 
                              Pharmacopeia, Inc.

                            Report on Form 10-K for
                        the year ended December 31, 1997

                               INDEX TO EXHIBITS

<TABLE> 
<CAPTION> 
 
  Exhibit                                 Exhibit Name                                   Sequentially
  Number                                                                                 Numbered Page
<C>         <S>                                                                          <C> 
10.9(c)     Amendment No.3 to Research, License and Royalty Agreement between
            the Company and Berlex Laboratories, Inc. dated November 21, 1997.
10.18       Employment Agreement effective November 1, 1997 between the
            Company and Joseph A. Mollica, Ph.D.
10.34       Collaboration and License Agreement between Pharmacopeia, Inc. and
            Bristol-Myers Squibb Company dated November 26, 1997.
21.0        Subsidiaries of Pharmacopeia, Inc.
23.1        Consent of Ernst & Young LLP
24.1        Powers of Attorney (see page 29 )
27.1        Financial Data Schedule (filed electronically with the SEC only)
</TABLE>