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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                            ------------------------
 
                                   FORM 10-K
                            ------------------------
 
[X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
     THE SECURITIES EXCHANGE ACT OF 1934
 
                    FOR FISCAL YEAR ENDED DECEMBER 31, 1998
                                       OR
 
[ ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF
     THE SECURITIES EXCHANGE ACT OF 1934
                               (NO FEE REQUIRED)
 
                        COMMISSION FILE NUMBER: 00-23473
 
                                COMBICHEM, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
<S>                                       <C>
                DELAWARE                                 33-0617379
      (STATE OR OTHER JURISDICTION                    (I.R.S. EMPLOYER
    OR INCORPORATION OR ORGANIZATION)                IDENTIFICATION NO.)
          9050 CAMINO SANTA FE
       SAN DIEGO, CALIFORNIA 92121                          92121
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                 (ZIP CODE)
</TABLE>
 
              REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
                                  619-530-0484
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
                                      NONE
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                         COMMON STOCK, PAR VALUE $0.001
 
     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]  No [ ]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  [X]
 
     The aggregate market value of the voting stock held by nonaffiliates of the
registrant as of February 28, 1999 was approximately $28,048,947. For the
purposes of this calculation, shares owned by officers, directors and 10%
shareholders known to the registrant have been deemed to be owned by affiliates.
This determination of affiliate status is not necessarily a conclusive
determination for other purposes.
 
     The number of shares outstanding of the registrant's Common Stock as of
February 28, 1999 was 13,440,421.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
     Portions of Registrant's Proxy Statement for the Annual Meeting of
Shareholders scheduled to be held on May 6, 1999, to be filed on or about April
6, 1999, referred to herein as the "Proxy Statement", are incorporated as
provided in Part III.
 
     Certain exhibits filed with the Registrant's prior registration statements
and Forms 10-Q are incorporated as provided in Part IV.
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<PAGE>   2
 
                                     PART I
 
ITEM 1. BUSINESS
 
OVERVIEW
 
     CombiChem is a computational product discovery company that is applying its
proprietary design technology and rapid synthesis capabilities to accelerate the
discovery process for new drugs and chemical products. We believe our approach
offers pharmaceutical and chemical companies the opportunity to conduct their
discovery efforts in a more productive and cost-effective manner. Using our
proprietary Discovery Engine(TM) process, we focus on the generation, evolution
and optimization of potential new lead candidates for our collaborative partners
who will then develop, manufacture, market and sell any resulting products. We
believe that our process is widely applicable to a variety of disease targets
and therapeutic indications as well as to other industries such as agrochemical,
industrial chemical and materials science. To date, we have established
collaborative agreements with Athena Neurosciences, Inc., a wholly owned
subsidiary of Elan Corporation, plc, ICOS Corporation, ImClone Systems
Incorporated, Novartis Crop Protection AG, Ono Pharmaceutical Co., Ltd., Roche
Bioscience, a division of Syntex (U.S.A.) Inc., Sumitomo Pharmaceuticals Co.,
Ltd. and Teijin Limited. In addition, we are using our approach on internal
programs to discover new lead candidates that will then be outlicensed to third
parties, while retaining a larger economic interest. In December 1998, we
further broadened the application of the technology by establishing a joint
venture with Chirotech Technology, Ltd., a member of the Chiroscience Group of
companies, to commercialize libraries of chiral compounds. The joint venture,
ChiroChem Discovery Services, LLC, was established to develop and sell
specifically designed chiral compound libraries.
 
  Industry Background
 
     During the past decade, significant advances in life sciences research and
the increasing appreciation of the complexity of biological processes have
highlighted the productivity limitations of traditional approaches to drug
discovery. These limitations, together with increased competition in the
pharmaceutical and biotechnology industries, have created intense pressure on
companies involved with drug development to reconsider the allocation of their
research budgets and to improve the cost-effectiveness of their drug discovery
process.
 
     Between 1976 and 1996, the number of new chemical entities approved by the
FDA remained relatively constant, ranging between 12 to 30 per year, despite a
more than 10-fold increase in research and development spending by
pharmaceutical and biotechnology companies. Furthermore, it typically takes 12
to 15 years from the original concept of affecting the activity of a particular
biological target to the market introduction of a drug that performs such a
function. The average cost of bringing a new drug to market has been estimated
to be in excess of $300 million.
 
     Frustrated with the inefficiencies of traditional drug discovery
approaches, pharmaceutical and biotechnology companies are beginning to embrace
new enabling technologies, such as combinatorial chemistry, genomics,
structure-based drug design, high-throughput screening and information
technologies, in order to gain a competitive advantage by accelerating the time
to develop and commercialize new compounds. These technologies also have the
potential to reduce significantly the cost associated with drug discovery.
 
  The Traditional Drug Discovery Process and its Limitations
 
     The traditional path to discovering a new drug typically begins with the
identification of one or more biological targets that are believed to affect a
disease state. A biological test or assay based on a target is then developed,
predicated on the scientific belief that a compound binding with this target may
have a therapeutic benefit with respect to the disease under study. Such an
assay facilitates the screening (testing to determine which of the compounds
have the desired activity against the target) of a collection of hundreds to
thousands of candidate compounds, typically contained in a library, that have
been synthesized in the laboratory. Compounds that bind to the target protein
and modulate its activity are referred to as hits. Medicinal chemists optimize
these hits until they have sufficient potency to become lead candidates and then
improve their preclinical characteristics (such as potency, specificity and in
vivo profile) further with the goal of producing drug development candidates.
 
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     In summary, the traditional drug discovery process consists of the
following steps:
                                    [CHART]
 
     The traditional drug discovery process is extremely expensive, inefficient
and unreliable. Failure at any point during this discovery process would
typically force the scientist either to abandon the project or to return to the
initial starting point and repeat the process. As a result, the discovery of a
new drug for a specified target can take years or can fail entirely.
 
     In recent years, the advent of robotic high-throughput screening and
automated synthesis technologies, such as combinatorial chemistry and parallel
synthesis, has begun to relieve one apparent bottleneck involving screening,
synthesis and purification of compounds in the library. While these technologies
facilitate the mechanics of drug discovery, they address neither the
unreliability of the process nor its principal inefficiency: the number of
iterations required to find a lead candidate. To address these problems, a novel
approach is needed that can provide information to improve the selection of each
subsequent library of compounds to synthesize, potentially reducing the number
of iterations. Only by improving the processes of data analysis and compound
selection can a laborious, iterative procedure be forced to converge on the lead
candidates with the most desirable pharmacological profiles.
 
  Current Combinatorial Chemistry and Computational Approaches and Their
Limitations
 
     Combinatorial chemistry involves the rapid creation of large collections of
chemical compounds for the purpose of identifying hits through random screening.
Combinatorial chemistry has made possible the synthesis of thousands or even
millions of molecules in a short period of time. The traditional approach
involved synthesizing only one molecule at a time. Over the last decade, the
field of combinatorial chemistry has evolved from only companies that design and
synthesize molecules to include those that develop software and automation to
facilitate design and synthesis. These companies tend to use highly varied
approaches, including: focusing on single, pure compounds versus making
mixtures; building large versus small, focused libraries; automating part versus
all of the process; and using or not using medicinal chemistry as a principal
guiding force.
 
     Computational methods are also employed in drug discovery. These methods
involve the use of computer-based and information technologies to manage large
chemical databases, to examine X-ray crystal structures of the target when
available (structure-based drug design), to operate the assorted automated
devices available for the synthesis of libraries, to determine how changes in
the structure affect the activity of a molecule (SAR activity) and to generate
"virtual libraries" using chemical building blocks from readily available
sources.
 
     Currently, the dominant method of pursuing drug discovery focuses on
screening large libraries to search for a lead candidate directly in the
library, or at least a hit, which can then be optimized by the more traditional
techniques of medicinal chemistry to generate a development candidate. We
believe this brute-force, trial-and-error approach is flawed because limited or
no information is factored into the library design to force the iterative drug
discovery process to converge. This limitation in current combinatorial
chemistry approaches is underscored by the fact that most compound libraries
used for screening have been constructed with the sole objective of isolating a
development candidate with the highest binding affinity to a target. In order to
achieve this objective against all possible targets, it is believed such
libraries would have to contain in excess of 100 million compounds. A library of
that size is well beyond current synthesis capabilities. In addition, the
challenge of drug discovery is not only to find a lead candidate that exhibits
activity against a biological target. It is also important to ensure that the
lead candidate will have characteristics that will enable it to overcome the
more difficult in vivo hurdles of toxicity, metabolism or problems with oral
administration, none of which will become evident until early testing. Unless
information can be extracted about which characteristics are most necessary for
binding, it is difficult to know how to modify a compound to maintain tight
binding affinity
 
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while overcoming these hurdles. Furthermore, if no hits are found after the
screening of a traditional combinatorial library, a scientist has no starting
point for the drug discovery process.
 
     While both combinatorial chemistry and computational approaches are useful
in drug discovery to some degree, they are severely taxed by the complexity of
properly using the information available for library design, as evidenced by the
following drawbacks: (1) the inability to derive and integrate information both
from compounds that are active and those that are inactive against the target;
(2) the inability to probe the target in order to compute ways of improving the
predictive models or hypotheses; and (3) the inability to handle the dual
requirements of speed and quality when large data sets must be analyzed. We
believe that these drawbacks constitute fundamental reasons that current
discovery approaches have been only moderately successful in generating lead
candidates and development candidates, despite the large number of initial hits.
 
  CombiChem's Solution and Advantages
 
     We believe that we offer a solution to drug discovery by combining our
proprietary design technology and rapid synthesis capabilities in a unique way.
Our convergent, iterative process for drug discovery -- our Discovery Engine
(see the following diagram) -- is based on compound libraries designed for
information.
 
     The design of libraries for information involves the selection of compounds
that collectively probe the biological target in a systematic way to determine
the chemical characteristics required for binding to such target. By identifying
features that discriminate between active and inactive compounds, predictive
models, called hypotheses, are constructed and then used to select a more
focused library of compounds. The compounds are chosen from our proprietary
Virtual Library, a computational representation of a very large number of
potential molecules chosen for ease of laboratory synthesis. We believe that by
repeating this process of selecting, synthesizing and screening informative
compounds and analyzing the resulting data, the Discovery Engine process quickly
converges on the most predictive hypothesis. This hypothesis describes the
characteristics a compound must possess to be active against the target and,
thus, is used to select a variety of potent lead candidates.
 
     Each cycle of the Discovery Engine refines the definition of the best
hypothesis for the target in question. After several cycles, the resulting
hypothesis can be used to design highly potent compounds from a broad range of
chemical classes including those not readily amenable to combinatorial synthesis
techniques. By facilitating the design of a variety of potent compounds for
preclinical testing, the Discovery Engine has the potential to increase greatly
the likelihood that at least one of these compounds passes the significant
downstream hurdles and eventually becomes a commercial drug.
 
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                                   [DIAGRAM]
 
     We believe that the advantages of our Discovery Engine include the
following:
 
     - Generating lead candidates from multiple structural series that exhibit
       the same biological activity. By using predictive hypotheses to search
       the Virtual Library, multiple structural series of compounds that have
       the same effect on the target can be identified. The availability of
       multiple structural series increases the likelihood that at least one of
       these molecules will overcome the in vivo hurdles in preclinical
       development. In addition, this provides an opportunity for us and our
       collaborators to enhance the intellectual property position that
       potentially can be developed around these compounds by having more than
       one patentable structural series.
 
     - Generating lead structures against a wide range of targets including
       those for which little or no information is available. The Universal
       Informer Library consists of a computer-designed, proprietary collection
       of approximately 13,000 physical compounds that can be screened against
       targets where little or no information is available about the molecular
       structures that may be active against those targets. Once the Universal
       Informer Library is screened, the information obtained is used to start
       the Discovery Engine process. In addition, because the Discovery Engine
       is not dependent on having prior knowledge about the target (for
       instance, an X-ray crystal structure representative of the target), it
       can potentially be used to discover drugs against any target.
 
     - Achieving rapid generation, evolution and optimization of lead
       candidates. By combining flexible design technology and rapid synthesis,
       our Discovery Engine can produce lead candidates for any of the three
       types of drug discovery programs -- lead generation, lead evolution or
       lead optimization -- with less than two years of effort.
 
     - Reducing synthesis and screening costs. Our design technology facilitates
       the use of small, informative libraries. Use of these small libraries
       decreases the costs associated with synthesis and screening. In addition,
       our Virtual Library of drug-like molecules has been explicitly
       constructed for ease of laboratory synthesis.
 
STRATEGY
 
     Our objective is to be the industry leader in the generation, evolution and
optimization of novel lead candidates. We intend to utilize our scientific and
technology assets in the discovery
 
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process through a mix of collaborative and internal programs by applying the
following business strategies:
 
     - Establish multiple collaborations with large pharmaceutical and
       biotechnology companies focused on biological targets chosen by the
       collaborators. We intend to collaborate with large pharmaceutical and
       biotechnology companies on fully funded programs aimed at biological
       targets chosen by these collaborators. Our collaborative efforts are
       exclusively focused on the discovery process, with a particular emphasis
       on the discovery of novel compounds against biological targets. We
       believe our technology platform provides us with opportunities to
       establish multiple collaborations, which may be for the same disease
       state. We believe this will allow us to build a portfolio of
       opportunities that may include project initiation fees, research support,
       milestone payments and royalties.
 
     - Conduct internal discovery efforts aimed at selected biological targets,
       retaining a larger economic interest in the subsequently outlicensed lead
       candidates. We also intend to conduct our own internally funded discovery
       programs by choosing biological targets of current scientific interest
       and working in collaboration with genomics, biotechnology or screening
       companies. After identifying lead candidates that are ready for
       development, we intend to outlicense them, retaining a larger economic
       interest in such candidates as they are developed and commercialized by a
       third party.
 
     - Broaden the scope of our technology through application of our Discovery
       Engine process in alternative industries such as the agrochemical and
       materials science field. We recently initiated a collaboration in the
       agrochemical field with Novartis. We also are considering additional
       opportunities in alternative industries, including the industrial
       chemical and materials science field. In December 1998, we established
       ChiroChem Discovery Services, LLC, to develop and sell specifically
       designed chiral libraries.
 
     - Maintain technology leadership in both software development and rapid
       synthesis capabilities. We intend to continue to extend our technology
       leadership through enhancements of existing software, design of future
       generations of software and continued advancements of our synthesis
       capabilities. We believe that these developments will allow us to
       decrease the time required to discover lead candidates and to maintain
       our technology leadership and competitive advantage.
 
COMBICHEM'S PROCESS: THE DISCOVERY ENGINE
 
     The successful implementation of our Discovery Engine process requires the
direct involvement of and interaction between our chemists and our software
applications team. This process consists of the following steps:
 
     Data analysis -- the compilation and analysis of screening data, literature
information and available data about the target. The starting point for a drug
discovery program varies depending on the amount of prior information that is
available. The collaborator may have tested its corporate collection of
compounds or some other chemical library. The collaborator may also have
information regarding structures of compounds that are initial hits (moderately
active compounds), information regarding structures that are inactive against
the particular target or prior information about the target structure itself. On
the other hand, if little or no prior information or screening data is available
on the initial hits or target, we can make available for screening our
proprietary Universal Informer Library as a way of generating a relevant set of
information with which to initiate the Discovery Engine. See "CombiChem's
Proprietary Technologies -- Universal Informer Library."
 
     The analysis of the available information is a critical step in the process
because it will determine what type of program will be undertaken -- lead
generation, lead evolution or lead optimization -- and the resources that will
be required. See "CombiChem's Discovery Programs."
 
     Hypothesis generation -- the software-based generation of models that
predict the biological activity of molecular structures. Once the analysis of
the available data is completed by our chemists and software applications team,
the information is used as input for hypothesis generation. The steps involved
in hypothesis generation are:
 
     - Conformational analysis. Conformational analysis is performed on each
       active and inactive molecule to determine which shapes or conformations
       such molecules can take.
 
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<PAGE>   7
 
       Because it is typically not known which of these shapes a particular
       molecule will assume when it shows its greatest activity against a
       biological target, all reasonable conformations are computationally
       described and analyzed. Our proprietary technology allows for the
       analysis of large data sets and complex molecular structures to be
       completed quickly and thoroughly.
 
     - Hypothesis generator. Using the screening data and the results of
       conformational analysis, the hypothesis generation software produces
       computational models, called hypotheses, that attempt to explain the
       observed differences in biological activity between active and inactive
       molecules. In the early phases of a discovery program, the hypothesis
       generator will often generate many hypotheses that are consistent with
       the data. The repeated application of the Discovery Engine cycle
       systematically tests the hypotheses, eliminating some while strengthening
       others by providing supporting data. Repeating this procedure results in
       predictive hypotheses. We believe that our proprietary design technology
       differs from others currently in use in that it (1) includes all of the
       screening data (including inactives) in generating hypotheses, (2) takes
       into account a much broader characterization of molecule-target
       interaction and (3) forces convergence to a predictive model of the
       important binding features by probing the target systematically using
       rapid synthesis and screening.
 
     Virtual Library search -- the computational search of the Virtual Library
to find molecular structures that fit the hypotheses. Once the hypotheses are
generated, they are used to search our proprietary Virtual Library to identify
molecular structures that have the features represented in the hypotheses. The
Virtual Library is a computational representation of a very large number of
molecules chosen for ease of laboratory synthesis. For each hypothesis that is
generated, a more focused library of tens to hundreds of molecules from the
Virtual Library is chosen for synthesis in the laboratory. The Virtual Library
is generated and searched by proprietary design technology, which can exploit
much larger libraries than is possible with commercially available tools. See
"CombiChem's Proprietary Technologies -- Virtual Library."
 
     Library synthesis -- the laboratory synthesis of molecular structures that
are selected from the Virtual Library using a wide range of chemistries. Once
the more focused library of compounds is designed using molecules chosen from
the Virtual Library, our chemists are responsible for synthesizing the compounds
in the laboratory. Unlike many combinatorial chemistry groups, our chemists are
not restricted to particular chemical reactions or a limited list of structural
templates, thus providing maximum flexibility to synthesize the libraries
quickly. See "CombiChem's Proprietary Technologies -- Synthesis and Analytical
Chemistry Technology."
 
     The above four steps in the Discovery Engine process are completed by our
project teams. Once the molecules are synthesized, those libraries are then sent
to the partner or a contract group for screening. Data from these assays will be
available to us for the next iteration of the cycle. With each iteration, the
Discovery Engine provides more information, improving the hypotheses and
increasing the likelihood of discovering active molecules with desirable
pharmacological characteristics. Eventually, the hypotheses will converge to
provide lead compounds that warrant further testing as development candidates.
It currently takes our scientists approximately three months to advance through
the steps in one Discovery Engine cycle. Depending upon the information
available to start a project, it may take two to four iterations of the cycle to
generate strongly predictive hypotheses that may eventually yield novel and
highly active lead candidates.
 
     Our Discovery Engine process is being validated by both our active
collaborative programs and retrospective analysis of drug discovery examples
taken from the recent scientific literature. In one such example, we applied our
design technology to a project where the data provided was a compilation of
third-party research into the design of HIV protease inhibitors. The objective
was to determine whether our process could be used to discover novel inhibitors
for the enzyme given a collection of only weakly active hits from screening. We
generated hypotheses with distinct features by collecting information on eight
weakly active HIV protease inhibitors and 500 randomly selected inactive
molecules with the same drug-like characteristics as the weakly active
compounds. Each of these weakly active compounds was found by either an academic
or commercial team in the early phases of trying to discover an HIV protease
drug. To assess whether the generated hypotheses are, in fact, able to predict
the activities of new molecules, several highly potent HIV protease inhibitors,
including currently marketed drugs, were added to a virtual library of several
hundred inactive compounds. Using the hypotheses, we searched the Virtual
Library.
 
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The search produced a list of highly ranked protease inhibitors with a variety
of chemical structures, including some of the highly potent HIV protease
inhibitors currently under development or marketed by major pharmaceutical
companies. The structures selected from the Virtual Library differ significantly
from those used to develop the hypotheses, validating our capabilities in lead
evolution. We have similarly validated our technology on over a dozen other
literature data sets and on several programs with collaborators. In our lead
evolution programs with several collaborators, we have already been successful
in evolving from one structural series to multiple, novel structural series
while improving biological activity. These results and a variety of equally
successful applications of the Discovery Engine demonstrate the viability of our
computational drug discovery methods and the strength of our proprietary
technology.
 
COMBICHEM'S PROPRIETARY TECHNOLOGIES
 
     To implement our Discovery Engine process, we have developed and assembled
an integrated set of proprietary technologies. These include the following:
 
  Universal Informer Library
 
     The use of many traditional drug discovery approaches presupposes the
existence of prior information to start the process. However, recent efforts
such as the Human Genome Project and others are producing a number of novel
targets about which there is limited prior information. In addition, there are
many known targets for which no suitable leads have been identified. To address
these situations, our scientists developed a Universal Informer Library. Our
Universal Informer Library consists of a computer-designed, proprietary
collection of approximately 13,000 physical compounds. Unlike other libraries
that are used to identify lead structures directly after screening, the
Universal Informer Library is used to gather information concerning the relevant
binding features that are important to the target. The compounds in the
Universal Informer Library are molecules with the potential to bind to many
different targets. Screening against the Universal Informer Library is therefore
intended to provide a few, weakly active compounds against the background of
many, varied inactive compounds. Using this data, hypotheses may be extracted,
which allow the Discovery Engine to be initiated.
 
     The Universal Informer Library was designed to provide hits for virtually
all possible targets. However, if there is some reason to expect certain
structural features to be relevant to a particular target, the Universal
Informer Library can be augmented with compounds that contain those features. In
this way, information gained from prior experience can be incorporated into the
Universal Informer Library; this may improve the hypotheses and therefore reduce
the number of cycles required to identify a lead candidate.
 
     We completed validation of our Universal Informer Library approach by
screening a subset of the Universal Informer Library against a wide range of
targets and achieving an outcome comparable to that typically seen in the
pharmaceutical industry with libraries containing hundreds of thousands of
compounds.
 
  Virtual Library
 
     Our Virtual Library is a computational representation of a very large
number of molecules chosen for the ease with which they can be synthesized in
the laboratory. To maximize the likelihood that the Virtual Library will contain
potent, patentable compounds active against most targets, we populated it with
hundreds of novel structural templates derived from a large range of chemical
reactions. Each of the templates has two to four sites at which a wide variety
of structural changes can be made synthetically using available chemicals. This
chemistry can also be scaled up to give ready access to quantities of each lead
candidate sufficient to perform early preclinical testing. The Virtual Library
is generated and searched by two components of our proprietary software: Virtual
Library Cascader(TM) software and Virtual Library Search software. See
"-- Design Technology."
 
  Synthesis and Analytical Chemistry Technology
 
     Once the Virtual Library is searched for collections of molecules that
match the hypotheses, our chemists initiate synthesis of these molecules in the
laboratory. The challenge for our chemists is to select the technique that will
most quickly achieve the synthesis of the library. While there is considerable
debate throughout the industry about the relative merits of various methods of
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chemical synthesis (solid versus solution phase, for example), our chemists have
the flexibility to use the appropriate approach for each specific synthesis
task. We believe we have expertise in most or all of the readily used techniques
and, in addition, have access to a number of new proprietary methods.
 
     As long as relatively straightforward chemistry is applied to library
production, synthesis is generally not the rate-limiting step. The challenge
lies in the isolation and purification of the library compounds. We apply
several approaches, including a number of proprietary semi-automated techniques,
to facilitate these procedures in order to achieve purity standards of greater
than 85%.
 
  Design Technology
 
     We rely on our proprietary design technology in order to complete several
of the key steps in our Discovery Engine. The proprietary design technology
includes:
 
     Conformational analysis software -- a computer program for identifying the
distinct three-dimensional shapes of a molecule. Conformational analysis is
performed on each active and inactive molecule to determine which shapes or
conformations such molecules can take. It is typically unknown which of these
shapes a particular molecule will assume when it shows its greatest activity
against a biological target. As a result, all reasonable conformations are
computationally described and analyzed. We have developed proprietary
conformational analysis software, which rapidly determines all the distinct,
reasonable shapes each molecule can assume. Both the speed and the thoroughness
of the conformational analysis software distinguish it from commercial chemistry
software and permit the Discovery Engine to handle large data sets.
 
     Hypothesis generation software -- a computer program for analyzing
screening data to identify the requirements a potential drug must satisfy to
bind to this target. Once conformational analysis has been applied to each of
the screened molecules, our proprietary hypothesis generation software produces
computational models that can estimate the biological activity of chemical
structures. These models, called hypotheses, are generated by applying methods
from statistics, information theory, physical chemistry and computer science to
the screening data in order to identify the differences between active and
inactive compounds. The predictive capabilities of the computational models and
the novel algorithms used to produce them distinguish our hypothesis generator
from commercial chemistry software.
 
     Virtual Library Cascader software -- a computer program for conveniently
describing virtual libraries. The Cascader software facilitates the rapid
specification of virtual libraries to the computer. By providing databases of
reagents and descriptions of reactions to the Cascader, a chemist can quickly
describe large libraries of compounds to the computer. The Cascader can use the
resulting description to construct explicit subsets of the large virtual library
and to present the structures to the chemist and to the Virtual Library Search
software.
 
     Virtual Library Search software -- a computer program for selecting
molecules from the Virtual Library that, when synthesized and screened, will
provide the most information about additional binding requirements. The Virtual
Library search software uses hypotheses to estimate computationally the potency
of prospective compounds. The goal is to increase the likelihood that the
chemists devote their synthesis efforts to compounds that fit the hypotheses and
are thus most likely to bind to the target. By using the computer to test the
compounds in the Virtual Library against the hypotheses, the Discovery Engine
can rapidly identify both active compounds which satisfy several different
hypotheses and informative compounds which discriminate among hypotheses.
Routinely searching virtual libraries with billions of compounds has generally
not been possible with commercial chemistry software.
 
     Each cycle of the Discovery Engine refines the assessment of the best
hypothesis for the target in question. After several cycles, the resulting
hypothesis can be used to design highly potent compounds from a broad range of
chemical classes including those not easily synthesized by standard techniques.
By facilitating the design of a variety of potent compounds for preclinical
testing, the Discovery Engine has the potential to increase greatly the
likelihood that at least one of these compounds passes the hurdles and
eventually becomes a commercial drug.
 
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COMBICHEM'S DISCOVERY PROGRAMS
 
     We are applying our technology to discover lead compounds for biological
targets chosen by our collaborators. In addition, we are selecting our own
biological targets of interest.
 
     In the first instance, where we are working on a target chosen by a
collaborator, the commercial terms are negotiated based on a number of factors,
including the number of targets to be included in the collaboration and the type
of program -- lead generation, lead evolution or lead optimization. Depending
upon the type of program, we will work on the program for a period of one to two
years. We will assign a dedicated project team, funded by the collaborator,
consisting of applications scientists and synthetic, medicinal and analytical
chemists. The team composition and size is dependent upon the type of program
and its objectives. To ensure confidentiality, we provide target exclusivity to
each of our collaborators. Each team works in a dedicated laboratory. At the
conclusion of the program, assuming its objectives have been met, the program
team will transfer the lead structure(s) to the collaborator. At this point, our
work is completed, but the partner will continue to develop the lead candidate.
As the collaborator develops the lead candidate and reaches certain agreed-upon
objectives, we will receive milestone payments. Eventually, when the lead
candidate becomes a marketed drug, we will receive royalties on the sales of the
drug.
 
     In our internal programs, we pay for all of the work to be completed and
will outlicense the lead structures to a partner for the development and
commercialization phases.
 
     Depending upon the data available, the Discovery Engine can be applied to
three types of discovery programs: lead generation, lead evolution and lead
optimization. Lead generation uses the Universal Informer Library to generate
information for the Discovery Engine in situations where little or no prior
information is known about the target. Lead evolution begins with existing
information (either from the collaborator or from the scientific literature)
regarding a lead candidate with the objective of identifying different
structural series that can provide either other development options or an
enhanced patent position. The evolution path may be chosen either as an
outgrowth of a lead optimization program or directly from a collaborator's
established lead candidate series. Lead optimization involves a lead candidate
provided by a collaborator that requires improvement prior to being identified
as a drug development candidate. Using our computational drug discovery
approach, initial libraries are constructed around a given template. Using a
convergent, iterative process, subsequent libraries are increasingly focused as
increased activity (e.g., affinity, selectivity) is achieved.
 
  Collaborative Agreements
 
     CombiChem's collaborative agreements are as follow:
 
<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------
      COMPANY NAME               TARGET OR THERAPEUTIC AREA OF FOCUS            TYPE OF PROGRAM
---------------------------------------------------------------------------------------------------
<S>                         <C>                                              <C>
 Elan/Athena                Multiple targets in central nervous system       Lead generation, lead
                            conditions                                         evolution, and lead
                                                                               optimization
 
 ICOS                       Identified, undisclosed target                   Lead evolution
 
 ImClone                    Multiple targets in oncology                     Lead generation, lead
                                                                               evolution
 
 Novartis Crop              Herbicide, fungicide and insecticide             Lead optimization
 Protection AG
 
 Ono                        Program based on Universal Informer Library      Target selection, Lead
                                                                             generation
 
 Roche Bioscience           Protein-Protein interaction                      Lead optimization
                            Enzyme                                           Lead evolution
                            Receptor                                         Lead optimization
 
 Sumitomo                   Target implicated in osteoarthritis and          Lead evolution
                            rheumatoid arthritis
 
 Teijin                     G-protein coupled receptor                       Lead evolution(1)
---------------------------------------------------------------------------------------------------
</TABLE>
 
(1) The Teijin program started as a lead optimization program.
 
                                        9
<PAGE>   11
 
  Internal Discovery Programs
 
     We are conducting our own internally funded discovery programs by choosing
biological targets of current scientific interest and working in collaboration
with genomics, biotechnology or screening companies. After identifying lead
candidates that are ready for development, we intend to outlicense them,
retaining a larger economic interest in such candidates as they are developed
and commercialized by a third party.
 
COMBICHEM'S COLLABORATIVE ARRANGEMENTS
 
     Our business model is to enter into collaborative arrangements focused on
drug discovery efforts to improve our chances of achieving profitability and to
minimize our financing requirements. Commercial terms of a collaborative
arrangement are driven by the number and nature of the targets. The key
components of the commercial terms typically contained in our collaborations
include project initiation fees, research funding, milestone payments and
royalties.
 
     We have the following completed or active collaborative arrangements:
 
  Athena Neurosciences, Inc., a wholly owned subsidiary of Elan Corporation, plc
 
     In October 1997, we entered into a multiple project collaborative agreement
with Athena Neurosciences, Inc., a wholly owned subsidiary of Elan Corporation,
plc. The agreement provides for a three-year research program to discover novel
therapeutic compounds for treatment of central nervous system conditions. The
first project was initiated upon signing, with a second project initiated in
March 1998. The agreement provides for Elan/Athena's access to the Universal
Informer Library as deemed necessary by the research management committee
composed of Elan/Athena and CombiChem representatives. Under the agreement,
Elan/Athena paid a project initiation fee and agreed to provide research funding
and milestone payments upon the achievement of pre-determined objectives.
Elan/Athena will also make royalty payments on worldwide sales of any products
resulting from the collaboration. The agreement may be terminated by either
party 90 days following an uncured material breach or by Elan/Athena after the
one-year anniversary upon 90 days prior written notice. In connection with the
initial collaborative agreement, Elan International Services Ltd., an affiliate
of Elan/Athena, purchased 1,000,000 shares of common stock for $8.0 million. In
addition, the same affiliate acquired 250,000 shares of common stock in the
initial public offering.
 
  ICOS Corporation
 
     In March 1998, we entered into a collaborative agreement with ICOS
Corporation providing for a lead evolution project on an undisclosed target.
Under the agreement, ICOS receives exclusive global rights to develop and market
any products resulting from the collaboration. ICOS made an advance payment in
April 1998, and agreed to pay research support funding, payments upon
achievement of certain clinical milestones and royalty payments on any product
sales. The lead evolution project terminates on August 31, 2000. The agreement
may be terminated by either party 90 days following an uncured material breach.
 
  ImClone Systems Incorporated
 
     In October 1997, we entered into a collaborative agreement with ImClone
Systems Incorporated providing for a two-year research program to identify and
characterize novel small molecule inhibitors to multiple targets for development
in oncology. The agreement provides for ImClone's access to our Universal
Informer Library and Virtual Library. Under the terms of the agreement, ImClone
agreed to provide us with research support payments, milestone payments upon the
achievement of certain program objectives and royalties on worldwide product
sales of therapeutic products that may arise out of the collaboration. The
agreement may be terminated by either party 90 days following an uncured
material breach. In connection with the collaborative agreement, ImClone
purchased 312,500 shares of common stock for $2.0 million.
 
  Novartis Crop Protection AG
 
     In May 1998, we entered into a collaborative agreement with Novartis Crop
Protection AG providing for a two-year lead optimization project for the
herbicide, fungicide and insecticide markets. Under the agreement, Novartis paid
a project initiation fee and agreed to provide
 
                                       10
<PAGE>   12
 
research funding and milestone payments upon the achievement of certain
milestones. Novartis has exclusive global rights to develop and market or
sub-license products resulting from the collaboration. We will be entitled to
royalties on sales of any products resulting from the collaboration. The
agreement may be terminated by either party 90 days following an uncured
material breach.
 
  Ono Pharmaceutical Co., Ltd.
 
     In December 1998, we entered into a collaborative agreement with Ono
Pharmaceutical Co., Ltd. providing for a two-year lead generation research
program on an undisclosed target. Under the agreement, Ono paid a project
initiation fee and agreed to provide research funding and milestone payments
upon the achievement of certain milestones. Ono will make royalty payments on
worldwide sales of any products resulting from the collaboration. The agreement
may be terminated by either party 90 days following an uncured material breach.
 
  Roche Bioscience, a division of Syntex (U.S.A.) Inc.
 
     In October 1996, we entered into a collaborative agreement with Roche
Bioscience providing for a broad two-year research program to perform research
against three initial targets, including a protein-protein interaction, an
enzyme and a receptor, with an option to add additional targets. Roche
Bioscience can elect one of the approaches -- lead generation, lead evolution or
lead optimization -- for each research program against each collaboration
target. A program may be initiated at any time during the term of the
collaboration, thereby extending the term to allow for completion of each
program. Under the agreement, Roche Bioscience paid a project initiation fee and
agreed to provide research funding and to make milestone payments upon the
achievement of certain milestones. Roche Bioscience will make royalty payments
on worldwide sales of any products resulting from the collaboration. As of
January 31, 1999, we had successfully concluded the research phase and delivered
lead candidates to Roche for further development. As this development process
continues, Roche will make additional payments if certain milestones are met.
During 1998, we achieved three research milestones in this collaboration,
triggering cash milestone payments in two of the three projects.
 
  Sumitomo Pharmaceuticals Co., Ltd.
 
     In August 1997, we entered into a collaborative agreement with Sumitomo
Pharmaceuticals Co., Ltd. providing for a two-year lead evolution program on a
target that is believed to play a fundamental role in osteoarthritis and
rheumatoid arthritis. Under the agreement, Sumitomo paid a project initiation
fee and agreed to provide research funding and milestone payments upon the
achievement of certain milestones. Sumitomo will make royalty payments on
worldwide sales of any products resulting from the collaboration. Sumitomo may
extend the research period for up to four successive six-month periods upon
mutual agreement. The agreement may be terminated by either party 90 days
following an uncured material breach.
 
  Teijin Limited
 
     In March 1996, we entered into a collaborative agreement with Teijin
Limited providing for a one-year research program on a G-protein coupled
receptor target. In March 1997, we amended our agreement to extend the research
phase of the collaborative agreement for an additional year. While the initial
focus of the collaboration was lead optimization, the effort was redirected to
lead evolution during the course of the research. Under the agreement, Teijin
paid a project initiation fee and agreed to provide research funding and
milestone payments upon the achievement of certain milestones. Teijin also
committed internal resources to the discovery effort. Teijin will make royalty
payments on any products resulting from the collaboration. We retain the rights
to the compounds arising under this collaboration in North and South America;
Teijin has rights to these compounds in Asia and Europe with a right of first
negotiation to acquire our rights. Under the original agreement, either party
may terminate the agreement in the event of a material breach remaining uncured
for 60 days. As of March 31, 1998, we successfully concluded the research phase
and delivered lead candidates to Teijin for further development. As this
development process continues, Teijin will make additional payments if certain
milestones are met.
 
                                       11
<PAGE>   13
 
RESEARCH AND DEVELOPMENT
 
     Our expenses for research and development activities were as follows:
 
<TABLE>
<CAPTION>
                                           YEAR ENDED DECEMBER 31,
                                          --------------------------
                                           1996      1997      1998
                                          ------    ------    ------
                                                (IN THOUSANDS)
<S>                                       <C>       <C>       <C>
Collaborative...........................  $  420    $4,317    $9,209
Proprietary.............................   4,820     4,400     5,849
</TABLE>
 
     The increases reflect the additional costs incurred with the expansion of
the Company's collaborative agreements and the investments in proprietary
technologies.
 
COMPETITION
 
     Many organizations are actively attempting to identify, optimize and
generate lead compounds for potential pharmaceutical development. We compete
with the research departments of pharmaceutical companies, biotechnology
companies, combinatorial chemistry companies and research and academic
institutions, as well as other computationally based drug discovery companies.
Many of these competitors have greater financial and human resources and more
experience in research and development than we have. Historically, large
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 one of the largest potential
markets for our products and services, are internally developing combinatorial
and computational approaches 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 we are working,
either on their own or through collaborative efforts. We anticipate that we will
face increased competition in the future as new companies enter the market and
advanced technologies become available. Our processes may be rendered obsolete
or uneconomical by technological advances or entirely different approaches
developed by one or more of our competitors. The existing approaches of our
competitors or new approaches or technology developed by our competitors may be
more effective than those developed by us.
 
PATENTS AND PROPRIETARY INFORMATION
 
     Our success will depend in large part on our own, our licensees' and our
licensors' ability to obtain and defend patents for each party's respective
technologies and the compounds and other products, if any, resulting from the
application of such technologies. Our success will also depend on our ability to
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 ours, are
uncertain and involve complex legal and factual questions for which important
legal principles are largely unresolved. We have pending United States and
foreign patent applications relating to various aspects of our technology,
certain systems, materials and methods used in screening compounds and the
libraries or compounds contained in the libraries. These patent applications are
either owned or co-owned by us or rights under them are licensed to us. To date,
one of our foreign patents has issued and two United States patents have issued.
To the extent that any foreign patent application filed in the European Patent
Office or the Japanese Patent Office issues as a patent, a challenge to the
validity of such patent may be presented in an opposition proceeding. Patents
may not issue as a result of any such pending applications. Even if patents are
issued, such patents may not be sufficiently broad to afford protection against
competitors with similar technologies. We are aware of five United States
patents issued to third parties that claim proprietary rights; two of these
patents are entitled "System and method for automatically generating chemical
compounds with desired properties", the third is entitled "System, method, and
computer program for at least partially automatically generating chemical
compounds having desired properties" and the fourth and fifth are entitled
"Method of generating a plurality of chemical compounds in a spatially arranged
array." Although we believe that our current activities do not infringe these
patents or the patents of other third
 
                                       12
<PAGE>   14
 
parties, we continually assess our position with respect to such patents. Our
belief about our activities may not be upheld in any litigation over patents. In
addition, our future technological developments may not be outside the scope of
these patents or the patents of other third parties. Further, third parties may
seek to assert such patent rights against us, which would result in significant
legal costs and require substantial management resources. We may need a license
from a third party to continue practicing our rights. We may not be able to
obtain such a license, if required, on commercially reasonable terms, if at all.
From time to time, we receive correspondence from third parties to license
patents owned or controlled by third parties. Our inability to obtain or
maintain patent protection or necessary licenses could have a material adverse
effect on our business and results of operations. Our inability either to
demonstrate non-infringement of these and other current and future patents,
whether issued in the United States or overseas, or to obtain the appropriate
licenses, would have a material adverse effect on our business and results of
operations. Moreover, there can be no assurance that we or our customers will be
able to obtain patent protection for lead compounds or pharmaceutical products
based upon our or our customers' technologies. Any patents issued to us or our
collaborative partners, or for which we have license rights, may be challenged,
invalidated or circumvented. The rights granted under any licenses may not
provide competitive advantages to us. To the extent that we or our consultants
or collaborators use intellectual property owned by others in their work for us,
disputes may also arise as to the rights in related or resulting know-how and
inventions. Litigation may be necessary to enforce our patent and license rights
or to determine the scope and validity of others' proprietary rights. Any such
litigation, whether or not the outcome thereof is favorable to us, could result
in substantial cost to and diversion of effort by us. Further, United States
patent law does not provide any remedies for infringement that occurred before
the patent is issued. Our commercial success will also depend upon successfully
avoiding the infringement of current and future patents issued to competitors
and upon maintaining the technology licenses upon which certain of our current
products are, or any future products under development might be, based. If our
competitors prepare and file patent applications in the United States that claim
inventions also claimed by us or our collaborators, we may have to participate
in interference proceedings declared by the Patent and Trademark Office to
determine the priority of invention, which could result in substantial cost to
us, even if the outcome is favorable to us. An adverse outcome could subject us
to significant liabilities to third parties and require us to license disputed
rights from third parties or cease using the technology.
 
     A United States patent application is maintained under conditions of
confidentiality while the application is pending in the Patent and Trademark
Office. As a result, we cannot determine the inventions being claimed in pending
patent applications filed by our competitors in the Patent and Trademark Office.
A number of pharmaceutical and biotechnology companies and research and academic
institutions have developed technologies, filed patent applications or received
patents on various technologies that may be related to our business. Some of
these technologies, applications or patents may conflict with our technologies
or patent applications. Such conflict could limit the scope of the patents, if
any, that we may be able to obtain, or result in the denial of our patent
applications. We may not be able to obtain licenses to patents held by third
parties that may cover our activities at a reasonable cost, if at all. To
continue to practice our technology we would have to develop or obtain
alternative technologies which we may not be able to do. We currently have
certain licenses from third parties and in the future may require additional
licenses from other parties. These licenses may be required to refine our
Discovery Engine further and to allow our collaborators to develop, manufacture
and market commercially viable products effectively. Such licenses may not be
obtainable on commercially reasonable terms, if at all. In addition, patents
underlying such licenses may not be valid and enforceable. Finally, the
proprietary nature of any patented technology underlying such licenses may not
remain proprietary. We rely substantially on certain technologies that are not
patentable or proprietary and are therefore available to our competitors. We
also rely on certain proprietary trade secrets and know-how that are not
patentable. Although we believe we have taken steps to protect our unpatented
trade secrets and know-how, in part through the use of confidentiality
agreements with our employees, consultants and certain of our contractors, there
can be no assurance that (1) these agreements will not be breached, (2) we would
have adequate remedies for any breach or (3) our trade secrets will not
otherwise become known or be independently developed or discovered by
competitors. Our failure to protect all or part of our patents, trade secrets
and know-how could have a material adverse effect on our business and results of
operations.
 
                                       13
<PAGE>   15
 
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 one of our customers or
collaborators or, in the event we decide to develop a drug beyond the early
testing phase, by us. The nature and the extent to which such regulation may
apply to our customers will vary depending on the nature of any such drugs.
Virtually all drugs developed by our customers will require regulatory approval
by governmental agencies prior to commercialization. In particular, drugs to be
administered to humans are subject to rigorous testing and other approval
procedures established by the FDA and by foreign regulatory authorities. Various
federal and, in some cases, state statutes and regulations also govern or
influence, among other things, the testing, manufacture, safety, efficacy,
labeling, storage, record keeping, approval, advertising and promotion of such
drugs. Non-compliance with applicable requirements can result in fines, warning
letters, recall or seizure of products, clinical study holds or delays, total or
partial suspension of production, refusal of the government to grant approvals,
and civil and criminal penalties. 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 first must
conduct studies in the laboratory and in animal models to gain preliminary
information on a compound's efficacy and to identify any safety problems.
Studies must be conducted by laboratories that comply with FDA regulations
regarding good laboratory practices. The results of these studies are submitted
as a part of an investigational new drug application that the FDA must review
before human testing of a potential drug can begin. In order to commercialize
any products, we or our customer will be required to sponsor and file an
investigational new drug application and will be responsible for initiating and
overseeing the human testing to demonstrate the safety and efficacy that are
necessary to obtain FDA and foreign regulatory authority approval of any such
drugs. Human testing is normally done in three phases and generally takes two to
five years but may take longer to complete. After completion of human testing of
a new product, FDA and foreign regulatory authority marketing approval must be
obtained. If the product is classified as a new drug, we or our customer will be
required to file a new drug application and receive approval before commercial
marketing of the drug can begin. The testing and approval processes require
substantial time and effort. Approvals may not be granted on a timely basis, if
at all. New drug applications 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 still subject to continual review. 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. Domestic manufacturing facilities used by us or our
customers are subject to biannual inspections by the FDA and must comply with
the FDA's current good manufacturing practices regulations. To comply with such
regulations, a manufacturer must spend funds, time and effort in the areas of
production and quality control to ensure full technical compliance. The FDA
stringently applies regulatory standards for manufacturing. For marketing
outside the United States, we or our customer will also be subject to foreign
regulatory requirements governing human testing and marketing approval for
drugs. The requirements governing the conduct of human testing, product
licensing, pricing and reimbursement vary widely from country to country.
 
     Our research and development processes involve the controlled use of
hazardous materials. We are 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 we believe that our
activities currently comply with the standards prescribed by such laws and
regulations, the risk of accidental contamination or injury from these materials
cannot be completely eliminated. In the event of such an accident, we could be
held liable for any damages that result, and any such liability could exceed our
resources. In addition, we may be required to incur significant costs to comply
with environmental laws and regulations in the future. The occurrence of any
such event could have a material adverse effect on our business and results of
operations.
 
                                       14
<PAGE>   16
 
SALES AND MARKETING
 
     We market our products directly to customers through participation in trade
conferences and seminars and publications in scientific and trade journals.
 
     To date, we have sold our product offerings to our collaborative partners
primarily through the efforts of our senior management and dedicated business
development professionals. In addition, we utilize outside consultants to
supplement our business development activities in targeted geographies or
industries.
 
HUMAN RESOURCES
 
     As of February 28, 1999, we had 93 full-time employees, 55 of whom have
Ph.D. degrees. Of these employees, 76 were engaged in research and development
and 17 were engaged in marketing and general administration. None of our
employees are covered by collective bargaining agreements. We consider our
relations with our employees to be good.
 
RISKS AND UNCERTAINTIES
 
     The following is a summary of some of the many risks we face in our
business. You should carefully review these risks in evaluating our business.
 
THE TECHNOLOGY WE USE IN OUR BUSINESS IS NEW AND HAS NOT BEEN SHOWN TO BE
SUCCESSFUL IN DISCOVERING NEW DRUGS.
 
     Our drug discovery process is new. We have not yet shown that it can
successfully be used to discover drug candidates that ultimately become
commercial products. Furthermore, our drug discovery efforts are focused on some
targets with unknown functions. Development of new drugs is highly uncertain.
Our drug discovery process may not result in drug candidates that will be safe
or effective or commercially successful as products. If our technology is not
validated through the successful discovery of drug candidates, our business will
be adversely affected.
 
     Our strategy, which is unproven, is to use our proprietary technology to
rapidly identify, optimize and obtain rights to as many drug candidates as
possible. Our near-term profitability depends entirely on whether we can enter
into additional collaborative agreements and maintain our current agreements.
The pricing and nature of our collaborative relationships, however, is such that
our potential customers may include only a limited number of drug, biotechnology
and agrochemical companies. Our strategy also involves conducting our own
discovery programs by choosing biological targets of current scientific interest
and working in collaboration with screening companies to discover drug
candidates. Accordingly, we cannot be certain that our strategy will prove
successful.
 
     Our success also depends on whether potential customers view our process as
an effective drug discovery tool. Historically, drug, biotechnology and
agrochemical companies have identified and optimized new drug candidates in
their own research departments. They have done so primarily to protect the
proprietary nature of their activities. To achieve our business objectives, we
must convince these companies that our technology and capabilities justify the
outsourcing of their programs to us. We may not, however, be able to attract any
future customers on acceptable terms for our products and services or develop a
sustainable, profitable business. Any failure to do so would adversely affect
our business.
 
     We generally structure each of our collaborative agreements to provide us
with payments for:
 
     - initiating the collaboration,
 
     - providing research for a specified period (typically over one or two
       years),
 
     - attaining specifically-negotiated milestones, and
 
     - earning royalties from the commercial sale of any successfully developed
       drug candidate.
 
     To date, we have generated most of our revenues from providing research
services under our collaborative agreements. We receive these revenues, however,
only for a limited period and they are generally offset by corresponding
research costs. After we complete the research phase of each collaborative
agreement, we will receive additional revenues only if our collaborators achieve
the
 
                                       15
<PAGE>   17
 
specified milestones or sell products on which we earn royalties from commercial
sales. Any failure to achieve the milestones or to earn royalties could
adversely affect our business.
 
WE MAY NEVER BE PROFITABLE.
 
     Our near term profitability depends entirely on whether we can enter into
additional collaborative agreements and maintain our current agreements. As a
result, we are unable to predict when, or if, we will become profitable. We have
not yet received, and may never receive, any revenues from royalties for
commercial sales by a customer. In addition, our strategy includes potentially
developing and licensing drug candidates that we have identified through our
internal programs, at our own expense, to others for further development. To
date, we have not entered into any of these licenses. We may never enter into
any of these licenses on acceptable terms or at all.
 
THE SUCCESSFUL IMPLEMENTATION OF OUR STRATEGY IS DEPENDENT ON THE ACTIVITIES OF
OTHERS, OVER WHICH WE HAVE NO CONTROL.
 
     Our strategy depends on our ability to enter into collaborative
arrangements with others on a regular basis. We may not be able to continue to
establish additional collaborative arrangements. If we are successful in
establishing additional arrangements, they may not be on favorable terms. The
collaborative arrangements also may not ultimately be successful. Any failure to
enter into additional collaborative arrangements on favorable terms would
adversely affect our business. The timing of when we receive revenues from
collaborative arrangements depends on both our efforts and our collaborators'
efforts. Generally, for any prospective drug candidate discovered with our
technology each of the following events must occur before the candidate results
in a commercialized product that will generate milestone payments and royalties:
 
     - the early and human testing of the drug candidate must be successful,
 
     - the required regulatory approvals, both in the United States and foreign
       countries, must be obtained,
 
     - manufacturing, sales and marketing capabilities must be established, and
 
     - the product must be successfully marketed in commercial quantities and at
       reasonable costs.
 
     We do not currently plan to perform any of these activities. Therefore, we
will depend on others' expertise and commitment to develop and commercialize
products based on drug candidates we discovered or optimized. The amount and
timing of resources that current and future collaborators devote to our
collaborations are not within our control, and we cannot be certain that their
efforts will be successful.
 
     In addition, when we are eligible to earn milestone payments differs for
each agreement. For instance, for some collaborations, we may not earn milestone
fees until the collaborator has advanced products into human testing, which may
be well into the future. Furthermore, our collaborative partners are not
obligated to develop or commercialize drug candidates we have discovered.
Rather, each collaborative partner may independently move forward with a
competing drug candidate that the partner developed either internally or in
collaboration with others, including our competitors. The potential drugs a
collaborative partner develops also may be derivatives of the drug candidates we
provided to the partner. While our existing collaborative agreements allow us to
retain milestone and royalty payment rights with respect to drugs developed from
certain derivatives, disputes may arise over how the payment provisions in our
agreements apply to those types of drugs.
 
     Conflicts also may arise between collaborative partners about who has the
proprietary rights to particular compounds or drug candidates. Additionally, our
collaborators generally may terminate their agreements with us upon short notice
and following an uncured material breach. Termination of our existing or future
collaborative agreements, would result in a loss of anticipated revenue and
could adversely affect our business.
 
     Furthermore, even though we use independent teams for each collaborative
project, conflicts may arise among our collaborators about which collaborator
has rights to any overlapping compounds or drug candidates developed with our
technologies. Any failure to manage our collaborative relationships
successfully, maintain confidentiality among our relationships or prevent these
types of conflicts could lead to costly and time consuming disputes and a loss
of
                                       16
<PAGE>   18
 
reputation, capital or current or future collaborators. Any of these events
could adversely affect our business.
 
SIGNIFICANT FLUCTUATIONS IN OUR QUARTERLY RESULTS COULD MATERIALLY IMPACT OUR
STOCK PRICE.
 
     Our operating results may vary substantially from quarter to quarter and
will not necessarily be indicative of results in later periods. Any quarterly
fluctuations in revenue or financial results may materially impact our stock
price. To date, we have received revenues from project initiation fees, research
funding and milestone fees paid under our collaborative agreements. We expect
that most of our revenues for the foreseeable future will continue to consist of
these payments. In any one quarter, we may receive multiple or no payments from
our collaborators.
 
OUR SUCCESS IS DEPENDENT ON OUR ABILITY TO BUILD AND MAINTAIN A STRONG
INTELLECTUAL PROPERTY POSITION; FAILURE TO DO SO WOULD HAVE AN ADVERSE EFFECT ON
OUR BUSINESS.
 
     Our success will depend on our ability and the ability of our licensors to
obtain and defend patents and other proprietary rights for our technologies and
the compounds and other products resulting from our technologies. In addition,
to be successful we must avoid infringing the proprietary rights of others. Our
patent position, like that of many drug and biotechnology companies, is
uncertain and involves complex legal and factual questions for which important
legal principles are unresolved. We may not develop or obtain rights to products
or processes that are patentable. Even if we do obtain patents, they may not
adequately protect the technology we own or have licensed. In addition, others
may challenge, seek to invalidate, infringe or circumvent any patents we own or
license, and rights we receive under those patents may not provide competitive
advantages to us. Further, our activities may infringe the patent rights of
others.
 
     We cannot be certain that any patents will issue as a result of any pending
applications. In addition, any issued patents still may not provide sufficient
protection against competitors with similar technologies. Although we believe
that our current activities do not infringe any patents of others, we
continually assess our position. We cannot be certain that we would be
successful in any litigation over patents or that our future technological
developments will be outside the scope of others' patent rights.
 
     We may also need to initiate litigation, which could be time consuming and
expensive, to enforce our proprietary rights or to determine the scope and
validity of others' rights. If litigation results, a court may find our patents
or those of our licensors invalid or may find that we have infringed on a
competitor's rights. If any of our competitors have filed patent applications in
the United States which claim technology we also have invented, the Patent and
Trademark Office may require us to participate in expensive interference
proceedings to determine who has the right to a patent for the technology.
 
     We currently license rights from other parties. In the future we may
require additional licenses from other parties to refine our drug discovery
process further and to allow our collaborators to develop, manufacture and
market commercially viable products effectively. We cannot be certain that:
 
     - we will be able to obtain any licenses on commercially reasonable terms,
       or at all,
 
     - any patents underlying such licenses will be valid and enforceable, or
 
     - the proprietary nature of any patented technology underlying such
       licenses will remain proprietary.
 
     In addition, if we breach any of our licenses, we may lose important
rights.
 
     We also rely on unpatented trade secrets and know-how to maintain our
competitive position, which we seek to protect, in part, by confidentiality
agreements with employees, consultants and others. These parties may breach or
terminate these agreements, and we may not have adequate remedies for any
breach. In addition, our competitors may independently discover our trade
secrets. We also rely substantially on certain technologies that are not
patentable or proprietary and are therefore available to our competitors.
 
                                       17
<PAGE>   19
 
OUR INDUSTRY IS EXTREMELY COMPETITIVE AND WE MAY ULTIMATELY PROVE UNSUCCESSFUL.
 
     Many organizations are actively attempting to identify, optimize and
generate compounds for potential drug development. We compete with the research
departments of drug companies, biotechnology companies, agrochemical companies,
combinatorial chemistry companies and research and academic institutions as well
as other drug discovery companies. Many of our competitors have greater
financial and human resources and more experience in research and development.
We anticipate that we will face increased competition in the future as new
companies enter the market and advanced technologies become available.
Ultimately, our processes may become obsolete or uneconomical as a result of new
technologies or approaches our competitors develop. For a more complete
description of the competitive nature of our industry, please see
"Business -- Competition."
 
FAILURE TO EXPAND OUR OPERATIONS AND MANAGE OUR EXPANDED OPERATIONS WOULD HAVE
AN ADVERSE EFFECT ON OUR BUSINESS.
 
     Our success will depend on whether we can expand our operations to service
additional collaborative arrangements and manage our expanded operations. To be
cost-effective, we must enhance our productivity by further automating our
processes and improving our technology generally. In addition, we must
successfully structure and manage additional collaborative relationships,
including maintaining the confidentiality of the research being provided to our
customers. We may not be able to add the technical personnel needed to meet the
staffing requirements of any additional collaborative relationships. In
addition, our efforts to automate our processes further or to improve our
technology may not be successful. Any failure to achieve these goals could
adversely affect our business.
 
THE LOSS OF ONE OR MORE OF THE KEY MEMBERS OF OUR SCIENTIFIC AND MANAGEMENT
STAFF COULD ADVERSELY AFFECT OUR BUSINESS.
 
     The loss of one or more of the key members of our scientific and management
staff could adversely affect our business. Our future success also depends on
the continued service of our key design, engineering, scientific, software and
management personnel and on our ability to identify, hire and retain any
additional personnel. There is intense competition for these qualified
personnel. We may not be able to continue to attract and retain the personnel
necessary to develop our business. Any failure to attract and retain key
personnel could adversely affect our business.
 
FAILURE TO COMPLY WITH REGULATORY REQUIREMENTS WOULD HAVE AN ADVERSE EFFECT ON
OUR BUSINESS.
 
     Any failure to comply with regulatory requirements in the United States and
overseas can result in fines, warning letters, recall or seizure of products,
clinical study holds or delays, total or partial suspension of production,
refusal of the government to grant approvals, and civil and criminal penalties.
United States and foreign government regulation will be a significant factor in
the production and marketing of any drug products that we, our customers or our
collaborators develop. The scope of the regulation will vary depending on the
type of products involved. Virtually all drug products our customers develop
will require regulatory approval. In particular, the FDA and foreign regulatory
authorities require vigorous early state and human testing and other procedures
for human drug products. Numerous regulations also govern the manufacturing,
safety, labeling, storage, record keeping, reporting and marketing of drug
products.
 
     The process of obtaining and complying with regulatory approvals is time
consuming and expensive. The testing and approval processes require substantial
time and we cannot be certain if or when any approval will be granted for any
products resulting from our technologies.
 
     Even if FDA regulatory clearances are obtained, a marketed product is still
subject to continual review. Later discovery of previously unknown problems or
failure to comply with the applicable regulatory requirements may result in
restrictions on a product's marketing or withdrawal of the product from the
market, as well as possible civil or criminal sanctions. In addition, domestic
manufacturing facilities are subject to regular FDA inspections and must comply
with the FDA's manufacturing practices regulations. To comply with these
regulations, a manufacturer must spend funds, time and effort on production and
quality control.
 
     For marketing outside the United States, we, our collaborators or customers
will also be subject to foreign regulatory requirements governing human clinical
trials and marketing approval.
 
                                       18
<PAGE>   20
 
For a more complete description of regulatory requirements we, our customers and
collaborators face, please see "Business -- Government Regulation."
 
OUR FUTURE CAPITAL NEEDS ARE UNCERTAIN AND MAY HAVE AN ADVERSE EFFECT ON OUR
BUSINESS.
 
     Our capital requirements depend on many factors, including:
 
     - our ability to enter into additional collaborative arrangements,
 
     - competing technological and market developments,
 
     - changes in our existing collaborative arrangements,
 
     - the cost of filing, prosecuting, defending and enforcing patent claims
       and other proprietary rights,
 
     - the purchase of additional equipment,
 
     - the progress in our drug discovery programs, and
 
     - our collaborators' ability to commercialize milestone and royalty-bearing
       compounds.
 
     We may be required to raise additional capital over a period of several
years to continue our operations. Additional funding, if necessary, may not be
available on favorable terms. If adequate funds are not available, we may be
required to curtail operations significantly or obtain funds through
arrangements with collaborative partners or others that may require us to
relinquish rights to certain of our technologies, product candidates, products
or potential markets that we would not otherwise relinquish. Any failure to
receive additional funding would adversely affect our business.
 
THE EFFORTS OF THE GOVERNMENT AND OTHERS TO REDUCE THE COST OF HEALTH CARE MAY
HAVE AN ADVERSE EFFECT ON OUR COLLABORATORS AND OUR BUSINESS.
 
     We expect that a substantial portion of our revenue in the foreseeable
future will be derived from products and services provided to the drug,
biotechnology and agrochemical industries. Accordingly, our success in the
foreseeable future depends on the success of the companies within those
industries and continued demand for our products and services.
 
     The efforts of governments and third party payors to contain or reduce the
cost of health care will continue to affect the business and financial condition
of these companies. For example, in certain foreign markets, pricing or
profitability of prescription pharmaceuticals is subject to governmental
control. In the United States, a number of legislative and regulatory proposals
to change the health care system have been proposed in recent years. In
addition, an increasing emphasis on managed care in the United States has and
will continue to increase pressure on drug pricing. We cannot predict whether
legislative or regulatory proposals will be adopted. If proposals or reforms are
adopted and adversely affect the business of our collaborators or customers, our
business may also be adversely affected.
 
OUR USE OF HAZARDOUS MATERIALS MAY SUBJECT US TO SIGNIFICANT ENVIRONMENTAL RISKS
WHICH COULD HAVE AN ADVERSE EFFECT ON OUR BUSINESS.
 
     We use hazardous materials in our research and development activities. As a
result, we are subject to federal, state and local laws and regulations
governing the use, manufacture, storage, handling and disposal of hazardous
materials. The risk of accidental contamination or injury exists. If an accident
occurs, we could be responsible for any damages and the amount of the damages
could exceed our resources. In addition, we may incur significant costs to
comply with environmental laws and regulations in the future. Any of these
events could adversely affect our business.
 
OUR EXECUTIVE OFFICERS, DIRECTORS AND THEIR AFFILIATES MAY INFLUENCE ALL MATTERS
REQUIRING STOCKHOLDER APPROVAL.
 
     Our executive officers and directors and their affiliates own approximately
30% of our outstanding common stock. As a result, these stockholders may
influence all matters requiring stockholder approval, including the election of
directors and the approval of significant corporate transactions. This
concentration of ownership could also delay or prevent a change in our ownership
that other stockholders may favor.
 
                                       19
<PAGE>   21
 
THE MARKET PRICE OF OUR COMMON STOCK IS VOLATILE AND YOU MAY NOT BE ABLE TO MAKE
A RETURN ON YOUR INVESTMENT.
 
     The market price of our common stock is likely to be volatile and could
fluctuate widely in response to many factors, including:
 
     - announcements of new technologies or products by us or our competitors,
 
     - developments concerning patents or other proprietary rights,
 
     - publicity regarding the status of compounds we or our collaborators are
       developing,
 
     - regulatory developments, both in the United States and foreign countries,
 
     - public concern about the effectiveness of new technologies,
 
     - changes in expectations of securities analysts concerning our company or
       our industry in general;
 
     - quarterly fluctuations in our revenues and financial results, and
 
     - general market conditions.
 
     As a result, our operating results may be below the expectations of market
analysts and investors, which could reduce the market price of our common stock.
 
     The stock market has experienced extreme price and volume fluctuations that
have particularly affected the market prices of the securities of many companies
in our industry. Often, these fluctuations have been unrelated or
disproportionate to the operating performance of the companies. These market
fluctuations, as well as general economic, political and market conditions, may
reduce the market price of our common stock. In addition, in the past,
securities class action litigation has often been instituted following periods
of volatility in the market prices of securities. If we face such litigation in
the future, it would be costly and time consuming and could adversely affect our
business.
 
OUR CHARTER, DELAWARE LAW AND CERTAIN CONTRACT PROVISIONS MAY PREVENT OR DELAY A
CHANGE OF CONTROL WHICH MAY NOT BE IN THE BEST INTERESTS OF OUR STOCKHOLDERS.
 
     Certain provisions of our charter and stock options, as well as certain
provisions of Delaware law, could delay or impede the removal of incumbent
directors and could make more difficult a merger, tender offer or proxy contest
involving us, even if the events could be beneficial to our stockholders. These
provisions could also limit the price that investors might be willing to pay for
our common stock. Our charter also authorizes our Board of Directors to issue
shares of undesignated preferred stock without stockholder approval on terms
that the Board may determine. The issuance of preferred stock could decrease the
amount of earnings and assets available for distribution to our other
stockholders or otherwise adversely affect the rights and powers, including
voting rights, of our other stockholders. Moreover, the issuance of preferred
stock may make it more difficult for another party to acquire, or may discourage
another party from acquiring, voting control of us.
 
WE MAY NOT BE SUCCESSFUL IN RESOLVING ALL OUR YEAR 2000 ISSUES WHICH COULD HAVE
AN ADVERSE EFFECT ON OUR BUSINESS.
 
     The year 2000 issue refers to the inability of certain date-sensitive
computer chips, software, and systems to recognize a two-digit date field as
belonging to the 21st century. This is a significant issue for most, if not all
companies, with far reaching implications, some of which cannot be anticipated
or predicted with any degree of certainty. The year 2000 issue may create
unforeseen risks to us from our internal computer systems as well as from
computer systems of third parties. Any failure of our and/or others' computer
systems could adversely affect our business. For a more complete description of
the status of our year 2000 readiness program and contingency plans we have
instituted, please see "Item 7 -- Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Year 2000."
 
ITEM 2. PROPERTIES
 
     We currently lease and occupy approximately 40,000 square feet of
laboratory and office space in San Diego, California. We also lease and occupy
approximately 6,000 square feet of office
                                       20
<PAGE>   22
 
space in Palo Alto, California. Our primary San Diego lease (34,000 sq. ft.)
expires in May 2006 and a 6,000 square foot laboratory lease expires in October
1999. The Palo Alto lease expires in October 2002.
 
     In February 1999, we entered into a 15-year lease agreement for 75,000
square feet of laboratory and office space in San Diego, California with a
target commencement date of November 1, 1999. Upon commencement of the new
lease, the existing lease for 34,000 square feet in San Diego, California will
terminate. Additionally, upon termination, the landlord will purchase all tenant
improvements from us at their projected net book value of $2.5 million.
 
ITEM 3. LEGAL PROCEEDINGS
 
     We are not a party to any legal proceedings.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     None.
 
                                       21
<PAGE>   23
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
     Shares of our common stock are traded on the Nasdaq National Market under
the symbol "CCHM." Prior to our initial public offering in May 1998, there was
no established published trading market for our common stock. The following
table presents the quarterly high and low sales prices of the common stock as
reported by Nasdaq. Such quotations represent inter-dealer prices without retail
markup, markdown or commission and may not necessarily represent actual
transactions.
 
<TABLE>
<S>                       <C>                     <C>
----------------------------------------------------------------------
                                       1998
----------------------------------------------------------------------
                          High                    Low
----------------------------------------------------------------------
 First quarter            n/a                     n/a
----------------------------------------------------------------------
 Second quarter           $8.75                   $6.13
----------------------------------------------------------------------
 Third quarter            $8.63                   $3.38
----------------------------------------------------------------------
 Fourth quarter           $5.88                   $3.38
----------------------------------------------------------------------
</TABLE>
 
     We had 191 stockholders of record and approximately 800 beneficial
stockholders as of February 28, 1999.
 
DIVIDEND POLICY
 
     We have not paid dividends on our common stock and intend to continue this
policy to retain earnings for use in our business.
 
USE OF PROCEEDS
 
     A Registration Statement on Form S-1 (File No. 333-37981) registering
2,587,500 shares of our common stock was declared effective by the SEC on May 7,
1998. The amount of net offering proceeds from the IPO and over-allotment option
was approximately $16.2 million. Such proceeds have been invested in short-term
investment-grade securities.
 
     The principal purposes of the offering were to: (1) increase our equity
capital, (2) create a public market for the our Common Stock in order to
facilitate future access to public equity markets and (3) create liquidity for
our existing stockholders. We intend to use the net proceeds of this offering,
together with our existing cash and cash equivalents and short-term investments,
to fund research and development, expand laboratory and office facilities and
for general corporate purposes. We may also use a portion of the net proceeds
for the acquisition of businesses, technologies or products complementary to us.
There are no present arrangements or agreements for any such acquisitions.
 
     The amounts actually expended for each purpose may vary significantly
depending upon numerous factors, including the amount and timing of additional
collaborative agreements, the progress of our development, technological
advances, the commercial potential of the our services and the status of the our
competitors. We believe that our existing cash, cash equivalents and short-term
investments, combined with the net proceeds of this offering, projected funding
from equipment leases and interest income will be adequate to satisfy our
capital requirements and fund operations for the foreseeable future.
 
                                       22
<PAGE>   24
 
ITEM 6. SELECTED FINANCIAL DATA
 
<TABLE>
<CAPTION>
                                       PERIOD FROM
                                       MAY 23, 1994
                                      (INCEPTION) TO          YEAR ENDED DECEMBER 31,
                                       DECEMBER 31,    -------------------------------------
                                           1994         1995      1996      1997      1998
                                      --------------   -------   -------   -------   -------
                                              (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                   <C>              <C>       <C>       <C>       <C>
STATEMENT OF OPERATIONS DATA:
  Total revenue.....................      $  --        $    50   $ 2,967   $ 7,471   $15,074
  Total operating expenses..........        711          6,763     8,085    12,004    19,111
                                          -----        -------   -------   -------   -------
  Loss from operations..............       (711)        (6,713)   (5,118)   (4,533)   (4,037)
  Net loss..........................      $(706)       $(6,675)  $(5,118)  $(4,322)  $(3,312)
                                          =====        =======   =======   =======   =======
  Basic net loss per share..........                   $(19.18)  $(11.30)  $ (4.45)  $ (0.36)
                                                       =======   =======   =======   =======
  Shares used in computing basic net
     loss per share.................                       348       453       971     9,140
                                                       =======   =======   =======   =======
</TABLE>
 
<TABLE>
<CAPTION>
                                                       AS OF DECEMBER 31,
                                        -------------------------------------------------
                                         1994     1995       1996       1997       1998
                                        ------   -------   --------   --------   --------
<S>                                     <C>      <C>       <C>        <C>        <C>
BALANCE SHEET DATA:
  Cash and cash equivalents...........  $1,622   $ 3,136   $    367   $  5,867   $ 20,334
  Short-term investments..............      --        --     12,166     11,055      9,025
  Working capital.....................   1,420     1,990      8,946     12,896     26,146
          Total assets................   1,796     3,997     16,505     25,376     41,980
  Long-term obligations, including
     current portion..................      --       584      2,541      4,944      6,214
  Redeemable convertible preferred
     stock............................   2,250     9,650     23,107     23,130         --
  Accumulated deficit.................    (706)   (7,381)   (12,499)   (16,821)   (20,133)
          Total stockholders'
            (deficit) equity..........    (682)   (7,414)   (12,516)    (6,449)    30,177
</TABLE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
       OF OPERATIONS
 
     This annual report may contain predictions, estimates and other
forward-looking statements that involve a number of risks and uncertainties,
which are discussed above in Item 1 at "Risks and Uncertainties." While this
outlook represents our current judgment on the future direction of our business,
such risks and uncertainties could cause actual results to differ materially
from any future performance suggested below. We undertake no obligation to
release publicly the results of any revisions to these forward-looking
statements to reflect events or circumstances arising after the date of this
annual report.
 
OVERVIEW
 
     CombiChem is a computational product discovery company that is applying its
proprietary design technology and rapid synthesis capabilities to accelerate the
discovery process for new drugs and chemical products. We believe our approach
offers pharmaceutical and chemical companies the opportunity to conduct their
discovery efforts in a more productive and cost-effective manner. Using our
proprietary Discovery Engine(TM)process, we focus on the generation, evolution
and optimization of potential new lead candidates for our collaborative partners
who will then develop, manufacture, market and sell any resulting products. We
believe that our process is widely applicable to a variety of disease targets
and therapeutic indications as well as to other industries such as agrochemical,
industrial chemical and materials science. To date, we have established
collaborative agreements with Athena Neurosciences, Inc., a wholly owned
subsidiary of Elan Corporation, plc, ICOS Corporation, ImClone Systems
Incorporated, Novartis Crop Protection AG, Ono Pharmaceutical Co., Ltd., Roche
Bioscience, a division of Syntex (U.S.A.) Inc., Sumitomo Pharmaceuticals Co.,
Ltd. and Teijin Limited. In addition, we are using our approach on internal
programs to discover new lead candidates that will then be outlicensed to third
parties, while retaining a larger economic interest. In December 1998, we
further broadened the application of the technology by establishing a joint
venture with Chirotech Technology, Ltd., a member of the Chiroscience Group of
companies, to commercialize libraries of chiral compounds.
 
                                       23
<PAGE>   25
 
The joint venture, ChiroChem Discovery Services, LLC, was established to develop
and sell specifically designed chiral compound libraries.
 
     Our revenue to date is primarily attributable to the receipt of project
initiation fees, milestone payments and research funding. Project initiation
fees are received from our collaborators upon, or shortly following, execution
of the collaborative agreement. Milestone payments are received from
collaborators upon achievement of certain pre-determined objectives. In
connection with the performance of research services, we receive research
funding under our collaborative agreements. Research funding typically is
received only during the life of the research program under the particular
collaboration. In addition, we may receive advance payments from our
collaborators or potential collaborators, which require us to complete certain
performance obligations. Such payments are recorded as deferred revenue when
received and are recognized as revenue when our performance obligations have
been met, as evidenced by our collaborator's written approval and acceptance.
The collaborative activities for which we receive revenue typically occur over a
one- to three-year period, if multiple projects are anticipated, or one to two
years for single project collaborations. The agreements provide for earlier
termination in certain circumstances. We expect that a significant portion of
our revenue for the foreseeable future will be comprised of such payments. The
receipt of project initiation fees is dependent on our ability to enter into
additional collaborative agreements that provide for such fees; the timing of
such payments will be difficult to predict. In addition, the timing of certain
revenue in the future will depend upon the completion of certain milestones as
provided for in our collaborative agreements, which are contingent and
uncertain. Milestone fees may be earned for different events or achievements in
different agreements. For certain collaborations, such fees may not be earned
until the collaborator has advanced products into human testing. In any one
fiscal quarter we may earn multiple or no payments from our collaborators.
Operating results may therefore vary substantially from period to period and
will not necessarily be indicative of results in subsequent periods. Completion
of the research phase of a single project collaboration or a single project
within a broad multiple project collaboration is not expected to have a material
adverse effect on our business. However, the termination or conclusion of any
collaborative agreement could have a material adverse effect on our business. In
addition, our failure to enter into additional collaborative agreements on
favorable terms would have a material adverse effect on our business.
 
     We have not been profitable since inception. We have incurred a cumulative
net loss of $20.1 million through December 31, 1998. Losses have resulted
principally from costs incurred in research and development activities related
to efforts to develop our technologies and from the associated administrative
costs of supporting these efforts. Our ability to achieve profitability is
dependent on our ability to market our technology and capabilities to
pharmaceutical, biotechnology, agrochemical and chemical companies.
 
RESULTS OF OPERATIONS
 
YEARS ENDED DECEMBER 31, 1998 AND 1997
 
  Revenue
 
     Our revenue for the year ended December 31, 1998 was $15.1 million, up from
$7.5 million for the same period in 1997. The increase in revenue resulted
primarily from entering into collaborative agreements with ICOS, Novartis and
Ono during 1998, the full-year effect of the Sumitomo, Elan/Athena and ImClone
agreements, which were executed in 1997, and the achievement of four milestones
in 1998. We received three milestone payments from Roche Bioscience and one from
Teijin during 1998. Revenue from collaborators exceeding 10% of total revenue
for the year ended December 31, 1998 was 38% from Roche, 17% from Sumitomo, 14%
from Elan/Athena and 12% from Ono.
 
  Operating Expenses
 
     Research and development expenses for the year ended December 31, 1998
totaled $15.1 million compared to $8.7 million for the same period in 1997.
Research and development costs incurred on behalf of our collaborators increased
$4.9 million due to an increase in the number of projects in the active
collaboration phase. Research and development costs incurred to advance our
proprietary technologies increased $1.4 million due to increased staffing and
the full year effect of operations added during 1997. We expect research and
development spending to increase over the
 
                                       24
<PAGE>   26
 
next several years due to increased activities related to collaborations,
internal programs and technology development.
 
     General and administrative expenses for the year ended December 31, 1998
totaled $4.1 million compared to $3.3 million for the same period in 1997. This
increase reflects increased business development activities and administrative
support for our expanded programs. These expenses will likely increase in future
periods to support our projected growth.
 
  Interest Income/Interest Expense
 
     Net interest income for the year ended December 31, 1998 was $0.9 million
compared to $0.4 million for the same period in 1997. This change reflects
increased cash and investment balances resulting from receipts under
collaborative agreements and our initial public offering in May 1998. Interest
income was partially offset by interest expense incurred on capital lease
obligations.
 
  Net Loss
 
     Net loss for the year ended December 31, 1998 was $3.3 million compared to
$4.3 million for the same period in 1997. The decreased loss is primarily
attributable to increased revenue from project initiation fees and milestone
achievements.
 
YEARS ENDED DECEMBER 31, 1997 AND 1996
 
  Revenue
 
     Revenue for the year ended December 31, 1997 was $7.5 million, up from $3.0
million for the same period in 1996. The increase in revenue resulted primarily
from entering into collaborative agreements with Sumitomo and Elan/Athena in
1997 and the full year effect of the Teijin and Roche collaborations, which were
executed in 1996. Revenues from collaborators exceeding 10% of total revenues
for the year ended December 31, 1997 was 39% from Sumitomo, 30% from Roche, and
18% from Elan/Athena.
 
  Operating Expenses
 
     Research and development expenses for the year ended December 31, 1997 were
$8.7 million, up from $5.2 million for the same period in 1996. This increase
reflects increased research and development expenses incurred on behalf of
collaborators. Such expenses include salaries for additional chemists and
molecular design staff for each project team and the associated depreciation of
new laboratory equipment. We have the ability to direct our scientific personnel
to work either on our collaborative agreements or on our internal research
projects as needs arise. We expect research and development spending to increase
over the next several years due to increased activities related to
collaborations, internal programs and technology development.
 
     General and administrative expenses for the year ended December 31, 1997
were $3.3 million, up from $2.8 million for the same period in 1996. This
increase reflects increased business development activities, including outside
consulting fees and increased travel costs, and administrative support for our
expansion in 1997. These expenses will likely continue to increase in future
periods to support our projected growth.
 
  Interest Income/Interest Expense
 
     Net interest income for the year ended December 31, 1997 was $0.4 million
compared to a break-even position for the same period in 1996. This change
reflects increased cash and investment balances resulting from receipts under
collaborative agreements and the sale of common stock in conjunction with the
signing of the Elan/Athena and ImClone agreements. Interest income was partially
offset by interest expense incurred on capital lease obligations
 
  Net Loss
 
     Net loss for the year ended December 31, 1997 was $4.3 million compared to
$5.1 million for the same period in 1996. The decrease is primarily attributable
to additional revenue generated from corporate collaborations during 1997.
 
                                       25
<PAGE>   27
 
LIQUIDITY AND CAPITAL RESOURCES
 
     From inception through December 31, 1998, we financed our operations
through proceeds from our initial public offering and private placements of
equity securities, payments from corporate collaborators, and the utilization of
capital equipment lease financing. In May 1998, we completed our initial public
offering of 2,359,500 shares of our common stock (including partial exercise of
the underwriters' over-allotment option), generating net proceeds of
approximately $16.2 million.
 
     Net cash used in operating activities for the year ended December 31, 1998
was $1.9 million compared to net cash used of $3.5 million for the corresponding
period in 1997. The decrease in net cash used in operating activities was
primarily attributable to the reduction of our net loss and the collection of
advance payments from collaborators.
 
     At December 31, 1998, we held cash and cash equivalents and short-term
investments with a value of $29.4 million. Our working capital at December 31,
1998 was $26.1 million. We have maintained capital lease arrangements since
1994. Under these arrangements, we have funded certain capital expenditures with
lease terms ranging from 36 to 48 months in duration. As of December 31, 1998,
we had utilized $9.2 million of an available $11.4 million financing facility.
We expect the net proceeds from our initial public offering completed in May
1998 and the interest income on the proceeds, together with the existing cash
and cash equivalents, short term investments, operating revenue and lease
financing arrangements, will be sufficient to finance our working capital and
capital requirements for the foreseeable future. Our capital requirements depend
on numerous factors. These factors include: (1) our ability to enter into
additional collaborative arrangements, (2) competing technological and market
developments, (3) changes in our existing collaborative relationships, (4) the
cost of filing, prosecuting, defending and enforcing patent claims and other
intellectual property rights, (5) the purchase of additional capital equipment,
(6) the progress of our drug discovery programs and (7) the progress of the
commercialization of milestone-and royalty-bearing compounds by our
collaborators. We may be required to raise additional capital over a period of
several years in order to continue to conduct our operations. Such capital may
be raised through additional public or private financing arrangements, as well
as collaborative arrangements, borrowings and other available sources. In
addition, we may from time to time earn milestone fees under our collaborations.
Milestone fees may be earned for different events or achievements in different
agreements. Furthermore, for certain collaborations, such fees may not be earned
until the collaborator has advanced products into human testing. Such milestones
may not be earned for several years, if at all. Our collaborative arrangements
may not produce revenue adequate to fund our operating expenses. Additional
funding, if necessary, may not be available on favorable terms, if at all. If
adequate funds are not available, we may be required to curtail operations
significantly or obtain funds through arrangements with collaborative partners
or others that may require us to relinquish rights to certain of our
technologies, product candidates, products or potential markets that we would
not otherwise relinquish. The failure to receive additional funding would have a
material adverse effect on our business and results of operations.
 
YEAR 2000 ISSUE
 
     Description of the Issue. The Year 2000 issue refers to the inability of
certain date-sensitive computer chips, software, and systems to recognize a
two-digit date field as belonging to the 21st century. Mistaking "00" for 1900
or any other incorrect year could result in a system failure or miscalculations
causing disruptions to operations, including manufacturing, a temporary
inability to process transactions, or send invoices, or engage in other normal
business activities. This is a significant issue for most, if not all companies,
with far reaching implications, some of which cannot be anticipated or predicted
with any degree of certainty. The Y2K issue may create unforeseen risks from our
internal computer systems as well as from computer systems of third parties with
which we deal. Our failures and/or those of third parties' computer systems
could have a material adverse impact on our ability to conduct our business.
 
     Year 2000 Readiness. We have formed a committee, including the chief
financial officer and the information technology manager, to evaluate Y2K risks
and readiness. The committee has addressed both information technology and
non-information technology systems. Examples of information technology systems
include hardware and software purchased from external sources and internally
developed software. Examples of non-information technology systems include
 
                                       26
<PAGE>   28
 
laboratory equipment and those systems that operate the facilities
infrastructure. The committee has also considered the systems of those third
parties with which we maintain a material relationship.
 
     We have substantially completed an assessment of our information technology
and non-information technology systems. The assessment phase is, however, an
on-going effort. As part of this effort, we are assessing the potential severity
of the impact of Y2K induced failures, conducting an inventory of information
systems for each business area, prioritizing systems or components to be
converted or replaced, and developing a contingency plan for mission critical
systems.
 
     Renovation procedures have begun on those systems that we have identified
in our assessment as being non-Y2K compliant. This renovation entails
installation of commercially-available software and firmware updates and
performance of system tests. The renovation phase of our Year 2000 efforts is
approximately 90% complete.
 
     Although the assessment and renovation phases are not 100% complete, based
on the work performed to date, we do not foresee an inherently complex Y2K
problem. Accordingly, we will concurrently validate and implement converted or
replaced mission-critical systems. Validation will take place in an environment
that is representative of the true operating environment. Implementation will
address the integration of Y2K compliant systems into our true operating
environment and will take into consideration the interdependencies of the
systems involved. Finally, we will ensure that the Y2K contingency plan is
available for each business area. The validation phase is currently in process
and we expect this phase to be competed in the third quarter of 1999.
 
     For material third parties, we are obtaining written assurances that their
systems and/or products are, or will be, Y2K compliant. However, we are not
independently verifying their representations. In addition, while we are not
dependent on any sole-source suppliers to conduct our laboratory operations,
efforts are ongoing to monitor the progress of the Y2K preparations of our
current major suppliers of laboratory materials.
 
     Year 2000 Costs. The total cost of our Y2K activities is funded through
operating cash flows. We are expensing these costs as they are incurred. As of
February 28, 1999, we have not incurred any incremental costs to resolve our Y2K
issue and we expect that the total cost to become fully compliant will not
exceed $50,000.
 
     Year 2000 Risks and Contingencies. In the event that systems of third-party
providers or vendors of laboratory supplies fail to resolve Y2K issues that
effect services or product deliveries to us, we may have to change providers or
vendors. Such changes are not anticipated to have a material adverse effect on
our business. As previously indicated, we are preparing a Y2K contingency plan
which addresses each of the mission-critical systems of our business areas. This
plan will also identify strategies and available resources necessary to restore
operations.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
 
     The Company's investment portfolio consists of short-term, high quality
debt securities. These securities are subject to interest rate risk, and will
decline in value if interest rates increase. An immediate 10% change in interest
rates would not have a material impact on our financial condition or results of
operations.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
     The Company's financial statements and supplemental data required by this
item are set forth at the pages indicated in Item 14(a)(1).
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
     Not applicable.
 
                                       27
<PAGE>   29
 
                                    PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     (a) Identification of Directors. The information under the caption
"Election of Directors," appearing in the Proxy Statement, is incorporated
herein by reference.
 
     (b) Identification of Executive Officers. The information under the heading
"Management," appearing in the Proxy Statement, is incorporated herein by
reference.
 
     (c) Section 16(a) Beneficial Ownership Regarding Compliance. The
information under the heading "Section 16 Beneficial Ownership Reporting
Compliance," appearing in the Proxy Statement, is incorporated herein by
reference.
 
ITEM 11. EXECUTIVE COMPENSATION
 
     The information under the headings "Executive Compensation and Other
Information," appearing in the Proxy Statement, is incorporated herein by
reference.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     The information under the heading "Ownership of Securities" appearing in
the Proxy Statement, is incorporated herein by reference.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     The information under the heading "Certain Transactions," appearing in the
Proxy Statement, is incorporated herein by reference.
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
(a) (1) FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
                                                              PAGE
                                                              NO.
                                                              ----
<S>                                                           <C>
Report of Ernst & Young LLP, Independent Auditors...........  F-2
Balance Sheets at December 31, 1997 and 1998................  F-3
Statements of Operations for the years ended December 31,
  1996, 1997 and 1998.......................................  F-4
Statements of Stockholders' Equity (Deficit) for the years
  ended December 31, 1996, 1997 and 1998....................  F-5
Statements of Cash Flows for the years ended December 31,
  1996, 1997 and 1998.......................................  F-6
Notes to Financial Statements...............................  F-7
</TABLE>
 
(2) FINANCIAL STATEMENT SCHEDULES
 
     All schedules are omitted because they are not applicable or the required
information is included in the financial statements or notes thereto.
 
(b) No reports on Form 8-K have been filed during the last quarter of the period
covered by this report.
 
                                       28
<PAGE>   30
 
(c) EXHIBITS
 
<TABLE>
<CAPTION>
        EXHIBIT
         NUMBER                            DESCRIPTION
        --------                           -----------
        <S>        <C>
         3.1++     Certificate of Incorporation of the Company, as amended.
         3.2++     Form of Amended and Restated Certificate of Incorporation of
                   the Company to become effective immediately prior to the
                   Offering.
         3.3++     Bylaws of the Company, as amended.
         3.4++     Form of Restated Bylaws of the Company to be effective upon
                   completion of the Offering.
         4.1++     Form of Certificate for Common Stock.
        10.9++     Amended and Restated Investors' Rights Agreement between the
                   Company and the stockholders listed on Schedule A thereto,
                   dated November 15, 1996.
        10.11++    Series J Preferred Stock Purchase Agreement between the
                   Company and Jonathan Greene, dated June 11, 1997.
        10.12++    Series J Preferred Stock Purchase Agreement between the
                   Company and Andrew Smellie, dated June 11, 1997.
        10.13++    Warrant Agreement to Purchase Shares of the Series Z
                   Preferred Stock, as amended between the Company and
                   Comdisco, Inc., dated December 20, 1994.
        10.14++    Common Stock Purchase Warrant between the Company and LJL
                   BioSystems, Inc., dated June 15, 1995.
        10.15++    Form of Warrant to Purchase Shares of Series C Preferred
                   Stock between the Company and the purchasers listed on
                   Schedule A thereto, dated August 17, 1995.
        10.16++    Form of Warrant Agreement to Purchase Shares of Series C
                   Preferred Stock of the Company, between the Company and
                   Comdisco, Inc. in the amounts listed on Schedule A thereto.
        10.17++    Form of Warrant to Purchase Shares of Series Z Preferred
                   Stock between the Company and the purchasers listed on
                   Schedule A thereto, dated May 20, 1996.
        10.18++    Master Lease Agreement with the Company and Comdisco Inc.,
                   dated November 6, 1994, Schedule VL-1, dated November 11,
                   1994, Schedule VL-2 dated April 15, 1996 and Schedule VL-3
                   dated April 15, 1996.
        10.19*++   Collaboration Agreement between the Company and Teijin
                   Limited, dated March 29, 1996, as amended.
        10.20*++   Collaborative Research and License Agreement between the
                   Company and Roche Bioscience, dated October 25, 1996.
        10.21*++   Research and Technology Development Agreement between the
                   Company and Sumitomo Pharmaceuticals Co., Ltd., dated August
                   18, 1997.
        10.22*++   Collaborative Research and License Agreement between the
                   Company and ImClone Systems Incorporated, dated October 10,
                   1997.
        10.23*++   Collaborative Research and License Agreement between the
                   Company and Athena Neurosciences, Inc., dated October 15,
                   1997, as amended.
        10.24++    Full Recourse Secured Promissory Note and Stock Pledge
                   Agreement between the Company and Peter Myers, dated
                   September 5, 1995.
        10.28++    Promissory Note Secured by Stock Pledge Agreement between
                   the Company and Vicente Anido, Jr., dated June 6, 1997.
        10.29++    Stock Pledge Agreement between the Company and Vicente
                   Anido, Jr., dated June 6, 1997.
        10.30++    Employment Agreement with Peter Myers, dated March 1, 1995.
        10.33++    Employment Agreement with Vicente Anido, Jr., dated March
                   14, 1996.
</TABLE>
 
                                       29
<PAGE>   31
 
<TABLE>
<CAPTION>
        EXHIBIT
         NUMBER                            DESCRIPTION
        --------                           -----------
        <S>        <C>
        10.34++    Employment Agreement with Lee R. McCracken, dated May 13,
                   1996.
        10.35++    Employment Letter with Karin Eastham, dated March 14, 1997.
        10.36++    Standard Industrial/Commercial Single-Tenant Lease between
                   the Company and Campson Corporation, dated December 22,
                   1995.
        10.38++    Lease Agreement between Harbor Investment Partners and the
                   Company, dated October 6, 1997.
        10.44++    1997 Stock Incentive Plan.
        10.45++    1997 Employee Stock Purchase Plan.
        10.46++    Form of Indemnification Agreement between the Company and
                   each of its directors.
        10.47++    Form of Indemnification Agreement between the Company and
                   each of its officers.
        10.48++    1997 Stock Incentive Plan Form of Notice of Grant of Stock
                   Option.
        10.49++    1997 Stock Incentive Plan Form of Stock Option Agreement.
        10.50++    1997 Stock Incentive Plan Form of Addendum to Stock Option
                   Agreement (Involuntary Termination Following Corporate
                   Transaction/ Change in Control).
        10.51++    1997 Stock Incentive Plan Form of Addendum to Stock Option
                   Agreement (Limited Stock Appreciation Right).
        10.52++    1997 Stock Incentive Plan Form of Stock Issuance Agreement.
        10.53++    1997 Stock Incentive Plan Form of Addendum to Stock Issuance
                   Agreement (Involuntary Termination Following Corporate
                   Transaction/ Change in Control).
        10.54++    1997 Stock Incentive Plan Form of Notice of Grant of
                   Automatic Stock Option (Initial Grant).
        10.55++    1997 Stock Incentive Plan Form of Notice of Grant of
                   Automatic Stock Option (Annual Grant).
        10.56++    1997 Stock Incentive Plan Form of Automatic Stock Option
                   Agreement.
        10.57++    1997 Employee Stock Purchase Plan Form of Stock Purchase
                   Agreement
        10.58*++   Collaborative Research and License Agreement between the
                   Company and ICOS Corporation, dated March 30, 1998.
        10.59*+    Collaborative Research and License Agreement by and between
                   the Company and Novartis Crop Protection AG, dated May 26,
                   1998.
        10.60+     Amendment No. 1 to the Promissory Note dated September 5,
                   1995 between the Company and Peter Myers dated as of June
                   15, 1998.
        10.61*+    Amendment to Collaborative Research and License Agreement by
                   and between the Company and Roche Bioscience a division of
                   Syntex (U.S.A.) Inc., dated as of July 31, 1998.
        10.62      Amended Promissory Note dated February 24, 1997 between the
                   Company and Vicente Anido Jr., Ph.D., amended as of November
                   8, 1998.
        10.63      Amendment No. 1 to Pledge Agreement by Vince Anido in favor
                   of the Company dated as of November 8, 1998.
        10.64*     Limited Liability Company Operating Agreement of ChiroChem
                   Discovery Services LLC between Chirotech Ltd. and CombiChem
                   JVR, Inc., dated as of December 1, 1998.
        10.65*     Cooperation Agreement between Chirotech Technology Ltd.,
                   Chirotech Ltd., CombiChem Inc., CombiChem JVR, Inc., and
                   ChiroChem Discovery Services LLC, dated as of December 1,
                   1998.
        10.66*     License Agreement between CombiChem Inc., and ChiroChem
                   Discovery Services LLC, dated as of December 1, 1998.
</TABLE>
 
                                       30
<PAGE>   32
 
<TABLE>
<CAPTION>
        EXHIBIT
         NUMBER                            DESCRIPTION
        --------                           -----------
        <S>        <C>
        10.67*     Services Agreement between CombiChem Inc. and ChiroChem
                   Discovery Services LLC, dated as of December 1, 1998.
        10.68*     Lead Generation Program Agreement by and between the Company
                   and Ono Pharmaceutical Co., Ltd., dated as of December 30,
                   1998.
        21.1       Subsidiaries of the Registrant.
        23.1       Consent of Ernst & Young LLP, Independent Auditors.
        24.1       Power of Attorney (see page 32).
        27.1       Financial Data Schedule.
</TABLE>
 
---------------
 +  Previously filed as an exhibit to Registrant's Quarterly Report on Form 10-Q
    for the quarter ended September 30, 1998 (No. 0-23473) and incorporated
    herein by reference.
 
++  Incorporated by reference to the same-numbered exhibit (except as otherwise
    indicated) to the Company's Registration Statement on Form S-1 (No.
    333-37981), as amended.
 
*   Certain confidential portions of this Exhibit were omitted by means of
    redacting a portion of the text (the "Mark"). This Exhibit has been filed
    separately with the Secretary of the Commission without the Mark pursuant to
    the Company's application requesting confidential treatment under Rule 406
    under the Securities Act.
 
SUPPLEMENTAL INFORMATION
 
     Copies of the Registrant's Proxy Statement for the Annual Meeting of
Shareholders to be held May 6, 1999 and copies of the form of proxy to be used
for such Annual Meeting will be furnished to the Commission at the same time
they are distributed to the shareholders.
 
                                       31
<PAGE>   33
 
                                   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.
 
                                              COMBICHEM, INC.
 
Date: March 30, 1999                          By:   /s/ VICENTE ANIDO JR.
 
                                                --------------------------------
                                                    Vicente Anido Jr., Ph.D.
                                                 President and Chief Executive
                                                             Officer
 
                               POWER OF ATTORNEY
 
     Know all men by these presents, that each person whose signature appears
below constitutes and appoints Vicente Anido Jr., Ph.D. or Karin Eastham, his or
her attorney-in-fact, with power of substitution in any and all capacities, to
sign any amendments to this Annual 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 the
attorney-in-fact or his or her substitute or substitutes may 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 in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
                   SIGNATURE                                TITLE                  DATE
                   ---------                                -----                  ----
<C>                                               <C>                         <S>
             /s/ VICENTE ANIDO JR.                President, Chief Executive  March 30, 1999
------------------------------------------------     Officer and Director
              Vicente Anido, Ph.D.
 
               /s/ KARIN EASTHAM                   Vice President, Finance    March 30, 1999
------------------------------------------------    and Administration and
                 Karin Eastham                     Chief Financial Officer
 
               /s/ PIERRE LAMOND                           Director           March 30, 1999
------------------------------------------------
                 Pierre Lamond
 
              /s/ PHILIPPE CHAMBON                         Director           March 30, 1999
------------------------------------------------
            Philippe Chambon, Ph.D.
 
                /s/ PETER MYERS                   Chief Scientific Officer,   March 30, 1999
------------------------------------------------   Chief Operating Officer
               Peter Myers, Ph.D.                        and Director
 
               /s/ ARTHUR REIDEL                           Director           March 30, 1999
------------------------------------------------
                 Arthur Reidel
 
               /s/ WILLIAM SCOTT                           Director           March 30, 1999
------------------------------------------------
              William Scott, Ph.D.
 
             /s/ MICHAEL J. PAZZANI                        Director           March 30, 1999
------------------------------------------------
           Michael J. Pazzani, Ph.D.
</TABLE>
 
                                       32
<PAGE>   34
 
                         INDEX TO FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
                                                              PAGE
                                                              ----
<S>                                                           <C>
COMBICHEM, INC.
Report of Ernst & Young LLP, Independent Auditors...........  F-2
Balance Sheets at December 31, 1997 and 1998................  F-3
Statements of Operations for the years ended December 31,
  1996, 1997 and 1998.......................................  F-4
Statements of Stockholders' Equity (Deficit) for the years
  ended December 31, 1996, 1997 and 1998....................  F-5
Statements of Cash Flows for the years ended December 31,
  1996, 1997 and 1998.......................................  F-6
Notes to Financial Statements...............................  F-7
</TABLE>
 
                                       F-1
<PAGE>   35
 
               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
 
The Board of Directors and Stockholders
CombiChem, Inc.
 
     We have audited the accompanying balance sheets of CombiChem, Inc. as of
December 31, 1997 and 1998, and the related statements of operations,
stockholders' equity (deficit), and cash flows for each of the three years in
the period ended December 31, 1998. 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 of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
 
     In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of CombiChem, Inc. at December
31, 1997 and 1998, and the results of its operations and its cash flows for each
of the three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles.
 
                                              /s/  ERNST & YOUNG LLP
 
San Diego, California
January 18, 1999, except for
Note 9, as to which the date is
March 5, 1999
 
                                       F-2
<PAGE>   36
 
                                COMBICHEM, INC.
 
                                 BALANCE SHEETS
 
                                     ASSETS
 
<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                        ----------------------------
                                                            1997            1998
                                                        ------------    ------------
<S>                                                     <C>             <C>
Current assets:
  Cash and cash equivalents...........................  $  5,866,635    $ 20,334,201
  Short-term investments, available-for-sale..........    11,054,725       9,024,714
  Accounts receivable.................................       527,633       2,891,981
  Prepaid expenses and other current assets...........       767,594       1,310,180
                                                        ------------    ------------
Total current assets..................................    18,216,587      33,561,076
  Property and equipment, net.........................     5,961,177       7,901,545
  Restricted cash.....................................       262,143         279,143
  Deposits and other assets...........................       879,845         238,247
  Notes receivable from employee/stockholders.........        56,303              --
                                                        ------------    ------------
Total assets..........................................  $ 25,376,055    $ 41,980,011
                                                        ============    ============
 
                   LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
  Accounts payable....................................  $    881,436    $  1,101,635
  Accrued liabilities.................................     1,394,046       1,295,386
  Deferred revenue....................................     1,475,752       3,192,981
  Current portion of obligations under capital
     leases...........................................     1,569,197       1,825,279
                                                        ------------    ------------
Total current liabilities.............................     5,320,431       7,415,281
Obligations under capital leases, less current
  portion.............................................     3,283,373       4,246,454
Deferred rent.........................................        91,227         141,771
Commitments
Redeemable convertible preferred stock, $.001 par
  value, 63,196,896 shares authorized at December 31,
  1997 and 5,000,000 authorized at December 31, 1998;
  31,019,635 and no shares issued and outstanding at
  December 31, 1997 and 1998, respectively............    23,129,968              --
Stockholders' equity (deficit):
Common stock, $.001 par value, 40,000,000 shares
  authorized; 3,227,005 and 13,399,201 shares issued
  and outstanding at December 31, 1997 and 1998,
  respectively........................................         3,227          13,399
Additional paid-in capital............................    12,519,952      51,861,673
Deferred compensation.................................    (1,582,320)     (1,140,684)
Notes receivable from stockholders....................      (569,061)       (424,830)
Accumulated deficit...................................   (16,820,742)    (20,133,053)
                                                        ------------    ------------
Total stockholders' equity (deficit)..................    (6,448,944)     30,176,505
                                                        ------------    ------------
Total liabilities and stockholders' equity
  (deficit)...........................................  $ 25,376,055    $ 41,980,011
                                                        ============    ============
</TABLE>
 
                            See accompanying notes.
                                       F-3
<PAGE>   37
 
                                COMBICHEM, INC.
 
                            STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31,
                                            -----------------------------------------
                                               1996           1997           1998
                                            -----------    -----------    -----------
<S>                                         <C>            <C>            <C>
Revenue:
Revenue under collaborative agreements:
  Project initiation fees and milestone
     payments.............................  $ 2,500,000    $ 3,333,331    $ 6,800,000
  Research and development funding........      420,000      4,137,250      8,274,434
Grant revenue.............................       47,400             --             --
                                            -----------    -----------    -----------
Total revenue.............................    2,967,400      7,470,581     15,074,434
Operating expenses:
  Research and development:
     Collaborative........................      420,000      4,316,938      9,208,931
     Proprietary..........................    4,820,253      4,399,620      5,848,672
                                            -----------    -----------    -----------
                                              5,240,253      8,716,558     15,057,603
  General and administrative..............    2,845,074      3,286,569      4,053,983
                                            -----------    -----------    -----------
Total operating expenses..................    8,085,327     12,003,127     19,111,586
                                            -----------    -----------    -----------
Loss from operations......................   (5,117,927)    (4,532,546)    (4,037,152)
Interest income...........................      144,639        662,525      1,429,363
Interest expense..........................     (145,139)      (251,665)      (524,522)
Foreign tax expense.......................           --       (200,000)      (180,000)
                                            -----------    -----------    -----------
Net loss..................................  $(5,118,427)   $(4,321,686)   $(3,312,311)
                                            ===========    ===========    ===========
Basic and diluted net loss per share......  $    (11.30)   $     (4.45)   $     (0.36)
                                            ===========    ===========    ===========
Shares used in computing basic net loss
  per share...............................      453,000        971,000      9,140,000
                                            ===========    ===========    ===========
</TABLE>
 
                            See accompanying notes.
                                       F-4
<PAGE>   38
 
                                COMBICHEM, INC.
 
                  STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
 
<TABLE>
<CAPTION>
                                                                                      NOTES
                                   COMMON STOCK       ADDITIONAL                    RECEIVABLE                        TOTAL
                               --------------------     PAID-IN       DEFERRED         FROM       ACCUMULATED     STOCKHOLDERS'
                                 SHARES     AMOUNT      CAPITAL     COMPENSATION   STOCKHOLDERS     DEFICIT      EQUITY (DEFICIT)
                               ----------   -------   -----------   ------------   ------------   ------------   ----------------
<S>                            <C>          <C>       <C>           <C>            <C>            <C>            <C>
Balance at December 31,
  1995.......................     660,165   $   660   $   119,057   $        --     $(150,000)    $ (7,380,629)    $ (7,410,912)
  Sale of common stock.......      74,000        74        22,126            --            --               --           22,200
  Repurchase and cancellation
    of common stock..........     (22,560)      (22)       (5,843)           --            --               --           (5,865)
  Net loss...................          --        --                          --            --       (5,118,427)      (5,118,427)
                               ----------   -------   -----------   -----------     ---------     ------------     ------------
Balance at December 31,
  1996.......................     711,605       712       135,340            --      (150,000)     (12,499,056)     (12,513,004)
  Sale of common stock.......   1,305,090     1,305    10,071,414            --            --               --       10,072,719
  Deferred compensation
    related to stock
    options..................          --        --     1,773,973    (1,773,973)           --               --               --
  Amortization of deferred
    compensation.............          --        --            --       191,653            --               --          191,653
  Sale of common stock for
    notes receivable.........   1,210,310     1,210       539,225            --      (540,435)              --               --
  Repayment of notes
    receivable...............          --        --            --            --       121,374               --          121,374
  Net loss...................          --        --                          --            --       (4,321,686)      (4,321,686)
                               ----------   -------   -----------   -----------     ---------     ------------     ------------
Balance at December 31,
  1997.......................   3,227,005     3,227    12,519,952    (1,582,320)     (569,061)     (16,820,742)      (6,448,944)
  Sale of common stock.......   2,456,275     2,456    16,231,301            --            --               --       16,233,757
  Conversion of redeemable
    convertible preferred
    stock to common stock....   7,754,933     7,755    23,122,213            --            --               --       23,129,968
  Repurchase of common
    stock....................     (39,012)      (39)      (11,793)           --            --               --          (11,832)
  Amortization of deferred
    compensation.............          --        --            --       441,636            --               --          441,636
  Repayment of notes
    receivable from
    stockholders.............          --        --            --            --       144,231               --          156,534
  Net loss...................          --        --                          --            --       (3,312,311)      (3,312,311)
                               ----------   -------   -----------   -----------     ---------     ------------     ------------
Balance at December 31,
  1998.......................  13,399,201   $13,399   $51,861,673   $(1,140,684)    $(424,830)    $(20,133,053)    $ 30,176,505
                               ==========   =======   ===========   ===========     =========     ============     ============
</TABLE>
 
                            See accompanying notes.
 
                                       F-5
<PAGE>   39
 
                                COMBICHEM, INC.
 
                            STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31,
                                            -----------------------------------------
                                                1996          1997           1998
                                            ------------   -----------   ------------
<S>                                         <C>            <C>           <C>
Cash flows from operating activities:
  Net loss................................  $ (5,118,427)  $(4,321,686)  $ (3,312,311)
  Adjustments to reconcile net loss to net
     cash used in operating activities:
     Depreciation of property and
       equipment..........................       310,765       849,285      1,671,681
     Amortization of premium on short-term
       investments........................            --        92,707        149,663
     Deferred rent........................        30,409        60,818         50,544
     Deferred revenue.....................     2,130,000      (654,248)     1,717,229
     Amortization of deferred
       compensation.......................            --       191,653        441,636
     Interest payable converted to
       preferred stock....................        20,913            --             --
     Change in operating assets and
       liabilities:
       Accounts receivable................      (198,419)     (329,214)    (2,364,348)
       Prepaid expenses and other current
          assets..........................      (154,152)     (422,366)      (400,708)
       Accounts payable and accrued
          liabilities.....................       607,106     1,032,345        121,539
                                            ------------   -----------   ------------
Net cash used in operating activities.....    (2,371,805)   (3,500,706)    (1,925,075)
Cash flows from investing activities:
  Purchases of short-term investments.....   (12,166,132)   (6,191,204)   (11,619,652)
  Maturities of short-term investments....            --     7,416,825     13,500,000
  Purchases of accrued interest on
     short-term investments...............            --      (206,913)      (141,878)
  Purchases of property and equipment.....    (2,575,690)   (3,911,307)    (3,612,049)
  Deposits and other assets...............      (102,077)     (741,750)       641,598
  Notes receivable from employees.........       (66,125)       12,688         56,303
                                            ------------   -----------   ------------
Net cash used in investing activities.....   (14,910,024)   (3,621,661)    (1,175,678)
Cash flows from financing activities:
  Advances on capital lease obligations...     2,337,375     3,257,645      3,096,873
  Principal repayments on capital lease
     obligations..........................      (410,876)     (915,816)    (1,877,710)
  Issuance of common stock................        22,200    10,072,719     16,233,757
  Repurchase of common stock..............        (5,865)           --        (11,832)
  Issuance of redeemable convertible
     preferred stock, net of issuance
     costs................................    12,995,390        23,240             --
  Payments on note payable................      (100,000)           --             --
  Receipt of payment on notes receivable
     from stockholders....................            --       121,374        144,231
  Restricted cash given as collateral for
     letter of credit.....................      (325,000)       62,857        (17,000)
                                            ------------   -----------   ------------
Net cash provided by financing
  activities..............................    14,513,224    12,622,019     17,568,319
                                            ------------   -----------   ------------
Net increase (decrease) in cash and cash
  equivalents.............................    (2,768,605)    5,499,652     14,467,566
Cash and cash equivalents at beginning of
  year....................................     3,135,588       366,983      5,866,635
                                            ------------   -----------   ------------
Cash and cash equivalents at end of
  year....................................  $    366,983   $ 5,866,635   $ 20,334,201
                                            ============   ===========   ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
  INFORMATION:
Interest paid.............................  $    124,266   $   258,109   $    522,521
                                            ============   ===========   ============
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING
  AND FINANCING ACTIVITIES:
Conversion of convertible notes payable
  and interest payable to redeemable
  convertible preferred stock.............  $    440,000   $        --   $         --
                                            ============   ===========   ============
</TABLE>
 
                            See accompanying notes.
                                       F-6
<PAGE>   40
 
                                COMBICHEM, INC.
 
                         NOTES TO FINANCIAL STATEMENTS
                               DECEMBER 31, 1998
 
 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
  Organization and Business
 
     CombiChem, Inc. is a computational product discovery company that is
applying its proprietary design technology and rapid synthesis capabilities to
accelerate the discovery process for new drugs and chemical products. The
Company believes its approach offers pharmaceutical and chemical companies the
opportunity to conduct their discovery efforts in a more productive and
cost-effective manner. Using its Discovery Engine(TM) process, the Company
focuses on the generation, evolution and optimization of potential new lead
candidates for its collaborative partners, who will then develop, manufacture,
market and sell any resulting products. CombiChem believes that its process is
widely applicable to a variety of disease targets and therapeutic indications as
well as to other industries such as agrochemical, industrial chemical and
materials science. In addition, the Company is using its approach on internal
programs to discover new lead candidates that will then be out licensed to third
parties, retaining a larger economic interest in such candidates.
 
  Cash, Cash Equivalents and Short-term Investments
 
     Cash and cash equivalents consist of cash and highly liquid investments
with maturities of three months or less when purchased. Short-term investments
are recorded at amortized cost which approximates market value.
 
     The Company applies Statement of Financial Accounting Standards No. 115,
Accounting for Certain Investments in Debt and Equity Securities (SFAS No. 115),
to its investments. Under SFAS No. 115, the Company classifies its short-term
investments as "Available-for-Sale" and records such assets at estimated fair
value in the balance sheet, with unrealized gains and losses, if any, reported
in stockholders' equity. As of December 31, 1998, the cost of cash equivalents
and short-term investments approximated fair market value.
 
  Concentration of Credit Risk
 
     The Company invests its excess cash in debt instruments of financial
institutions and corporations with strong credit ratings. The Company has
established guidelines relative to diversification and maturities that maintain
safety and liquidity. The Company historically has not experienced any material
losses on its cash equivalents or short-term investments.
 
  Property and Equipment
 
     Property and equipment are carried at cost. Depreciation of equipment is
computed using the straight-line method over the estimated useful lives of the
assets, generally three to seven years. Leasehold improvements are amortized
over the shorter of the estimated useful lives of the assets or the remaining
term of the lease. Amortization of equipment under capital leases is reported
with depreciation of property and equipment.
 
  Impairment of Long-Lived Assets
 
     Statement of Financial Accounting Standards No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of
(SFAS No. 121), requires impairment losses to be recorded on long-lived assets
used in operations when indicators of impairment are present and the
undiscounted cash flows estimated to be generated by those assets are less than
the assets' carrying amount. SFAS No. 121 also addresses the accounting for
long-lived assets that are expected to be disposed. To date there have been no
such indicators of impairments.
 
  Basic Net Loss Per Share
 
     Effective December 31, 1997, the Company adopted Statement of Financial
Accounting Standards No. 128 Earnings Per Share ("SFAS No. 128"). SFAS No. 128
requires the
 
                                       F-7
<PAGE>   41
                                COMBICHEM, INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                               DECEMBER 31, 1998
 
 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
presentation of basic earnings (loss) per share and diluted earnings (loss) per
share, if more dilutive, for all periods presented.
 
     In accordance with SFAS No. 128, Earnings Per Share and Securities and
Exchange Commission Staff Accounting Bulletin No. 98, basic net loss per share
has been computed using the weighted-average number of shares of Common Stock
outstanding during the period.
 
  Basic Net Loss Per Share
 
     A reconciliation of shares used in the calculation of basic net loss per
share follows (in thousands, except per share data):
 
<TABLE>
<CAPTION>
                                                 YEARS ENDED DECEMBER 31,
                                               -----------------------------
                                                1996       1997       1998
                                               -------    -------    -------
<S>                                            <C>        <C>        <C>
Net loss.....................................  $(5,118)   $(4,322)   $(3,312)
                                               =======    =======    =======
Weighted average shares of Common Stock
  outstanding (shares used in computing basic
  net loss per share)........................      453        971      9,140
                                               =======    =======    =======
Basic and diluted net loss per share.........  $(11.30)   $ (4.45)   $ (0.36)
                                               =======    =======    =======
</TABLE>
 
     The diluted EPS computation is the same as basic because all potential
common shares are antidilutive.
 
  New Accounting Standards
 
     In 1998, the Company adopted Statement of Financial Accounting Standards
No. 130, Reporting Comprehensive Income (SFAS No. 130) and Statement of
Financial Accounting Standards No. 131, Segment Information (SFAS No. 131). SFAS
No. 130 requires that all components of comprehensive income, including net
income, be reported in the financial statements in the period in which they are
recognized. Comprehensive income is defined as the change in equity during a
period from transactions and other events and circumstances from non-owner
sources. Net income and other comprehensive income, including foreign currency
translation adjustments, and unrealized gains and losses on investments, shall
be reported, net of their related tax effect, to arrive at comprehensive income.
Comprehensive loss was the same as net loss.
 
     SFAS No. 131 amended the requirements for public enterprises to report
financial and descriptive information about its reportable operating segments.
Operating segments, as defined in SFAS No. 131, are components of an enterprise
for which separate financial information is available and is evaluated regularly
by the Company in deciding how to allocate resources and in assessing
performance. The financial information is required to be reported on the basis
that is used internally for evaluating the segment performance. The Company
believes it operates in one business and operating segment and accordingly,
adoption of this standard did not have an impact on the Company's financial
statements.
 
  Revenues under Collaborative Agreements and Research and Development Costs
 
     The Company currently generates revenue primarily through its collaborative
agreements. Contract research revenue is recognized as research activities are
performed under the terms of the research contracts. Contract payments are
generally received in advance of the performance of the related research
activities. Such payments received in excess of amounts earned are recorded as
deferred revenue.
 
     Project initiation fees are recognized as revenue upon contract execution.
These fees are nonrefundable and the Company has no future performance
obligations related to such fees.
 
     Research and development costs are expensed as incurred. Costs of services
under the Company's collaborative agreements generally approximate the research
revenue under such agreements. Project initiation fees and milestone payments do
not have associated cost of services.
 
                                       F-8
<PAGE>   42
                                COMBICHEM, INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                               DECEMBER 31, 1998
 
 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
     The Company's accounts receivable consist primarily of payments due under
these agreements. Substantially all of such receivables are collected within 30
days of the balance sheet date.
 
     The Company's revenues are concentrated among a small number of customers,
as follows:
 
<TABLE>
<CAPTION>
                                                    YEARS ENDED
                                                    DECEMBER 31,
                                                --------------------
                                                1996    1997    1998
                                                ----    ----    ----
<S>                                             <C>     <C>     <C>
Novartis......................................   --      --       *
Elan/Athena...................................   --      18%     14%
ICOS..........................................   --      --       *
ImClone.......................................   --       *       *
Roche.........................................   67%     30%     38%
Sumitomo......................................   31%     39%     17%
Teijin........................................   --       *       *
Ono...........................................   --      --      12%
</TABLE>
 
---------------
* Amount earned represents less than 10% of revenues for the period.
 
  Stock-Based Compensation
 
     As permitted by Statement of Financial Accounting Standards No. 123 (SFAS
No. 123), the Company has elected to follow Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to Employees (APB 25), and related
Interpretations in accounting for its employee stock options. Under APB 25, when
the exercise price of the Company's employee stock options is not less than the
market price of the underlying stock on the date of grant, no compensation
expense is recognized. Options granted to consultants and non-employees are
measured at fair value in accordance with SFAS No. 123 and are expensed over the
period the related services are rendered.
 
  Use of Estimates
 
     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
 
  Reclassification
 
     Reclassifications have been made to certain prior period amounts to conform
to the 1998 presentation.
 
 2. BALANCE SHEET INFORMATION
 
  Investments
 
     There were no realized gains or losses on the sale of securities during the
three years ended December 31, 1998.
 
The Company's short-term investments classified as available-for-sale are as
follows:
 
<TABLE>
<CAPTION>
                                         DECEMBER 31,
                                   -------------------------
                                      1997           1998
                                   -----------    ----------
<S>                                <C>            <C>
Corporate bonds..................  $10,555,534    $9,024,714
Tax exempt municipal bonds.......      499,191            --
                                   -----------    ----------
                                   $11,054,725    $9,024,714
                                   ===========    ==========
</TABLE>
 
                                       F-9
<PAGE>   43
                                COMBICHEM, INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                               DECEMBER 31, 1998
 
 2. BALANCE SHEET INFORMATION (CONTINUED)
     The Company has one debt security, with a value of $3,000,000, with a
contractual maturity in the year 2000. All other debt securities held by the
Company at December 31, 1998 have a contractual maturity less than one year. The
amortized cost of the debt securities approximates fair value. Actual maturities
may differ from contractual maturities because the issuers of the securities may
have the right to prepay obligations without prepayment penalties.
 
  Property and Equipment
 
     Property and equipment consist of the following:
 
<TABLE>
<CAPTION>
                                         DECEMBER 31,
                                  --------------------------
                                     1997           1998
                                  -----------    -----------
<S>                               <C>            <C>
Laboratory and computer
  equipment.....................  $ 4,131,762    $ 7,299,758
Leasehold improvements..........    2,524,919      3,042,052
Office furniture, fixtures and
  equipment.....................      576,255        503,175
                                  -----------    -----------
                                    7,232,936     10,844,985
Less accumulated depreciation
  and amortization..............   (1,271,759)    (2,943,440)
                                  -----------    -----------
                                  $ 5,961,177    $ 7,901,545
                                  ===========    ===========
</TABLE>
 
 3. COMMITMENTS
 
  Leases
 
     The Company leases its facilities in San Diego and Palo Alto under two
operating lease agreements that expire in May 2006 and October 2002,
respectively. Rent expense was approximately $383,000, $613,000 and $713,000 for
the years ended December 31, 1996, 1997 and 1998, respectively. Lease payments
under both agreements are subject to future increases based upon the terms of
the lease agreements.
 
     The Company leases certain equipment under capital lease obligations. Cost
and accumulated amortization of equipment under capital leases were $6,599,000
and $1,140,000 at December 31, 1997 and $9,697,000 and $2,740,000 at December
31, 1998, respectively.
 
     Annual future minimum obligations for operating and capital leases as of
December 31, 1998 are as follows:
 
<TABLE>
<CAPTION>
       YEAR ENDING DECEMBER 31:         OPERATING LEASES    CAPITAL LEASES
       ------------------------         ----------------    --------------
<S>                                     <C>                 <C>
     1999.............................     $  683,341         $2,759,275
     2000.............................        699,778          2,109,571
     2001.............................        712,106          1,736,497
     2002.............................        682,799            299,998
     2003.............................        480,786                 --
     Thereafter.......................      1,263,944                 --
                                           ----------         ----------
Total minimum lease payments..........     $4,522,754          6,905,341
                                           ==========
Less amount representing interest.....                           833,608
                                                              ----------
Present value of obligations under
  capital leases......................                         6,071,733
Less current portion..................                         1,825,279
                                                              ----------
Long-term obligations under capital
  leases..............................                        $4,246,454
                                                              ==========
</TABLE>
 
                                      F-10
<PAGE>   44
                                COMBICHEM, INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                               DECEMBER 31, 1998
 
 4. STOCKHOLDERS' EQUITY (DEFICIT)
 
  Initial Public Offering
 
     In May 1998, the Company completed the sale of 2,359,500 shares of common
stock (including partial exercise of underwriters' over-allotment option) in its
initial public offering, for net proceeds of $16.2 million. In conjunction with
the offering, the Company reincorporated from California to Delaware, effected a
one-for-four reverse stock split of its common stock and all outstanding
preferred shares were converted into common stock on a one-for-four basis. All
share and per share amounts and stock option data have been restated to
retroactively give effect to the reverse stock split and the related change in
shares outstanding.
 
  1997 Stock Incentive Plan
 
     The Company's 1997 Stock Incentive Plan (the 1997 Plan) serves as the
successor equity incentive program to the Company's 1995 Plan. The 1997 Plan was
adopted by the Board of Directors and the stockholders on October 7, 1997 and
became effective upon completion of the initial public offering. A total of
1,072,170 shares of Common Stock have been authorized for issuance under the
1997 Plan. Under the 1997 Plan, options may be designated as incentive stock
options or nonstatutory stock options. Options under the 1997 Plan have a term
of up to 10 years from the date of grant. The exercise price of options shall be
fixed by the Board of Directors, but shall not be less than 100% of the fair
market value per share of common stock on the option grant dates.
 
     Under the 1997 Plan, selected employees, directors and consultants may be
issued shares of common stock at no less than 100% of the fair market value on
the date of grant. The vesting schedule for each option grant is determined by
the Board of Directors.
 
  1997 Stock Incentive Plan
 
     Information with respect to the 1995/1997 Plans is as follows:
 
<TABLE>
<CAPTION>
                                                           WEIGHTED-
                                                            AVERAGE
                                             SHARES      EXERCISE PRICE
                                           ----------    --------------
<S>                                        <C>           <C>
  Granted................................     562,980        $0.30
  Exercised..............................          --           --
  Cancelled..............................          --           --
                                           ----------
Balance at December 31, 1995.............     562,980        $0.30
  Granted................................     531,479        $0.30
  Exercised..............................     (72,589)       $0.30
  Cancelled..............................     (12,536)       $0.30
                                           ----------
Balance at December 31, 1996.............   1,009,334        $0.30
  Granted................................     721,543        $2.79
  Exercised..............................  (1,210,310)       $0.45
  Cancelled..............................     (32,471)       $0.34
                                           ----------
Balance at December 31, 1997.............     488,096        $3.56
  Granted................................     284,694        $6.26
  Exercised..............................     (16,774)       $0.49
  Cancelled..............................      (7,360)       $0.66
                                           ----------
Balance at December 31, 1998.............     748,656        $4.68
                                           ==========
</TABLE>
 
     At December 31, 1998, options to purchase 103,244 shares were vested and
338,464 shares remain available for grant. All options are exercisable when
issued, and are subject to repurchase if certain vesting requirements aren't
met.
 
                                      F-11
<PAGE>   45
                                COMBICHEM, INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                               DECEMBER 31, 1998
 
 4. STOCKHOLDERS' EQUITY (DEFICIT) (CONTINUED)
     Following is a further breakdown of the options outstanding as of December
31, 1998:
 
<TABLE>
<CAPTION>
                                                                                               WEIGHTED-
                                                                                                AVERAGE
                                                                 WEIGHTED-                     EXERCISE
                                                 WEIGHTED         AVERAGE                      PRICE OF
                                                  AVERAGE         EXERCISE        VESTED        VESTED
                                                 REMAINING         PRICE        OUTSTANDING   OUTSTANDING
                                   OPTIONS        LIFE IN        OF OPTIONS       OPTIONS       OPTIONS
   RANGE OF EXERCISE PRICES      OUTSTANDING       YEARS        OUTSTANDING     EXERCISABLE   EXERCISABLE
   ------------------------      -----------   -------------    -----------     -----------   -----------
<S>                              <C>           <C>             <C>              <C>           <C>
$0.30 - $0.40..................     66,193         7.18            $0.332          37,347       $0.352
$1.00..........................     26,485         8.55            $1.000           8,658       $1.000
$2.00 - $3.00..................     16,875         6.81            $2.741          10,742       $2.864
$4.00 - $5.00..................    421,653         5.69            $4.152          34,747       $4.449
$6.00 - $8.00..................    217,450         9.26            $7.623          11,750       $8.000
                                   -------                                        -------
                                   748,656         6.99            $4.679         103,244       $2.916
                                   =======                                        =======
</TABLE>
 
     Pro forma information regarding net loss and net loss per share is required
by SFAS No. 123 and has been determined as if the Company had accounted for its
employee stock options and stock purchase plan under the fair value method of
SFAS No. 123. The fair value for these options was estimated at the date of
grant using the "Minimum Value" method for option pricing with the following
assumptions for 1996, 1997 and through May 6, 1998: risk-free interest rates of
6.50%, dividend yield of 0%, and a weighted-average expected life of the options
of five years; and from May 7, 1998 through December 31, 1998: risk free
interest rates of 5.65%, dividend yield of 0%, volatility of .65, and a
weighted-average expected life of the options of five years.
 
     For purposes of pro forma disclosures, the estimated fair value of the
options are amortized to expense over the vesting period. The Company's adjusted
pro forma information is as follows:
 
<TABLE>
<CAPTION>
                                             YEAR ENDED DECEMBER 31,
                                    -----------------------------------------
                                       1996           1997           1998
                                    -----------    -----------    -----------
<S>                                 <C>            <C>            <C>
Pro forma net loss................  $(5,137,253)   $(4,376,686)   $(3,354,245)
Pro forma basic net loss per
  share...........................  $    (11.34)   $     (4.51)   $     (0.37)
</TABLE>
 
     The weighted-average fair value of options granted during 1996, 1997 and
1998 was $0.08, $0.72 and $0.79, respectively. The pro forma effect on net loss
is not likely to be representative of the pro forma effects on reported net
income or loss in future years because these amounts reflect less than four
years of vesting.
 
     The 1997 Employee Stock Purchase Plan (the "Purchase Plan") was adopted by
the Board of Directors and the stockholders on October 7, 1997 and became
effective upon completion of the initial public offering. A total of 150,000
shares of Common Stock have been authorized for issuance under the Purchase
Plan. The Purchase Plan permits eligible employees of the Company to purchase
shares of Common Stock, at semi-annual intervals, through periodic payroll
deductions. Payroll deductions may not exceed 10% of the participant's base
salary, and the purchase price will not be less than 85% of the lower of the
fair market value of the stock at either the beginning or the end of the
semi-annual intervals.
 
  Warrants
 
     As of December 31, 1998, the Company has issued warrants to purchase an
aggregate of 130,728 shares of common stock at prices ranging from $2.00 to
$2.48 per share. The warrants are exercisable in whole or in part through
various dates. The Company also has issued warrants to purchase 8,750 shares of
common stock at $0.30 per share. The warrants are exercisable in whole or in
part at any time at or prior to June 2000.
 
 5. NOTES RECEIVABLE FROM STOCKHOLDERS
 
     During 1995, the Company loaned $150,000 to an employee and stockholder for
the purchase of a residence in connection with the individual's employment
agreement. The note bears interest
 
                                      F-12
<PAGE>   46
                                COMBICHEM, INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                               DECEMBER 31, 1998
 
 5. NOTES RECEIVABLE FROM STOCKHOLDERS (CONTINUED)
at approximately 5.8% and matures on the earlier of (i) April 30, 2000, (ii) 30
days following cessation of employment, (iii) the date on which more than 50% of
the Company's outstanding shares of common stock are acquired by a single
purchaser or a group of purchasers (iv) the Company merges with or into another
organization, or (v) 10 days following the date on which the Maker sells or
transfers the Maker's real property. The note is secured by 87,500 shares of the
Company's common stock owned by the employee at the date of the note, plus any
capital stock thereafter acquired.
 
     In August 1996, the Company loaned $66,125 to an employee for relocation in
connection with employment, which is secured by a deed of trust on the
employee's residence. The loan was paid in full in December 1998.
 
     During 1997, the Company instituted an employee loan program whereby the
proceeds of full-recourse employee loans are used to purchase common stock from
the exercise of the employee's stock options. Under the program, the employee
pays 25% of the total exercise price, and the Company loans the employee the
remaining 75% of the purchase price. The loans bear interest at an adjustable
rate that is the minimum rate allowable by the Internal Revenue Service, subject
to quarterly adjustments by the Company. The loans will be repaid through 3
equal payments on the first three anniversary dates of the loan. The Company has
$262,527 in loans outstanding as of December 31, 1998 and $419,061 outstanding
at December 31, 1997, respectively.
 
 6. COLLABORATIVE RESEARCH AND DEVELOPMENT AGREEMENTS
 
  Athena Neurosciences, Inc., a wholly owned subsidiary of Elan Corporation, plc
 
     In October 1997, the Company entered into a collaborative agreement with
Athena Neurosciences, Inc. (Elan/Athena), a wholly owned subsidiary of Elan
Corporation, plc providing for a three-year program to discover novel
therapeutic compounds for treatment of central nervous system conditions. The
first project was initiated upon signing of this collaboration agreement, with a
second project initiated in March 1998. The agreement provides for Elan/Athena's
access to the Universal Informer Library as deemed necessary by the research
management committee composed of representatives of the Company and Elan/Athena.
Under the agreement, Elan/ Athena paid a project initiation fee and agreed to
provide research funding and milestone payments upon the achievement of
pre-determined objectives. Elan/Athena will also make royalty payments on
worldwide sales of products resulting from the collaboration. The agreement may
be terminated by either party 90 days following an uncured material breach or by
Elan/Athena after the one-year anniversary upon 90 days prior written notice. In
connection with the collaborative agreement, Elan International Services Ltd.,
an affiliate of Elan/Athena, purchased 1,000,000 shares of Common Stock for $8.0
million in October 1997. In addition, the same affiliate acquired 250,000 shares
of common stock in the initial public offering.
 
  ICOS Corporation
 
     In March 1998, the Company entered into a collaborative agreement with ICOS
Corporation (ICOS) providing for a lead evolution project on an undisclosed
target. Under the agreement, ICOS received exclusive global rights to develop
and market any products resulting from the collaboration. ICOS made an advance
payment in April 1998 and agreed to pay research support funding, payments upon
achievement of certain clinical milestones and royalty payments on any product
sales. The lead evolution project terminates on August 31, 2000. The agreement
may be terminated by either party 90 days following an uncured material breach.
 
  ImClone Systems Incorporated
 
     In October 1997, the Company entered into a collaborative agreement with
ImClone Systems Incorporated (ImClone) providing for a two-year program to
identify and characterize novel small molecule inhibitors to multiple targets
for development in oncology. The agreement provides for
 
                                      F-13
<PAGE>   47
                                COMBICHEM, INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                               DECEMBER 31, 1998
 
 6. COLLABORATIVE RESEARCH AND DEVELOPMENT AGREEMENTS (CONTINUED)
ImClone's access to the Company's Universal Informer Library and Virtual
Library. Under the terms of the agreement, ImClone agreed to provide the Company
research support payments, milestone payments upon the achievement of certain
program objectives and royalties on worldwide product sales of therapeutic
products that may arise out of the collaboration. The agreement may be
terminated by either party 90 days following an uncured material breach. In
connection with the collaborative agreement, ImClone purchased 312,500 shares of
Common Stock for $2.0 million.
 
  Novartis Crop Protection AG
 
     In May 1998, the Company entered into a collaborative agreement with
Novartis Crop Protection AG (Novartis) providing for a two-year lead
optimization project for the herbicide, fungicide and insecticide markets. Under
the agreement, Novatris paid a project initiation fee and agreed to provide
research funding and milestone payments upon the achievement of certain
milestones. Novartis has exclusive global rights to develop and market or
sub-license products resulting from the collaboration. The Company will be
entitled to royalties on sales of products resulting from the collaboration. The
agreement may be terminated by either party 90 days following an uncured
material breach.
 
  Ono Pharmaceutical Co., Ltd.
 
     In December 1998, the Company entered into a collaborative agreement with
Ono Pharmaceutical Co., Ltd. (Ono) providing for a two-year lead generation
research program on an undisclosed target. Under the agreement, Ono paid a
project initiation fee and agreed to provide research funding and milestone
payments upon the achievement of certain milestones. Ono will make royalty
payments on worldwide sales of products resulting from the collaboration. The
agreement may be terminated by either party 90 days following an uncured
material breach.
 
  Roche Bioscience, a division of Syntex (U.S.A.) Inc.
 
     In October 1996, the Company entered into a collaborative agreement with
Roche Bioscience providing for a broad two-year program to perform research
against three initial targets, including a protein-protein interaction, an
enzyme and a receptor, with an option to add additional targets. Roche
Bioscience can elect one of the approaches -- lead generation, lead evolution or
lead optimization -- for each research program against each collaboration
target. A program may be initiated at any time during the term of the
collaboration, thereby extending the term to allow for completion of each
program. Under the agreement, Roche Bioscience paid a project initiation fee to
the Company and agreed to provide research funding and to make milestone
payments upon the achievement of certain milestones. Roche Bioscience will make
royalty payments on worldwide sales of products resulting from the
collaboration.
 
  Sumitomo Pharmaceuticals Co., Ltd.
 
     In August 1997, the Company entered into a collaborative agreement with
Sumitomo Pharmaceuticals Co. Ltd. (Sumitomo) providing for a two-year lead
evolution program on a target that is believed to play a fundamental role in
osteoarthritis and rheumatoid arthritis. Under the agreement, Sumitomo paid a
project initiation fee and agreed to provide research funding and milestone
payments upon the achievement of certain milestones. Sumitomo will make royalty
payments on worldwide sales of products resulting from the collaboration.
Sumitomo may extend the research period for up to four successive six-month
periods upon mutual agreement. The agreement may be terminated by either party
90 days following an uncured material breach.
 
  Teijin Limited
 
     In March 1996, the Company entered into a collaborative agreement with
Teijin Limited (Teijin) providing for a one-year program on a G-protein coupled
receptor target. In March 1997, the Company and Teijin amended their agreement
to extend the collaboration for an additional
                                      F-14
<PAGE>   48
                                COMBICHEM, INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                               DECEMBER 31, 1998
 
 6. COLLABORATIVE RESEARCH AND DEVELOPMENT AGREEMENTS (CONTINUED)
year. While the initial focus of the collaboration was lead optimization, the
effort was redirected to lead evolution during the course of the research.
 
     Under the agreement, Teijin paid a project initiation fee to the Company
and agreed to provide research funding and milestone payments upon the
achievement of certain milestones. Teijin also committed internal resources to
the discovery effort. Teijin will make royalty payments on products resulting
from the collaboration. The Company retains the rights to the compounds arising
under this collaboration in North and South America; Teijin has rights to these
compounds in Asia and Europe with a right of first negotiation to acquire the
Company rights. Under the original agreement, either party may terminate the
agreement in the event of a material breach remaining uncured for 60 days. As of
March 1998, the Company has successfully concluded its research phase and
delivered lead candidates to Teijin for further development. As this development
process continues, Teijin will make additional payments if certain milestones
are met.
 
  7. BENEFIT PLAN
 
     The Company sponsors a 401(k) plan which covers employees who meet certain
age and service requirements. Employees may contribute a portion of their
earnings each plan year subject to certain Internal Revenue Service limitations.
The Company made no discretionary contributions to the plan for the years ended
December 31, 1998 and 1997.
 
  8. INCOME TAXES
 
     At December 31, 1998, the Company had federal and California income tax net
operating loss carryforwards of approximately $18,319,000 and $17,074,000,
respectively.
 
     The federal and California tax loss carryforwards will begin to expire in
2009 and 2002, respectively, unless previously utilized. The Company also has
federal and California research tax credit carryforwards of approximately
$653,000 and $426,000, respectively, which will begin to expire in 2010 unless
previously utilized. The Company also has a federal foreign tax credit
carryforward of approximately $380,000, which will begin to expire in 2002
unless previously utilized.
 
     Pursuant to Sections 382 and 383 of the Internal Revenue Code, annual use
of the Company's net operating loss and credit carryforwards may be limited in
the event of cumulative changes in ownership of more than 50%. However, the
Company does not believe such limitation will have a material effect upon the
utilization of these carryforwards.
 
     Significant components of the Company's deferred tax assets are shown
below. A valuation allowance, which was increased by $1,602,000 in 1998, has
been recognized to offset the deferred tax assets as of December 31, 1998 and
1997 as realization of such assets is uncertain.
 
<TABLE>
<CAPTION>
                                                   YEAR ENDED DECEMBER 31,
                                                  --------------------------
                                                     1997           1998
                                                  -----------    -----------
<S>                                               <C>            <C>
Deferred tax assets:
  Net operating loss carryforwards..............  $ 6,325,000    $ 7,436,000
  Research and development credits..............      558,000        930,000
  Foreign tax credit............................      200,000        380,000
  Other, net....................................      240,000        179,000
                                                  -----------    -----------
Total deferred tax assets.......................    7,323,000      8,925,000
Valuation allowance for deferred tax assets.....   (7,323,000)    (8,925,000)
                                                  -----------    -----------
Net deferred tax assets.........................  $        --    $        --
                                                  ===========    ===========
</TABLE>
 
     The Company recorded foreign tax expense of $200,000 and $180,000 for the
years ended December 31, 1997 and 1998, respectively, for taxes payable to the
Japanese tax authority resulting from revenues under the Sumitomo and the Ono
collaborations, respectively.
 
                                      F-15
<PAGE>   49
                                COMBICHEM, INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
                               DECEMBER 31, 1998
 
  9. SUBSEQUENT EVENTS
 
     In March 1999, the Company entered into a new lease agreement for its San
Diego research and administrative facility with a target commencement date of
November 1, 1999. The new lease agreement is for a term of 15 years at
$2,295,000 per year subject to annual increases related to the Consumer Price
Index. The Company negotiated an agreement with the landlord of its current
facility to vacate the facility on terms which did not result in a financial
penalty or loss to the Company.
 
                                      F-16