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                       SECURITIES AND EXCHANGE COMMISSION
                              Washington, DC 20549

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

                                   FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
                                      1934

                  For the fiscal year ended December 31, 2000

                        Commission File Number: 0-26137

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

                              drugstore.com, inc.
             (Exact Name of Registrant as Specified in its Charter)

<TABLE>
<S>                                <C>
            Delaware                                 04-3416255
  (State or Other Jurisdiction                    (I.R.S. Employer
of Incorporation or Organization)               Identification No.)
</TABLE>

       13920 Southeast Eastgate Way, Suite 300 Bellevue, Washington 98005
                                 (425) 372-3200
  (Address, including zip code, and telephone number, including area code, of
                   Registrant's Principal Executive Offices)

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

          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 $0.0001 per share
                                (Title of Class)

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

   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 registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [_]

   Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in part III of this Form 10-K or any
amendment to this Form 10-K. [_]

   The aggregate market value of Common Stock held by non-affiliates of the
Registrant was approximately $34,557,954 as of March 1, 2001, based upon the
closing price of $1.3125 on the Nasdaq National Market reported on such date.
Shares of Common Stock held by each executive officer and director and by each
person who beneficially owns more than 5% of the outstanding Common Stock have
been excluded in that such persons may under certain circumstances be deemed to
be affiliates. This determination of executive officer and affiliate status is
not necessarily a conclusive determination for other purposes.

   As of March 1, 2001, the number of shares of Common Stock outstanding was
66,067,272.

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                              drugstore.com, inc.

                                   FORM 10-K
                  For the Fiscal Year Ended December 31, 2000

                                     Index

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 <C>      <S>                                                             <C>
                                      PART I

 ITEM 1.  BUSINESS......................................................    1

 ITEM 2.  PROPERTIES....................................................   17

 ITEM 3.  LEGAL PROCEEDINGS.............................................   17

 ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...........   17

                                      PART II

 ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
           STOCKHOLDER MATTERS..........................................   18

 ITEM 6.  SELECTED FINANCIAL DATA.......................................   19

 ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
           AND RESULTS OF OPERATION.....................................   20

 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK....   42

 ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...................   42

 ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
           AND FINANCIAL DISCLOSURE.....................................   42

                                     PART III

 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............   43

 ITEM 11. EXECUTIVE COMPENSATION........................................   43

 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
           MANAGEMENT...................................................   43

 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................   43

                                      PART IV

 ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON
           FORM 8- K....................................................   44
</TABLE>
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                                     PART I

ITEM 1. BUSINESS

Overview

   drugstore.com is a leading online drugstore and information site offering A
Very Healthy Way to Shop(TM) for health, beauty, wellness, personal care and
pharmacy products. We also sell prestige beauty products through Beauty.com, an
online retailer of prestige beauty products that we acquired in February 2000.
As of December 31, 2000, we have sold our products to approximately 1,669,000
customers. We were incorporated in April 1998 and commercially launched our Web
site on February 24, 1999. We have designed our store to provide a convenient,
private and informative shopping experience that encourages consumers to
purchase products essential to healthy, everyday living. Our Web site can be
accessed 24 hours a day, seven days a week from anywhere that a consumer has
Internet access. We believe we offer a larger selection of products than
typical store-based retailers, along with a wealth of health-related
information, buying guides and other tools designed to help consumers make more
educated purchasing decisions. Our shopping lists and e-mail reminders are
designed to make it easier for our customers to regularly purchase their
preferred products. We believe that our online store provides a customer with a
superior shopping experience.

Industry Background

 The Growth of the Internet and Electronic Commerce

   The Internet has become an important medium for communicating, finding
information and purchasing products and services. We believe that the number of
Web users in the United States will increase as a result of a number of factors
including:

  .  The large installed base of personal computers in the workplace and
     home;

  .  Advances in the performance and reductions in the cost of personal
     computers and modems;

  .  Improvements in the ease of use and security of the Internet;

  .  The availability of a broader range of online products, information and
     services; and

  .  Growing awareness among consumers and businesses of the benefits of
     online shopping.

   The Internet has unique and powerful characteristics that differentiate it
from traditional distribution channels and have facilitated its use as a
purchasing medium. We believe consumers using the Internet to purchase goods
expect a more information-intensive experience than when they shop at a
traditional retail store. We believe the ability to obtain relevant, up-to-date
information makes the consumer better prepared to make a purchase. Accessing
the Internet from a computer in the home or office allows a consumer to easily
scroll through and search articles, pages of product data and related topics.
This allows consumers to research and then purchase products at their
convenience.

 Healthcare Trends on the Internet

   Healthcare is one of the largest segments of the U.S. economy, representing
an annual expenditure of roughly $1 trillion, and health and medical
information is one of the fastest growing areas of interest on the Internet. We
believe that a large number of consumers shop for healthcare products online
and that the number of adults in the United States searching online for health
and medical information has grown and will continue to grow.

 The drugstore.com Market

   The market we address can be divided into five primary categories: health,
beauty, wellness, personal care and pharmacy. Many products in this market are
personal (being used on a person's skin or in a person's body) and essential,
and often are purchased repeatedly. In this market, vendors frequently
introduce new products,

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and consumers seek comprehensive product information. Consumers currently shop
for these products primarily in chain drugstores, mass market retailers,
supermarkets, warehouse clubs and independent drugstores. However, category-
specific retailers and catalogs also serve each of these categories. Overall,
distribution of products in our primary market categories is fragmented.

   Key aspects of the primary categories of the drugstore.com market are as
follows:

   Health. The health category includes over-the-counter remedies (such as
cough, cold, allergy and pain relief medications), first aid, medical devices
for home healthcare, contraceptives and other products related to the body's
health needs. We believe that the aging U.S. population, along with a greater
portion of prescription drugs becoming available as over-the-counter
medications, will contribute to growth in this market category. Consumers in
the health category often seek significant amounts of product information to
determine which products will meet their health needs. Consumers generally buy
health products from chain drugstores, mass market retailers, supermarkets, and
warehouse clubs as well as from locally-owned, independent drugstores and
convenience stores. Representative brands carried in our health product
category include Advil, Tylenol, Pepcid, Bausch & Lomb and Metamucil.

   Beauty. The beauty category includes cosmetics, fragrances and a variety of
skin care products. Some of the factors driving consumer demand for beauty
products include regular and seasonal new product introductions, as well as
changing fashion trends. Consumers often seek advice regarding these trends or
the functionality of new products. The beauty category can be broadly
classified into two subcategories: mass market and prestige products. Consumers
for mass market beauty products typically purchase such products in mass market
retailers, drugstores and supermarkets. In February 2000 we acquired
Beauty.com, Inc., an online retailer of prestige beauty products. Consumers for
prestige products generally shop in department stores, beauty specialty stores,
or spas and salons. Representative brands carried in our beauty product
category include Revlon, L'Oreal, Cover Girl and Neutrogena.

   Wellness. The wellness category includes vitamins, nutritional supplements,
herbs, homeopathy, and other natural products. We believe that increasing
consumer interest in nutritional and wellness products to improve physical and
mental well-being has contributed to growth in this category. We believe
supplemental product information is important to these consumers because they
are interested in the intended physiological effects of these products.
Consumers can obtain these products at chain drugstores, mass market retailers,
supermarkets, warehouse clubs, and specialty stores as well as through catalogs
or online vitamin and nutrition stores. Representative brands carried in our
wellness product category include Centrum, One-A-Day, Nature Made, Twinlab,
Natrol and Nature's Way. We are also the exclusive online retailer of General
Nutrition Companies, Inc. (GNC) wellness products.

   Personal Care. The personal care market category includes products related
to hair, body and eye care, shaving, oral hygiene and feminine needs. The
personal care category is comprised of a number of different product groups
that consumers typically shop for at mass market retailers, chain drugstores,
supermarkets, warehouse clubs and specialty stores. Representative brands
carried in our personal care product category include Gillette, Colgate,
Johnson & Johnson, Rogaine and Pampers.

   Pharmacy. This category consists primarily of prescription medication for
chronic illnesses, such as high blood pressure, osteoporosis and depression. We
believe that a significant percentage of prescription sales for chronic
illnesses are distributed through retail channels, and that the number of
prescriptions written for chronic illnesses will grow due to an aging
population and the increasing utilization of pharmaceuticals in medical
management. Over the past ten years, mail order pharmacies have become an
increasingly important source of pharmaceuticals for chronic illnesses.

                                       2
<PAGE>

 Limitations on Traditional Channels of Distribution

   Traditional channels of retail distribution for health, beauty, wellness,
personal care and pharmacy products have many limitations, including:

   Inconvenience. Consumers often view shopping for many of these products as a
chore. Shopping at a physical store can be highly inconvenient. It generally
involves time-consuming activities such as making a trip to the store, finding
a parking space, searching for the desired products, and waiting in line to
fill a prescription or make a purchase. This process can be especially
difficult for customers with disabilities or parents with young children. To
increase convenience for consumers, traditional store-based retailers often
need to open new stores, which is time-consuming and expensive. Each new store
results in significant investments in inventory, real estate, building
improvements and the hiring and training of store personnel. The required
investment may limit the ability of traditional store-based retailers to serve
geographic areas that are not densely populated. Also, an existing store may
face substantial added costs if it attempts to build more parking spaces or
hire more clerks in order to reduce parking and waiting inconveniences.

   Narrow Selection. Consumers value the opportunity to select items from a
broad range of products that best fit their needs. However, consumers must
often choose from a narrow product selection at traditional store-based
retailers. Stores may not carry a full range of products, especially prestige,
specialty or regional products, or carry a full assortment of sizes. Desired
items may be out of stock. Overcoming these difficulties can be prohibitively
expensive for traditional retail stores, usually due to shelf space
limitations, the cost of carrying inventory and the resulting need to allocate
inventory dollars to popular products. To the extent that mass market retailers
allocate physical store space to items such as alcohol, lawn furniture, motor
oil and snack foods, they may have to reduce the number of health, beauty,
wellness and personal care products that they offer. Product selection in
traditional store-based retailers cannot be tailored to individual needs
because it is driven by aggregate demand.

   Limited Information and Communication. Consumers buying health, beauty,
wellness, personal care and pharmacy products often seek information and
knowledgeable advice to assist them in making purchasing decisions. Many
traditional store-based retailers do not provide consumers with access to
useful product information or readily-available on-site experts who can provide
helpful advice. Employees at traditional store-based retailers, especially
supermarkets and mass market retailers, may have limited if any interaction
with their customers. Often there is no direct contact, except at the check-out
line. Customers may also face difficulties following up with questions after a
purchase. While traditional store-based retailers could take steps to increase
the availability of customized information and on-site experts, such steps
would involve substantial investments in printing and training. In addition, it
is difficult for a traditional retail store to use information about a
particular consumer to personalize that consumer's shopping experience.

   Lack of Privacy. Because many health, beauty, wellness, personal care and
pharmacy products are inherently personal, consumers often desire ways to
preserve the anonymity of their purchases and the confidentiality of the
information transferred in the buying process. Many consumers may feel
uncomfortable purchasing certain drugstore products, such as birth control
devices, feminine care products, and incontinence products, in a traditional
retail store. Many consumers have encountered the unpleasant experience of
placing such a product on a checkout stand's conveyor belt in front of store
clerks and other waiting customers. Consumers may hesitate to ask store
personnel questions about which product best meets a need, or how to use a
product, especially if either the question or the answer is embarrassing or may
be overheard by others. Overcoming this limitation is very difficult for
traditional retail stores because the consumer must visit a physical store
frequented by other customers and must interact in person with store employees.

The drugstore.com Solution

   We are a leading online drugstore: a retail store and information site for
health, beauty, wellness, personal care and pharmacy products. We designed our
store to provide a convenient, private and informative shopping

                                       3
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experience that encourages consumers to purchase products essential to healthy,
everyday living. We believe our online store provides customers with a superior
shopping experience, making buying What Every Body Needs(TM) less of a chore.

   We draw and retain consumers by emphasizing key attributes of our store:

   Convenience. Our user-friendly Web store may be reached from wherever the
shopper has Internet access, such as the shopper's home or office. Further
convenience advantages at our store include:

  .  Shopping 24 hours a day, seven days a week;

  .  Direct delivery to the shopper's home or office, avoiding the need for a
     trip to a physical store;

  .  The opportunity for customers to order refills of their existing Rite
     Aid prescriptions on our Web site for pick up at a local Rite Aid store
     or for delivery using one of our standard delivery options;

  .  A personal shopping list for every customer, allowing for quick and easy
     reordering in future visits;

  .  Simplified searching for products and information using advanced search
     technology;

  .  Confidential access by a customer to his or her individual medication
     profiles at any time; and

  .  Ability to purchase and send products easily to others.

   Selection. Because we do not have shelf-space limitations, we believe we
offer a significantly greater number of products than are available in a
traditional chain drugstore. Not only do we offer traditional chain drugstore
items (prescription drugs, over-the-counter medications and personal care), we
offer a broad selection of health, beauty and wellness products. Many
traditional chain drugstores do not carry a wide range of these products. We
believe that we offer one of the largest selections of drugstore products
available on the Internet. We are also the only online retailer that offers GNC
wellness products.

   Information. Because the Web has become an increasingly important tool for
researching healthcare topics, we believe that providing useful information is
a critical aspect of enabling consumers to make informed purchasing decisions.
We have assembled a broad array of information on our Web site that can enable
our consumers to make informed purchasing decisions. This information is
focused on key aspects of our market segments and is produced in-house, by
third-party expert sources or submitted to our Web site's Test Drive feature by
customers who test our products. Consumers can either access our information
directly, through a number of content features on our Web site, or can get free
help directly from our advisors and experts by contacting them through e-mail.
Our information services include:

  .  Full Product Packaging Information. Almost every product available on
     our Web site can be viewed in an expanded format where all package
     information, including ingredients, directions and warnings, can be read
     next to an enlarged photograph of the product.

  .  Easy Access to Drug Information and Personalized Pharmacy
     Advice. Consumers can access our extensive drug information library
     directly at our Web site, anytime at their own convenience. Patient
     information and drugstore.com drug prices can be accessed via our drug
     index. We provide information to help consumers understand generic drug
     alternatives and determine whether their medicines interact with each
     other. We also provide health- and pharmacy-related editorial content.
     Our pharmacists can provide personal guidance by phone or e-mail to
     ensure that each customer understands the correct usage, possible side
     effects and expected beneficial outcomes of a prescription or an over-
     the-counter medication.


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<PAGE>

   Communication. We can communicate with customers on a regular basis through
the convenience of e-mail. In addition to our Ask Your Pharmacist feature, we
offer the following means of communication with our store:

  .  Reminders. We have the ability to e-mail a customer when a prescription
     or non-prescription product is about to run out, reminding him or her to
     order a replacement product or a prescription refill. Customers simply
     tell us how often they need a product and we can send them a notice
     before it is scheduled to run out.

  .  Specialized Customer Care. To ensure timely and high-quality customer
     service, we have established specialty teams within the drugstore.com
     customer care department. Our Web site, product and insurance
     specialists respond to customer e-mails and calls that are related to
     shopping orders, insurance, prices, and shipping. Once an order is made,
     customers can view order-tracking information on our Web site.

  .  Personalized Communications. As customers use our Web site, they can
     provide us with information about their buying preferences and habits.
     We can use this information to develop personalized communications and
     deliver useful newsletters, special offers and new product announcements
     to our customers via e-mail and other means. In addition, we use e-mail
     to alert customers to important developments and merchandising
     initiatives.

   Privacy. Customers can shop in the privacy of their own homes or offices.
When shopping at a physical store, many shoppers feel embarrassed or
uncomfortable buying items that may reveal personally-sensitive aspects of
their health or lifestyle to store personnel or other shoppers. Shoppers at
drugstore.com avoid these problems. Through Ask Your Pharmacist, customers can
obtain answers to questions that they would otherwise be uncomfortable asking
in public.

   Pharmacy. We employ licensed pharmacists and are able to ship prescription
products to all 50 U.S. states, and we offer customers the opportunity to order
refills of their existing Rite Aid prescriptions on our Web site for pick-up at
a conveniently located Rite Aid store or for delivery using one of our standard
delivery options. Through our relationships with Rite Aid, insurance companies
and PBMs, we are able to obtain insurance reimbursement coverage for many
insured prescriptions. Customers can ask our pharmacists about medications and
receive other information about prescriptions drugs and health-related products
using the Ask Your Pharmacist feature of our Web site.

   Although we believe we offer significant advantages over traditional chain
drugstores, certain customers may feel that traditional chain drugstores offer
several advantages over our service, and we may not be able to meet the needs
of some customers. For example, we cannot serve emergency needs and we cannot
serve customers who do not have access to the Internet. Some customers may also
prefer to touch and see products in person, rather than view them on a computer
screen or prefer to talk to a pharmacist in person. Some customers may also
have general concerns about the privacy and security of information transmitted
over the Internet and will therefore prefer to shop in physical stores.

Shopping at drugstore.com

   Shoppers at drugstore.com see a home page that highlights our six product
departments, as well as editorial content and promotions. A shopper can browse
through the store by clicking on the permanently displayed department names,
move directly to a department's home page and view promotions and featured
products. All product lists allow a shopper to select products based on brand
or unique attributes of the category, such as tartar control or whitening for
toothpaste, or color for lipstick or eye shadow. Shoppers can also search the
site by entering text in the search box at the top of any page.


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   A customer can select products to purchase by clicking on the "buy" button
in the product list. The products are then added to the customer's shopping
bag. If a customer needs more information to make a purchase, we supply
interactive tools and content to aid in the decision, such as:

  .  Your List. Returning customers can easily view their previous purchases
     by consulting their personalized shopping lists through our Your List
     feature. The shopping lists make buying regularly-replenished items even
     easier to purchase because the customer can move products into their
     shopping bag directly from their personalized shopping list, without
     browsing the site. If requested by the customer, we also send e-mail
     reminders to consumers when items on their lists are scheduled to run
     out and need to be replenished.

  .  Ask Your Pharmacist. Our Ask Your Pharmacist feature allows customers to
     ask our pharmacists questions about over-the-counter and wellness
     products as well as prescription drugs.

  .  Getting Help. From every page of our Web site, a customer can click on a
     "help" button to go to our customer care area. In this area, we assist
     customers in searching for, shopping for, ordering and returning our
     products. In addition, we provide customers with answers to the most
     frequently asked questions and encourage our visitors to send us
     feedback and suggestions via e-mail.

   When the customer finishes selecting the desired products, he or she goes to
checkout. The only information required to checkout is an e-mail
identification, password (to protect account privacy), shipping address and a
valid credit card number. All of this information is maintained in a secure
format and remains available for the customer's future access.

Pharmacy Services

   The pharmacy services at drugstore.com are provided by experienced
professionals using advanced information technologies. We employ licensed
pharmacists who ensure private, personal customer service. We have received
Verified Internet Pharmacy Practice Sites (VIPPS) certification from the
National Association of Boards of Pharmacy. The VIPPS program sets standards
for Internet pharmacies and informs the public of those Web sites that are
fully licensed and have agreed to comply with its standards. We are able to
ship prescription products to all 50 U.S. states, and through our arrangement
with Rite Aid, customers may also order refills of their existing Rite Aid
prescriptions on our Web site for pick-up at any of the almost 3,800 Rite Aid
stores in the United States or for delivery using one of our standard delivery
options.

   Services. We seek to provide a high level of responsiveness and customer
support. In addition to our extensive drug information, specialized customer
care features and refill reminders, our pharmacy services include:

  .  Ask Your Pharmacist. Our Ask Your Pharmacist feature allows customers to
     ask our pharmacists questions about medication, dosage, delivery
     systems, common side effects and other information about prescription
     drugs and health-related products. Our pharmacists seek to provide an
     initial answer via e-mail within one business day.

  .  Private Access to drugstore.com Prescription History. Customers who fill
     their prescriptions at drugstore.com can access their secure, individual
     medication profiles at any time. A written patient information document
     accompanies all medications dispensed to drugstore.com customers. This
     service enables customers to maintain a record of their prescription
     purchases for clinical, insurance and tax reporting purposes.

  .  eMedAlert. We innovated the eMedAlert(TM) program to alert our customers
     to critical and timely information regarding prescriptions and over-the-
     counter product warnings, updates and recalls. Through the eMedAlert
     program, our goal is to rapidly communicate vital, complete and up-to-
     date drug and product recall/warning information to customers in a
     private, secure manner. The eMedAlert program combines public
     notifications on our Web site with targeted e-mail messages sent to
     customers who have purchased the drug or product that is the subject of
     the recall/warning.

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  .  Consumer Drug Interaction Checker. Consumers can use this feature to
     research interactions among prescription drugs, herbal supplements and
     dietary supplements, as well as to identify ingredient duplications
     between drugs. The checker also allows consumers to search for potential
     interactions between medications and food, alcohol and tobacco products.

  .  Frequently Asked Questions. Working in conjunction with our pharmacists,
     we have created a searchable database of almost 800 answers to
     frequently asked health questions.

   Filling Prescriptions. We only accept prescriptions from licensed health
care providers. We do not prescribe medications or otherwise practice medicine.
We focus on dispensing medications used by consumers on a chronic basis. For
acute care needs, meaning when a customer has a single episode of a short-term
illness or an exacerbation of a chronic condition in either case requiring
immediate attention, we recommend that customers pick up their prescriptions
from a local pharmacy because the treatment of acute care needs are extremely
time sensitive and the delivery time required by online purchases could be too
slow for the customer's needs. Medications used for acute care needs include
antibiotics and pain medications. We also do not dispense certain controlled
substances known as Schedule II pharmaceuticals at this time because there are
increased risks associated with their dispensation, such as fraud, illegal
resale of prescription drugs, and special storage shipping and handling
requirements. Schedule II Pharmaceuticals are drugs classified by the
Controlled Substance Act of 1970 as having a high potential for abuse, such as
opiates (including morphine) and products that contain oxycodone stimulants
(including amphetamine and methylphenidate) and depressants (including
secobarbital and amobarbital). We accept, verify and cross-check prescriptions
much like traditional retail and mail service pharmacies:

  .  Accepting Prescriptions. For new prescriptions, customers can direct
     their physicians to call or fax their prescriptions to us at 1-800-
     DRUGSTORE, or request that we contact their physician directly to obtain
     prescription information. For transfers, customers can direct their
     pharmacy to transfer their prescriptions or request us to contact their
     pharmacy to transfer the prescription to drugstore.com. For refills,
     customers may order directly from our Web site or respond to one of our
     e-mail refill reminders.

  .  Verifying Prescriptions. Our pharmacists verify the validity and
     completeness of prescription drug orders utilizing methods similar to
     those used by community-based pharmacists. The standard practice for
     verification of prescription drug orders is that the pharmacist will
     contact the physician's office by telephone or fax if there is any
     reason to question the validity, accuracy or authenticity of any order.
     In addition, our pharmacists call and verify the validity of
     prescription drug orders for allowable controlled substances, i.e.,
     Schedule III-V drugs. In addition, our pharmacists verify that all
     legally required information is recorded on the prescription drug order
     and utilize a database to verify physician identifying information, if
     necessary.

  .  Drug Utilization Review. To use our prescription drug services, all
     customers are asked to provide our pharmacists with information
     regarding drug allergies, current medical conditions and current
     medications. Our pharmacists use advanced technologies to cross-check
     every prescription against the information we receive from the customer
     for drug-, disease- and allergy-drug interactions.

   Payment. Customers may pay for their prescriptions with cash, by credit card
or by entering insurance information that shows that they are covered by a
managed care organization, insurance plan or PBM with whom we have a contract.
To date, the majority of our prescriptions have been submitted by customers
with insurance coverage. As a result of our relationship with Rite Aid, we are
able to fill prescriptions for most customers with pharmacy benefits covered by
a plan accepted by Rite Aid, and we participate in substantially all of the
retail pharmacy networks of Advanced PCS that were formerly owned by PCS and
the retail pharmacy networks managed by WellPoint Health Networks, Inc.
(WellPoint). In total, these networks claim to provide pharmacy benefit
management services for more than 70 million individuals in the United States.

   Pharmacy Supply. Until we opened our own distribution center facility, a
substantial majority of our pharmaceutical products delivered by mail were
supplied by RxAmerica. Upon the opening of our own

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distribution center in January 2000, we became obligated to purchase all of our
pharmaceutical products from Rite Aid, unless we are able to obtain better
overall terms from another vendor. We currently expect that Rite Aid will
continue to be the supplier for a majority of our pharmaceutical product
purchases. This purchase commitment will continue for the term of the Rite Aid
relationship.

Marketing and Promotion of our Site

   Our marketing and promotion strategy is designed to build brand recognition,
increase customer traffic to our store, add new customers, build strong
customer loyalty, maximize repeat purchases and develop incremental revenue
opportunities.

   We intend to continue to use the unique resources of the Internet as a means
of marketing in an effort to encourage traffic and repeat purchases. Our
advertising campaigns are focused on highly visited Internet portals, health-
related Web sites and other highly visited Web sites. We also have strategic
relationships with Amazon.com, Rite Aid and GNC, all of whom promote our Web
site. We believe that the marketing benefits of our relationship with
Amazon.com include the integration of various shopping features of our Web
site, the creation of a persistent drugstore.com shopping presence on
Amazon.com's Web site and the promotion of our site by one of the premier e-
commerce companies. In addition, Rite Aid has agreed to include drugstore.com
in a significant portion of Rite Aid's own advertisements, as well as on
shopping bags, prescription vials caps, in-store signs and permanent links from
its Web site. We also extend our market presence through our Associates
Program, which enables associated Web sites to make our products and services
available to their audiences through a link to our Web site.

Merchandising Strategy

   We believe that the breadth and depth of our product selection, together
with the flexibility of our online store and our range of helpful and useful
shopping services, enables us to pursue a strong merchandising strategy.
Aspects of this strategy include:

   Easy Access to a Wide Selection of Products. Our easy-to-use Web site and
robust search capabilities enable customers to browse our product selection by
brand, product and price, as well as combinations of these categories. For
example, a customer can easily search for all aspirin products or for Tylenol
for children without consulting store personnel or searching traditional store
shelves. Combination searching allows customers to find desired items easily
among our large selection of products.

   Flexible & Unique Merchandising. Our online store gives us flexibility to
change featured products or promotions without having to alter the physical
layout of a store. We are also able to dynamically adjust our product mix in
response to changing customer demand, new seasons or upcoming holidays and
introduce special promotions. Our technology also allows us to customize the
shopping experience by personalizing the products that are presented to
customers.

   Specialty Stores. We have created specialty stores in each of our product
categories. One specialty store, the boutique, sells high-end cosmetics. We
have also established the GNC LiveWell Store, which is dedicated to GNC
nutritional products and other products typically sold in GNC stores. We are
the exclusive distributor of GNC brand products on the Internet subject to our
meeting performance parameters during the third and fifth years of the
relationship. The specialty store format allows us to market products by life
stage, life style, health condition, specific consumer groups or seasonal
themes. Other specialty stores include natural, baby, salon, home spa and
holiday store.

   Extensive Product Information. A key component of our merchandising strategy
is the ability to use information as a tool for consumers. We combine
manufacturer information with editorial information to allow customers to make
more informed buying decisions and to comparison-shop more easily for products.
In addition, our Web site allows us to market products to customers in many
different ways, such as by product category or by product characteristics, such
as price or ingredients.

                                       8
<PAGE>

   Targeted Promotions. We have the ability to offer products to individual
customers based on their affinities or conditions. In addition, we can present
merchandise to a customer tailored to personal interests and shopping
histories. We also cross-sell a brand across our departments to promote impulse
buying by customers. For example, we might promote mothers' products in our
Pregnancy and Infant Center.

   Sampling. We have programs that allow us to provide samples of products to
customers as trials. We may also use sampling to work with manufacturers to
introduce new products.

   Marketing Programs for Suppliers. We host programs for branded manufacturers
to strategically market their brands. These programs motivate the manufacturers
to invest resources in marketing on our Web site. We believe that these branded
promotions improve the customer's shopping experience, because the
manufacturers provide our customers with purchase incentives along with the
information to make informed purchase and treatment decisions.

Delivery of Our Customer's Orders

   In January 2000, we began operating our own 290,000 square foot distribution
center in New Jersey to achieve greater control over the distribution process
and to ensure adequate supplies of products to our customers. As of June 2000,
all of our orders delivered by mail are processed from our distribution center.
In connection with opening our distribution center, we also expanded our
pharmacy operations through our arrangement with Rite Aid. Operating our own
distribution center facility has required us to hire and train a significant
number of new employees, increase inventory levels substantially and establish
a significant number of direct relationships with manufacturers.

   In connection with establishing our own distribution center, we became
obligated to buy our pharmaceutical products from Rite Aid, unless we are able
to obtain better overall terms from other vendors. As the number of orders
filled out of the pharmacy operation in our distribution center increases, we
expect that purchases from Rite Aid will account for an increasingly
significant portion of our total pharmaceutical product purchases. For
prescriptions filled through the pharmacy, we operate under our arrangement
with Rite Aid. For prescriptions filled through our distribution center
facility, our pharmacists perform all aspects of the prescription fulfillment
process and all aspects of customer service working together with a Rite Aid
"pharmacist in charge."

   Our warehouse management system provides us real-time data on inventory
receiving, shipping, inventory quantities and inventory location. This enables
us to notify customers on a real-time basis if the product is in stock. In
addition, we offer an order tracking system for our customers on our Web site.

   The inventories of Rite Aid and other vendors consist of items typically
found in traditional chain drugstores. Rite Aid purchases its pharmaceutical
products from a variety of manufacturers as well as wholesalers.

   For nonpharmaceutical orders, we generally charge our customers a shipping
charge that covers a portion of our expenses of shipping. We offer a variety of
shipping options, including next-day delivery for orders received during the
business week. We ship anywhere in the United States that is served by the
United Parcel Service or the U.S. Postal Service. Priority orders are flagged
and expedited through our fulfillment processes. For non-prescription product
orders, our goal is to ship within 24 hours of the time the order is placed.
For prescription products, our goal is to ship as soon as the prescription has
been verified and our pharmacists have completed drug utilization reviews.

   In addition, customers are able to order refills of their existing Rite Aid
prescriptions online at our Web site for pick-up at their choice of any one of
the almost 3,800 Rite Aid stores or for delivery using one of our standard
delivery options.


                                       9
<PAGE>

Customer Care

   We believe that a high level of customer service and support is critical to
retaining and expanding our customer base. Our customer care specialists are
available 24 hours a day, 7 days a week to provide assistance via e-mail or
phone. We strive to answer all customer inquiries within 24 hours. Our customer
care specialists handle questions about orders and how to use our Web site,
assist customers in finding desired products and register customers' credit
card information over the telephone. Our customer care specialists are a
valuable source of feedback regarding user satisfaction. Our Web site also
contains a customer care page that outlines store policies and provides answers
to frequently asked questions. In addition, our pharmacists can provide advice
to our customers about medication, dosage, delivery systems, common side
effects and other information about prescription drugs.

Operations and Technology

   We have implemented a broad array of services and systems for site
management, searching, customer interaction, transaction processing and
fulfillment. We use a set of software applications for:

  .  Accepting and validating customer orders;

  .  Organizing, placing and managing orders with vendors and fulfillment
     partners;

  .  Receiving product and assigning it to customer orders; and

  .  Managing shipment of products to customers based on various ordering
     criteria.

   These services and systems use a combination of our own proprietary
technologies and commercially available, licensed technologies. We focus our
internal development efforts on creating and enhancing the specialized,
proprietary software that is unique to our business. To enhance the online and
offline experience for Rite Aid and drugstore.com customers, we have integrated
certain of our information and pharmacy systems with Rite Aid's. Rite Aid has
granted us a nonexclusive, fully-paid license to the Rite Aid systems that are
integrated with our systems, subject to third party rights to such technology.

   We also have a technology license and advertising agreement with Amazon.com
under which we mutually agreed to license certain existing and future
technology used in the operation of our Web sites as long as we do not use the
technology to compete with each other. We currently are not using any
Amazon.com technology but could do so in the future if it would benefit us. See
"--Relationship with Amazon.com" for a further description of our agreements
with Amazon.com.

   Our core merchandise catalog, customer interaction, order collection,
fulfillment and back-end systems are proprietary to drugstore.com, but are
available to Amazon.com under our agreement with them. Our software platform
and architecture are integrated with an Oracle database system. The systems
were designed to provide real-time connectivity to the distribution center
systems for pharmacy and the non-pharmacy products. These include an inventory-
tracking system, real-time order tracking system, executive information system
and replenishment system. Our Internet servers use SSL technology with Verisign
issued digital certificates to help conduct secure communications and
transactions. Our systems infrastructure is hosted at Exodus Communications in
Tukwila, Washington, which provides communication lines from multiple providers
including UUNet and AT&T, as well as 24 hour monitoring and engineering
support. Exodus has its own generators and multiple back up systems in Tukwila.

   We maintain customer care centers in our Bellevue, Washington office and in
our prescription distribution facility in New Jersey, and use a real time
interactive voice response system with transfer capabilities between our
customer care centers in these locations. We also operate a toll-free number,
1-800-DRUGSTORE, through which customers can place orders and receive
information. In addition, customers who choose not to transmit their credit
card information via the Internet have the option of submitting their credit
card information by telephone.


                                       10
<PAGE>

Competition

   The online commerce market for health, beauty, wellness, personal care and
pharmacy products is intensely competitive and highly fragmented. Our
competitors can be divided into several groups: chain drugstores, such as
Walgreen's, CVS and Eckerd; mass market retailers such as Wal-Mart, Kmart and
Target; supermarkets, such as Safeway, Albertson's and Kroger; specialty
retailers and major department stores, such as Nordstrom, Macys and
Bloomingdale's; prescription benefit managers, such as Express Scripts and
Merck-Medco; Internet portals and online service providers that feature
shopping services, such as America Online, MSN and Yahoo!; and other online
retailers and/or mail order retailers of health, beauty, wellness, personal
care and/or pharmaceutical products. Each of these competitors operates within
one or more of the health, beauty, wellness, personal care and pharmacy product
categories.

   We believe that the following are principal competitive factors in our
market:

  .  Brand recognition;

  .  Product selection;

  .  Convenience;

  .  Price;

  .  Web site features, functionality and performance;

  .  Customer service;

  .  Quality of information services; and

  .  Reliability and speed of order shipment.

   Many of our current and potential competitors have longer operating
histories, larger customer or user bases, greater brand recognition and
significantly greater financial, marketing and other resources than we do. Many
of these current and potential competitors can devote substantially more
resources to their Web site and systems development than we can. In addition,
larger, well-established and well-financed entities may acquire, invest in or
form joint ventures with online competitors as the use of the Internet and
other online services increases.

   Some of our current and potential competitors may be able to secure products
from vendors on more favorable terms, fulfill customer orders more efficiently
and adopt more aggressive pricing or inventory availability policies than we
can. Traditional store-based retailers also enable customers to see and feel
products in a manner that is not possible over the Internet. Traditional store-
based retailers can also sell products to address immediate, acute care needs,
which we and other online sites cannot do.

Strategic Relationships

 Relationship with Amazon.com

   We have a strategic relationship with Amazon.com whereby Amazon.com
advertises our Web service. We believe that the benefits of our relationship
with Amazon.com include their advertising of our Web site and the beneficial
aspects of our being associated with one of the premier e-commerce companies.
Amazon.com is our largest shareholder, and Jeffrey P. Bezos, Amazon.com's
chairman of the board and chief executive officer is a member of our board of
directors. As part of our relationship with Amazon.com, we entered into a
technology license and advertising agreement. This agreement extends for ten
years and can be terminated for breach or in the event that we are acquired by
a competitor of Amazon.com. This agreement contains provisions generally
relating to the sharing of technology and technical support; however, we have
decided to develop our own technology and there has been no exchange of
technology by either party to date. Specifically, this agreement provides for
the license of substantially all of each company's technology to the other for
use within their

                                       11
<PAGE>

respective businesses that may be developed through August 10, 2008. Neither
company may use the other's technology to compete against the other. In
addition, each party has committed to providing the other with advertising on
our respective Web sites through the term of the agreement as mutually agreed
upon. In addition, we agreed not to place advertisements competitive to
Amazon.com's business on our site. We have also agreed not to sell advertising
on our Web site to, link our Web site to, or promote on our Web site any
company that sells products or services competitive with those which Amazon.com
offers or which Amazon.com is preparing to produce or market. We are currently
restricted with respect to books, music, videos electronics, toys, home
improvement products, software, gift centers, cards, auctions and third party
marketplace services through which third parties may advertise and sell
products or services. If Amazon.com expands into other areas this may further
limit the companies we can promote on our Web site. If we are acquired by an
Amazon.com competitor and Amazon.com does not vote in favor of the transaction,
we would lose our rights to advertise on Amazon.com's website, to restrict
Amazon.com's ability to compete in the online drugstore business, and to use
Amazon.com's technology (if we are then using any).

   On January 24, 2000 we entered into an agreement with Amazon.com to
integrate various shopping features of our Web site and to create a persistent
drugstore.com shopping presence on Amazon.com's Web site. Amazon.com has agreed
to promote the drugstore.com health and beauty product section of its Web site
to its customer base in a manner similar to its efforts with respect to its
other product sections. Under the agreement, the parties will also work to
implement additional features on the Amazon.com Web site designed to improve
customer shopping experiences, including integrated search and browse
capabilities and a shared shopping basket. The agreement also contains
exclusivity provisions restricting (1) the percentage of total revenues we can
obtain from the sale on our Web site of products or services other than health,
beauty (including cosmetics, fragrance, bathing and hair and skin products),
wellness, personal care and prescription drug products, and (2) the percentage
of revenues Amazon.com or any other Amazon.com marketing partner can receive
from the sale of these types of products on its Web site other than through its
relationship with us. The consideration for the agreement included 1,066,667
shares of our common stock with a fair value of $30.0 million issued
immediately in a private placement transaction and minimum cash payments
totaling $75.0 million over the three-year term of the agreement. In July 2000,
Amazon.com agreed to reduce the remaining minimum cash payments due over the
three-year term of the agreement from $75.0 million to $30.0 million.
Additionally, we agreed to pay additional amounts in cash if the advertising
services exceed certain performance thresholds in the second and third year of
the agreement. We also issued to Amazon.com a fully vested, nonforfeitable and
exercisable warrant to purchase 2.5 million shares of our common stock at $4.94
per share. The agreement may be terminated for breach or on the occurrence of
certain other events.

Relationship With Rite Aid

   In June 1999, we entered into a strategic relationship with Rite Aid. Under
the relationship, customers are able to order refills of their existing Rite
Aid prescriptions from us at our site and either use our standard delivery
options or pick up the prescriptions at the almost 3,800 Rite Aid stores
nationwide. We recognize revenues on all orders filled by us or picked up at
Rite Aid stores where our customer has used our Web site to order
prescriptions. In the case of orders from customers who have elected to pick up
their prescriptions in a Rite Aid store, we pay Rite Aid for the cost of such
products based on a contractually agreed upon price. In addition, Rite Aid and
drugstore.com have agreed to promote each other's services both online and
offline, including a link from Rite Aid's Web site to our Web site. We believe
that potential benefits of our relationship with Rite Aid include additional
revenue and traffic generated by customers who visit our Web site, the pharmacy
benefit coverage provided by the insurance companies and PBMs with which Rite
Aid has a relationship, including PCS, and the co-promotion and co-branding
activities both companies have undertaken. In connection with this
relationship, Rite Aid also became one of our largest stockholders, and as of
March 1, 2001, owned approximately 14.1% of our outstanding common stock. In
addition, Mary Sammons, Rite Aid's president and chief operating officer, is a
member of our board of directors.

                                       12
<PAGE>

   As part of the relationship, both Rite Aid and drugstore.com agreed to
certain exclusivity provisions that limit drugstore.com's ability to promote or
affiliate with any other physical retail drugstore and from operating a
traditional physical drugstore, and preclude Rite Aid from offering or selling
products or services on the Internet other than through our Web site. In
addition, the agreement provides that we are obligated to purchase all of our
pharmaceutical requirements from Rite Aid unless we are able to obtain better
overall terms from another vendor. The agreement contains additional provisions
providing for the licensing by Rite Aid to drugstore.com of information
technology systems and the integration of the information technology and
pharmacy systems of the two companies. This agreement extends for ten years,
but can be terminated for breach prior to such time.

Relationship With GNC

   In June 1999, we entered into a relationship with GNC whereby we are the
exclusive online provider of GNC-branded products. We have the exclusive right
to sell GNC's wellness products over the Internet, including the PharmAssure
brand of pharmacist recommended vitamins and nutritional supplements, subject
to our meeting performance parameters based on traffic to our Web site and
sales of GNC products in the third and fifth year of the relationship. As long
as we have the exclusive right to distribute GNC's products over the Internet,
we will not promote any other retail health food store or operate a physical
retail health food store. If the exclusivity provisions of the agreement
terminate, we have the non-exclusive right to sell these products for the
remaining term of the agreement. As part of this relationship, we have created
a separate part of our Web site called the GNC LiveWell Store that is dedicated
to selling on a consignment basis GNC products. We are entitled to retain a
percentage of the gross revenues that we collect from sales of GNC products and
will recognize only the net amount retained as revenues. In connection with
this relationship, GNC acquired 2,947,853 shares of our Series E preferred
stock (all of which was converted into common stock, on a one-for-one basis, at
the closing of our initial public offering). GNC and drugstore.com also agreed
to co-promote each other's products and services in both their traditional and
online marketing efforts, including GNC's placement of a link to our Web site
on their Web site. The agreement extends for ten years, but can be terminated
for breach prior to such time. GNC is a subsidiary of Royal Numico N.V., a
European maker of nutrition products.

 Other Relationships

   In June 2000, we entered into a five-year agreement with WellPoint a leading
health plan owned pharmacy benefit management company. Pursuant to this
agreement, we are designated WellPoint's preferred Internet pharmacy and
drugstore and have access to WellPoint's members. In exchange, we issued
WellPoint 750,000 shares of our common stock with a fair value of approximately
$5.0 million and will make certain cash payments to WellPoint over the five-
year term of the agreement.

   Also in June 2000, we entered into a five-year agreement with CIGNA
HealthCare companies (CIGNA), one of the nation's leading providers of health
benefit programs. Pursuant to this agreement, we will provide health and beauty
products to CIGNA's plan participants by providing them direct access to our
Web site from the home page of CIGNA's Internet site and through CIGNA's mail
order pharmacy. In exchange, we issued CIGNA a warrant to purchase 500,000
shares of our common stock at $7.76 per share.

Government Regulation

   Our business is subject to extensive federal, state and local regulations.
In particular, entities engaging in the practice of pharmacy are subject to
federal and state regulatory and licensing requirements. For example, pursuant
to the Omnibus Budget Reconciliation Act of 1990 and related state and local
regulations, pharmacists are required to offer counseling, without additional
charge, to customers about medication, dosage, delivery systems, common side
effects, adverse effects or interactions and therapeutic contraindications,
proper storage, prescription refill, and other information deemed significant.
Entities that distribute "controlled substances" are also subject to the
Controlled Substances Act and regulations issued by the federal Drug
Enforcement

                                       13
<PAGE>

Administration. Entities engaged in the practice of medicine are also subject
to state and local regulatory and licensing requirements.

   We also sell dietary supplements, medical devices, cosmetics, conventional
foods, drug products (prescription, over-the-counter, and homeopathic), and
consumer products subject to regulation by the Food and Drug Administration
(FDA), Federal Trade Commission (FTC), Consumer Product Safety Commission
(CPSC), and state regulatory authorities. In addition to regulating the claims
made for specific types of products, the FDA and FTC may also attempt to
regulate the format of Web sites that offer products to consumers. As we expand
our product and service offerings, more of our products and services will
likely be subject to FDA, FTC, CPSC, and state regulation.

   We have structured our business, and entered into arrangements with our
business partners, in order to comply with pharmacy regulatory and licensing
requirements, requirements applicable to distributors of controlled substances,
and requirements associated with the practice of medicine. We have also
structured our business in order to comply with FDA, FTC, CPSC, and state
regulatory requirements applicable to the sale of products to consumers.
Regulations in all of the above-mentioned areas often require subjective
interpretation, and we cannot be certain that our attempts to comply with the
above regulations will be deemed sufficient by the appropriate regulatory
agencies. Violations of any regulations could result in various civil and
criminal penalties, including but not limited to suspension or revocation of
any applicable licenses or registrations, seizure of our inventory, or monetary
fines that could adversely affect our operations.

   Regulatory requirements to which we are subject may expand over time.
Congress and the federal agencies continue to scrutinize the benefits and risks
of online pharmacies, focusing especially on those sites that illegally issue
prescriptions and illegally sell prescription drugs. To combat the illegal
issuance of prescriptions and illegal sale of prescription drugs over the
Internet, certain members of Congress have proposed additional regulation of
Internet pharmacies, primarily regarding disclosure of certain identifying
information on Web sites, as well as additional enforcement mechanisms and
funding for such efforts. In addition, a federal effort initiated by the
previous administration is the Internet Working Group, charged with studying
the issue of whether existing federal laws provide a sufficient basis for
effective investigation and prosecution of unlawful conduct involving use of
the Internet, including the sale of prescription drugs. This study has yet to
be completed. In December 1999, the Clinton Administration announced a proposal
to eliminate the illegal sale of prescription drugs over the Internet by
unlicensed Web site operators. If approved by Congress, the proposal would,
among other things, establish new federal requirements for Internet pharmacies
to ensure that they comply with state and federal laws, create new civil
penalties for the illegal sale of pharmaceuticals, and authorize additional
federal enforcement powers. We believe we are in compliance with existing
federal and state requirements for pharmacy licensing and registration, and
with laws relating to dispensing of prescription drugs, security, record-
keeping and reporting of pharmacy sales. Thus, we believe that our business
would not be negatively affected by any laws or regulations that result from
this government oversight or the Clinton Administration's proposal. However, we
do believe that any resulting laws or regulations will likely increase our
reporting and monitoring requirements.

   The National Association of Boards of Pharmacy, a coalition of state
pharmacy boards, has developed the VIPPS program, a model for voluntary
regulation for online pharmacies that provides certification of compliance with
all state laws and regulations and other criteria established to ensure good
pharmacy practice. We have received VIPPS program certification.

   At the end of December 2000, former President Clinton and the Department of
Health and Human Services (HHS) released regulations to protect the privacy of
individually identifiable health information. The regulations are required
under the Health Insurance Portability and Accountability Act of 1996 (HIPPA).
HIPPA mandated the development of standards and requirements to control the
flow of health information throughout the health care system. The HIPPA
regulations are still open for public comment and have not been finalized.
Covered organizations and practitioners will have two years to comply with the
regulations once they become effective. Several of the requirements in the
regulaitons could create financial and administrative

                                       14
<PAGE>

burdens for pharmacies, including online pharmacies. Other legislation and
regulations currently being considered at the federal and state level could
affect our business, including legislation or regulations relating to
confidentiality of patient records, electronic access and storage. In addition,
state legislatures may add or amend legislation related to the regulation of
nonresident pharmacies.

   The inclusion of outpatient prescription drugs as a Medicare benefit has
been the subject of numerous bills in the U.S. Congress. Should legislation on
prescription drug coverage for Medicare recipients be enacted into law, we
would be subject to compliance with any corresponding rules and regulations.

Intellectual Property

   We regard the protection of our copyrights, service marks, trademarks, trade
dress and trade secrets as critical to our future success and rely on a
combination of copyright, trademark, service mark and trade secret laws and
contractual restrictions to establish and protect our proprietary rights in
products and services. We have entered into confidentiality and invention
assignment agreements with our employees and contractors, and nondisclosure
agreements with our vendors, fulfillment partners and strategic partners to
limit access to and disclosure of our proprietary information. We cannot be
certain that these contractual arrangements or the other steps taken by us to
protect our intellectual property will prevent misappropriation of our
technology. We have licensed in the past, and expect that we may license in the
future, certain of our proprietary rights, such as trademarks or copyrighted
material, to third parties. For example, as noted above, we have licensed our
technology to Amazon.com and we have also granted nonexclusive rights to our
trademarks in connection with advertising and affiliate relationships. While we
attempt to ensure that the quality of the drugstore.com products brand is
maintained by such licensees, we cannot assure that such licensees will not
take actions that might hurt the value of our proprietary rights or reputation.
We also rely on technologies that we license from third parties, such as Oracle
and Microsoft, the suppliers of key database technology, the operating system
and specific hardware components for our service. As part of our relationship
with Rite Aid, we have also licensed information technology systems from Rite
Aid. We cannot be certain that these third-party technology licenses will
continue to be available to us on commercially reasonable terms. The loss of
such technology could require us to obtain substitute technology of lower
quality or performance standards or at greater cost, which could harm our
business.

   We have filed applications for the registration of some of our trademarks
and service marks in the United States and in some other countries, including
for drugstore.com(TM). We have not secured registration of any of our marks to
date. DRUGSTORE.COM(TM), the drugstore.com logo, THE BOUTIQUE(TM), WHAT EVERY
BODY NEEDS(TM), WHERE EVERY BODY SHOPS(TM), WHAT YOUR BODY NEEDS(TM), HEALTH .
BEAUTY . WELLNESS(TM), WELLNESS CONNECTIONS(TM), LET THE DRUGSTORE COME TO
YOU(TM), QUICK LISTS, TEST DRIVE(TM), ONE VERY HEALTHY ATTITUDE(TM) and
EPUNCHCARD(TM) are our trademarks. We may be unable to secure such registered
marks. It is also possible that our competitors or others will use marks
similar to ours, which could impede our ability to build brand identity and
lead to customer confusion. In addition, there could be potential trade name or
trademark infringement claims brought by owners of other registered trademarks
or trademarks that incorporate variations of the term drugstore.com(TM). Any
claims or customer confusion related to our trademark, or our failure to obtain
trademark registration, would negatively affect our business. In addition, the
laws of some foreign countries do not protect our proprietary rights to the
same extent as do the laws of the United States, and effective copyright,
trademark and trade secret protection may not be available in such
jurisdictions. Our efforts to protect our intellectual property rights may not
prevent misappropriation of our content. Our failure or inability to protect
our proprietary rights could substantially harm our business.

                                       15
<PAGE>

Employees

   As of December 31, 2000, we had 553 full-time employees. None of our
employees is represented by a labor union. We have not experienced any work
stoppages and consider our employee relations to be good.

Executive Officers of the Registrant

   The following table sets forth information with respect to our executive
officers as of March 2, 2001:

<TABLE>
<CAPTION>
            Name           Age                    Position
            ----           ---                    --------
   <C>                     <C> <S>
   Peter M. Neupert.......  44 Chairman of the Board of Directors, President
                               and Chief Executive Officer

   Kal Raman..............  31 Senior Vice President and Chief Operating
                               Officer

   Robert A. Barton.......  34 Vice President of Finance and Chief Financial
                               Officer

   Christopher G. Hauser..  49 Vice President, Operations

   Sean P. Nolan..........  32 Vice President of Technology and Chief
                               Technology Officer

   Alesia L. Pinney.......  37 Vice President, General Counsel and Secretary
</TABLE>

   Peter M. Neupert has served as a director and the President and Chief
Executive Officer of drugstore.com since July 1998 and as chairman of the board
of directors since July 1999. From March 1987 to July 1998, he worked for
Microsoft Corporation in several positions, most recently as Vice President of
News and Publishing for Microsoft's interactive media group. Mr. Neupert holds
an M.B.A. from the Amos Tuck School of Business at Dartmouth College and a B.A.
from Colorado College.

   Kal Raman (formerly known as Kalyanaraman Srinivasan) has served as Senior
Vice President and Chief Operating Officer of drugstore.com since November
1999. He served as Vice President, Technology and Chief Information Officer of
drugstore.com from August 1998 to May 1999, as Vice President, Technology and
Operations and Chief Information Officer from March 1999 to May 1999 and as
Senior Vice President, Operations and Chief Information Officer from May 1999
to November 1999. From March 1998 to August 1998, Mr. Raman served as the Chief
Information Officer and Vice President of Nations Rent and from February 1997
to March 1998, he served as Senior Director, Information Systems of Blockbuster
Inc. From May 1992 to February 1997, Mr. Raman served as Director,
International Division of Wal-Mart Stores Inc.

   Robert Barton has served as Vice President of Finance and Chief Financial
Officer of drugstore.com since January, 2001. He has been with drugstore.com
since September of 1998 serving in various senior financial management and
operational roles, including Vice President and General Manager of Pharmacy
from June, 2000 to January, 2001. Prior to joining drugstore.com, Mr. Barton
was the Director of Business Planning and also managed various accounting and
analysis groups for AT&T Wireless Services from August 1995 to August 1998, and
was an Accounting and Auditing Manager with Deloitte & Touche LLP from February
1989 to August 1995. Mr. Barton holds a CPA license in the state of Washington
and a B.A. in business administration from Washington State University.

   Christopher G. Hauser has served as Vice President, Operations of
drugstore.com since July 1999. Prior to that time, he was Senior Vice
President, Information Technologies and Operations for Multiple Zones
International. From 1994 to 1996, Mr. Hauser was Director of Distribution for
Fingerhut Companies, Inc., and from 1991 to 1994, he commanded the largest
distribution center in the U.S. Department of Defense. Mr. Hauser received an
M.S. in Logistics Operations and an M.B.A. from the United States Naval
Academy.

   Sean P. Nolan has served as Vice President of Technology and Chief Technical
Officer of drugstore.com since May 4, 2000. Mr. Nolan joined drugstore.com in
August 1998 as Development Manager. Prior to joining drugstore.com, Mr. Nolan
served as Chief Executive Officer of Turtleback Software from August 1997 to
August 1998. In 1996, Mr. Nolan co-founded and served as Vice President of
Technology for Cognisoft, Inc.,

                                       16
<PAGE>

which was acquired in 1997 by Verity, where Mr. Nolan served as Vice President
of Technology for the Information Application Division until July 1997. From
1991 through 1996, Mr. Nolan worked at Microsoft Corporation. Mr. Nolan holds a
B.A. in Cognitive Science and Psychology from Dartmouth College.

   Alesia L. Pinney has served as Vice President, General Counsel and Secretary
of drugstore.com since October 2000. From January 1999 through October 2000,
she served as Assistant Secretary and Associate General Counsel of
drugstore.com. Prior to joining drugstore.com, Ms. Pinney was a lawyer with
Perkins Coie LLP, a limited liability partnership from May 1994 through July
1997 and from January 1998 to January 1999. From July 1997 through December
1997, Ms. Pinney was Corporate Counsel to RealNetworks, Inc. Ms. Pinney holds a
J.D. from the Seattle University School of Law (formerly, the University of
Puget Sound School of Law), an M.T. from the University of Denver and a B.A.
from Seattle University.

ITEM 2. PROPERTIES

   Our principal executive offices are located in Bellevue, Washington, where
we lease approximately 55,000 square feet under a lease that expires in July
2005. In addition, we lease for additional executive office space of
approximately 34,000 square feet in Bellevue, Washington under a lease that
expires in February 2003. Our distribution facility is located in Bridgeport,
New Jersey, where we lease approximately 290,000 square feet under a lease that
expires in April 2005, with options to renew for two additional five-year
periods.

ITEM 3. LEGAL PROCEEDINGS

   We are not a party to any material legal proceedings at this time.

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

   None.

                                       17
<PAGE>

                                    PART II

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

Market Information

   Our common stock has been quoted on the Nasdaq National Market under the
symbol "DSCM" since our initial public offering on July 27, 1999. Prior to that
time, there was no public market for our common stock. The following table sets
forth, for the periods indicated, the high and low reported intraday sales
prices per share of our common stock.

<TABLE>
<CAPTION>
                                                                  Common Stock
                                                                      Price
                                                                  -------------
                                                                   High   Low
                                                                  ------ ------
   <S>                                                            <C>    <C>
   Fiscal Year Ended January 2, 2000:
   Third Quarter (from July 27, 1999)............................ $70.00 $32.50
   Fourth Quarter................................................ $55.00 $27.13

   Fiscal Year Ended December 31, 2000:
   First Quarter................................................. $39.38 $12.38
   Second Quarter................................................ $13.38 $ 5.88
   Third Quarter................................................. $ 8.13 $ 3.06
   Fourth Quarter................................................ $ 4.56 $ 0.72
</TABLE>

   On March 1, 2001, the reported last sale price of our common stock on the
Nasdaq National Market was $1.3125 per share, and there were approximately 448
holders of record of our common stock.

Dividend Policy

   We have never declared or paid cash dividends on our capital stock. We
currently intend to retain all available funds and any future earnings for use
in the operation and expansion of our business and do not anticipate paying any
cash dividends in the foreseeable future.

                                       18
<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                  Period from
                                                                 April 2, 1998
                                         Year Ended  Year Ended  (Inception) to
                                        December 31, January 2,   December 31,
                                            2000        2000          1998
                                        ------------ ----------  --------------
                                           (in thousands, except share and
                                                   per share data)
<S>                                     <C>          <C>         <C>
Consolidated Statements of Operations
 Data:
Net sales..............................  $  109,979  $   34,848     $   --
Costs and expenses:
  Cost of sales........................     100,711      43,332         --
  Fulfillment and order processing(1)..      37,464      15,985         --
  Marketing and sales(2)...............      76,183      40,615       3,092
  Technology and content(3)............      27,377      14,918       2,178
  General and administrative(4)........      20,002      11,126       1,861
  Charitable contribution..............         --        3,600         --
  Amortization of intangible assets....      34,774      10,640          33
  Amortization of stock-based
   compensation........................      15,115      15,375       1,037
                                         ----------  ----------     -------
    Total costs and expenses...........     311,626     155,591       8,201
                                         ----------  ----------     -------
Operating loss.........................    (201,647)   (120,743)     (8,201)
Interest income, net...................       8,632       4,912         174
Net loss...............................  $ (193,015) $ (115,831)    $(8,027)
                                         ==========  ==========     =======
Basic and diluted net loss per share...  $    (3.56) $    (6.13)    $(14.70)
                                         ==========  ==========     =======
Weighted average shares outstanding
 used to compute basic and diluted net
 loss per share........................  54,212,080  18,880,969     546,149
                                         ==========  ==========     =======
</TABLE>

<TABLE>
<CAPTION>
                                            December 31, January  December 31,
                                                2000     2, 2000      1998
                                            ------------ -------- ------------
                                                      (in thousands)
<S>                                         <C>          <C>      <C>
Consolidated Balance Sheet Data:
Cash, cash equivalents and marketable
 securities................................   $129,888   $132,754   $14,408
Working capital............................   $134,088   $106,960   $17,050
Total assets ..............................   $458,523   $395,708   $22,517
Capital lease obligations, less current
 portion...................................   $  2,399   $  2,687   $   975
Total stockholders' equity.................   $411,989   $350,749   $19,347
</TABLE>
--------
(1) Excludes amortization of stock-based compensation of $1,630 for the year
    ended December 31, 2000, $1,549 for the period ended January 2, 2000 and
    $26 for the period from April 2, 1998 (inception) to December 31, 1998.

(2) Excludes amortization of stock-based compensation of $1,561 for the year
    ended December 31, 2000, $2,181 for the period ended January 2, 2000 and
    $163 for the period from April 2, 1998 (inception) to December 31, 1998.

(3) Excludes amortization of stock-based compensation of $3,976 for the year
    ended December 31, 2000, $3,153 for the year ended January 2, 2000 and $209
    for the period from April 2, 1998 (inception) to December 31, 1998.

(4) Excludes amortization of stock-based compensation of $7,948 for the year
    ended December 31, 2000, $8,492 for the year ended January 2, 2000 and $639
    for the period from April 2, 1998 (inception) to December 31, 1998.

                                       19
<PAGE>

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

   The following discussion should be read in conjunction with the financial
statements and notes thereto included elsewhere in this report.

Overview

   drugstore.com is a leading online drugstore: a retail store and information
site for health, beauty, wellness, personal care and pharmacy products and
information. We offer a larger selection of products than typical store-based
retailers at competitive prices, along with a wealth of health-related
information, buying guides and other tools designed to help consumers make more
educated purchasing decisions.

   We were incorporated in April 1998 and commercially launched our Web site on
February 24, 1999. From the period from inception through the commercial launch
of our site, our primary activities consisted of:

  .  Developing our business model;

  .  Raising funds and developing strategic alliances;

  .  Designing and developing our Web site;

  .  Recruiting and training employees;

  .  Selecting our fulfillment partners and integrating their systems and
     processes with ours;

  .  Negotiating advertising contracts with several of the major Web portals;
     and

  .  Developing the drugstore.com brand.

   Since the commercial launch of our site, we have continued these operating
activities and have also focused on acquiring and retaining customers,
expanding our product offerings, building vendor relationships, promoting our
brand name, improving the efficiency of our order fulfillment processes,
establishing customer service operations and developing our own distribution
capabilities.

   All customer orders are processed through our Web store and can be either
shipped to the customer or, in the case of refills of existing drugstore.com or
Rite Aid prescriptions, picked up by the customer at any Rite Aid store in the
United States. If ordered on our Web store, orders are either billed to the
customer's credit card or, in the case of prescriptions covered by insurance,
billed to third parties. Sales of pharmaceutical products covered by third
parties are recorded at the net amount to be received. Generally, we collect
cash from credit card sales in two to five days from the date the order is
shipped. Amounts billed to third parties are, on average, collected in
approximately 30 days; however, such timing can vary depending on the payor.
Sales billed to third party insurance companies and PBMs through our
relationship with Rite Aid currently represent a significant percentage of our
pharmacy sales. We expect that sales billed to these third parties will
continue to represent a significant percentage of our pharmacy sales for the
forseeable future.

   We routinely offer discounts and coupons to customers. In addition, if a
customer is not satisfied with a particular product or the level of customer
service we provide, we generally refund all or a portion of the sale.
Allowances for refunds and sales price incentives, including discounts and
coupons, are netted against the related sales price in net sales. We may in the
future expand or increase the coupons and discounts we offer to our customers.

   In January 2000, we began operating our own 290,000 square foot distribution
center. In connection with opening our distribution center, we also opened our
own pharmacy as part of our agreement with Rite Aid. Operating our own
distribution facility has required us to hire and train a significant number of
new employees, increase inventory levels substantially and establish a
significant number of direct relationships with nonpharmaceutical product
manufacturers. We are obligated to buy our pharmaceutical products from Rite
Aid unless we are able to obtain better overall terms from other vendors.

                                       20
<PAGE>

   In February 2000, we acquired Beauty.com, a Web store specializing in
prestige beauty products. We currently operate Beauty.com as a separate Web
store, and perform all of Beauty.com's fulfillment activities from our own
distribution center.

   In January 2001, we laid off approximately 100 employees. As a result of the
layoffs, we decided to consolidate certain of our corporate facilities and are
attempting to sublease or exit the leases associated with the excess
facilities. In March 2001, we negotiated the cancellation of a lease for new
corporate office space in exchange for forfeiting a portion of our lease
deposit, thereby reducing our minimum commitments through 2012 by approximately
$46.9 million. Accordingly in the first quarter of 2001, we expect to record a
charge ranging from approximately $7.0 million to $8.0 million associated with
the costs of exiting such leases, forfeiting our lease deposit and writing off
the related leasehold improvements and equipment.

   We have incurred net losses of $316.9 million from inception to December 31,
2000. We believe that we will continue to incur net losses for at least the
next four years (and possibly longer). We have a limited operating history on
which to base an evaluation of our business and prospects. Our prospects must
be considered in light of the risks, expenses, and difficulties encountered by
companies in their early stage of development, particularly companies in new
and rapidly-evolving markets, such as e-commerce.

   In view of our limited operating history and the rapidly evolving nature of
our business, we believe that period-to-period comparisons of our operating
results are not meaningful and should not be relied upon as an indication of
future performance. It is likely that in some future quarter our operating
results may fall below the expectations of securities analysts and investors.
In this event, the trading price of our common stock may fall significantly.

Results of Operations

 Net Sales

<TABLE>
<CAPTION>
                                  Fiscal Year          Fiscal Year Fiscal Year
                                     2000     % Change    1999        1998
                                  ----------- -------- ----------- -----------
                                                ($ in thousands)
   <S>                            <C>         <C>      <C>         <C>
   Net sales.....................  $109,979     216%    $  34,848     $ --
   New customers.................   974,000      40%      695,000       --
   Orders from repeat customers
    as a percentage of total
    orders.......................        59%                   36%      --
   % of net sales from
    pharmaceutical products......        51%                   54%      --
</TABLE>

   Net sales includes gross revenues from sales of product and related shipping
fees, net of discounts and provision for sales returns, third-party
reimbursement and other allowances. We generally refund to customers all or a
portion of the selling price, including related shipping fees if applicable, in
the event a customer is not satisfied with the product purchased or the quality
of customer service provided. Sales returns and allowances have not been
significant to date.

   Revenues from sales of product shipped to customers, and related shipping
fees, are recognized upon shipment. Prior to opening our own distribution
center, we arranged for shipment of product to customers through various
contractual relationships with third-party fulfillment partners. Revenues from
sales of certain pharmaceutical products ordered through our Web store for
delivery at a Rite Aid store are recognized when the product is delivered to
the customer.

   We currently utilize Rite Aid as a fulfillment partner, and prior to opening
our own distribution center, utilized RxAmerica L.L.C. for pharmaceutical
products and Walsh Distribution, Inc. for non-pharmaceutical products as
fulfillment partners. Upon receiving and validating a customer's order for
products that will be purchased by us from a fulfillment partner, and
subsequently shipped or delivered to the customer by that fulfillment partner,
we submit relevant order information and, if applicable, shipping instructions
to that

                                       21
<PAGE>

fulfillment partner for processing. We believe we act as a principal in
connection with orders shipped or delivered to customers by fulfillment
partners on our behalf because, among other things, we establish the retail
prices of significantly all of its non-pharmaceutical and non-insured
pharmaceutical products (and accept contractual reimbursement amounts from
third-party payors for insured pharmaceutical products) and shipping fees;
contractually take title to, and assume risk of loss of, products prior to
their shipment; bear credit and collection risk from the customer or, in the
case of certain pharmaceutical sales, third-party payors; and bear the risk
that the product will be returned. Title to products ordered by customers and
shipped or delivered by a fulfillment partner passes to us at the fulfillment
partners' distribution center or, for certain pharmaceutical sales, when the
pharmaceuticals are made available for customer retrieval at a Rite Aid store.

   Net sales also includes consignment service fees earned under arrangements
in which we do not take title to the inventory and cannot establish pricing.
Consignment service fees earned have not been significant to date.

   Our net sales in both the pharmaceutical and non-pharmaceutical categories
have increased each year since we commenced operations in February 1999 due to
increases in new customers and repeat orders. Additionally, the average net
sales per order has increased from approximately $32 in the year ended January
2, 2000 to approximately $46 in the year ended December 31, 2000. Such increase
is primarily attributable to higher average basket sizes for repeat customers
and changes in the mix of products merchandised in our Web store, including
seasonal and prestige beauty products. The decrease in pharmaceutical product
sales as a percent of total net sales was primarily related to higher net sales
of seasonal and prestige beauty products more than offsetting the full year of
Rite Aid in-store pickup service for prescription refills in 2000, which
commenced service in the third quarter of 1999.

   We currently expect that net sales for fiscal year 2001 will range from
approximately $135 million to $145 million. The level of our net sales that we
actually achieve will depend on a number of factors including, but not limited
to, the following:

  .  The number of customers we are able to acquire and retain;

  .  The frequency of our customers' purchases;

  .  The quantity and mix of products our customers purchase;

  .  The quantity of the types of products we are able to offer for sale;

  .  The price we charge for our products;

  .  The amount we charge for shipping;

  .  The extent of sales price incentives, including coupons and discounts
     that we offer;

  .  The extent of reimbursement available from third-party payors;

  .  The level of customer returns we experience; and

  .  The seasonality that we may experience in our business.

 Cost of Sales

<TABLE>
<CAPTION>
                                   Fiscal Year          Fiscal Year Fiscal Year
                                      2000     % Change    1999        1998
                                   ----------- -------- ----------- -----------
                                                 ($ in thousands)
   <S>                             <C>         <C>      <C>         <C>
   Cost of sales..................  $100,711     132%     $43,332      $ --
   Percentage of net sales........        92%                 124%       --
</TABLE>

   Cost of sales consists primarily of the cost of products sold to our
customers, including allowances for shrinkage and slow moving and expired
inventory, as well as outbound and inbound shipping costs.

                                       22
<PAGE>

Additionally, expenses related to promotional inventory included in shipments
to customers are included in cost of sales. Payments that we receive from
vendors in connection with joint merchandising activities, net of related
costs, are netted against cost of sales in the period in which the activities
take place.

   Cost of sales as a percent of net sales decreased as a result of fewer sales
incentives offered to customers, including promotional inventory, coupons and
discounts. Additionally, we experienced a more favorable mix of product sales
in fiscal year 2000, associated primarily with seasonal merchandise and
prestige beauty products. We continue to offer promotional merchandise, coupons
and discounts as a strategy to attract new customers, although such amounts
have decreased over time as a percentage of net sales. Promotional coupons can
only be used by customers to offset the price of non-pharmaceutical products.
Additionally, our shipping costs exceeded the amount we charged our customers
for shipping in both fiscal year 2000 and 1999. We expect to continue to
subsidize a portion of our shipping costs for the foreseeable future as a
strategy to attract and retain customers.

   We expect cost of sales to increase in absolute dollars to the extent that
our sales volume increases. Cost of sales as a percentage of net sales is
expected to range from 84% to 86% in fiscal year 2001, and will fluctuate based
on a number of factors, including, but not limited to, the following:

  .  The cost of our products, including the extent of promotional
     allowances, payments for joint merchandising activities and purchase
     volume discounts that we are able to obtain from suppliers;

  .  Our pricing strategy relative to the cost of our products, including the
     extent to which we offer promotional merchandise, coupons or discounts;

  .  The mix of products our customers purchase;

  .  The mix of consignment service fees versus product sales;

  .  The mix of cash payments vs. insurance reimbursement for our pharmacy
     products;

  .  Our shipping pricing strategy relative to the cost of shipping; and

  .  The extent to which we are able to control product damage, shrinkage and
     expiration through inventory management practices.

 Fulfillment and Order Processing

<TABLE>
<CAPTION>
                                 Fiscal Year          Fiscal Year Fiscal Year
                                    2000     % Change    1999        1998
                                 ----------- -------- ----------- -----------
                                               ($ in thousands)
   <S>                           <C>         <C>      <C>         <C>
   Fulfillment and order
    processing..................   $37,464     134%     $15,985      $ --
   Percentage of net sales......        34%                  46%       --
</TABLE>

   Fulfillment and order processing expenses include expenses related to
distribution center equipment and packaging supplies, per-unit fulfillment fees
charged by third parties, bad debt expense, credit card processing fees, and
payroll and related expenses for personnel engaged in customer service,
purchasing, and distribution and fulfillment activities, including pharmacists
engaged in prescription verification activities and warehouse personnel. These
expenses also include rent expense and depreciation related to the Company's
distribution center.

   Fulfillment and order processing expenses decreased as a percentage of net
sales as a result of the efficiencies gained through higher volumes and in
operating our own distribution center in fiscal year 2000. We expect that
fulfillment and order processing expenses in 2001 will decrease both in
absolute dollars and as a percentage of net sales due to the elimination of the
costs associated with certain duplicative fulfillment activities incurred
during the transition to our own distribution center in fiscal year 2000 and
increased operational efficiencies in fiscal year 2001.

                                       23
<PAGE>

 Marketing and Sales

<TABLE>
<CAPTION>
                            Fiscal Year          Fiscal Year          Fiscal Year
                               2000     % Change    1999     % Change    1998
                            ----------- -------- ----------- -------- -----------
                                        ($ in thousands)
   <S>                      <C>         <C>      <C>         <C>      <C>
   Marketing and sales.....   $76,183      88%     $40,615    1,214%    $3,092
   Percentage of net
    sales..................        69%                 117%                --
</TABLE>

   Marketing and sales expenses include advertising and marketing expenses,
promotional expenditures, and payroll and related expenses for personnel
engaged in marketing and merchandising activities. Advertising expenses include
media, agency and production costs associated with our branding campaign as
well as costs associated with Web portal advertising contracts.

   The increases in marketing and sales expenses are primarily attributable to
increases in headcount and related expenses as well as increased media, agency
and production costs associated with our branding campaign in fiscal year 1999
and the first half of fiscal year 2000. Additionally in fiscal year 2000, we
acquired and began promoting Beauty.com, and we incurred additional expenses
associated with our portal advertising agreement with Amazon.com.

   We expect that marketing and sales expenses will decrease both in absolute
dollars and as a percentage of net sales in fiscal year 2001 due to
significantly reduced spending on branding and promotional activities and
reductions in headcount and related expenses.

 Technology and Content

<TABLE>
<CAPTION>
                             Fiscal Year          Fiscal Year          Fiscal Year
                                2000     % Change    1999     % Change    1998
                             ----------- -------- ----------- -------- -----------
                                               ($ in thousands)
   <S>                       <C>         <C>      <C>         <C>      <C>
   Technology and content..    $27,377      84%     $14,918     585%     $2,178
   Percentage of net
    sales..................         25%                  43%                --
</TABLE>

   Technology and content expenses consist primarily of payroll and related
expenses for personnel engaged in maintaining and making minor upgrades and
enhancements to our Web site and content. These expenses also include payroll
and related expenses for information technology personnel, Internet access and
hosting charges and Web site content and design expenses.

   Technology and content expenses increased in each of the past two years,
primarily due to increased expenses associated with the depreciation of Web
servers and other equipment and the addition of information technology
personnel and additional use of consultants and contract labor. Such personnel
assisted in maintaining and making minor upgrades and enhancements to our Web
store as well as maintaining the systems supporting the Web site.

   We expect that technology and content expenses will decrease both in
absolute dollars and as a percentage of net sales in fiscal year 2001 due to
reduced headcount and related expenses.

 General and Administrative

<TABLE>
<CAPTION>
                            Fiscal Year          Fiscal Year          Fiscal Year
                               2000     % Change    1999     % Change    1998
                            ----------- -------- ----------- -------- -----------
                                              ($ in thousands)
   <S>                      <C>         <C>      <C>         <C>      <C>
   General and
    administrative.........   $20,002      80%     $11,126     498%     $1,861
   Percentage of net
    sales..................        18%                  32%                --
</TABLE>

   General and administrative expenses consist of payroll and related expenses
for executive and administrative personnel, corporate facility expenses,
professional services expenses, travel and other general corporate expenses.

                                       24
<PAGE>

   General and administrative expenses increased in each of the past two years,
primarily due to increased expenses associated with the addition of general and
administrative personnel, additional professional fees and the cost of
corporate facilities, including those associated with Beauty.com, which we
acquired in February 2000.

   We expect general and administrative expenses will decrease both in absolute
dollars and as a percentage of net sales in fiscal year 2001 due to reduced
headcount and related expenses.

 Charitable Contribution

   In the third quarter of fiscal 1999, we donated 200,000 shares of our common
stock to a foundation established by us and recognized an expense of $3,600,000
in that quarter based on the fair value of the donated common stock.

 Amortization of Intangible Assets

<TABLE>
<CAPTION>
                            Fiscal Year          Fiscal Year          Fiscal Year
                               2000     % Change    1999     % Change    1998
                            ----------- -------- ----------- -------- -----------
                                              ($ in thousands)
   <S>                      <C>         <C>      <C>         <C>      <C>
   Amortization of
    intangible assets......   $34,774     227%     $10,640    32,142%     $33
</TABLE>

   Amortization of intangible assets includes the amortization expense
associated with the assets received in connection with agreements with Rite Aid
and with GNC, including access to insurance coverage and a vendor agreement;
assets acquired in connection with the purchase of Beauty.com, including
goodwill and domain names; and other intangibles, including a technology
license agreement, domain names and trademarks.

   Amortization of intangible assets increased in each of the last two years
due to the amortization of intangible assets received in connection with the
Rite Aid and the GNC transactions completed in July 1999 and the amortization
of the goodwill, domain names and other intangible assets acquired in the
Beauty.com acquisition in February 2000.

   We expect that amortization of intangible assets will increase in fiscal
year 2001 due to a full year of amortization expense being recorded in
connection with the Beauty.com acquisition.

   Intangible assets are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount may not be recoverable. Such
events could include, but are not limited to, our inability to achieve our
planned penetration rate with respect to insured prescriptions, our inability
to achieve the planned growth rates for our Rite Aid local pickup, GNC-branded
product or prestige beauty businesses, a decision by Rite Aid to substantially
curtail its marketing spending with respect to us for an extended period of
time, or the loss of key prestige beauty vendors. Impairment is measured by
comparing the carrying value of the intangible assets to the estimated
undiscounted future cash flows expected to result from use of the assets and
their ultimate disposition. In circumstances where impairment is determined to
exist, we will write down the asset to its fair value based on the present
value of estimated expected future cash flows. To date, no such impairment has
been indicated.

 Amortization of Stock-based Compensation

<TABLE>
<CAPTION>
                            Fiscal Year   %     Fiscal Year   %     Fiscal Year
                               2000     Change     1999     Change     1998
                            ----------- ------  ----------- ------  -----------
                                            ($ in thousands)
   <S>                      <C>         <C>     <C>         <C>     <C>
   Amortization of stock-
    based compensation.....   $15,115     (2)%    $15,375   1,383%    $1,037
   Percentage of net
    sales..................        14%                 44%               --
</TABLE>

                                       25
<PAGE>

   We record deferred stock-based compensation in connection with stock options
granted and restricted stock issued to our employees. The deferred stock-based
compensation amounts represent the difference between the exercise price of
stock option grants and the deemed fair value of our common stock at the time
of such grants. In the case of restricted stock, the deferred stock-based
compensation represents the difference between the purchase price of the
restricted stock and the deemed fair value of our common stock on the date of
purchase. Such amounts are amortized to expense over the vesting periods of the
applicable agreements. The amortization expense relates to options awarded to
employees in all operating expense categories. Deferred stock-based
compensation as of December 31, 2000 for stock options and restricted stock
issued to our employees will be subsequently recognized as expense for each of
the next four fiscal years as follows:

<TABLE>
<CAPTION>
       Fiscal Year                                                    Amount
       -----------                                                --------------
                                                                  (in thousands)
       <S>                                                        <C>
       2001......................................................     $9,897
       2002......................................................      1,865
       2003......................................................        464
       2004......................................................         82
</TABLE>

 Interest Income and Expense

<TABLE>
<CAPTION>
                               Fiscal Year   %    Fiscal Year   %     Fiscal Year
                                  2000     Change    1999     Change     1998
                               ----------- ------ ----------- ------  -----------
                                               ($ in thousands)
   <S>                         <C>         <C>    <C>         <C>     <C>
   Interest income, net.......   $8,632      76%    $4,912    2,723%     $174
</TABLE>

   Interest income consists of earnings on our cash, cash equivalents and
marketable securities and interest expense consists of interest associated with
capital lease obligations. Net interest income has increased for each of the
past two years, primarily due to higher average outstanding cash, cash
equivalents and marketable securities balances associated with our equity
financings. We expect net interest income to decrease in fiscal year 2001 as
our average outstanding balance of cash, cash equivalents and marketable
securities reduces over time.

   Income Taxes. There was no provision or benefit for income taxes for any
period since inception due to our operating losses. As of December 31, 2000, we
had approximately $261.1 million of net operating loss carryforwards for
federal income tax purposes, which expire beginning in 2018. Due to the
issuance and sale of Series E preferred stock in 1999 and our acquisition of
Beauty.com, we incurred ownership changes pursuant to applicable regulations in
effect under the Internal Revenue Code of 1986, as amended. Therefore, our use
of losses incurred through the date of these ownership changes will be limited
during the carryforward period. We estimate that the use of the approximately
$63.0 million of net operating losses incurred prior to the date of the
ownership change would be limited to approximately $15.5 million per year in
order to offset future taxable income. To the extent that any single-year loss
is not utilized to the full amount of the limitation, such unused loss is
carried over to subsequent years until the earlier of its utilization or the
expiration of the relevant carryforward period. Our initial public offering and
subsequent equity financings in 2000 did not cause additional ownership changes
that would result in additional limitations on the utilization of net operating
loss carryforwards. We have provided a full valuation allowance on the deferred
tax asset, consisting primarily of such net operating loss carryforwards,
because management has determined that it is more likely than not that we will
not earn income sufficient to realize the deferred tax assets during the
carryforward period.

Liquidity and Capital Resources

   We have incurred net losses of $316.9 million from inception to December 31,
2000. We believe that we will continue to incur net losses for the foreseeable
future. From our inception through December 31, 2000, we have financed our
operations primarily through the sale of equity securities, included common and
preferred stock, yielding net cash proceeds of $377.6 million.

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<PAGE>

   Net cash used in operating activities was $142.3 million of the year ended
December 31, 2000, $56.8 million for the year ended January 2, 2000, and $6.3
million in the period from April 2, 1998 (inception) to December 31, 1998. Net
cash used in operating activities for each of these periods primarily reflects
our net losses offset by changes in working capital.

   Net cash provided by investing activities was $61.0 million for the year
ended December 31, 2000. For the year ended January 2, 2000 and the period from
April 2, 1998 (inception) to December 31, 1998, net cash used in investing
activities was $120.0 million, and $1.5 million, respectively. Net cash
provided by investing activities in fiscal year 2000 was primarily related to
the sales of marketable securities outstanding as of January 2, 2000 net of
capital expenditures primarily attributable to establishing our own
distribution center. Net cash used in investing activities for the year ended
January 2, 2000 was primarily related to the investment of the proceeds from
our initial public offering in marketable securities with an original maturity
greater than 90 days. Additionally, net cash used in investing activities for
all periods presented includes leasehold improvements and purchases of
equipment and systems, computer equipment and fixtures and furniture.

   For the year ended December 31, 2000, net cash provided by financing
activities was $162.8 million and consisted primarily of cash proceeds from our
secondary public offering consummated in March 2000 yielding net cash proceeds
of $101.6 million and our private placement of common and preferred stock in
August 2000 yielding net cash proceeds of $62.3 million. For the year ended
January 2, 2000, net cash provided by financing activities was $188.9 million
and consisted primarily of $104.6 million in net proceeds from the issuance of
common stock in our initial public offering and the concurrent private
placement, and $84.6 million in net proceeds from the issuance of convertible
preferred stock. During the period from April 2, 1998 (inception) to December
31, 1998, net cash provided by financing activities was $22.3 million,
consisting primarily of cash proceeds of $22.2 million from the issuance of
convertible preferred stock.

   As of December 31, 2000 we had $129.9 million of cash, cash equivalents and
marketable securities. As of that date, and excluding a lease for our new
corporate headquarters that we cancelled in March 2001, our principal
commitments consisted of obligations outstanding under capital and operating
leases and strategic agreements with Amazon.com and WellPoint, aggregating
approximately $59.0 million through 2005.

   We believe that our existing cash, cash equivalents and marketable
securities will be sufficient to fund our operations until we begin generating
operating cash flow. We currently expect to begin generating operating cash
flow in 2004, although there can be no assurances as to such timing or that we
will ever generate operating cash flow. We may need to raise additional funds
if, for example, we pursue business or technology acquisitions or experience
operating losses that exceed our current expectations. If we raise additional
funds through the issuance of equity, equity-related or debt securities, such
securities may have rights, preferences or privileges senior to those of the
rights of our common stock and our stockholders may experience additional
dilution. We cannot be certain that additional financing will be available to
us on acceptable terms when required, or at all.

Factors That May Affect Our Business

   An investment in our securities involves certain risks. In evaluating us and
our business, investors should give careful consideration to the factors listed
below. If any of the following risks actually occurs, our business, financial
condition or operating results could be materially adversely affected. In such
case, the trading price of our common stock could decline.

 We Are an Early Stage Company in a New and Rapidly Evolving Market, Which
 Makes It Difficult for Investors to Determine Whether We Will Accomplish Our
 Objectives

   Because drugstore.com was founded in April 1998 and we only began selling
products in February 1999, we have a limited operating history on which
investors can base an evaluation of our business strategy. We have limited
insight into trends that may emerge and affect our business. An investor in our
common stock

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<PAGE>

must consider the risks and difficulties frequently encountered by early stage
companies, as well as the risks we face due to our participation in a new and
rapidly-evolving market. These challenges include our:

  .  Need to increase our brand awareness;

  .  Need to attract and retain customers at a reasonable cost;

  .  Need to achieve a critical mass of customers;

  .  Need to improve our gross margin and fulfillment cost;

  .  Dependence on Web site and transaction processing performance and
     reliability;

  .  Need to compete effectively;

  .  Need to establish ourselves as an important participant in the evolving
     market for healthcare products and services on the Internet; and

  .  Need to establish and develop relationships in the healthcare industry,
     particularly in the areas of reimbursement and managed care.

 Consumers of Health, Beauty, Wellness, Personal Care and Pharmacy Products May
 Not Accept Our Solution, Which Would Harm Our Revenues and Prevent Us From
 Becoming Profitable

   If we do not attract and retain a high volume of online customers to our
store at a reasonable cost, we will not be able to increase our revenues or
achieve profitability. We may not be able to convert a large number of
customers from traditional shopping methods to online shopping for health,
beauty, wellness, personal care and pharmacy products. Even if we are
successful at attracting online customers, we expect it will take several years
to build a critical mass of these customers. Specific factors that could
prevent widespread customer acceptance include:

  .  Shipping charges, which do not apply to shopping at traditional
     drugstores;

  .  Delivery time associated with Internet orders, as compared to the
     immediate receipt of products at a physical store;

  .  Pricing that does not meet customer expectations of "finding the lowest
     price on the Internet;"

  .  Additional steps and delays in ensuring insurance coverage for
     prescription products;

  .  Lack of coverage of customer prescriptions by some insurance carriers;

  .  Lack of consumer awareness of our online pharmacy;

  .  Customer concerns about the security of online transactions and the
     privacy of their personal health information;

  .  Product damage from shipping or shipments of wrong or expired products
     from us or other vendors, resulting in a failure to establish customers'
     trust in buying drugstore items online;

  .  Delays in responses to customer inquiries or in deliveries to customers;

  .  Inability to serve the acute care needs of customers, including
     emergency prescription drugs and other urgently needed products; and

  .  Difficulties in returning or exchanging orders.

 We Expect Continuing Losses for the Next Several Years

   We incurred net losses of $316.9 million for the period from inception
through December 31, 2000. We have not achieved profitability. We only began
selling products in February 1999 and cannot be certain that we will obtain
enough customer traffic or a high enough volume of purchases to generate
sufficient revenues and

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<PAGE>

achieve profitability. We believe that we will continue to incur operating and
net losses for at least the next three years (and possibly longer) as we:

  .  Fulfill more customer orders as the volume of purchases increases;

  .  Increase our sales and marketing activities;

  .  Provide our customers with promotional benefits, such as selling
     selected products or offering shipping below our actual costs;

  .  Increase our general and administrative functions to support our growing
     operations; and

  .  Develop enhanced technologies, features and fulfillment processes to
     improve our Web site.

   We may find that these efforts are more expensive than we currently
anticipate, which would further increase our losses.

 We May Not Succeed in Establishing the drugstore.com Brand, Which Would
 Adversely Affect Customer Acceptance and Our Revenues

   Due to the early stage and competitive nature of the online market for
drugstore products, if we do not establish our brand quickly, we may lose the
opportunity to build a critical mass of customers. Promoting and positioning
our brand will depend largely on the success of our marketing efforts and our
ability to provide consistent, high quality customer experiences. To promote
our brand, we have incurred and expect to continue to incur substantial expense
in our advertising efforts. If these brand promotion activities do not yield
increased revenues, we will incur additional losses. Even if our efforts are
successful, adverse publicity about our strategic partners could damage our
brand and negatively affect customer acceptance of our site.

 We Expect Our Quarterly Financial Results to Fluctuate And Our Early Stage of
 Development Limits Our Ability to Predict Revenues and Expenses Precisely

   Historical trends and quarter-to-quarter comparisons of our operating
results are not a good indicator of our future performance. It is likely that
in some future quarter our operating results may be below the expectations of
public market analysts and investors. In this event, the price of our common
stock may fall. Our revenues and operating results are expected to vary
significantly from quarter to quarter due to a number of factors, including:

  .  Demand for our products;

  .  Our ability to attract visitors to our Web store and convert those
     visitors into customers;

  .  The frequency of repeat purchases by customers;

  .  Changes in the growth rate of Internet usage;

  .  Average order size;

  .  The mix of products sold;

  .  Promotional benefits, such as selling selected products or offering
     shipping below our actual costs, that we may provide our customers;

  .  Our ability to enhance our technology to accommodate any future growth
     in our operations or customers;

  .  Our ability to manage inventory levels and ensure sufficient product
     supply;

  .  Changes in our pricing policies or the pricing policies of our
     competitors;

  .  Changes in government regulation;

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<PAGE>

  .  The availability of reimbursement for pharmacy products; and

  .  Costs related to potential acquisitions of technology or businesses.

   Our operating expenses are largely based on anticipated revenue trends and a
high percentage of our expenses are fixed in the short term. As a result, a
delay in generating or recognizing revenue for any reason could result in
substantial additional operating losses. The volume and timing of orders of
health, beauty, wellness, personal care and pharmacy products on our Web store
are difficult to predict because the online market for such products is in its
early stages. Due to the limited operating history of our Web store, we may
have difficulty forecasting revenue from regular customers or overall
anticipated revenue trends.

   A portion of our revenues may also be seasonal in nature, especially with
respect to the sale of certain beauty products, which depend to some extent on
seasonal product changes and seasonal purchasing patterns. Consumer "fads" and
other changes in consumer trends may cause shifts in purchasing patterns,
resulting in significant fluctuations in our operating results from one quarter
to the next. Our limited operating history makes it difficult to fully assess
the impact of these factors.

 If We Are Unable to Obtain Insurance Reimbursement Coverage for Our Customers,
 Our Ability to Sell Pharmacy Products Online Could Decrease, Which Would Harm
 Our Revenues

   To obtain reimbursement on behalf of our customers for the prescription
products that they purchase on our Web site, we must maintain relationships
with insurance companies and PBMs, either directly or through our relationship
with Rite Aid. We currently rely primarily on Rite Aid's relationships with
insurance companies and PBMs and the extension of these relationships to cover
prescriptions processed by us. Sales billed through Rite Aid's relationships
currently represent a significant percentage of our pharmacy sales. We have
also entered into direct relationships with PBMs and insurers, including
WellPoint and Cigna. If we are unable to maintain and leverage our direct
relationships, and to the extent Rite Aid is unable to maintain its
relationships, or if these relationships do not extend to cover the
prescriptions we process, our ability to obtain reimbursement coverage for our
customers would be reduced. This would reduce the number of customers that fill
prescriptions through our Web site, which would reduce our revenues.

   Our ability to enter into direct relationships with insurance companies and
PBMs, or retain our existing relationships for an extended period of time, is
uncertain for the following reasons:

  .  Many of these companies are in the early stages of evaluating the impact
     of the Internet and online pharmacies on their businesses. These
     companies may delay their decisions to contract with online pharmacies
     or may decide to develop their own Internet capabilities that may
     compete with us.

  .  Many insurance companies have existing contracts with chain drugstores
     and PBMs that have announced their intentions to establish online
     pharmacies.

  .  Some insurance companies and PBMs will likely contract with only one or
     a limited number of online pharmacies. If our online competitors obtain
     these contracts and we do not, we would be at a competitive
     disadvantage.

   Many of our agreements with insurance companies and PBMs are short-term, may
be terminated with less than 30 days' prior notice, and are subject to
amendment by such insurance companies and PBMs. Our contract with PCS is a 10-
year agreement that could terminate earlier if our agreement with Rite Aid is
terminated. Our contract with WellPoint is a 5-year agreement that could
terminate earlier if we experience a change of control. In addition, we must
process each insurance application individually, which may raise the costs of
processing prescription orders and delay our order processing time. Customers
may not initially embrace our online insurance coverage procedure.

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<PAGE>

 We Depend on a Limited Number of Distribution Partners; If They Do Not
 Perform, We Will Not Be Able to Effectively Ship Orders

   We are obligated to purchase all of our pharmaceutical products from Rite
Aid unless we are able to obtain better overall terms from another vendor. Our
business could be significantly disrupted if Rite Aid was to breach its
contract or suffer adverse developments that affect its ability to supply
products to us. If for any reason Rite Aid is unable or unwilling to supply
products to us in sufficient quantities and in a timely manner, we may not be
able to secure alternative fulfillment partners on acceptable terms in a
timely manner, or at all. For a discussion of certain potentially adverse
developments at Rite Aid, see "Our Relationship with Rite Aid Involves Many
Risks and May Restrict Our Ability to Promote, Contract With, or Operate
Traditional Retail Stores."

   We also rely on third-party carriers for shipments to and from distribution
facilities and to customers. We are therefore subject to the risks, including
employee strikes and inclement weather, associated with our carriers' ability
to provide product fulfillment and delivery services to meet our distribution
and shipping needs. Failure to deliver products to our customers in a timely
and accurate manner would harm our reputation, the drugstore.com brand and our
results of operations.

 Opening and Operating Our Own Distribution Center Will Require Significant
 Investments in Management Resources

   Prior to June 2000, we relied primarily on third parties to fulfill our
orders. We began operating our own 290,000 square foot distribution center to
achieve greater control over the distribution process and to ensure adequate
supplies of products to our customers. As of June 2000, all of our orders
delivered by mail are processed from our distribution center. If we do not
successfully operate our distribution center to accommodate peak volumes, or
if the distribution center fails to operate properly, it could significantly
limit our ability to meet customer demand.

   Operating our distribution center requires that we:

  .  Effectively manage our product purchasing function and our inventory
     levels to avoid product shortages or markdowns due to unpopular or
     expired inventory; and

  .  Control product damage and shrinkage through effective security measures
     and inventory management practices.

   We have limited experience processing customer order fulfillment through
our distribution center and managing significant levels of inventory, and
issues arising with respect to the operation of our distribution center could
divert management attention from other aspects of our business. In addition,
we may be unable to obtain products on favorable terms. In connection with the
opening of our distribution center, we also expanded our pharmacy operations
through our arrangement with Rite Aid. Our pharmacy operations will subject us
to additional regulatory requirements and related costs.

   We believe that our new distribution center will provide us with sufficient
distribution capacity for the foreseeable future. However, we may need to
increase our distribution capacity sooner than anticipated, and any further
expansion would require additional financing that may not be available to us
on favorable terms when required, or at all.

 Any Errors in the Filling or Packaging of the Prescription Drugs We Dispense
 May Expose Us to Liability and Negative Publicity

   Pharmacy errors relating to prescriptions, dosage and other aspects of the
medication dispensing process can produce liability for us that our insurance
may not cover. Because we distribute pharmaceutical products directly to the
consumer, we are the most visible participant in the medication distribution
chain and therefore have more exposure to liability claims.

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<PAGE>

   Our pharmacists are required by law to offer counseling, without additional
charge, to our customers about medication, dosage, delivery systems, common
side effects and other information deemed significant by the pharmacists. Our
pharmacists may have a duty to warn customers regarding any potential adverse
effects of a prescription drug if the warning could reduce or negate such
effects. This counseling is in part accomplished through e-mail and inserts
included with the prescription, which may increase the risk of miscommunication
because the customer is not personally present or may not have provided all
relevant information. We also post product information on our Web store.
Providing information on pharmaceutical and other products creates the
potential for claims to be made against us for negligence, personal injury,
wrongful death, product liability, malpractice, invasion of privacy or other
legal theories based on our product or service offerings. Our general
liability, product liability and professional liability insurance may not cover
potential claims of this type or may not be adequate to protect us from all
liability that may be imposed.

   Pharmacy errors either by drugstore.com or our competitors may also produce
significant adverse publicity either for us or the entire online pharmacy
industry. Because of the significant amount of recent press coverage on
Internet retailing and online pharmacies, we believe that we will be subject to
a higher level of media scrutiny than other pharmacy product channels. The
amount of negative publicity that we or the online pharmacy industry receive as
a result of pharmacy or prescription processing errors could be
disproportionate in relation to the negative publicity received by other
pharmacies making similar mistakes. We have no control over the pharmacy
practices of our competitors, and we cannot ensure that our pharmacists or our
prescription processing will be able to operate without error. We believe
customer acceptance of our online shopping experience is based in large part on
consumer trust, and negative publicity could erode such trust, or prevent it
from growing. This could result in an immediate reduction in the amount of
orders we receive and adversely affect our revenue growth.

 We Face the Risk of Systems Interruptions and Capacity Constraints on Our Web
 Site, Possibly Resulting in Adverse Publicity, Revenue Losses and Erosion of
 Customer Trust

   The satisfactory performance, reliability and availability of our Web site,
transaction processing systems and network infrastructure are critical to our
reputation and our ability to attract and retain customers and to maintain
adequate customer service levels. Any future systems interruption that results
in the unavailability of our Web site or reduced order fulfillment performance
could result in negative publicity and reduce the volume of goods sold and the
attractiveness of our Web store, which could negatively affect our revenues.
From time to time, we have experienced temporary system interruptions for a
variety of reasons, including power failures, software bugs and an overwhelming
number of visitors trying to reach our Web site. We may not be able to correct
any problem in a timely manner. Because we outsource certain aspects of our
system and because some of the reasons for a systems interruption may be
outside of our control, we also may not be able to exercise sufficient control
to remedy the problem quickly or at all.

   We opened our site for customers in February 1999 and to the extent that
customer traffic grows substantially, we will need to expand the capacity of
our systems to accommodate a larger number of visitors. Any inability to scale
our systems may cause unanticipated system disruptions, slower response times,
degradation in levels of customer service, impaired quality and speed of order
fulfillment, or delays in reporting accurate financial information. We are not
certain that we will be able to project the rate or timing of increases, if
any, in the use of our Web site accurately or in a timely manner to permit us
to effectively upgrade and expand our transaction-processing systems or to
integrate smoothly any newly developed or purchased modules with our existing
systems.

 We Have Grown Very Rapidly, and We Need to Manage Changing and Expanding
 Operations

   We have rapidly and significantly expanded our operations, and anticipate
that we will continue to expand. Our number of employees has grown from 85 on
December 31, 1998 to 553 on December 31, 2000. This growth has placed, and our
anticipated future operations will continue to place, a significant strain on
our management systems and resources. We will not be able to implement our
business strategy in a rapidly

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<PAGE>

evolving market without an effective planning and management process. We will
not be able to increase revenues unless we continue to improve our
transaction-processing, operational, financial and managerial controls and
reporting systems and procedures, expand, train and manage our work force and
manage multiple relationships with third parties. Many of our senior
management have no prior senior management experience at public companies, and
none of our executive officers have prior management experience in the
healthcare or retail drugstore industry.

 Expanding the Breadth and Depth of Our Product and Service Offerings Is
 Expensive and Difficult, and We May Receive No Benefit From Our Expansion

   We intend to expand the breadth and depth of our product and service
offerings by promoting new or complementary products or sales formats. We
cannot be certain that these new offerings will generate sufficient revenues
for the costs involved. Expansion of our offerings in this manner could
require significant additional expenditures and could strain our management,
financial and operational resources. For example, we may need to incur
significant marketing expenses, develop relationships with new fulfillment
partners or manufacturers, or comply with new regulations. We cannot be
certain that we will be able to expand our product and service offerings in a
cost-effective or timely manner. Furthermore, any new product or service
offering or sales format that is not favorably received by consumers could
damage the reputation of our brand. The lack of market acceptance of such
efforts or our inability to generate satisfactory revenues from such expanded
offerings to offset their cost could harm our business. Finally, our agreement
with Amazon.com contains prohibitions that limit our ability to work with
other companies in markets for products and services that are competitive with
those offered by Amazon.com, although we are able to sell products and
services in these markets ourselves.

 Our Relationship With Amazon.com May Restrict Some of Our Activities

   Our relationship with Amazon.com may restrict our activities and is subject
to change. We entered into a technology license and advertising agreement in
August 1998 with Amazon.com. In addition, in January 2000 we entered into a
three-year agreement with Amazon.com to integrate various shopping features of
our Web sites and create a persistent drugstore.com shopping presence on the
Amazon.com Web site. Amazon.com is currently our largest stockholder and
Jeffrey P. Bezos, Amazon.com's chairman of the board and chief executive
officer, is a member of our board of directors. Our relationship with
Amazon.com has received significant media attention, but the parties'
obligations to provide support to each other are limited.

   Pursuant to these agreements, each party has committed to providing the
other with advertising on our respective Web sites. The agreement we entered
into in January 2000 contains provisions restricting the percentage of total
revenues we can obtain from the sale on our Web site of products or services
other than health, beauty, wellness, personal care and pharmaceutical
products. We may not assign this agreement without Amazon.com's consent. Under
the technology license and advertising agreement, we are restricted from
promoting on our Web site any company that sells products or services
competitive with those that Amazon.com offers or is preparing to produce or
market. If we were acquired by a competitor of Amazon.com and Amazon.com did
not vote in favor of the transaction, we would lose our rights to advertise on
Amazon.com's Web site and to use Amazon.com's technology (if we are then using
any). In addition, we have agreed not to sell advertising on our Web site to
any company that sells products or services competitive with those offered by
Amazon.com, although the sale of advertising on our Web site is not presently,
and is not expected to be, part of our business strategy.

   In addition, due to Amazon.com's significant ownership of our common stock,
it will be able to significantly influence all matters requiring approval by
our stockholders, including the election of directors and the approval of
mergers or other business combination transactions.

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<PAGE>

 Our Relationship with Rite Aid Involves Many Risks and May Restrict Our
 Ability to Promote, Contract With, or Operate Traditional Retail Stores

   In June 1999, we entered into a series of agreements with Rite Aid. These
agreements involve many aspects of our businesses and the operation of our
respective Web sites, the fulfillment of orders and the extension of Rite
Aid's insurance relationships to cover prescriptions processed by us. This
type of arrangement is complex and requires a great deal of effort to operate
successfully. As a result, there are many risks related to these arrangements,
including some that we may not have foreseen. It is difficult to assess the
likelihood of occurrence of these risks, including the lack of success of the
overall arrangement to meet the parties' objectives. In the event that we do
not realize the intended benefits of these relationships, we will have
expended a great deal of time and effort that could have been directed to more
beneficial activities. In addition, customer perceptions and our business may
be adversely impacted if these relationships are not successful.

   While Rite Aid has committed to promoting drugstore.com in its stores and
in its advertising, we do not control the choice of ads that will feature us
and this form of advertising may not result in additional drugstore.com
customers. While the Rite Aid relationship substantially broadens our ability
to provide prescription medications to consumers with insurance reimbursement
plans, it may not allow all of our potential customers to purchase these
medications from drugstore.com and receive insurance reimbursement, which
could adversely affect consumer perceptions and our revenues. We have agreed
not to promote any other traditional chain drugstore or operate one ourselves.
We have also agreed not to contract with another traditional retail store to
fill pharmacy product orders we receive unless a Rite Aid store is not
conveniently located. These restrictions could limit our flexibility and
ability to grow our business if our relationship with Rite Aid does not
develop successfully.

   Rite Aid has received significant negative publicity regarding its
financial situation following its announcements regarding the restructuring
and extension of its banking facilities, including amendments to financial
covenants, the planned restatements of its 1999, 1998 and 1997 financial
statements and the resignation of its independent auditors in November 1999.
Rite Aid has since engaged new auditors and made significant changes to its
senior management team. Our relationship with Rite Aid is important to us,
particularly in our pharmacy fulfillment operations and in our ability to
offer insurance reimbursement coverage to our customers. If Rite Aid's
financial condition were to worsen, it may be unable to continue to fulfill
its obligations to us under our agreements, and this would have an adverse
effect on our business. In addition, negative publicity regarding Rite Aid
could negatively affect the drugstore.com brand and our stock price.

   Our relationship with PCS was established at the same time as, and in
connection with, our relationship with Rite Aid. Rite Aid sold PCS to Advanced
Paradigm. Advanced Paradigm may not demonstrate the same level of commitment
to our relationship with PCS as Rite Aid.

   Rite Aid currently owns approximately 14.1% of our outstanding common
stock. As a result, Rite Aid is able to significantly influence all matters
requiring approval by our stockholders, including the election of directors
and the approval of mergers or other business combination transactions.

 We Are Dependent on Our Strategic Relationships to Help Promote Our Web Site
 and Expand Our Product Offerings; If We Fail to Maintain or Enhance These
 Relationships, Our Development Could Be Hindered

   We believe that our strategic relationships with Amazon.com, Rite Aid, PCS
and GNC as well as portals and third party distributors are critical to
attract customers, facilitate broad market acceptance of our products and the
drugstore.com brand and enhance our sales and marketing capabilities. If we
are unable to develop or maintain key relationships, our ability to attract
customers would suffer and our business would be adversely affected. In
addition, we are subject to many risks beyond our control that influence the
success or failure of our strategic partners. Our business could be harmed if
any of our key strategic partners were to experience financial or operational
difficulties or if other corporate developments adversely affect their
performance under our agreements.

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<PAGE>

 We Face Uncertainty Related to Pharmaceutical Costs and Pricing, Which Could
 Affect Our Revenues and Profitability

   We expect that pharmacy sales will account for a significant percentage of
our total sales. Sales of our products will depend in part on the availability
of reimbursement from third-party payors such as government health
administration authorities, private health insurers, health maintenance
organizations (HMOs), PBMs and other organizations. Because these organizations
are traditionally focused on reduced cost to employer groups, whereas we are
focused more on direct customer service, we must devote time and resources to
develop third-party payor confidence in our approach.

   In addition, third-party payors are increasingly challenging the price and
cost-effectiveness of medical products and services. The efforts of third-party
payors to contain costs will place downward pressures on profitability from
sales of prescription drugs. Our revenues from prescription drug sales may also
be affected by health care reform initiatives of federal and state governments,
including proposals designed to significantly reduce spending on Medicare,
Medicaid and other government programs, changes in programs providing for
reimbursement for the cost of prescription drugs by third-party payors and
regulatory changes related to the approval process for prescription drugs. Such
initiatives could lead to the enactment of federal and state regulations that
may adversely impact our prescription drug sales.

   We cannot be certain that our products or services will be considered cost
effective or that adequate third-party reimbursement will be available to
enable us to maintain price levels sufficient to realize a profit.

 Competition From Both Traditional and Online Retailers May Result in Price
 Reductions and Decreased Demand for Our Products and Services

   We compete in a market that is highly competitive and expect competition to
intensify in the future. We currently or potentially compete with a variety of
companies, many of which have significantly greater financial, technical,
marketing and other resources. These competitors include (1) various online
stores that sell pharmaceutical as well as over-the-counter drug and health,
wellness, beauty and personal care items; (2) mail service pharmacies; and (3)
existing bricks and mortar drugstores. Most of these drugstores, which include
national, regional and local drugstore chains, discount drugstores,
supermarkets, combination food and drugstores, discount general merchandise
stores, mass market retailers, independent drugstores and local merchants, have
existed for a longer period, have greater financial resources, have established
marketing relationships with leading manufacturers and advertisers, and have
secured greater presence in distribution channels. Some of these companies may
also commence or expand their presence on the Internet. We also compete with
hospitals, HMOs and mail order prescription drug providers, all of whom are or
may begin offering products and services over the Internet. Finally, we are
aware of numerous other smaller entrepreneurial companies that are focusing
significant resources on developing and marketing products and services that
will compete directly with those offered at drugstore.com.

   We believe that there may be a significant advantage in establishing a large
customer base before our competitors do so. If we fail to attract and retain a
large customer base and our competitors establish a more prominent market
position relative to ours, this could inhibit our ability to grow.

   We also believe we may face a significant competitive challenge from our
competitors forming alliances with each other. Our direct online competitors
may form partnerships with PBMs, HMOs or chain drugstores. The combined
resources of these partnerships could pose a significant competitive challenge
to drugstore.com. In addition, certain PBMs and HMOs could form alliances with
our competitors that would prevent them from also entering into relationships
with drugstore.com. Our inability to partner with a major PBM or HMO could be a
major competitive disadvantage to us.

   We believe the principal factors that will draw end users to an online
shopping application include brand availability, selection, personalized
services, convenience, price, accessibility, customer services, quality of
search tools, quality of content, and reliability and speed of fulfillment for
products ordered. We will have little

                                       35
<PAGE>

or no control over how successful our competitors are in addressing these
factors. In addition, with little difficulty, our online competitors can
duplicate many of the products, services and content offered on our site.

   Increased competition could result in price reductions, fewer customer
orders, fewer search queries served, reduced gross margins and loss of market
share.

 Acquisitions Could Result in Dilution, Operating Difficulties and Other
 Harmful Consequences

   If appropriate opportunities present themselves, we intend to acquire
complementary or strategic businesses, technologies, services or products. The
process of integrating an acquired business, technology, service or product
into our business and operations may result in unforseen operating
difficulties and expenditures. Integration of an acquired company may also
require significant management resources that would otherwise be available for
ongoing development of our business. Moreover, the anticipated benefits of any
acquisition may not be realized or may depend on the continued service of
acquired personnel who could choose to leave. We currently do not have any
understandings, commitments or agreements with respect to any other
acquisition and no other material acquisition is currently being pursued.
Future acquisitions could also result in potentially dilutive issuances of
equity securities, the incurrence of debt, contingent liabilities or
amortization expenses related to goodwill and other intangible assets, any of
which could harm our business.

 Our Systems and Operations, and Those of Our Distributors, Are Vulnerable to
 Natural Disasters and Other Unexpected Problems

   Substantially all of our computer and communications hardware is located at
our leased facility in Bellevue, Washington and our systems infrastructure is
hosted at an Exodus Communications facility in Tukwila, Washington. Our
systems and operations are vulnerable to damage or interruption from fire,
flood, power loss, telecommunications failure, earthquakes and similar events.
In addition, our servers are vulnerable to computer viruses, physical or
electronic break-ins and similar disruptions, which could lead to
interruptions, delays, loss of data or the inability to accept and fulfill
customer orders. We do not currently have redundant systems or a formal
disaster recovery plan and do not carry sufficient business interruption
insurance to compensate for all losses that may occur. Our distribution
facility in New Jersey also faces these risks.

   We depend on the efficient operation of Internet connections from customers
to our systems. These connections, in turn, depend on the efficient operation
of Web browsers, Internet service providers and Internet backbone service
providers, all of which have had periodic operational problems or experienced
outages. Any system delays, failures or loss of data, whatever the cause,
could reduce customer satisfaction with our applications and services and harm
our sales.

   We retain confidential customer and patient information in our processing
centers. Therefore, it is critical that our facilities and infrastructure
remain secure and that our facilities and infrastructure are perceived by the
marketplace to be secure. A material security breach could damage our
reputation or result in liability to us.

 Governmental Regulation of Our Business Could Require Significant Expenses,
 and Failure to Comply With Certain Regulations Could Result in Civil and
 Criminal Penalties

   Our business is subject to extensive federal, state and local regulations.
In particular, entities engaging in the practice of pharmacy are subject to
federal and state regulatory and licensing requirements. Regulations in this
area often require subjective interpretation, and we cannot be certain that
our attempts to comply with these regulations will be deemed sufficient by the
appropriate regulatory agencies. Violations of any regulations could result in
various civil and criminal penalties, including suspension or revocation of
our licenses or registrations, seizure of our inventory, or monetary fines,
which could adversely affect our operations.

   We are also subject to laws and regulations regarding homeopathic drugs,
and we may face enforcement actions, lawsuits or claims asserting that we have
not complied with these laws and regulations. As we expand

                                      36
<PAGE>

our product and service offerings, more of our products and services will
likely be subject to regulation by the FDA, which regulates drug advertising
and promotion. Complying with FDA regulations is time consuming, burdensome and
expensive, and could delay our introduction of new products or services.

   Legislation and regulations currently being considered at the federal and
state level could affect our business, including legislation or regulations
relating to confidentiality of patient records, including electronic access and
storage of such records, disclosure requirements for Internet pharmacies, as
well as the inclusion of prescription drugs as a Medicare benefit. In addition,
state legislatures may add or amend legislation related to the regulation of
nonresident pharmacies. Compliance with new laws or regulations could increase
our expenses.

   The Health Insurance Portability and Accountability Act of 1996 mandates the
use of standard transactions, standard identifiers, security and other
provisions. Regulations have been proposed to implement these requirements, and
we are designing our applications to comply with the proposed regulations.
However, until these regulations become final, possible changes in these
regulations could cause us to use additional resources and lead to delays as we
revise our Web site and operations.

   We are subject to extensive regulation relating to the confidentiality and
release of patient records. Additional legislation governing the distribution
of medical records exists or has been proposed at both the state and federal
level. It may be expensive to implement security or other measures designed to
comply with any new legislation. Moreover, we may be restricted or prevented
from delivering patient records electronically. This could have an adverse
impact on our ability to gain and retain customers.

 Failure to Attract and Retain Experienced Personnel and Senior Management
 Could Hurt Our Ability to Grow Our Business

   Our future success also depends upon the continued service of our executive
officers and senior management. None of our employees is bound by an employment
agreement for any specific term. We do not have "key person" life insurance
policies covering any of our employees. In addition, none of the members of our
senior management team have prior experience in the healthcare industry or in
drugstore operations.

 We Cannot Be Certain That We Will Be Able to Protect Our Intellectual
 Property, and We May Be Found to Infringe Proprietary Rights of Others, Which
 Could Harm Our Business

   We rely or may in the future rely on a combination of patent, trademark,
trade secret and copyright law and contractual restrictions to protect our
intellectual property. These afford only limited protection. Despite our
efforts to protect our proprietary rights, unauthorized parties may attempt to
copy aspects of our sales formats or to obtain and use information that we
regard as proprietary, such as the technology used to operate our Web site, our
content and our trademarks.

   We have filed applications for U.S. trademark registrations for
"drugstore.com" and certain other trademarks. We may be unable to secure these
registrations. It is also possible that our competitors or others will adopt
service names similar to ours, thereby impeding our ability to build brand
identity and possibly leading to customer confusion. In addition, there could
be potential trade name or trademark infringement claims brought by owners of
other registered trademarks or trademarks that incorporate variations of the
term drugstore.com or our other trademark applications. Any claims or customer
confusion related to our trademarks, or our failure to obtain any trademark
registration, could negatively affect our business.

   Litigation or proceedings before the U.S. Patent and Trademark Office may be
necessary in the future to enforce our intellectual property rights, to protect
our trade secrets and domain name and determine the validity and scope of the
proprietary rights of others. Any litigation or adverse priority proceeding
could result in substantial costs and diversion of resources and could
seriously harm our business and operating results. Finally, we may in the
future sell our products internationally, and the laws of many countries do not
protect our proprietary rights to as great an extent as do the laws of the
United States.

                                       37
<PAGE>

   Third parties may also claim infringement by us with respect to past,
current or future technologies. We expect that participants in our markets
will be increasingly subject to infringement claims as the number of services
and competitors in our industry segment grows. Any such claim, whether
meritorious or not, could be time-consuming, result in costly litigation,
cause service upgrade delays or require us to enter into royalty or licensing
agreements. Such royalty or licensing agreements might not be available on
terms acceptable to us or at all.

 We May Not Be Able to Protect Our Domain Names In All Countries or Against
 All Infringers, Which Could Decrease the Value of Our Brand Name and
 Proprietary Rights

   We currently hold the Internet domain name "drugstore.com," as well as
various other related names. Domain names generally are regulated by Internet
regulatory bodies. The regulation of domain names in the United States and in
foreign countries is subject to change. Regulatory bodies could establish
additional top-level domains, appoint additional domain name registrars or
modify the requirements for holding domain names. As a result, we may not
acquire or maintain the "drugstore.com" domain name in all of the countries in
which we conduct business.

   The relationship between regulations governing domain names and laws
protecting trademarks and similar proprietary rights is unclear. Therefore, we
could be unable to prevent third parties from acquiring domain names that
infringe or otherwise decrease the value of our brand name, trademarks and
other proprietary rights.

 We May Face Liability for Content on Our Web Site

   Because we post product information and other content on our Web site, we
face potential liability for negligence, copyright, patent, trademark,
defamation, indecency and other claims based on the nature and content of the
materials that we post. Such claims have been brought, and sometimes
successfully pressed, against Internet content distributors. In addition, we
could be exposed to liability with respect to the unauthorized duplication of
content or unauthorized use of other parties' proprietary technology. Although
we maintain general liability insurance, our insurance may not cover potential
claims of this type or may not be adequate to indemnify us for all liability
that may be imposed. Any imposition of liability that is not covered by
insurance or is in excess of insurance coverage could harm our business.

 Our Officers, Directors and Certain Existing Stockholders Control the
 Majority of Our Common Stock, Which Could Discourage an Acquisition of Us or
 Make Removal of Incumbent Management More Difficult

   Executive officers, directors and entities affiliated with them
beneficially own approximately 62.5% of our outstanding common stock. These
stockholders, if acting together, would be able to significantly influence all
matters requiring approval by our stockholders, including the election of
directors and the approval of mergers or other business combination
transactions. In addition, Amazon.com beneficially owns approximately 22.6%
and Rite Aid beneficially owns 14.1% of our outstanding common stock.
Therefore, Amazon.com and Rite Aid will each be able to significantly
influence all matters requiring approval by our stockholders, including the
election of directors and the approval of mergers or other business
combination transactions. Amazon.com's and Rite Aid's substantial equity
stakes in drugstore.com could also make us a much less attractive acquisition
candidate to potential acquirors, because either Amazon.com or Rite Aid alone
could have sufficient votes to prevent the tax-free treatment of an
acquisition.

 We May Need Additional Capital in the Future to Support Our Growth, and Such
 Additional Financing May Not Be Available To Us

   Our available funds may not be sufficient to meet all of our long-term
business development requirements, and we may seek to raise additional funds
through public or private debt or equity financings in order to:

  .  Take advantage of favorable business opportunities, including
     acquisitions of complementary businesses or technologies;

                                      38
<PAGE>

  .  Increase brand awareness;

  .  Increase our ability to attract visitors to our Web store and convert
     those visitors into customers;

  .  Develop and upgrade our technology infrastructure;

  .  Enhance and increase our distribution capacity;

  .  Develop new product and service offerings; and

  .  Respond to competitive pressures.

We cannot assure you that any additional financing that we may need will be
available on terms favorable to us, or at all.

 Our Net Sales Would Be Harmed if We Experience Significant Credit Card Fraud

   A failure to adequately control fraudulent credit card transactions would
harm our net sales and results of operations because we do not carry insurance
against this risk. Under current credit card practices, we are liable for
fraudulent credit card transactions because we do not obtain a cardholder's
signature.

 Certain Antitakeover Provisions and Significant Equity Ownership by Amazon.com
 and Rite Aid Could Preclude an Acquisition

   Provisions of our certificate of incorporation, bylaws, Washington law and
Delaware law could make it more difficult for a third party to acquire us, even
if doing so would be beneficial to our stockholders. Further, because
Amazon.com and Rite Aid each own a significant percentage of our capital stock,
a competitor of Amazon.com or Rite Aid as well as other potential acquirors
could determine not to merge with or acquire us. In addition, if we were
acquired by an Amazon.com competitor and Amazon.com did not vote in favor of
the transaction, we would lose our rights to promotional placements on
Amazon.com's Web site, and to use Amazon.com's technology (if we are then using
any). The potential loss of these rights could inhibit offers to acquire us.

 We Depend on Continued Use of the Internet and Growth of the Online Drugstore
 Market

   Our future revenues and profits, if any, substantially depend upon the
widespread acceptance and use of the Internet as an effective medium of
business and communication by our target customers. Rapid growth in the use of
and interest in the Internet has occurred only recently. As a result,
acceptance and use may not continue to develop at historical rates, and a
sufficiently broad base of consumers may not adopt, and continue to use, the
Internet and other online services as a medium of commerce.

   In addition, the Internet may not be accepted as a viable long-term
commercial marketplace for a number of reasons, including potentially
inadequate development of the necessary network infrastructure or delayed
development of enabling technologies and performance improvements. Our success
will depend, in large part, upon third parties maintaining the Internet
infrastructure to provide a reliable network backbone with the speed, data
capacity, security and hardware necessary for reliable Internet access and
services.

   Further, the online market for drugstore products is in its infancy. The
market is significantly less developed than the online market for books,
auctions, music, software and numerous other consumer products. Even if use of
the Internet and electronic commerce continues to increase, the rate of growth,
if any, of the online drugstore market could be significantly less than the
online market for other products. Our rate of revenue growth could therefore be
significantly less than other online merchants.

                                       39
<PAGE>

 If We Are Required To Collect Taxes In Additional Jurisdictions On The
 Products We Sell, We May Be Subject To Liability For Past Sales And Our
 Future Sales May Decrease

   In accordance with current industry practice, we do not currently collect
sales taxes or other taxes with respect to shipments of goods into states
other than Washington. Our new distribution center, and any future
distribution centers, along with other aspects of our evolving business, may
result in additional sales and other tax obligations. One or more states or
the federal government may seek to impose sales or other tax collection
obligations on out-of-jurisdiction companies that engage in electronic
commerce as we do. Moreover, one or more states or the federal government
could begin to impose sales taxes on sales of prescription products, which are
not generally taxed at this time. If so, customers who order prescriptions at
our Web site and pick them up at a Rite Aid store would be required to pay
sales tax. A successful assertion by one or more states or the federal
government that we should collect sales or other taxes on the sale of our
products could result in substantial tax liabilities for past sales, decrease
our ability to compete with traditional retailers and otherwise harm our
business.

   Recent federal legislation limits the imposition of U.S. state and local
taxes on Internet-related sales. In 1998, Congress passed the Internet Tax
Freedom Act, which places a three-year moratorium on state and local taxes on
Internet access, unless such tax was already imposed prior to October 1, 1998,
and on discriminatory taxes on electronic commerce. There is a possibility
that Congress may not renew this legislation in 2001. If Congress chooses not
to renew this legislation, U.S. state and local governments would be free to
impose new taxes on electronically purchased goods. The imposition of taxes on
goods sold over the Internet by U.S. states and local government would create
administration burdens for us and decrease our future sales.

 If We Do Not Respond to Rapid Technological Changes, Our Services Could
 Become Obsolete and Our Business Would Be Seriously Harmed

   As the Internet and online commerce industry evolve, we must license
leading technologies useful in our business, enhance our existing services,
develop new services and technology that address the increasingly
sophisticated and varied needs of our prospective customers and respond to
technological advances and emerging industry standards and practices on a
cost-effective and timely basis. We may not be able to successfully implement
new technologies or adapt our Web store, proprietary technology and
transaction-processing systems to customer requirements or emerging industry
standards. If we are unable to do so, it could adversely impact our ability to
build the drugstore.com brand and attract and retain customers.

 Governmental Regulation of the Internet and Data Transmission Over the
 Internet Could Affect Our Business

   Laws and regulations directly applicable to communications or commerce over
the Internet are becoming more prevalent. For example, the U.S. Congress has
passed legislation resulting in Internet laws regarding children's privacy,
copyrights, taxation and the transmission of sexually explicit material. The
European Union has also enacted its own privacy regulations. In particular,
many government agencies and consumers are focused on the privacy and security
of medical and pharmaceutical records. The law of the Internet, however,
remains largely unsettled, even in areas where there has been some legislative
action. It may take years to determine whether and how existing laws such as
those governing privacy, libel and taxation apply to Internet stores such as
ours. The rapid growth and development of the market for online commerce may
prompt calls for more stringent consumer protection laws, both in the United
States and abroad, that may impose additional burdens on companies conducting
business online and in particular companies that fill prescriptions or
maintain medical or pharmaceutical records. The adoption or modification of
laws or regulations relating to Internet businesses could adversely affect our
ability to attract and serve customers.

 Our Stock Price is Likely to Continue to Fluctuate, Which Could Result in
 Substantial Losses for Investors

   The market price of our common stock has been and is likely to continue to
be extremely volatile. Our stock price could be subject to wide fluctuations
in response to a number of factors, some of which are beyond

                                      40
<PAGE>

our control, and these fluctuations could result in substantial losses for
investors. Factors that could cause our stock price to fluctuate include:

  .  Quarterly variations in operating results;

  .  Changes in financial estimates by securities analysts;

  .  Announcements by us or our competitors concerning new products,
     significant contracts, acquisitions or strategic relationships;

  .  Publicity about our company, our products and services, our strategic
     partners, our competitors, the online pharmacy industry, or e-commerce
     in general;

  .  Additions or departures of key personnel;

  .  Any future sales of our common stock or other securities; and

  .  Stock market price and volume fluctuations of publicly-traded companies
     in general and Internet-related companies in particular.

   The trading prices of Internet-related companies and e-commerce companies in
particular have been especially volatile. Investors may be unable to resell
their shares of our common stock at or above the offering price. In the past,
securities class action litigation has often been brought against a company
following periods of volatility in the market price of its securities. We may
be the target of similar litigation in the future. Securities litigation could
result in substantial costs and divert management's attention and resources,
which could seriously harm our business and operating results.

   In addition if our stock price continues to decline, we may not be able to
maintain the standards required for continued listing on the Nasdaq National
Market. Delisting would eliminate the substantial benefit currently enjoyed by
holders of our common stock of being able to easily buy or sell our common
stock. For continued listing of our common stock on the Nasdaq National Market,
we must, among other things, maintain a minimum bid price of $1.00 per share.
As of March 26, 2001, our stock price was $1.00 per share.

 Subsequent Sales of Our Common Stock Could Adversely Affect Our Stock Price
 and Our Ability To Raise Funds in New Equity Offerings

   As of March 26, 2001 we have incentive stock purchase rights outstanding to
purchase an aggregate of approximately 3.9 million shares of our common stock
at $0.01 per share. Approximately 1.6 million of these rights will be
exercisable on April 12, 2001 and the remainder will vest ratably every six
months for one year thereafter. In addition, beginning on April 2, 2001,
5,606,646 shares of our common stock held by existing stockholders will become
available for resale under Rule 144 of the Securities Act of 1933, as amended.
Future sales of substantial amounts of our common stock by new or existing
stockholders could adversely affect prevailing market price for our common
stock and could materially impair our future ability to raise capital through
an offering of equity securities.

Special Note Regarding Forward-Looking Statements

   This Annual Report on Form 10-K contains forward-looking statements that
involve risks and uncertainties. These statements relate to future events or
our future financial performance and include, but are not limited to,
statements concerning:

  .  The anticipated benefits and risks of our key strategic partnerships,
     business relationships and acquisitions;

  .  Our ability to attract and retain customers;

  .  The anticipated benefits and risks associated with our business
     strategy, including those relating to our distribution and fulfillment
     strategy and our current and future product and service offerings;

                                       41
<PAGE>

  .  Our future operating results and the future value of our common stock;

  .  The anticipated size or trends of the market segments in which we
     compete and the anticipated competition in those markets;

  .  Potential government regulation; and

  .  Our future capital requirements and our ability to satisfy our capital
     needs.

Furthermore, in some cases, you can identify forward-looking statements by
terminology such as may, will, could, should, expect, plan, intend, anticipate,
believe, estimate, predict, potential or continue, the negative of such terms
or other comparable terminology. These statements are only predictions. Actual
events or results may differ materially. Factors that could cause such
differences include, but are not limited to, those identified herein under
"Factors That May Affect Our Business," and other risks included from time to
time in the Company's other Securities and Exchange Commission ("SEC") reports
and press releases, copies of which are available from the Company upon
request.

   Although we believe that the expectations reflected in the forward-looking
statements are reasonable, we cannot guarantee future results, levels of
activity, performance or achievements. Moreover, neither we nor any other
person assumes responsibility for the accuracy and completeness of the forward-
looking statements. We are under no duty to update any of the forward-looking
statements to conform such statements to actual results or to changes in our
expectations.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

   We have assessed our vulnerability to certain market risks, including
interest rate risk associated with financial instruments included in cash, cash
equivalents and marketable securities. Due to the short-term nature of these
investments and our investment policies and procedures, we have determined that
the risk associated with interest rate fluctuations related to these financial
instruments does not pose a material risk to us.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

   The financial statements required pursuant to this item are filed under Part
IV, Item 14(a)(1) of this Annual Report on Form 10-K. The financial statement
schedule required under Regulation S-X is filed under Part IV, Item 14 (a)(2)
of this Annual Report on Form 10-K.

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

   None.

                                       42
<PAGE>

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

   Information regarding our executive officers required by Part III, Item 10,
is set forth in Item 1 of Part I herein under the caption "Executive Officers
of the Registrant." Information required by Part III, Item 10, regarding our
directors is included in our Proxy Statement relating to our annual meeting of
stockholders to be held on June 13, 2001, and is incorporated herein by
reference. Information relating to compliance with Section 16(a) of the
Securities Exchange Act of 1934, as amended, is set forth in the Proxy
Statement and incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

   Information required by Part III, Item 11, is included in our Proxy
Statement relating to our annual meeting of stockholders to be held on June 13,
2001, and is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

   Information required by Part III, Item 12, is included in our Proxy
Statement relating to our annual meeting of stockholders to be held on June 13,
2001, and is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   Information regarding certain of our relationships and related transactions
is included in our Proxy Statement relating to our annual meeting of
stockholders to be held on June 13, 2001, and is incorporated herein by
reference.

                                       43
<PAGE>

                                    PART IV

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

   (a) The following documents are filed as a part of this Report:

   1. Index to Consolidated Financial Statements:

<TABLE>
<CAPTION>
                                                                            Page
                                                                            ----
   <S>                                                                      <C>
   Report of Ernst & Young LLP, Independent Auditors.......................  46
   Consolidated Balance Sheets.............................................  47
   Consolidated Statements of Operations...................................  48
   Consolidated Statements of Stockholders' Equity.........................  49
   Consolidated Statements of Cash Flows...................................  52
   Notes to Consolidated Financial Statements..............................  53

   2. Index to Financial Statement Schedules:

   Schedule II--Valuation and qualifying accounts..........................  72
</TABLE>

     All other schedules have been omitted because the required information
  is included in the consolidated financial statements or the notes thereto,
  or is not applicable or required.

   3. List of Exhibits:

<TABLE>
<CAPTION>
 Exhibit
   No.                                    Item
 -------                                  ----
 <C>     <S>
  3.2    Amended and Restated Certificate of Incorporation of drugstore.com
          (Incorporated by reference to exhibit number 3.2 to drugstore.com's
          registration statement on Form S-1 (file number 333-96441)
          filed February 9, 2000).

  3.3    Amended and Restated Bylaws (Incorporated by reference to exhibit
          number 3.3 to drugstore.com's registration statement on Form S-1
          (file number 333-96441) filed February 9, 2000).

 10.1    1999 Employee Stock Purchase Plan as amended. (Incorporated by
          reference to exhibit number 10.3 to drugstore.com's registration
          statement on Form S-1 (file number 333-96441) filed February 9,
          2000).

 10.2    Fifth Amended and Restated Voting Agreement dated December 23, 1999
          (Incorporated by reference to exhibit number 10.20 to drugstore.com's
          registration statement on Form S-1 (file number 333-96441) filed
          February 9, 2000).

 10.3    Office Lease Agreement dated November 22, 1999 between WRC Sunset
          North LLC and drugstore.com. (Incorporated by reference to exhibit
          number 10.34 to drugstore.com's registration statement on Form S-1
          (file number 333-96441) filed February 9, 2000).

 10.4    Agreement dated January 24, 2000 between Amazon.com Commerce Services
          Inc. and drugstore.com, inc. (Incorporated by reference to exhibit
          number 10.35 to drugstore.com's registration statement on Form S-1
          (file number 333-96441) filed February 9, 2000).

 10.5    Performance Guarantee dated January 24, 2000 by Amazon.com, Inc. of
          Amazon.com Commerce Services, Inc.'s obligations under the Agreement
          dated January 24, 2000 between Amazon.com Commerce Services, Inc. and
          drugstore.com, inc. (Incorporated by reference to exhibit number 3.2
          to drugstore.com's registration statement on Form S-1 (file number
          333-96441) filed February 9, 2000).

 10.6    Stock Purchase Letter Agreement dated January 24, 2000 between
          drugstore.com, inc. and Amazon.com, Inc. (Incorporated by reference
          to exhibit number 10.37 to drugstore.com's registration statement on
          Form S-1 (file number 333-96441) filed February 9, 2000).
</TABLE>


                                       44
<PAGE>

<TABLE>
<CAPTION>
 Exhibit
   No.                                    Item
 -------                                  ----
 <C>     <S>
 10.7    Third Addendum to Fourth Amended and Restated Investors' Rights
          Agreement dated January 24, 2000 (Incorporated by reference to
          exhibit number 10.38 to drugstore.com's registration statement on
          Form S-1 (file number 333-96441) filed February 9, 2000).

 21.1    Subsidiaries (Incorporated by reference to exhibit number 21.1 to
          drugstore.com's registration statement on Form S-1 (file number 333-
          96441) filed February 9, 2000).

 23.1    Consent of Ernst & Young LLP, Independent Auditors.
</TABLE>

   (b) Reports on Form 8-K.

   The Company filed one report on Form 8-K during the quarter ended December
31, 2000. On December 14, 2000, the Company disclosed the intention of Peter
Neupert, President and Chief Executive Officer, to speak to the press regarding
the Company and the holiday season.


                                       45
<PAGE>

               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
drugstore.com, inc.

   We have audited the accompanying consolidated balance sheets of
drugstore.com, inc. and subsidiaries as of December 31, 2000 and January 2,
2000, and the related consolidated statements of operations, stockholders'
equity, and cash flows for the years ended December 31, 2000 and January 2,
2000 and the period from April 2, 1998 (inception) to December 31, 1998. Our
audits also included the financial statement schedule listed in the Index at
Item 14(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

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

   In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of drugstore.com,
inc. and subsidiaries at December 31, 2000 and January 2, 2000, and the
consolidated results of their operations and their cash flows for the years
ended December 31, 2000 and January 2, 2000 and the period from April 2, 1998
(inception) to December 31, 1998, in conformity with accounting principles
generally accepted in the United States. Also, in our opinion, the related
financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.

                                          Ernst & Young LLP

Seattle, Washington
January 19, 2001, except as to the fourth paragraph of
 Note 6, as to which the date is March 20, 2001

                                       46
<PAGE>

                              DRUGSTORE.COM, INC.

                          CONSOLIDATED BALANCE SHEETS
                       (in thousands, except share data)

<TABLE>
<CAPTION>
                                                        December 31,  January
                                                            2000      2, 2000
                                                        ------------ ---------
<S>                                                     <C>          <C>
                        ASSETS

Current assets:
  Cash and cash equivalents............................  $ 108,032   $  26,526
  Marketable securities................................     21,856     106,228
  Accounts receivable, less allowance for doubtful
   accounts and sales returns of $319 and $251.........      6,003       4,273
  Inventories..........................................      8,608       2,862
  Prepaid marketing expenses...........................     22,718       8,010
  Other current assets.................................      1,686       1,333
                                                         ---------   ---------
    Total current assets...............................    168,903     149,232
Fixed assets, net of accumulated depreciation and
 amortization of $13,844 and $3,179....................     38,680      25,208
Intangible assets, net of accumulated amortization of
 $45,448 and $10,674...................................    221,114     200,742
Prepaid marketing expenses.............................     23,714      19,465
Note receivable from officer...........................        --          269
Deposits and other assets..............................      6,112         792
                                                         ---------   ---------
    Total assets.......................................  $ 458,523   $ 395,708
                                                         =========   =========

         LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
  Accounts payable, including amounts due to related
   party of $13,310 and $4,391.........................  $  22,600   $  25,788
  Accrued compensation.................................      4,953       4,231
  Accrued marketing expenses, including amounts due to
   related party of $30 and $1,500.....................      2,232       8,520
  Other current liabilities............................      2,186       1,245
  Current portion of capital lease obligations.........      2,844       2,488
                                                         ---------   ---------
    Total current liabilities..........................     34,815      42,272
Capital lease obligations, less current portion........      2,399       2,687
Other long term liabilities............................      9,320         --

Commitments and contingencies (See Note 6)

Stockholders' equity:
  Preferred stock, $.0001 par value:
   Authorized shares--10,000,000
   Issued and outstanding shares--None.................        --          --
  Common stock, $.0001 par value, stated at amounts
   paid in:
   Authorized shares--250,000,000
   Issued and outstanding shares--65,843,250 and
    43,508,808 as of December 31, 2000 and January 2,
    2000, respectively.................................    741,170     485,377
  Deferred stock-based compensation....................    (12,308)    (10,770)
  Accumulated deficit..................................   (316,873)   (123,858)
                                                         ---------   ---------
    Total stockholders' equity.........................    411,989     350,749
                                                         ---------   ---------
    Total liabilities and stockholders' equity.........  $ 458,523   $ 395,708
                                                         =========   =========
</TABLE>

          See accompanying notes to consolidated financial statements.

                                       47
<PAGE>

                              DRUGSTORE.COM, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                (in thousands, except share and per share data)

<TABLE>
<CAPTION>
                                                                  Period from
                                                                 April 2, 1998
                                         Year Ended  Year Ended  (Inception) to
                                        December 31, January 2,   December 31,
                                            2000        2000          1998
                                        ------------ ----------  --------------
<S>                                     <C>          <C>         <C>
Net sales..............................  $  109,979  $   34,848     $   --
Costs and expenses:
  Cost of sales........................     100,711      43,332         --
  Fulfillment and order processing(1)..      37,464      15,985         --
  Marketing and sales(2)...............      76,183      40,615       3,092
  Technology and content(3)............      27,377      14,918       2,178
  General and administrative(4)........      20,002      11,126       1,861
  Charitable contribution..............         --        3,600         --
  Amortization of intangible assets....      34,774      10,640          33
  Amortization of stock-based
   compensation........................      15,115      15,375       1,037
                                         ----------  ----------     -------
    Total costs and expenses...........     311,626     155,591       8,201
                                         ----------  ----------     -------
Operating loss.........................    (201,647)   (120,743)     (8,201)
Interest income, net...................       8,632       4,912         174
                                         ----------  ----------     -------
Net loss...............................  $ (193,015) $ (115,831)    $(8,027)
                                         ==========  ==========     =======
Basic and diluted net loss per share...  $    (3.56) $    (6.13)    $(14.70)
                                         ==========  ==========     =======
Weighted average shares outstanding
 used to compute basic and diluted net
 loss per share........................  54,212,080  18,880,969     546,149
                                         ==========  ==========     =======
Pro forma basic and diluted net loss
 per share (unaudited).................  $    (3.48)
                                         ==========
Weighted average shares outstanding
 used to compute pro forma basic and
 diluted net loss per share
 (unaudited)...........................  55,448,923
                                         ==========
</TABLE>
--------
(1) Excludes amortization of stock-based compensation of $1,630 for the year
    ended December 31, 2000, $1,549 for the year ended January 2, 2000 and $26
    for the period from April 2, 1998 (inception) to December 31, 1998.

(2) Excludes amortization of stock-based compensation of $1,561 for the year
    ended December 31, 2000, $2,181 for the year ended January 2, 2000 and $163
    for the period from April 2, 1998 (inception) to December 31, 1998.

(3) Excludes amortization of stock-based compensation of $3,976 for the year
    ended December 31, 2000, $3,153 for the year ended January 2, 2000 and $209
    for the period from April 2, 1998 (inception) to December 31, 1998.

(4) Excludes amortization of stock-based compensation of $7,948 for the year
    ended December 31, 2000, $8,492 for the year ended January 2, 2000 and $639
    for the period from April 2, 1998 (inception) to December 31, 1998.

          See accompanying notes to consolidated financial statements.

                                       48
<PAGE>

                              DRUGSTORE.COM, INC.

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                       (in thousands, except share data)

<TABLE>
<CAPTION>
                                                      Preferred Stock
                        ----------------------------------------------------------------------------                   Deferred
                            Series A          Series B       Series C      Series D      Series E      Common Stock     Stock-
                        ----------------- ---------------- ------------- ------------- ------------- ---------------- based Com-
                          Shares   Amount  Shares   Amount Shares Amount Shares Amount Shares Amount  Shares   Amount pensation
                        ---------- ------ --------- ------ ------ ------ ------ ------ ------ ------ --------- ------ ----------
<S>                     <C>        <C>    <C>       <C>    <C>    <C>    <C>    <C>    <C>    <C>    <C>       <C>    <C>
Initial issuance
of common shares
to founders in
exchange for
cash and
intellectual
property........               --  $ --         --  $  --   --     $--    --     $--    --     $--   2,315,000 $ 113    $  --
Issuance of
Series A
preferred stock,
net of offering
costs of $14....         5,000,000 3,986        --     --   --      --    --      --    --      --         --    --        --
Issuance of
Series A
preferred stock
in exchange for
Technology
License and
Advertising
Agreement.......         5,000,000 4,000        --     --   --      --    --      --    --      --         --    --        --
Issuance of
Series B
preferred stock,
net of offering
costs of $8.....               --    --   5,446,268 18,237  --      --    --      --    --      --         --    --        --
Exercise of
common stock
options.........               --    --         --     --   --      --    --      --    --      --       8,000     1       --
Deferred stock-
based
compensation....               --    --         --     --   --      --    --      --    --      --         --  4,966    (4,966)
Amortization of stock-
based Compensation..           --    --         --     --   --      --    --      --    --      --         --    --      1,037
Net loss and
comprehensive
loss............               --    --         --     --   --      --    --      --    --      --         --    --        --
                        ---------- -----  --------- ------  ---    ----   ---    ----   ---    ----  --------- -----    ------
Balance at
December 31,
1998............        10,000,000 7,986  5,446,268 18,237  --      --    --      --    --      --   2,323,000 5,080    (3,929)
<CAPTION>
                         Accu-
                        mulated
                        Deficit  Total
                        -------- -------
<S>                     <C>      <C>
Initial issuance
of common shares
to founders in
exchange for
cash and
intellectual
property........        $  --    $  113
Issuance of
Series A
preferred stock,
net of offering
costs of $14....           --     3,986
Issuance of
Series A
preferred stock
in exchange for
Technology
License and
Advertising
Agreement.......           --     4,000
Issuance of
Series B
preferred stock,
net of offering
costs of $8.....           --    18,237
Exercise of
common stock
options.........           --         1
Deferred stock-
based
compensation....           --        --
Amortization of stock-
based Compensation..       --     1,037
Net loss and
comprehensive
loss............        (8,027)  (8,027)
                        -------- -------
Balance at
December 31,
1998............        (8,027)  19,347
</TABLE>


         See accompanying notes to consolidated financial statements.

                                       49
<PAGE>

                              DRUGSTORE.COM, INC.

         CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY--(Continued)
                       (in thousands, except share data)

<TABLE>
<CAPTION>
                                                             Preferred Stock
                  --------------------------------------------------------------------------------------------------------------
                       Series A              Series B              Series C              Series D               Series E
                  --------------------  --------------------  --------------------  --------------------  ----------------------
                    Shares     Amount     Shares     Amount     Shares     Amount     Shares     Amount     Shares      Amount
                  -----------  -------  ----------  --------  ----------  --------  ----------  --------  -----------  ---------
<S>               <C>          <C>      <C>         <C>       <C>         <C>       <C>         <C>       <C>          <C>
Balance at
December 31,
1998............   10,000,000    7,986   5,446,268    18,237         --        --          --        --           --         --
Issuance of
Series C
preferred stock,
net of offering
costs of $19....          --       --          --        --    4,472,844    34,981         --        --           --         --
Issuance of
Series D
preferred stock,
net of offering
costs of $18....          --       --          --        --          --        --    2,266,289    44,982          --         --
Issuance of
Series E
preferred stock,
net of offering
costs of $396...          --       --          --        --          --        --          --        --    12,282,599    243,567
Conversion of
preferred stock
to common stock
in conjunction
with initial
public
offering........  (10,000,000)  (7,986) (5,446,268)  (18,237) (4,472,844)  (34,981) (2,266,289)  (44,982) (12,282,599)  (243,567)
Issuance of
common stock for
cash in initial
public offering,
net of offering
costs of
$8,921..........          --       --          --        --          --        --          --        --           --         --
Private
placement of
common stock....          --       --          --        --          --        --          --        --           --         --
Contribution of
common stock to
charitable
foundation......          --       --          --        --          --        --          --        --           --         --
Issuance of
warrants to
purchase common
Stock...........          --       --          --        --          --        --          --        --           --         --
Exercise of
common stock
options and
Warrants........          --       --          --        --          --        --          --        --           --         --
Deferred stock-
based
compensation....          --       --          --        --          --        --          --        --           --         --
Amortization of
stock-based
Compensation....          --       --          --        --          --        --          --        --           --         --
Forfeiture of
common stock
options.........          --       --          --        --          --        --          --        --           --         --
Net loss and
comprehensive
loss............          --       --          --        --          --        --          --        --           --         --
                  -----------  -------  ----------  --------  ----------  --------  ----------  --------  -----------  ---------
Balance at
January 2,
2000............          --       --          --        --          --        --          --        --           --         --
<CAPTION>
                                        Deferred
                     Common Stock        Stock-    Accu-
                  -------------------- based Com- mulated
                    Shares    Amount   pensation  Deficit    Total
                  ---------- --------- ---------- --------- ---------
<S>               <C>        <C>       <C>        <C>       <C>
Balance at
December 31,
1998............   2,323,000    5,080    (3,929)    (8,027)   19,347
Issuance of
Series C
preferred stock,
net of offering
costs of $19....         --       --        --         --     34,981
Issuance of
Series D
preferred stock,
net of offering
costs of $18....         --       --        --         --     44,982
Issuance of
Series E
preferred stock,
net of offering
costs of $396...          --      --        --         --    243,567
Conversion of
preferred stock
to common stock
in conjunction
with initial
public
offering........  34,468,000  349,753       --         --         --
Issuance of
common stock for
cash in initial
public offering,
net of offering
costs of
$8,921..........   5,750,000   94,579       --         --     94,579
Private
placement of
common stock....     555,555   10,000       --         --     10,000
Contribution of
common stock to
charitable
foundation......     200,000    3,600       --         --      3,600
Issuance of
warrants to
purchase common
Stock...........         --        24       --         --         24
Exercise of
common stock
options and
Warrants........     212,253      125       --         --        125
Deferred stock-
based
compensation....         --    22,630   (22,630)       --        --
Amortization of
stock-based
Compensation....         --       --     15,375        --     15,375
Forfeiture of
common stock
options.........         --      (414)      414        --        --
Net loss and
comprehensive
loss............         --       --        --    (115,831) (115,831)
                  ---------- --------- ---------- --------- ---------
Balance at
January 2,
2000............  43,508,808  485,377   (10,770)  (123,858)  350,749
</TABLE>

         See accompanying notes to consolidated financial statements.

                                       50
<PAGE>

                              DRUGSTORE.COM, INC.

         CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY--(Continued)
                       (in thousands, except share data)

<TABLE>
<CAPTION>
                                                Preferred Stock
                  -----------------------------------------------------------------------------                       Deferred
                       Series A           Series B      Series C      Series D      Series E       Common Stock        Stock-
                  --------------------  ------------- ------------- ------------- ------------- -------------------  based Com-
                    Shares     Amount   Shares Amount Shares Amount Shares Amount Shares Amount   Shares    Amount   pensation
                  ----------  --------  ------ ------ ------ ------ ------ ------ ------ ------ ---------- --------  ----------
<S>               <C>         <C>       <C>    <C>    <C>    <C>    <C>    <C>    <C>    <C>    <C>        <C>       <C>
Balance at
January 2,
2000............         --        --    --      --    --      --    --      --    --      --   43,508,808  485,377    (10,770)
Issuance of
common stock for
cash in
secondary
offering, net of
offering costs
of $6,400.......         --        --    --      --    --      --    --      --    --      --    6,000,000  101,600        --
Issuance of
preferred and
common stock for
cash in private
placement, net
of offering
costs of $420...   45,939.89    22,683   --      --    --      --    --      --    --      --    8,101,264   39,580        --
Conversion of
preferred stock
to common Stock
upon shareholder
vote............  (45,939.89)  (22,683)  --      --    --      --    --      --    --      --    4,593,989   22,683        --
Issuance of
common stock for
marketing
services,
intangible asset
and software....         --        --    --      --    --      --    --      --    --      --    1,816,667   30,679        --
Issuance of
warrant to
purchase common
stock for
marketing
services........         --        --    --      --    --      --    --      --    --      --          --     9,499        --
Acquisition of
beauty.com......         --        --    --      --    --      --    --      --    --      --    1,235,530   37,619     (4,626)
Exercise of
stock options...         --        --    --      --    --      --    --      --    --      --      383,961      253        --
Employee stock
purchase plan...         --        --    --      --    --      --    --      --    --      --      200,399    1,853        --
Deferred stock-
based
compensation....         --        --    --      --    --      --    --      --    --      --        2,632   17,582    (17,582)
Amortization of
stock-based
compensation....         --        --    --      --    --      --    --      --    --      --          --       --      15,115
Forfeiture of
common stock
options.........         --        --    --      --    --      --    --      --    --      --          --    (5,555)     5,555
Net loss and
comprehensive
loss............         --        --    --      --    --      --    --      --    --      --          --       --         --
                  ----------  --------   ---   -----   ---   -----   ---   -----   ---   -----  ---------- --------   --------
Balance at
December 31,
2000............         --   $    --    --    $ --    --    $ --    --    $ --    --    $ --   65,843,250 $741,170   $(12,308)
                  ==========  ========   ===   =====   ===   =====   ===   =====   ===   =====  ========== ========   ========
<CAPTION>
                    Accu-
                   mulated
                   Deficit     Total
                  ---------- ----------
<S>               <C>        <C>
Balance at
January 2,
2000............   (123,858)   350,749
Issuance of
common stock for
cash in
secondary
offering, net of
offering costs
of $6,400.......        --     101,600
Issuance of
preferred and
common stock for
cash in private
placement, net
of offering
costs of $420...        --      62,263
Conversion of
preferred stock
to common Stock
upon shareholder
vote............        --         --
Issuance of
common stock for
marketing
services,
intangible asset
and software....        --      30,679
Issuance of
warrant to
purchase common
stock for
marketing
services........        --       9,499
Acquisition of
beauty.com......        --      32,993
Exercise of
stock options...        --         253
Employee stock
purchase plan...        --       1,853
Deferred stock-
based
compensation....        --         --
Amortization of
stock-based
compensation....        --      15,115
Forfeiture of
common stock
options.........        --         --
Net loss and
comprehensive
loss............   (193,015)  (193,015)
                  ---------- ----------
Balance at
December 31,
2000............  $(316,873) $ 411,989
                  ========== ==========
</TABLE>

         See accompanying notes to consolidated financial statements.

                                       51
<PAGE>

                              DRUGSTORE.COM, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                    Period from
                                                                   April 2, 1998
                                           Year Ended  Year Ended  (Inception) to
                                          December 31, January 2,   December 31,
                                              2000        2000          1998
                                          ------------ ----------  --------------
<S>                                       <C>          <C>         <C>
OPERATING ACTIVITIES:
  Net loss..............................   $(193,015)  $(115,831)     $(8,027)
  Adjustments to reconcile net loss to
   net cash used in operating
   activities:
  Non-cash expenses:
   Depreciation.........................      11,715       3,242           57
   Marketing and sales..................      18,191       4,947           58
   Charitable contributions.............         --        3,600          --
   Amortization of intangible assets....      34,774      10,640           33
   Amortization of stock-based
    compensation........................      15,115      15,375        1,037
  Changes in:
   Accounts receivable..................      (1,683)     (4,273)         --
   Inventories..........................      (4,799)     (2,862)         --
   Prepaid marketing expenses...........        (649)       (161)        (552)
   Other current assets.................        (300)       (857)        (484)
   Deposits and other assets............      (5,812)       (616)        (176)
   Accounts payable and accrued
    expenses............................     (16,117)     30,079        1,723
   Other................................         269        (103)         --
                                           ---------   ---------      -------
   Net cash used in operating
    activities..........................    (142,311)    (56,820)      (6,331)
INVESTING ACTIVITIES:
  Purchases of marketable securities....     (39,119)   (881,072)         --
  Sales of marketable securities........     123,491     774,844          --
  Purchases of fixed assets.............     (22,972)    (13,630)      (1,202)
  Purchases of intangible assets........         (32)        (95)         (90)
  Business acquisition, net of cash
   received.............................        (335)        --           --
  Issuance of note receivable to
   officer..............................         --          --          (250)
                                           ---------   ---------      -------
   Net cash provided by (used in)
    investing activities................      61,033    (119,953)      (1,542)
FINANCING ACTIVITIES:
  Net proceeds from sales of common
   stock................................     141,180     104,578           90
  Net proceeds from exercise of stock
   options, warrants and employee stock
   purchase plan........................       2,106         126            1
  Net proceeds from sales of preferred
   stock................................      22,683      84,598       22,223
  Proceeds from capital lease
   obligations..........................         127         538          --
  Principal payments on capital lease
   obligations..........................      (3,312)       (949)         (33)
                                           ---------   ---------      -------
   Net cash provided by financing
    activities..........................     162,784     188,891       22,281
                                           ---------   ---------      -------
Net increase in cash and cash
 equivalents............................      81,506      12,118       14,408
Cash and cash equivalents at beginning
 of period..............................      26,526      14,408          --
                                           ---------   ---------      -------
Cash and cash equivalents at end of
 period.................................   $ 108,032   $  26,526      $14,408
                                           =========   =========      =======
SUPPLEMENTAL CASH FLOW INFORMATION:
  Cash paid for interest................   $     395   $     108      $    48
  Equipment acquired through capital
   lease agreements.....................   $   3,254   $   4,138      $ 1,480
  Issuance of equity and debt
   instruments in exchange for prepaid
   marketing, intangible assets,
   software and a vendor agreement......   $  49,498   $ 238,956      $ 4,023
  Issuance of common stock in connection
   with business acquisition............   $  37,619   $     --       $   --
</TABLE>

          See accompanying notes to consolidated financial statements.

                                       52
<PAGE>

                              DRUGSTORE.COM, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. The Company and Summary of Significant Accounting Policies

 The Company

   drugstore.com, inc. and its subsidiaries, (collectively, the Company) are
engaged in the development of Internet-based retailing opportunities focused on
filling needs for health, wellness, beauty, personal care and pharmacy products
and related information. The Company was incorporated on April 2, 1998 and
launched its Web store and commenced commercial operations on February 24,
1999.

   All customer orders are processed through the Company's Web store. In the
first half of 2000, the Company opened its own distribution center, providing
distribution capabilities for all of its pharmaceutical and non-pharmaceutical
orders delivered by mail. Previously, the Company primarily utilized third-
party fulfillment partners to purchase a majority of its inventory and deliver
its products. Under the terms of an agreement with Rite Aid Corporation (Rite
Aid), customers are also able to order existing drugstore.com and Rite Aid
prescriptions for pick up at any Rite Aid store.

 Principles of Consolidation and Basis of Presentation

   The accompanying consolidated financial statements include those of
drugstore.com, inc. and its subsidiaries. All material intercompany
transactions and balances have been eliminated.

   On January 1, 1999, the Company adopted a 52/53 week fiscal year ending on
the Sunday closest to December 31, with each of the fiscal quarters
representing a 13-week period. The effect of the change on reported periods is
insignificant.

 Use of Estimates

   The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements. Actual results could differ from those estimates.

 Cash Equivalents

   The Company considers all highly liquid investments with a maturity of three
months or less at the date of purchase to be cash equivalents.

 Concentration of Credit Risk

   Financial instruments, which potentially subject the Company to
concentrations of credit risk, consist principally of its holdings of cash and
marketable securities. The Company's credit risk is managed by investing its
cash and marketable securities in high-quality money market instruments and
securities of the U.S. government and its agencies, foreign governments and
high-quality corporate issuers. The Company's credit risk is managed through
monitoring the stability of the financial institutions utilized and
diversification of its financial resources. At December 31, 2000, the Company
had no significant concentrations of credit risk.

 Financial Instruments

   Financial instruments consist of cash and cash equivalents, marketable
securities and capital lease obligations. The fair value of all financial
instruments approximates the carrying amount based on the current rate offered
for similar instruments.

                                       53
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   At December 31, 2000 and January 2, 2000, marketable securities, which are
considered available-for-sale, consist primarily of commercial paper and short-
term obligations and corporate notes and bonds and were carried at cost, which
approximates market value. Unrealized holding gains and losses at December 31,
2000 and January 2, 2000 were not significant. Approximately $7,301,000 of the
Company's marketable securities as of December 31, 2000 mature in greater than
one year.

 Accounts Receivable

   Accounts receivable consists primarily of the net amounts to be collected
from third parties including managed care organizations and pharmacy benefit
management and insurance companies as well as amounts collectible related to
credit card purchases. Under the terms of the Company's agreement with Rite
Aid, Rite Aid collects insurance reimbursement payments on the Company's
behalf. As of December 31, 2000 and January 2, 2000, accounts receivable
included $5,325,000 and $3,839,000, respectively, being collected by Rite Aid
on the Company's behalf. Accounts receivable is recorded net of an allowance
for doubtful accounts and sales returns.

 Inventories

   Inventories are stated at the lower of cost (using the weighted average cost
method) or market. The Company currently purchases the majority of its non-
pharmaceutical inventory directly from manufacturers. The Company is
contractually obligated to purchase all of its pharmaceutical inventory from
Rite Aid unless it can obtain better overall terms from other vendors. Prior to
opening its own distribution center, the Company purchased substantially all of
its non-pharmaceutical and pharmaceutical inventory from third party
fulfillment partners.

 Fixed Assets

   Fixed assets are stated at cost less accumulated depreciation and
amortization, which includes the amortization of assets recorded under capital
leases. Depreciation and amortization is provided using the straight-line
method over the estimated useful lives of the related assets, which range from
two to ten years. Fixed assets purchased under capital leases and leasehold
improvements are amortized over the shorter of the lease term or estimated
useful life.

 Intangible Assets

   Intangible assets consists of assets received in connection with agreements
between the Company and Rite Aid and General Nutrition Companies, Inc. (GNC)
including access to insurance coverage and a vendor agreement; assets acquired
in connection with the purchase of Beauty.com including goodwill and domain
names; and other intangibles including a technology license agreement, domain
names and trademarks. Intangible assets are being amortized over their expected
useful lives, which range from three to ten years.

 Long-Lived Assets

   Long-lived assets and intangible assets are reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount may not be
recoverable. Such events could include, but are not limited to, the Company's
inability to achieve its planned penetration rate with respect to insured
prescriptions, the Company's inability to achieve the planned growth rates for
the Rite Aid local pickup, GNC-branded product or prestige beauty businesses, a
decision by Rite Aid to substantially curtail its marketing spending with
respect to the Company for an extended period of time, or the loss of key
prestige beauty vendors.

                                       54
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Impairment is measured by comparing the carrying value of the long-lived assets
to the estimated undiscounted future cash flows expected to result from use of
the assets and their ultimate disposition. In circumstances where impairment is
determined to exist, the Company will write down the asset to its fair value
based on the present value of estimated expected future cash flows. To date, no
such impairment has been indicated.

 Net Sales

   Net sales includes gross revenues from sales of product and related shipping
fees, net of discounts and provision for sales returns, third-party
reimbursement and other allowances. The Company generally refunds to customers
all or a portion of the selling price, including related shipping fees if
applicable, in the event a customer is not satisfied with the product purchased
or the quality of customer service provided. Sales returns and allowances have
not been significant to date.

   Revenues from sales of product shipped to customers, and related shipping
fees, are recognized upon shipment. Prior to opening its own distribution
center, the Company arranged for shipment of product to customers through
various contractual relationships with third-party fulfillment partners.
Revenues from sales of certain pharmaceutical products ordered through the
Company's Web store for delivery at a Rite Aid store are recognized when the
product is delivered to the customer.

   The Company currently utilizes Rite Aid as a fulfillment partner, and prior
to opening its own distribution center, utilized RxAmerica L.L.C. for
pharmaceutical products and Walsh Distribution, Inc. for non-pharmaceutical
products as fulfillment partners. Upon receiving and validating a customer's
order for products that will be purchased by the Company from a fulfillment
partner, and subsequently shipped or delivered to the customer by that
fulfillment partner, the Company submits relevant order information and, if
applicable, shipping instructions to that fulfillment partner for processing.
The Company believes it acts as a principal in connection with orders shipped
or delivered to customers by fulfillment partners on the Company's behalf
because, among other things, the Company establishes the retail prices of
significantly all of its non-pharmaceutical and non-insured pharmaceutical
products (and accepts contractual reimbursement amounts from third-party payors
for insured pharmaceutical products) and shipping fees; contractually takes
title to, and assumes risk of loss of, products prior to their shipment; bears
credit and collection risk from the customer or, in the case of certain
pharmaceutical sales, third-party payors; and bears the risk that the product
will be returned. Title to products ordered by customers and shipped or
delivered by a fulfillment partner passes to the Company at the fulfillment
partner's distribution center or, for certain pharmaceutical sales, when the
pharmaceuticals are made available for customer retrieval at a Rite Aid store.

   Net sales also includes consignment service fees earned under arrangements
where the Company does not take title to the inventory and cannot establish
pricing. Consignment service fees earned have not been significant to date.

   Net sales for the fiscal year ended December 31, 2000 included $55,566,000
related to pharmaceutical products and $54,413,000 related to non-
pharmaceutical products and other. Net sales for the fiscal year ended January
2, 2000 included $18,782,000 related to pharmaceutical products and $16,066,000
related to non-pharmaceutical products and other.

 Cost of Sales

   Cost of sales consists primarily of the cost of products sold to our
customers, including allowances for shrinkage and slow moving and expired
inventory, as well as outbound and inbound shipping costs. Additionally,
expenses related to promotional inventory included in shipments to customers
are included in cost

                                       55
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

of sales. Payments that the Company receives from vendors in connection with
joint merchandising activities, net of related costs, are netted against cost
of sales in the period in which the activities take place.

 Fulfillment and Order Processing

   Fulfillment and order processing expenses include expenses related to
distribution center equipment and packaging supplies, per-unit fulfillment fees
charged by third parties, bad debt expense, credit card processing fees, and
payroll and related expenses for personnel engaged in customer service,
purchasing, and distribution and fulfillment activities, including pharmacists
engaged in prescription verification activities and warehouse personnel. These
expenses also include rent expense and depreciation related to the Company's
distribution center.

 Marketing and Sales

   Marketing and sales expenses include advertising and marketing expenses,
promotional expenditures, and payroll and related expenses for personnel
engaged in marketing and merchandising activities.

   Advertising production costs are expensed as incurred. Costs of
communicating advertising associated with television, radio, print and other
media are expensed when such services are used. Costs associated with Web
portal advertising contracts are amortized on a straight-line basis over the
period such advertising is expected to be used. Advertising expense for the
years ended December 31, 2000 and January 2, 2000 and the period ended December
31, 1998, was $50,258,000, $28,567,000 and $1,638,000, respectively.

 Technology and Content

   Technology and content expenses consist primarily of payroll and related
expenses for personnel engaged in maintaining and making minor upgrades and
enhancements to the Company's Web site and content. These expenses also include
payroll and related expenses for information technology personnel, Internet
access and hosting charges and Web site content and design expenses.

 General and Administrative

   General and administrative expenses consist of payroll and related expenses
for executive and administrative personnel, corporate facility expenses,
professional services expenses, travel and other general corporate expenses.

 Interest Income and Expense

   Interest income consists of earnings on our cash, cash equivalents and
marketable securities, and interest expense consists primarily of interest
associated with capital lease obligations. Interest income for fiscal years
2000, 1999 and 1998 totaled $9,199,000, $5,036,000 and $177,000, respectively.
Interest expense for fiscal years 2000, 1999 and 1998 totaled $567,000,
$124,000, and $3,000 respectively.

 Income Taxes

   The Company accounts for income taxes under the liability method. Under the
liability method, deferred tax assets and liabilities are determined based on
differences between financial reporting and tax bases of assets and liabilities
and are measured using the enacted tax rates and laws that will be in effect
when the differences are expected to be recovered. Valuation allowances are
established, when necessary, to reduce deferred tax assets to the amounts
expected to be realized.

                                       56
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Stock-Based Compensation

   The Company has elected to follow Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees (APB No. 25), and related
interpretations, in accounting for employee stock options rather than the
alternative fair value accounting allowed by Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation (SFAS No. 123). APB
No. 25 provides that the compensation expense relative to the Company's
employee stock options is measured based on the intrinsic value of the stock
option. SFAS No. 123 requires companies that continue to follow APB No. 25 to
provide a pro forma disclosure of the impact of applying the fair value method
of SFAS No. 123 (see Note 9). The Company accounts for stock issued to non-
employees in accordance with the provisions of SFAS No. 123 and the Emerging
Issues Task Force (EITF) consensus in Issue No. 96-18, Accounting for Equity
Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services.

 Net Loss Per Share

   Net loss per share is computed using the weighted average number of shares
of common stock outstanding less the number of shares that are subject to
repurchase agreements or contingently issuable pursuant to contractual terms.
Shares associated with stock options, warrants and the convertible preferred
stock are not included in the calculation of diluted net loss per share because
they are antidilutive.

   Pro forma net loss per share is computed using the weighted average number
of common shares outstanding, including the pro forma effects of the conversion
of all outstanding convertible preferred stock into shares of common stock
effective upon shareholder approval in November 2000 as if such conversion
occurred at the date of original issuance.

   The following table sets forth the computation of basic and diluted net loss
per share and pro forma basic and diluted net loss per share for the periods
indicated:

<TABLE>
<CAPTION>
                                                                    Period from
                                                                   April 2, 1998
                                      Year Ended     Year Ended    (Inception) to
                                     December 31,    January 2,     December 31,
                                         2000           2000            1998
                                     -------------  -------------  --------------
<S>                                  <C>            <C>            <C>
Numerator:
    Net loss........................ $(193,015,000) $(115,831,000)  $(8,027,000)
                                     =============  =============   ===========
Denominator:
  Weighted average common shares
   outstanding......................    55,183,750     20,005,233     1,462,311
  Less weighted average common
   shares issued subject to
   repurchase agreements or
   contingently issuable pursuant to
   contractual terms................      (971,670)    (1,124,264)     (916,162)
                                     -------------  -------------   -----------
  Denominator for basic and diluted
   calculation......................    54,212,080     18,880,969       546,149
                                                    =============   ===========
  Weighted average effect of pro
   forma conversion of securities:
    Convertible preferred stock.....     1,236,843
                                     -------------
    Denominator for pro forma basic
     and diluted calculation
     (unaudited)....................... 55,448,923
                                     =============
Net loss per share:
    Basic and diluted............... $       (3.56) $       (6.13)  $    (14.70)
                                     =============  =============   ===========
    Pro forma basic and diluted
     (unaudited).................... $       (3.48)
                                     =============
</TABLE>


                                       57
<PAGE>

                                 DRUGSTORE.COM

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

   At December 31, 2000, January 2, 2000 and December 31, 1998 there were
17,682,126, 5,850,658 and 1,515,334 stock options and warrants, respectively,
that were excluded from the computation of actual and pro forma diluted net
loss per share as their effect was antidilutive. If the Company had reported
net income, the calculation of these per share amounts would have included the
dilutive effect of these common stock equivalents using the treasury stock
method.

 Segment and Geographic Information

   The Company operates in one principal business segment in the United States.
No geographic area accounted for more than 10% of net sales in the years ended
December 31, 2000 and January 2, 2000. There were no transfers between
geographic areas during the years ended December 31, 2000 and January 2, 2000.
All of the Company's operating results and identifiable assets are in the
United States.

 New Accounting Pronouncements

   In July 1999, the Financial Accounting Standards Board (FASB) announced the
delay of the effective date of Statement of Financial Accounting Standards 133,
"Accounting for Derivative Instruments and Hedging Activities" (SFAS 133), to
the first quarter of 2001. SFAS 133 establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. It requires companies
to recognize all derivatives as either assets or liabilities on the balance
sheet and measure those instruments at fair value. Gains or losses resulting
from changes in the values of those derivatives would be accounted for
depending on the use of the derivative and whether it qualifies for hedge
accounting under SFAS 133. The Company does not expect the adoption of this
consensus to have a material impact on its financial statements.

   In March 2000, the EITF of the FASB reached a consensus on EITF Issue 00-2,
"Accounting for Web Site Development Costs." This consensus provides guidance
on what types of costs incurred to develop a Web site should be capitalized or
expensed. The Company adopted this consensus in the third quarter of 2000, and
it did not have a material impact on the Company's financial statements.

   In May 2000, the EITF reached a consensus on EITF Issue 00-14, "Accounting
for Certain Sales Incentives." This consensus addresses the recognition,
measurement, and income statement classification for sales incentives (such as
discounts, coupons, and rebates) that a company offers to its customers for use
in a single transaction. The Company adopted EITF issue 00-14 in the third
quarter of 2000. Accordingly, expenses related to promotional inventory
included in shipments to customers, formerly classified as marketing and sales
expense, are now classified as cost of sales. All prior periods have been
retroactively reclassified to reflect this modification. The adoption of EITF
Issue No. 00-14 did not impact the Company's net sales, operating losses or net
losses as previously reported.

   In July 2000, the EITF reached a consensus on EITF Issue 99-19, "Reporting
Revenue Gross as a Principal versus Net as an Agent." This consensus provides
guidance on whether a company should recognize revenue in the amount of the
gross amount billed to the customer because it has earned revenue from the sale
of the goods or services or whether the company should recognize revenue based
on the net amount retained because, in substance, it has earned a commission
from the vendor-manufacturer of the goods or services on the sale. As the
Company's current accounting policies are in accordance with EITF Issue 99-19,
this consensus did not have an impact on the Company's financial statements.

   In July 2000, the EITF reached a consensus on EITF Issue 00-10 "Accounting
for Shipping and Handling Fees and Costs." This consensus indicates that
amounts billed to a customer in a sale transaction related to shipping and
handling, if any, represents revenue to the vendor and should be classified as
revenue. As the

                                       58
<PAGE>

                                 DRUGSTORE.COM

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Company currently classifies shipping fees charged to a customer in net sales,
this did not have an impact on the Company's financial statements. In September
2000, the EITF reached a final consensus with respect to the classification of
costs related to shipping and handling incurred by the seller. The Task Force
determined that the classification of shipping and handling costs is an
accounting policy decision that should be disclosed. A company may adopt a
policy of including shipping and handling costs in cost of sales, or if
shipping costs or handling costs are significant and are not included in cost
of sales, a company should disclose both the amount(s) of such costs and the
line item(s) on the income statement that include them. The Company includes
costs of shipping in cost of sales; however, in accordance with this consensus,
handling costs, formerly classified in marketing and sales expense, have been
displayed separately as fulfillment and order processing expenses. Handling
costs include expenses related to distribution center equipment and packaging
supplies; per-unit fulfillment fees charged by third parties; bad debt expense;
credit card fees and payroll and expenses for personnel engaged in customer
service, purchasing and fulfillment. All prior periods have been retroactively
reclassified to reflect this modification. The adoption of EITF Issue No. 00-10
did not impact the Company's net sales, operating losses or net losses as
previously reported.

   In November 2000, the EITF reached a consensus on EITF Issue 00-19,
"Determination of Whether Share Settlement Is within the Control of the Company
for Purposes of Applying EITF Issue No. 96-13, "Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company's Own
Stock.' " EITF 00-19 provided further clarification with respect to the
classification and accounting treatment of derivative financial instruments
indexed to a Company's own stock. In accordance with the provisions of EITF No.
00-19, the Company was required to reclassify $9,320,000 from stockholders'
equity to a long-term liability due to certain contractual requirements that
may require the Company to pay the difference between the fair value of the
stock issued to WellPoint and $10 million in cash. The portion reclassified
represents the difference between $10 million and the fair value of the
Company's stock on December 31, 2000. The Company will make a similar
reclassification at the end of the first quarter of fiscal year 2001 based upon
the fair value of the Company's stock at that time. At the end of the second
quarter of fiscal year 2001, which is the effective date of EITF No. 00-19, the
Company will record a cumulative effect adjustment of a change in accounting
principle based upon difference between the fair value of the Company's common
stock as of June 30, 2001 and $5.0 million, the fair value of the common stock
on the original date of the agreement. Beginning in the third quarter of fiscal
year 2001, any changes in the fair market value of the liability, which will be
based upon the fair value of the Company's stock, will be recorded as a gain or
loss in the Company's Consolidated Statement of Operations.

 Reclassifications

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

                                       59
<PAGE>

                                 DRUGSTORE.COM

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


2. Business Acquisition and Strategic Agreements

 Rite Aid and GNC

   In July 1999, the Company consummated a series of agreements with Rite Aid
and GNC to issue 12,282,599 shares of Series E preferred stock in exchange for
an aggregate of $10 million in cash and other consideration, including access
to insurance coverage, advertising commitments and a vendor agreement with an
estimated fair value of $233.9 million. The $233.9 million non-cash portion of
the consideration from the Rite Aid and GNC agreements was allocated to the
following components based on a valuation obtained from an independent
valuation expert (in millions):

<TABLE>
     <S>                                                                  <C>
     Access to insurance coverage........................................ $182.1
     Advertising commitments.............................................   22.9
     Vendor agreement....................................................   28.9
                                                                          ------
                                                                          $233.9
                                                                          ======
</TABLE>

 Amazon.com

   In January 2000, the Company reached an agreement with Amazon.com, Inc.
(Amazon.com) to provide certain advertising and technical services over a
three-year term for $105.0 million. The consideration included 1,066,667 shares
of the Company's common stock with a fair value of $30.0 million issued
immediately in a private placement transaction and minimum cash payments
totaling $75.0 million over the three-year term of the agreement. In July 2000,
Amazon.com and the Company agreed to reduce the remaining minimum cash payments
due over the three-year term of the agreement from $75.0 million to $30.0
million. Additionally, the Company agreed to pay additional amounts in cash if
the advertising services exceed certain performance thresholds in the second
and third year of the agreement. The Company also issued to Amazon.com a fully
vested, nonforfeitable and exercisable warrant to purchase 2.5 million shares
of the Company's common stock at $4.94 per share. The Company estimates that
the fair value of the warrant was $7.3 million and is amortizing the aggregate
minimum value of the total consideration under the agreement of $67.3 million
to primarily marketing and sales expense on a straight-line basis over the
three-year term of the agreement. For year ended December 31, 2000, the Company
recognized marketing and sales expense associated with such agreement of $15.2
million.

 Beauty.com

   In February 2000, the Company acquired Beauty.com, Inc. (Beauty.com), an
online retailer of prestige beauty products, in exchange for 1,266,289 shares
of the Company's common stock and the assumption of outstanding stock options.
In July 2000, the Company and Beauty.com's founder amended certain provisions
of the initial purchase agreements, including eliminating the contingency on
the issuance of approximately 587,000 shares of the Company's common stock
related to the continued employment of Beauty.com's founder and reducing the
total consideration to 1,235,530 shares of the Company's common stock. The
final purchase price, as amended, was determined to be $37.6 million.
Subsequent to the amendment of the purchase agreements, all of the shares have
been issued to the former Beauty.com shareholders except for 126,628 shares
that will remain in escrow until February 2001 as security for certain
indemnification provisions of the purchase agreement. The acquisition has been
accounted for as a purchase, and all identifiable assets were assigned a
portion of the purchase price based on their respective fair values. In
connection with the acquisition and subsequent amendment of the purchase
agreements, the Company recognized approximately $45.1 million of intangible
assets allocated to domain names, customer lists and goodwill based on an
independent valuation. Of the $45.1 million, $10.8 million was recorded in the
third quarter of 2000, including $10.4 million that was reclassified from
deferred stock-based compensation to goodwill as of the date the purchase
agreements were

                                       60
<PAGE>

                                 DRUGSTORE.COM

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

amended. These intangible assets are being amortized over the remaining portion
of their estimated useful lives of three years. The pro forma consolidated
financial information for the years ended December 31, 2000 and January 2,
2000, determined as if the Beauty.com acquisition had occurred at the beginning
of each fiscal year, would have indicated net sales of $110.1 million and $35.1
million, net loss of $197.9 million and $149.4 million, and basic and diluted
net loss per share of $(3.63) and $(7.48), respectively. This unaudited
pro forma information is presented for illustrative purposes only and is not
necessarily indicative of the results that would have been achieved had the
Company and Beauty.com been combined during the specified periods.

 Medibuy

   In February 2000, the Company entered into a five-year agreement with
Medibuy.com, Inc. (Medibuy), an e-commerce solution for healthcare supply
procurement, to develop a co-branded e-commerce marketplace targeted at the
home healthcare market. As of December 31, 2000, no revenues or expenses had
been recorded as a result of this transaction and the Company has been informed
by Medibuy that it no longer intends to develop the co-branded e-commerce
marketplace contemplated in the original agreement and wishes to terminate the
original agreement. The Company is currently in the process of evaluating its
options with respect to Medibuy's termination proposal and does not expect that
such termination negotiations will result in an outcome having a material
effect on its financial statements. In connection with this agreement, the
Company received fully vested, nonforfeitable and exercisable warrants to
purchase 700,000 shares of Medibuy common stock. Because Medibuy is a privately
owned company and due to the lack of available financial information about
Medibuy's future operations, the Company could not obtain an independent
valuation of the value of the warrants to purchase Medibuy common stock. As the
Company could not obtain an independent valuation of Medibuy and due to
Medibuy's limited operating history and related uncertainties as to their
financial condition, the Company could not determine the fair value of the
warrants; accordingly, such amounts are not reflected on the Company's
consolidated balance sheet as of December 31, 2000.

 WellPoint

   In June 2000, the Company entered into a five-year strategic partnership
with WellPoint Health Networks Inc. (WellPoint), a leading health plan owned
pharmacy benefit management company. Pursuant to this agreement, the Company is
designated as WellPoint's preferred Internet pharmacy and drugstore, with
access to WellPoint's members. In exchange, the Company issued WellPoint
750,000 shares of the Company's common stock with a fair value of approximately
$5.0 million and will make certain cash payments to WellPoint over the five-
year term of the agreement. If the 750,000 shares of the Company's common stock
does not have a fair value of $10.0 million at the end of the second year, the
Company is required to pay WellPoint the difference between the fair value of
the stock and $10.0 million, in either cash or the Company's common stock. The
amount of such difference as of December 31, 2000 was $9,320,000 and is
reflected in other long term liabilities on the Company's consolidated balance
sheet. The Company recorded the guaranteed value of the stock issuable in
connection with this agreement totaling $10 million as an intangible asset and
is amortizing the asset over the five-year term of the agreement.

 CIGNA

   In June 2000, the Company entered a five-year agreement with CIGNA
HealthCare companies (CIGNA), one of the nation's leading providers of health
benefit programs. Pursuant to this agreement, the Company will provide health
and beauty products to CIGNA's plan participants by providing them direct
access to the Company's Web site from the home page of CIGNA's Internet site or
through CIGNA HealthCare's mail order pharmacy. In exchange, the Company issued
CIGNA Healthcare a warrant to purchase 500,000 shares of the Company's common
stock at $7.76 per share. The fair value of such warrant was estimated at $2.2
million and is being amortized to marketing and sales expense on a straight-
line basis over the five-year term of the agreement.

                                       61
<PAGE>

                                 DRUGSTORE.COM

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


3. Fixed Assets

   Fixed assets consists of the following:

<TABLE>
<CAPTION>
                                                        December 31, January 2,
                                                            2000        2000
                                                        ------------ ----------
                                                            (in thousands)
     <S>                                                <C>          <C>
     Computers and equipment...........................   $ 29,979    $ 9,208
     Purchased software................................      8,133      2,148
     Furniture and fixtures............................      2,870        102
     Leasehold improvements............................     11,542      2,694
     Construction in progress..........................        --      14,235
                                                          --------    -------
                                                            52,524     28,387
     Less accumulated depreciation and amortization....    (13,844)    (3,179)
                                                          --------    -------
                                                          $ 38,680    $25,208
                                                          ========    =======
</TABLE>

   Included in computers and equipment and purchased software as of December
31, 2000 are assets acquired under capital leases with an original cost of
approximately $9,201,000 and $365,000, respectively. Included in computers and
equipment and purchased software as of January 2, 2000 are assets acquired
under capital leases with an original cost of approximately $5,791,000 and
$365,000, respectively. Accumulated amortization on the leased assets as of
December 31, 2000 and January 2, 2000 was approximately $3,836,000 and $794,000
respectively.

4. Intangible Assets

   Intangible assets consists of the following:

<TABLE>
<CAPTION>
                                                          December 31, January
                                                              2000     2, 2000
                                                          ------------ --------
                                                             (in thousands)
     <S>                                                  <C>          <C>
     Access to insurance.................................   $192,142   $182,142
     Goodwill............................................     38,661        --
     Vendor agreement....................................     28,890     28,890
     Technology license, domain names and other..........      6,869        384
                                                            --------   --------
                                                             266,562    211,416
     Less accumulated amortization.......................    (45,448)   (10,674)
                                                            --------   --------
                                                            $221,114   $200,742
                                                            ========   ========
</TABLE>

5. Note Receivable from Officer

   On December 3, 1998, the Company loaned an officer $250,000 evidenced by a
full recourse promissory note bearing 7% interest. The loan and accrued
interest totaling $286,000 was forgiven by the Company's board of directors on
January 2, 2001 and was charged to expense in the year ended December 31, 2000.

6. Commitments and Contingencies

   The Company leases office and distribution center facilities under
noncancelable operating leases, which call for fixed rental payments through
2005. In addition, the Company leases various office equipment under operating
leases. The Company has the option to extend some of these leases for
additional terms ranging from

                                       62
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

three to five years. Total rent expense under operating leases for the years
ended December 31, 2000 and January 2, 2000 and the period ended December 31,
1998 approximated $6,250,000, $2,054,000 and $127,000, respectively.

   The Company also leases computer equipment under noncancelable capital
leases. Capital lease obligations bear interest at rates ranging from 4% to 9%
and mature 24 to 36 months from the date of funding. At December 31, 2000, the
Company had additional financing available under certain lease agreements
totaling approximately $3.2 million.

   The Company has entered into certain advertising and content agreements with
Amazon.com, WellPoint Health Networks Inc. and certain content providers which
require the Company to make fixed payments over the term of the agreements. The
costs associated with these agreements are amortized on a straight-line basis
over the period such advertising and content is expected to be used.

   Future minimum commitments at December 31, 2000, as adjusted for the lease
canceled on March 20, 2001 (see Note 12), are as follows:

<TABLE>
<CAPTION>
                                                 Capital  Operating Marketing
                                                 Leases    Leases   Agreements
                                                 -------  --------- ----------
                                                        (in thousands)
   <S>                                           <C>      <C>       <C>
   2001......................................... $ 3,106   $ 3,358   $ 9,108
   2002.........................................   1,888     3,367    16,750
   2003.........................................     457     2,834     9,750
   2004.........................................     131     2,706     2,750
   2005.........................................      71     1,187     1,500
   Thereafter...................................     --        --        --
                                                 -------   -------   -------
   Total minimum lease payments.................   5,653   $13,452   $39,858
                                                           =======   =======
   Less amounts representing interest...........    (410)
                                                 -------
   Present value of minimum payments............   5,243
   Less current portion of capital lease
    obligations.................................  (2,844)
                                                 -------
   Noncurrent portion of capital lease
    obligations................................. $ 2,399
                                                 =======
</TABLE>

   The Company is party to routine claims and litigation incidental to its
business. The Company believes the ultimate resolution of these routine matters
will not have a material adverse effect on its financial position and results
of operations or cash flows.

7. Income Taxes

   The Company did not provide any current or deferred United States federal
income tax provision or benefit for any of the periods presented because it has
experienced operating losses since inception. The Company provided a full
valuation allowance on the net deferred tax asset, consisting primarily of net
operating loss carryforwards and research and development credit carryforwards,
because management has determined that it is more likely than not that the
Company will not earn income sufficient to realize the deferred tax assets
during the carryforward period.

   At December 31, 2000, the Company had approximately $261.1 million of net
operating loss carryforwards that will expire beginning in 2018. Due to the
issuance and sale of Series E preferred stock in 1999 and the acquisition of
Beauty.com, the Company incurred ownership changes pursuant to applicable

                                       63
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

regulations in effect under the Internal Revenue Code of 1986, as amended.
Therefore, the Company's use of losses incurred through the date of these
ownership changes will be limited during the carryforward period. The Company
estimates that the use of approximately $63.0 million of net operating losses
incurred through the date of the ownership change would be limited to
approximately $15.5 million per year in order to offset future taxable income.
To the extent that any single-year loss is not utilized to the full amount of
the limitation, such unused loss is carried over to subsequent years until the
earlier of its utilization or the expiration of the relevant carryforward
period. The initial public offering and subsequent equity financings in 2000
did not cause additional ownership changes that would result in additional
limitations on the utilization of net operating carryforwards.

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

<TABLE>
<CAPTION>
                                                        December 31, January 2,
                                                            2000        2000
                                                        ------------ ----------
                                                            (in thousands)
   <S>                                                  <C>          <C>
   Deferred tax assets:
     Net operating loss carryforward...................   $ 88,783    $ 33,449
     Research and development credit carryforward......         32          32
     Amortization of intangible assets.................      3,978       1,547
     Charitable contribution...........................      1,224       1,224
     Nonqualified stock options........................      1,687         --
     Other temporary differences.......................      2,889         279
                                                          --------    --------
   Total gross deferred tax assets.....................     98,593      36,531
   Less valuation allowance............................    (98,593)    (36,531)
                                                          --------    --------
   Net deferred tax assets.............................   $    --     $    --
                                                          ========    ========
</TABLE>

   In connection with the Beauty.com acquisition, the Company recorded deferred
tax assets totaling $3,433,000 and a corresponding increase in the valuation
allowance.

   A reconciliation of income taxes computed at the statutory rate to the
income tax amount recorded is as follows:

<TABLE>
<CAPTION>
                             December 31, January 2, December 31,
                                 2000        2000        1998
                             ------------ ---------- ------------
                                        (in thousands)
   <S>                       <C>          <C>        <C>
   Income tax benefit at
    statutory rate.........    $ 65,625    $ 39,378    $ 2,729
   Stock-based
    compensation...........      (2,842)     (5,228)      (351)
   Amortization of
    intangible assets......      (4,134)        --         --
   Other permanent
    differences............         (20)        (21)        (8)
   Research and development
    credit.................         --          --          32
   Increase in valuation
    allowance..............     (58,629)    (34,129)    (2,402)
                               --------    --------    -------
   Income tax benefit......    $    --     $    --     $   --
                               ========    ========    =======
</TABLE>

                                       64
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


8. Stockholders' Equity

 Outstanding Warrants

   In connection with the strategic agreements entered into with Amazon.com and
CIGNA (see Note 2), the Company issued warrants to purchase the Company's
common stock at a predetermined price. Amazon.com was granted the right to
purchase 2.5 million shares of the Company's common stock at $4.94 per share,
expiring in July 2002. CIGNA was granted the right to purchase 500,000 shares
of the Company's common stock at $7.76 per share, expiring in June 2005.

 Convertible Preferred Stock

   In June and August 1998, the Company issued 10,000,000 shares of Series A
preferred stock in a private placement offering in exchange for gross cash
proceeds of $4,000,000, and a Technology License and Advertising Agreement with
Amazon.com that provides for the right to license certain technology and
receive certain technological and advertising support from Amazon.com. In
addition, the Company agreed to license its technology to Amazon.com and
participate in mutually agreed upon advertising activities. No cash payments
are required under the Technology License and Advertising Agreement with
Amazon.com. The Company valued the right to license certain technology and
receive such technological and advertising support at $4,000,000 based on the
value of Series A preferred stock issued concurrently for cash. Such value was
allocated to prepaid marketing expense, license rights and prepaid technical
consulting services in the amount of $3,765,000, $150,000 and $85,000,
respectively, based on their estimated fair value. The prepaid marketing
expense was amortized over five months commencing in February 1999. The license
rights and prepaid technical consulting are being amortized over five years and
approximately eight months, respectively, commencing on the date of the
agreement. For the years ended December 31, 2000 and January 2, 2000 and the
period ended December 31, 1998, the Company recognized expenses under such
agreement totaling $28,000, $3,830,000 and $58,000 respectively.

   In October, November and December 1998, the Company issued 5,446,268 shares
of Series B preferred stock in a private placement offering in exchange for
gross cash proceeds of $18,245,000.

   In January and March 1999, the Company issued 4,472,844 shares of Series C
preferred stock in a private placement offering in exchange for gross cash
proceeds of $35,000,000.

   In June 1999, the Company issued 2,266,289 shares of Series D preferred
stock in a private placement offering in exchange for $40 million in cash and
$5 million in cable television advertising obligations. The cable television
advertising is not expected to be aired within the next 12 months and has been
classified as a noncurrent asset in prepaid marketing expenses.

   In July 1999, the Company consummated a series of agreements with Rite Aid
and GNC to issue 12,282,599 shares of Series E preferred stock in exchange for
an aggregate of $10 million in cash and other consideration, including access
to insurance coverage, advertising commitments and a vendor agreement with an
estimated fair value of $233.9 million. The $233.9 million non-cash portion of
the consideration from the Rite Aid and GNC agreements was allocated to the
following components based on a valuation obtained from an independent
valuation expert (in millions):

<TABLE>
     <S>                                                                 <C>
     Access to insurance coverage....................................... $182.1
     Advertising commitments............................................   22.9
     Vendor agreement...................................................   28.9
                                                                         ------
                                                                         $233.9
                                                                         ======
</TABLE>

                                       65
<PAGE>

                                 DRUGSTORE.COM

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The access to insurance coverage and the vendor agreement have been
classified as intangible assets and the advertising commitments have been
classified within prepaid marketing expenses. All of the assets are to be
amortized on a straight-line basis over their contractual life of 10 years.

 Common Stock

   In July 1999, the Company completed its initial public offering of
5,750,000 shares of common stock resulting in approximately $94.6 million in
net proceeds. In connection with the closing of the offering, all of the
outstanding convertible preferred stock was converted into an aggregate of
34,468,000 shares of common stock. Through a separate private placement
transaction, the Company also issued 555,555 shares of common stock to
Amazon.com, Inc., resulting in proceeds of approximately $10 million.
Subsequent to the Company's initial public offering, the total number of
authorized shares was changed to 260,000,000 shares, of which 250,000,000
shares are common stock and 10,000,000 shares are undesignated preferred
stock. Additionally, the par value of the Company's common and preferred stock
was changed to $.0001 per share. The accompanying financial statements have
been restated to reflect the change in the par value of the common stock.

   In July 1999, the Company donated 200,000 shares of its common stock to the
drugstore.com Foundation, a separately organized 501(c)(3) organization in
which the Company is neither a trustee or beneficiary, and recognized the fair
market value of the shares donated as a $3,600,000 charitable contribution
expense.

   In March 2000, the Company completed the sale of 6,020,000 shares of its
common stock at $18.00 per share. Of the 6,020,000 shares offered, 6,000,000
were offered by the Company and 20,000 were offered by an existing
stockholder. Net proceeds to the Company aggregated approximately $101.6
million.

   In August 2000, the Company completed the sale of approximately 8.1 million
shares of common stock at $4.9375 per share and approximately 46,000 shares of
preferred stock at $493.75 per share. The preferred stock was a participating,
non-voting, preferred instrument that converted into 4,593,989 shares of
common stock on November 10, 2000 upon stockholder approval. Net proceeds to
the Company aggregated approximately $62.3 million.

   A portion of the Company's shares outstanding are subject to repurchase by
the Company over a three year period. As of December 31, 2000, there were
472,500 shares subject to repurchase rights at $0.04 per share. Additionally,
in connection with the Beauty.com acquisition, as of December 31, 2000, there
were 126,628 shares outstanding that will remain in escrow until February 2001
as security for certain indemnification provisions of the purchase agreement.

 Common Stock Reserved for Future Issuance

   The following table represents the number of shares reserved for future
issuance as of December 31, 2000:

<TABLE>
     <S>                                                              <C>
     Stock option plan............................................... 17,438,190
     Employee stock purchase plan....................................    799,601
     Warrants to purchase common stock...............................  3,000,000
                                                                      ----------
                                                                      21,237,791
                                                                      ==========
</TABLE>

                                      66
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


9. Employee Benefit Plans

 Defined Contribution Plan

   Effective April 1999, the Company adopted a defined contribution retirement
plan under Section 401(k) of the Internal Revenue Code which covers
substantially all employees. Eligible employees may contribute amounts to the
plan, via payroll withholding, subject to certain limitations. Under the 401(k)
plan, employees may elect to reduce their current compensation by up to the
statutorily prescribed annual limit ($10,500 in 2000) and to have the amount of
such reduction contributed to the 401(k) plan. The 401(k) plan permits, but
does not require, additional matching contributions to the 401(k) plan by the
Company on behalf of all participants in the 401(k) plan. To date, the Company
has not made any matching contributions to the 401(k) plan.

 1998 Stock Plan

   Under the terms of the 1998 stock plan, the board of directors may grant
incentive and nonqualified stock options to employees, officers, directors,
agents, consultants, and independent contractors of the Company. In connection
with the introduction of the 1998 stock plan, 2,735,000 shares of common stock
were reserved for future issuance. During 1999, the Company increased the
number of shares reserved for future issuance under such plan by 8,265,000.
During 2000, the Company's shareholders approved an increase in the number of
shares reserved for future issuance under such plan of 7,000,000 shares,
bringing the total shares reserved for future issuance to 18,000,000.
Additionally, the Company's shareholders approved an automatic annual increase,
beginning on the first day of our fiscal year starting in 2001, equal to (i)
the lesser of (a) 5% of the outstanding shares of common stock as of the end of
the immediately preceding fiscal year and (b) 6,000,000 shares or (ii) a lesser
amount determined by the plan administrator; provided that any shares from any
such increase in previous years that are not actually issued will be added to
the aggregate number of shares available for issuance under the 1998 stock
plan. Pursuant to this provision, 3,292,162 additional shares were reserved for
future issuance under the 1998 stock plan on January 1, 2001.

   Generally, the Company grants stock options with exercise prices equal to
the fair market value of the common stock on the date of grant, as determined
by the board of directors. Options generally vest over a four to five year
period and expire ten years from the date of grant.

   In May 2000, the Company's board of directors granted options to purchase an
aggregate of approximately 3.3 million shares of its common stock to certain of
its existing employees at an exercise price of $7.00 per share, which was below
the fair market value on the date of the grant. The options were granted under
the Company's 1998 stock plan and will vest over a four-year period at the rate
of one-fourth of the total number of shares subject to the options six months
after the grant date, with the remaining shares vesting in equal installments
at the end of each six-month period thereafter. Accordingly, during the second
quarter of 2000 the Company recorded deferred stock-based compensation of
approximately $5.3 million, which is being amortized over the vesting period of
the options using the multiple-option approach.

   In October 2000, the Company's board of directors granted options to
purchase an aggregate of approximately 4.9 million shares of its common stock
to certain of its existing employees at an exercise price of $0.01 per share,
which was below the fair market value on the date of the grants. The options
were granted under the Company's 1998 stock plan and will vest over an 18 month
period at the rate of 40% of the total number of shares subject to the options
six months after the grant date, with the remaining shares vesting in equal
installments at the end of each six-month period thereafter. Accordingly,
during the fourth quarter of 2000 the Company recorded deferred stock-based
compensation of approximately $12.2 million, which is being amortized over the
vesting period of the options using the multiple-option approach.

                                       67
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The following table summarizes activity under the Company's stock plan:

<TABLE>
<CAPTION>
                                                       Outstanding Options
                                                   ----------------------------
                                  Shares Available Number of   Weighted-Average
                                     for Grant       Shares     Exercise Price
                                  ---------------- ----------  ----------------
   <S>                            <C>              <C>         <C>
     Initial authorization.......     2,735,000           --           --
     Options granted.............    (1,683,584)    1,683,584       $  .17
     Options exercised...........           --         (8,000)      $  .12
     Options forfeited...........       160,250      (160,250)      $  .04
                                    -----------    ----------
   Outstanding at December 31,
    1998.........................     1,211,666     1,515,334       $  .18
     Additional authorizations...     8,265,000           --           --
     Options granted.............    (4,958,075)    4,958,075       $19.99
     Options exercised...........           --       (202,253)      $  .23
     Options forfeited...........       420,498      (420,498)      $ 6.84
                                    -----------    ----------
   Outstanding at January 2,
    2000.........................     4,939,089     5,850,658       $16.49
     Additional authorizations
      and options assumed in the
      Beauty.com acquisition.....     7,032,404           --           --
     Options granted.............   (12,635,424)   12,635,424       $ 6.69
     Options exercised...........           --       (383,961)      $  .66
     Options forfeited...........     3,419,995    (3,419,995)      $13.01
                                    -----------    ----------
   Outstanding at December 31,
    2000.........................     2,756,064    14,682,126       $ 9.27
                                    ===========    ==========
</TABLE>

   The following table summarizes information regarding stock options
outstanding and exercisable as of December 31, 2000:

<TABLE>
<CAPTION>
                                Outstanding Options         Exercisable Options
                          -------------------------------- ---------------------
                                                Weighted-
                                     Weighted-   Average   Vested and  Weighted-
                                      Average   Remaining  Exercisable  Average
                          Number of  Exercise  Contractual  Number of  Exercise
Exercise Price              Shares     Price      Life       Shares      Price
--------------            ---------- --------- ----------- ----------- ---------
<S>                       <C>        <C>       <C>         <C>         <C>
$.01 to $2.50............  6,014,844  $ 0.10    9.4 years     576,200   $ 0.30
$2.51 to $7.50...........  4,653,149  $ 6.55    9.4 years     957,390   $ 6.95
$7.51 to $15.00..........    905,217  $ 9.73    8.8 years     200,546   $ 8.48
$15.01 to $30.00.........  1,153,398  $23.85    9.0 years      67,349   $16.62
$30.01 to $67.50.........  1,955,518  $35.11    8.9 years     405,465   $36.42
                          ----------                        ---------
Total.................... 14,682,126  $ 9.27    9.3 years   2,206,950   $11.06
                          ==========                        =========
</TABLE>

   Under APB No. 25, no compensation expense is recognized when the exercise
price of the Company's employee stock options equals the fair value of the
underlying stock on the date of grant. Deferred stock-based compensation is
recorded for those situations where the exercise price of an option or the
purchase price of restricted stock was lower than the deemed fair value for
financial reporting purposes of the underlying common stock. For the years
ended December 31, 2000 and January 2, 2000 and the period ended December 31,
1998, the Company recorded aggregate deferred stock-based compensation of
$17,582,000, $22,630,000 and $4,966,000, respectively. The deferred stock-based
compensation is being amortized over the vesting period of the underlying
options and restricted stock. For the years ended December 31, 2000 and January
2, 2000 and the period ended December 31, 1998, total amortization of stock-
based compensation recognized was $15,115,000, $15,375,000 and $1,037,000,
respectively.

                                       68
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   Had the stock-based compensation for the Company's stock option plan and
restricted stock agreements been determined based on the Black-Scholes model
using the multiple-option approach, the Company's net loss would have been
adjusted to the following pro forma amount for the years ended December 31,
2000 and January 2, 2000 and the period ended December 31, 1998:

<TABLE>
<CAPTION>
                                                                 Period from
                                                       Year     April 2, 1998
                                         Year ended    ended    (Inception) to
                                        December 31,  January    December 31,
                                            2000      2, 2000        1998
                                        ------------ ---------  --------------
                                        (in thousands, except per share data)
<S>                                     <C>          <C>        <C>
Net loss--as reported..................  $(193,015)  $(115,831)    $(8,027)
Incremental pro forma compensation
 expense under SFAS No. 123............    (32,815)     (2,589)        (12)
                                         ---------   ---------     -------
Net loss--pro forma....................  $(225,830)  $(118,420)    $(8,039)
                                         =========   =========     =======
Basic and diluted net loss per share--
 as reported...........................  $   (3.56)  $   (6.13)    $(14.70)
                                         =========   =========     =======
Basic and diluted net loss per share--
 pro forma.............................  $   (4.17)  $   (6.27)    $(14.72)
                                         =========   =========     =======
Pro forma basic and diluted net loss
 per share--as reported................  $   (3.48)
                                         ---------
Pro forma basic and diluted net loss
 per share--pro forma..................  $   (4.07)
                                         =========
</TABLE>

   The weighted-average fair value of options granted during the years ended
December 31, 2000 and January 2, 2000 and the period from April 2, 1998
(inception) to December 31, 1998 was $9.06, $14.87 and $1.41, respectively, for
options granted at fair market value. The initial impact on pro forma net loss
may not be representative of compensation expense in future years, when the
effect of amortization of multiple awards would be reflected in pro forma
earnings.

   The fair value at each option grant is estimated on the date of grant using
the Black-Scholes option pricing model, assuming no expected dividends. The
volatility of the Company's stock prior to its initial public offering was
estimated based on a review of a peer group of Internet companies at a
comparable developmental stage. Subsequent to the Company's initial public
offering, the volatility of the Company's stock was based on actual stock
prices subsequent to the initial month of trading. The following weighted
average assumptions were utilized in arriving at the fair value of each option
grant:

<TABLE>
<CAPTION>
                                                                Period from
                             January 3,   July 27,  January 1, April 2, 1998
                              2000 to     1999 to    1999 to   (Inception) to
                            December 31, January 2,  July 26,   December 31,
                                2000        2000       1999         1998
                            ------------ ---------- ---------- --------------
   <S>                      <C>          <C>        <C>        <C>
   Average risk-free
    interest rate..........      6.25%        6.5%       6.5%         4.5%
   Average expected life...   3 years     3 years    3 years      3 years
   Volatility..............       130%         80%        50%          50%
</TABLE>

 1999 Employee Stock Purchase Plan

   The Company's 1999 employee stock purchase plan was adopted by the board of
directors in 1999, and was effective upon the completion of the Company's
initial public offering of its common stock. A total of 500,000 shares of
common stock has been reserved for issuance under the employee stock purchase
plan plus an annual increase on the first day of each of the fiscal years
beginning in 2000, 2001, 2002, 2003 and 2004 equal to the lesser of (1) 500,000
shares, (2) three percent (3%) of our shares outstanding on the last day of the
immediate preceding fiscal year, or (3) such lesser number of shares as is
determined by the board of directors. Eligible employees may purchase common
stock at 85% of the lesser of the fair market value of the

                                       69
<PAGE>

                                 DRUGSTORE.COM

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Company's common stock on the first or the last day of the applicable six month
purchase period. In the year ended December 31, 2000, employees purchased
200,399 shares of the Company's common stock in exchange for $1,853,000.

10. Related Parties

   The Company purchased $46,169,000 of inventory and fulfillment-related
services and recognized $2,290,000 of marketing and sales expense during the
year ended December 31, 2000 in connection with the agreements between the
Company and Rite Aid. The Company purchased $10,454,000 of inventory and
fulfillment-related services and recognized $1,145,000 of marketing and sales
expense during the year ended January 2, 2000 in connection with the agreements
between the Company and Rite Aid. Approximately $13,310,000 and $4,391,000
relating to the purchase of inventory and fulfillment-related services from
Rite Aid was payable as of December 31, 2000 and January 2, 2000, respectively.

   The Company recognized marketing and sales expense in connection with its
strategic relationship with Amazon.com totaling approximately $20,259,000,
$5,265,000 and $58,000 for the years ended December 31, 2000 and January 2,
2000 and the period ended December 31, 1998, respectively. Approximately
$30,000 and $1,500,000 of these expenses were payable as of December 31, 2000
and January 2, 2000, respectively.

11. Quarterly Results (unaudited)

   The following tables contain selected unaudited Consolidated Statement of
Operations information for each quarter of fiscal years 2000 and 1999. The
Company believes that the following information reflects all normal recurring
adjustments necessary for a fair presentation of the information for the
periods presented. The operating results for any quarter are not necessarily
indicative of results for any future period.

<TABLE>
<CAPTION>
                                      Year Ended December 31, 2000
                               ----------------------------------------------
                                 Fourth      Third       Second      First
                                Quarter     Quarter     Quarter     Quarter
                               ----------  ----------  ----------  ----------
                                (in thousands, except share and per share
                                                  data)
<S>                            <C>         <C>         <C>         <C>
Net sales.....................   $ 36,159    $ 26,480    $ 24,602    $ 22,738
Cost of sales(1)..............     30,916      24,047      22,867      22,881
Net loss......................    (43,173)    (45,703)    (54,657)    (49,482)
Basic and diluted loss per
 share(2).....................   $  (0.68)   $  (0.80)   $  (1.07)   $  (1.09)
Shares used in computation of
 basic and diluted loss per
 share........................ 63,157,832  57,324,506  50,987,471  45,229,624
<CAPTION>
                                       Year Ended January 2, 2000
                               ----------------------------------------------
                                 Fourth      Third       Second      First
                                Quarter     Quarter     Quarter     Quarter
                               ----------  ----------  ----------  ----------
                                (in thousands, except share and per share
                                                  data)
<S>                            <C>         <C>         <C>         <C>
Net sales.....................   $ 18,488    $ 12,158    $  3,550    $    652
Cost of sales(1)..............     21,502      14,729       6,278         823
Net loss......................    (43,505)    (41,973)    (19,761)    (10,592)
Basic and diluted loss per
 share(2).....................   $  (1.02)   $  (1.33)   $ (19.10)   $ (10.89)
Shares used in computation of
 basic and diluted loss per
 share........................ 42,586,940  31,512,007   1,034,696     972,614
</TABLE>
--------
(1) Cost of sales amounts have been retroactively adjusted to reflect the
    adoption of EITF No. 00-14, which was adopted in the third quarter of
    fiscal year 2000.

(2) The sum of the quarterly per share amounts may not equal per share amounts
    reported for year-to-date periods. This is due to changes in the weighted-
    average shares outstanding and the effects of rounding for each period.

                                       70
<PAGE>

                              DRUGSTORE.COM, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


12. Subsequent Events (unaudited)

   In January 2001, the Company laid off approximately 100 employees. As a
result of the layoffs, the Company decided to consolidate certain of its
corporate facilities and is attempting to sublease or exit the leases
associated with the excess facilities. In March 2001, the Company negotiated
the cancellation of a lease for new corporate office space in exchange for
forfeiting a portion of the Company's lease deposit, thereby reducing the
Company's minimum commitments through 2012 by approximately $46.9 million.
Accordingly in the first quarter of 2001, the Company expects to record a
charge ranging from approximately $7.0 million to $8.0 million associated with
the costs of exiting such leases, forfeiting the Company's lease deposit and
writing off the related leasehold improvements and equipment.

                                       71
<PAGE>

                              DRUGSTORE.COM, INC.

                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
                                 (in thousands)

<TABLE>
<CAPTION>
                                      Charged to
                           Balance at  Revenue,  Charged               Balance
                           Beginning   Costs or  to Other              at End
                           of Period   Expenses  Accounts Deductions  of Period
                           ---------- ---------- -------- ----------  ---------
<S>                        <C>        <C>        <C>      <C>         <C>
Period from April 2, 1998
 (Inception) to December
 31, 1998
  Allowance for doubtful
   accounts..............    $ --       $  --      $ --     $ --       $  --
  Allowance for sales
   returns...............    $ --       $  --      $ --     $ --       $  --
  Reserve for inventory
   obsolescence..........    $ --       $  --      $ --     $ --       $  --

Year Ended January 2,
 2000
  Allowance for doubtful
   accounts..............    $ --       $  385     $ --     $ 215(A)   $  170
  Allowance for sales
   returns...............    $ --       $  336     $ --     $ 255(B)   $   81
  Reserve for inventory
   obsolescence..........    $ --       $  606     $ --     $  50(C)   $  556

Year Ended December 31,
 2000
  Allowance for doubtful
   accounts..............    $ 170      $  511     $ --     $ 527(A)   $  154
  Allowance for sales
   returns...............    $  81      $  996     $ --     $ 912(B)   $  165
  Reserve for inventory
   obsolescence..........    $ 556      $1,101     $ --     $ 596(C)   $1,061
</TABLE>
--------
(A) Deductions consist of write-offs of uncollectible accounts, net of
    recoveries.

(B) Deductions consist of sales credits to customers for product returns.

(C) Deductions consist of write-off of obsolete inventory.

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<PAGE>

                                   SIGNATURES

   Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized, in the City of Bellevue, State of
Washington, on March 30, 2001.

                                          DRUGSTORE.COM, INC.

                                                 /s/ Peter M. Neupert
                                          By: _________________________________
                                                     Peter M. Neupert,
                                               President and Chief Executive
                                                          Officer

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