<PAGE>

                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
                            ----------------------

                                   FORM 10-K

                       FOR ANNUAL AND TRANSITION REPORTS
                       PURSUANT TO SECTIONS 13 OR 15(d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934

Mark One

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

For the fiscal year ended  December 31, 2000
                          -------------------

                                      OR

       TRANSITION REPORT PURSUANT TO SECTION 13 OF 15(d)
[_]    OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from               to               .
                               -------------    --------------

                         Commission File No. 000-31135

                         INSPIRE PHARMACEUTICALS, INC.
                         -----------------------------
            (Exact name of registrant as specified in its charter)

             Delaware                                04-3209022
----------------------------------     -----------------------------------------
 (State or other jurisdiction of          (I.R.S. Employer Identification No.)
 incorporation or organization)

     4222 Emperor Boulevard, Suite 470, Durham, North Carolina 27703-8466
     --------------------------------------------------------------------
           (Address of principal executive offices)            (zip code)

                                (919) 941-9777
                                --------------
             (Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

      Title of each class              Name of each exchange on which registered
----------------------------------     -----------------------------------------
             None                                      None

Securities registered pursuant to Section 12(g) of the Act:

                         Common Stock, $.001 par value
                         -----------------------------
                               (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 the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

               Yes      X                         No
               -----------------                  ------------------

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

     State the aggregate market value of the equity stock held by non-affiliates
of the Registrant: $235,396,350 at January 22, 2001 based on the last sales
price on that date.

     Indicate the number of shares outstanding of each of the Registrant's
classes of common stock, as of March 15, 2001.

                           Class                       Number of Shares
               -----------------------------           ----------------
               Common Stock, $.001 par value              25,585,534

Documents incorporated by reference
-----------------------------------

     The Proxy Statement to be filed with respect to the Annual Meeting of
Stockholders to be held on June 1, 2001 is incorporated by reference into Part
III.

<PAGE>

Item 1.    Business.

Overview

     We discover and develop new drugs, or pharmaceutical products, to treat
diseases characterized by deficiencies in the body's innate defense mechanisms
of mucosal hydration and mucociliary clearance as well as other non-mucosal
disorders. Our products are based on our proprietary technology relating to P2Y
receptors. Studies indicate that a subtype of this family, the P2Y2 receptor,
coordinates the mechanisms of mucosal hydration and mucociliary clearance. These
complex mechanisms, which involve movement of salt and water, a protein
substance made in specialized cells that act to lubricate surfaces, called
mucin, and the movement of cilia, or hairlike projections on the surface of
cells that move together in a sweeping motion to move liquid and particles
forward, can be regulated therapeutically through the stimulation of this
receptor. Our lead products target respiratory and ophthalmic diseases with
inadequate current treatments. We currently have four product candidates in
clinical development:

     .    INS365 Respiratory for the treatment of chronic bronchitis;

     .    INS365 Ophthalmic for the treatment of dry eye disease;

     .    INS316 Diagnostic to aid in the diagnosis of lung cancer and lung
          infection; and

     .    INS37217 Respiratory for the treatment of cystic fibrosis.

     In addition, we have two products that are scheduled to enter clinical
trials within the next 12 months: INS37217 Respiratory for the treatment of
sinusitis and INS37217 Ophthalmic for the treatment of retinal disease. We have
entered into development and commercialization alliances with Genentech Inc.
("Genentech"), Kissei Pharmaceuticals Co., Ltd. ("Kissei") and Santen
Pharmaceutical Co., Ltd. ("Santen") and Kirin Brewery Co., Ltd. Pharmaceutical
Division ("Kirin"). We are also exploring other target diseases where we believe
P2Y receptors play important biological roles.

     We commenced operations in March 1995. At that time, we acquired a license
to our initial technology, including patents relating to P2Y receptors and on
method of use for P2Y2 receptor agonists in the respiratory area, from The
University of North Carolina at Chapel Hill. We initially focused on the
clinical development of INS316 for the treatment of respiratory diseases such as
cystic fibrosis and chronic bronchitis. In early 1996, we initiated a research
program to develop an improved P2Y2 agonist compound, INS365. A joint patent for
this compound was granted to us and The University of North Carolina at Chapel
Hill. We began preclinical studies of INS365 for respiratory uses in 1997, and
clinical testing of INS365 for respiratory uses in early 1998. We filed an
investigational new drug application (IND) in the United States in the spring of
1998. We acquired an exclusive license to use INS365 to treat respiratory
disease from The University of North Carolina at Chapel Hill in 1998. During the
development of INS365 for respiratory uses, our scientists began to recognize
the potential for using INS365 to treat eye diseases such as dry eye. We
initiated ophthalmic clinical testing of INS365 in the United Kingdom in early
1999, filed an IND in the United States in the fall of 1999 and completed a
Phase II clinical trial in the fall of 2000. Our chemistry lab also synthesized
INS37217, a new P2Y2 receptor agonist, in 1998. We began preclinical testing of
INS37217 for respiratory uses in 1998 and for ophthalmic uses in 1999. This
preclinical work for the initial indications in both the respiratory and
ophthalmic areas has now been completed. In the fall of 2000, we filed an IND
for INS37217 Respiratory for the treatment of cystic fibrosis and in December
2000 we filed an IND for INS37217 Ophthalmic for the treatment of retinal
disease.

Industry Background

     Mucosal hydration and mucociliary clearance processes are observed at a
number of human mucosal surfaces including those in the respiratory tract, eyes,
sinuses, vaginal and endocervical surfaces. Mucosal hydration and mucociliary
clearance are natural mechanisms for cleansing and protecting mucosal surfaces
and require a coordinated balance of salt, water and mucus. Studies indicate
that P2Y2 receptors regulate these mechanisms on
<PAGE>

epithelial cells that line mucosal surfaces. Diseases that are characterized by
impairment of mucosal hydration and mucociliary clearance include chronic
bronchitis, sinusitis, cystic fibrosis, dry eye disease and vaginal dryness.

Respiratory

     For lungs to function normally, airway surfaces must be kept properly
hydrated and clear of particles. Airway liquid, including salt and water, is
secreted through channels in the membranes of respiratory epithelial cells.
Mucus, secreted by goblet cells, traps microorganisms and particulates.
Specialized epithelial cells containing cilia beat synchronously to propel the
overlying "mucociliary blanket" of salt, water and mucus to the mouth and throat
where secretions are swallowed or expelled. This process is the principal
mechanism by which the body keeps airway surfaces free of dust, pollutants,
bacteria and viruses. Genetic and environmental factors can lead to a breakdown
in the normal process of mucosal hydration and mucociliary clearance that is
observed in many debilitating respiratory diseases, including chronic bronchitis
and cystic fibrosis. Studies indicate that stimulating P2Y2 receptors with
effective agonists can help restore the respiratory system's innate defense
mechanisms.

     Chronic Bronchitis

     Chronic bronchitis is a serious and potentially life-threatening lung
condition characterized by acute and chronic airway inflammation, chronic
obstruction of airflow and a mucus-producing cough. Patients with chronic
bronchitis experience shortness of breath, labored breathing, excessive and
chronic coughing and production and retention of excessive mucus. Chronic
bronchitis can be caused by smoking, environmental toxins, and viral or
bacterial infections. Chronic bronchitis is defined by the American Thoracic
Society as the presence of a mucus-producing cough most days of the month, three
months of the year, for at least two successive years without obvious
alternative explanation. Patients with chronic bronchitis experience acute
flare-ups of the illness, their medication usage increases and they may require
hospitalization. If left untreated, these patients experience progressive
deterioration in lung function, which can eventually result in respiratory
failure and death.

     The American Thoracic Society guidelines for the treatment of chronic
bronchitis recommend three main objectives to pharmaceutical intervention:
dilation of the airways, reduction of airway inflammation, and clearance of
retained respiratory secretions. Current management of chronic bronchitis treats
the symptoms, but does not cure the disease, and is based on the degree of
airflow obstruction and the extent of the patient's disability. Physicians
generally prescribe bronchodilators, which act to open airways in the lungs.
These are usually inhaled medications such as Serevent(R), Ventolin(R),
Atrovent(R), or Combivent(R). Physicians may also prescribe inhaled steroids
such as Beclovent(R) and Azmacort(R) to reduce the inflammation in the airways.
Additionally, physicians often use antibiotics during acute flare-ups of the
illness if they diagnose or suspect bacterial infections. There is currently no
FDA approved pharmaceutical agent that effectively clears retained mucous
secretions in this disease.

     Approximately 35.5 million patients have been diagnosed with chronic
bronchitis in the eight major international prescription pharmaceutical markets,
including 13 million in the United States, making it more prevalent than asthma.
Chronic bronchitis is estimated to account for approximately $15 billion in
direct costs in the United States annually. In the United States, there are
estimated to be 500,000 hospitalizations per year due to acute flare-ups of
chronic bronchitis and it is the fourth leading cause of death. In the eight
major international prescription pharmaceutical markets, sales of
ethical/proprietary pharmaceutical products to treat chronic bronchitis were
approximately $1.3 billion in 1996 and have been estimated to reach
approximately $2.5 billion in 2001.

     Cystic Fibrosis

     Cystic fibrosis is a life-threatening disease involving a genetic mutation
that disrupts the cystic fibrosis transmembrane regulator protein. In healthy
individuals, this protein acts as an ion-specific channel that modulates salt
and water movement. In cystic fibrosis patients, a defect in this channel leads
to poorly hydrated, thickened mucous secretions in the airways and severely
impaired mucociliary clearance. Impairments in these vital lung defense
mechanisms typically begin in early childhood. Chronic secondary infections
invariably occur, resulting in progressive lung dysfunction and deterioration.
Cystic fibrosis-induced damage to the respiratory tract accounts for

                                      -2-
<PAGE>

more than 95% of the morbidity and mortality associated with this disease.
According to the U.S. Cystic Fibrosis Foundation, the median life expectancy for
patients is 32 years.

     The current therapeutic approaches to address cystic fibrosis mainly treat
the symptoms, but do not cure the disease, and are aimed at reducing respiratory
infections and breaking up thickened mucous secretions that cause airflow
obstruction and harbor bacteria. For example, TOBI(R) is an inhaled antibiotic
that treats the infection, and Pulmozyme(R) is an inhaled protein that breaks up
excessive DNA in cystic fibrosis mucus that reduces the thickness and tackiness
of the respiratory secretions. While both products are approved for the
treatment of cystic fibrosis, neither product is designed to address the
underlying ion-transport defect, which results in dehydrated mucus and severely
impaired mucociliary clearance.

     There are approximately 30,000 diagnosed cystic fibrosis patients in the
United States and approximately 75,000 in the eight major international
prescription pharmaceutical markets. The average annual cost of treating a
cystic fibrosis patient in the United States exceeds $45,000, and the annual
cost for patients in the United States is over $1 billion. We estimate that in
the United States sales of ethical/proprietary pharmaceutical products to treat
cystic fibrosis currently are in excess of $200 million annually.

     Respiratory Diagnostics

     Physicians use microscopic examination of lung cells to diagnose lung
cancer and lung infections, including pneumonia and tuberculosis. Effective
diagnosis requires the collection of an adequate specimen, one which is enriched
with deep-lung material obtained from the lower part of the lung. Bronchoscopy,
an invasive medical procedure, can be performed to obtain a specimen; however it
is a procedure that costs over $1,000 and poses a risk to patients with impaired
lung function. The induction of sputum, either spontaneously or with inhaled
solutions, is a less invasive and less costly alternative for obtaining a
deep-lung specimen. Once the specimens are collected, they are tested for the
presence of cancerous cells or pathogens associated with lung infections.
However, many patients have difficulty producing adequate specimens on their
own, which is a key barrier to early and effective diagnosis and treatment.

     There are no FDA approved agents currently available to enhance the
production of an adequate deep-lung specimen. In an effort to produce a quality
specimen, non-approved agents are frequently used, including inhaled solutions
such as hypertonic saline and propylene glycol, which cause irritation and
excessive coughing. Because these agents have limited utility and are often
poorly tolerated, pulmonologists and respiratory therapists have expressed a
strong interest in a better-tolerated and more effective therapy, which could
reduce the need for bronchoscopies.

     Market research conducted by us, including interviews with pulmonologists
and oncologists, indicates that deep-lung specimens are frequently collected for
the diagnosis of lung cancer and lung infections. The testing of specimens is a
recommended component of annual physical examinations in Japan.

Ophthalmic

     The eyes and inner eyelids are surrounded by a mucosal surface which serves
as an important innate defense mechanism, keeping the surface of the eye, or
ocular surface, moist, clear and free from infection. Tears produced by the
mucosal hydration process and the lacrimal glands help maintain eye moisture and
in response to physical stimuli can be greatly increased to flush out irritants.
This tear film is a complex mixture of fluid, ions, mucin and proteins that,
when mixed in the proper proportions, coats the cornea with a protective film.
The mucosal hydration process and the lacrimal glands maintain an optimal
balance of salt, water, mucin and proteins in people with a healthy ocular
surface. Studies indicate that stimulating P2Y2 receptors with effective
compounds can help restore the eye's innate mucosal defense mechanism on the
ocular surface.

                                      -3-
<PAGE>

     Dry Eye Disease

     Dry eye, an ocular surface disease, is the general term for a condition in
which abnormalities in the eye's tear film lead to burning, painful, red,
irritated and dry eyes. These abnormalities are typically characterized by a
decrease in tear production, an increase in tear evaporation or the improper
mixture of the eye's tear film components. If left untreated, dry eye disease
can result in permanent corneal damage and visual impairment.

     The current treatments for dry eye disorders in the major markets consist
of artificial tear solutions and lubricant drops. In some cases, small plugs are
inserted by physicians in the corner of the eyes to slow tear drainage.
Artificial tears, which are available as over-the-counter and, in some
countries, as prescription products, provide temporary relief of symptoms, but
also wash out the natural proteins and other components that keep an eye
healthy. There are currently no approved pharmacologically active agents, drugs
that work by affecting a biological process such as stimulation of a receptor,
for dry eye disease.

     We estimate, based on an extrapolation from United States data, that
moderate to severe dry eye affects approximately nine million people in the
eight major international prescription pharmaceutical markets and can be caused
by eye stress, aging, environmental factors, autoimmune disorders and various
medications. The market for dry eye treatments consists of both prescription and
over-the-counter products. Because dry eye disease is more prevalent among the
elderly and post-menopausal women, this market is expected to grow as
populations age. We estimate that, in the eight major international prescription
pharmaceutical markets, sales of ethical/proprietary pharmaceutical products for
dry eye treatments exceed $230 million annually.

Inspire's Solution

     Mucosal hydration and mucociliary clearance are natural mechanisms for
cleansing and protecting epithelial surfaces and require a coordinated balance
of salt, water and mucus. Studies indicate that P2Y2 receptors coordinate these
processes that can be regulated therapeutically by the local delivery of
compounds that bind to and stimulate these receptors. We have focused our
initial efforts on developing P2Y2 receptor agonists to treat diseases by
activating natural processes of mucosal hydration and mucociliary clearance.

     We believe that P2Y2 agonists represent a new, pharmacological approach to
the treatment of respiratory and eye diseases. We also believe that a P2Y2
agonist may be effective as a drug that enhances the production of deep-lung
sputum samples for diagnostic tests. Importantly, our product candidates
currently in clinical testing can be applied directly to these mucosal surfaces
in a topical form such as inhaled aerosols and eye drops. These products act and
are degraded locally, resulting in minimizing the potential for systemic side
effects. Our current products are designed to address the medical need for
effective new products for chronic bronchitis, cystic fibrosis, respiratory
diagnostics, dry eye disease and other diseases that involve impairment of
mucosal hydration and mucociliary clearance on epithelial surfaces. Our
principal product candidates are:

          INS365 Respiratory. We are developing INS365 Respiratory as an inhaled
     product for the treatment of chronic bronchitis. We believe our product
     will be the first FDA approved product that addresses the need for an
     effective agent to clear the build-up of mucus in the airways of bronchitis
     sufferers. Thus, we believe our product will reduce the need for
     antibiotics, steroids and bronchodilators, and may reduce the frequency and
     length of flare-ups of the illnesses and hospitalizations. In many cases,
     we believe that our product will be complementary to existing treatments.

          INS37217 Respiratory. We are developing INS37217 Respiratory as an
     inhaled product for the treatment of cystic fibrosis. We believe our
     product will be the first FDA approved product that mitigates the
     underlying ion-transport defect in the airways of patients with cystic
     fibrosis. We believe our product will improve respiratory symptoms, reduce
     infections and enhance the health status of patients with this disease and
     will be complementary to other currently approved products.

          INS316 Diagnostic. We are developing INS316 Diagnostic as an inhaled
     diagnostic drug to aid in the detection of lung cancer and lung infection.
     We believe that INS316 Diagnostic will be an effective

                                      -4-
<PAGE>

     acute-use product to enhance the production of adequate deep-lung specimens
     for diagnostic purposes. As such, we believe our product will facilitate
     the diagnosis of lung cancer and lung infection and potentially reduce the
     need for costly and invasive bronchoscopies.

          INS365 Ophthalmic. We are developing INS365 Ophthalmic as an eye drop
     for dry eye disease. We believe that, by promoting the eyes' natural
     defense mechanism, INS365 Ophthalmic will be one of the first FDA approved
     pharmacologically effective agents to treat the symptoms of dry eye, and
     the first one with this mechanism of action. We believe our product will
     help restore a natural corneal tear film, reduce dry eye symptoms, help
     prevent long-term corneal damage, and improve ocular surface health in dry
     eye sufferers.

Our Strategy

     Our objective is to become a leading biopharmaceutical company focused on
developing new treatments for diseases involving impaired mucosal hydration or
inadequate mucociliary clearance and other disorders. The principal elements of
our strategy include:

          Aggressively Advance Our Lead Products. Our focus is on discovering
     and developing therapies where current treatments are ineffective and where
     large therapeutic market opportunities exist. By the end of 2001, we expect
     to have six products in clinical development that target chronic
     bronchitis, cystic fibrosis, respiratory diagnostics, dry eye disease,
     retinal detachment and sinusitis. We intend to continue to rapidly develop
     and commercialize these products and to advance other preclinical product
     candidates toward clinical development.

          Establish Collaborative Relationships with Market Leaders while
     Selectively Retaining Marketing Rights. In order to minimize the costs to
     us of late-stage clinical trials and in order to more effectively market
     our products, we will continue to establish and expand strategic alliances
     with leading corporations in our target markets. In general, we seek to
     advance our compounds into later-stage clinical trials before partnering
     such compounds so as to retain maximum economic benefit to us.
     Additionally, we may selectively retain partial or full commercialization
     rights to our products in some limited indications. An example is our
     co-development and co-promotion options under the Genentech agreement for
     cystic fibrosis that enable us to retain additional economic benefit in
     this opportunity.

          Use Our Proprietary Technology Relating to P2Y Receptors to Develop
     New Products. Our research focus is to discover new pharmaceutical products
     based on our P2Y receptor technology. Studies indicate that a subtype of
     this family, the P2Y2 receptor, has broad applicability as a regulator of
     the body's innate defense mechanisms of mucosal hydration and mucociliary
     clearance. One of our key strengths is our ability to understand the role
     and importance of P2Y2 receptors and, through research, high-volume
     screening techniques and pharmacology models, develop compounds that target
     a patient's impaired mucosal hydration and clearance mechanisms and other
     non-mucosal applications. Our discovery group is pursuing opportunities to
     expand our base of compounds and therapeutic targets for P2Y2 agonists and
     the biological role of other P2Y receptor subtypes. This group generates
     additional mucosal and non-mucosal opportunities internally and through
     collaborative relationships with academic and governmental organizations
     and private enterprises.

          Protect and Enhance Our Technology Leadership Position. We have a
     substantial intellectual property position related to our technology. We
     intend to continue to pursue an aggressive patent strategy to protect our
     expanding proprietary discoveries.

                                      -5-
<PAGE>

Product Development Programs

     The following table provides a summary of our development programs by
indication, development status and corporate partners.

<TABLE>
<CAPTION>
======================================================================================================================
          Indication                Product Candidate          Development Status         Corporate Partners
======================================================================================================================

----------------------------------------------------------------------------------------------------------------------
<S>                            <C>                         <C>                            <C>
Respiratory
----------------------------------------------------------------------------------------------------------------------
    Chronic bronchitis         INS365 Respiratory          Phase II underway in U.S.;     Genentech (ex-Japan)
                                                           Phase I in Japan               Kissei (Japan)
----------------------------------------------------------------------------------------------------------------------
    Cystic fibrosis            INS37217                    Phase I/II planned for 2001    Genentech (ex-Japan)
                               Respiratory
----------------------------------------------------------------------------------------------------------------------
    Sinusitis                  INS37217                    Preclinical; Phase I           Genentech
                               Respiratory                 planned for 2001               (worldwide)
----------------------------------------------------------------------------------------------------------------------
    Diagnostic aid for         INS316 Diagnostic           Phase III planned to start     Kirin (Asia) Uncommitted
    lung disease                                           in 2001                        outside Asia
----------------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------------
Ophthalmic
----------------------------------------------------------------------------------------------------------------------
    Dry eye                    INS365 Ophthalmic           Phase III underway in          Santen (Asia)
                                                           U.S.; Phase I in Japan         Uncommitted
                                                                                          outside Asia
----------------------------------------------------------------------------------------------------------------------
    Retinal disease            INS37217                    IND filed; Phase I planned     Uncommitted
                               Ophthalmic                  to
                                                           start in 2001
======================================================================================================================
</TABLE>

                                      -6-
<PAGE>

     INS365 Respiratory for Chronic Bronchitis

     INS365 Respiratory is being developed in an inhaled form for the treatment
of chronic bronchitis. We have completed five Phase I clinical trials of INS365
Respiratory. These trials have evaluated the safety and preliminary efficacy of
INS365 Respiratory in healthy volunteers, chronic smokers who are at a high risk
for developing chronic bronchitis and cystic fibrosis patients with airflow
obstruction. In total, these studies enrolled approximately 250 subjects. These
studies have indicated that INS365 Respiratory was well tolerated and
significantly enhanced mucus clearance when compared to placebo. One of these
studies, conducted in 35 chronic smokers, indicated that INS365 Respiratory in
single inhaled doses significantly enhanced clearing of mucus from the lungs,
which occurred rapidly following dosing. This effect was dose-related and was
significantly greater than mucus cleared from lungs following inhalation of a
saline placebo; the results were statistically significant. We have conducted a
series of good laboratory practice toxicology studies, including 28-day
inhalation studies, which, together with the Phase I data, have allowed us to
progress INS365 Respiratory into a Phase II program.

     We have initiated, in consultation with our strategic partner, Genentech, a
Phase II clinical study in patients with chronic bronchitis which is now
underway. This trial is a multi-center study enrolling patients with mild to
moderate chronic bronchitis. We intend to dose patients for up to one month
using standard air-jet nebulizers. The clinical efficacy measures in this study
are intended to include respiratory symptoms and health status, using a
validated respiratory questionnaire, lung function and adverse events. Kissei,
our partner in Japan, filed a Japanese IND for INS365 Respiratory in December
1999 and has completed an initial Phase I clinical trial in smokers and
non-smokers. This study demonstrated safety and tolerability in the subject
population.

     We have developed a drug delivery strategy for INS365 Respiratory based on
segmenting the chronic bronchitis patient population by severity of
disease--mild, moderate and severe. We anticipate that each segment may have
different drug delivery needs based on convenience, ease of use, and degree of
patient mobility, such as whether the patient is working, homebound or
hospitalized. In recognizing this variety of needs, we are exploring various
delivery options which will allow for flexibility in dosing across the various
segments of the chronic bronchitis market. One option will be plastic unit-dose
vials that are used with a standard air-jet nebulizer system. Another possible
approach, a new, hand-held, portable delivery system, has been evaluated in two
radio-labeled lung deposition studies. These studies included 12 healthy
volunteers and 12 chronic smokers. Results from these studies suggest that this
new system can be used to deliver a small volume of concentrated INS365
Respiratory in one to two breaths providing rapid delivery in a convenient
manner to patients. These studies have also demonstrated that INS365 respiratory
significantly enhances mucus clearance with this new system. These studies have
been conducted to assist our strategic partners to demonstrate that this product
can be delivered in a more convenient device. The intention is to gain approval
first with a standard nebulizer, then to potentially add approval of a portable
delivery system.

     In September 1998, we entered into a joint development, license and supply
agreement with Kissei through which Kissei received exclusive rights to develop
and market INS365 Respiratory for respiratory therapeutic indications in Japan.
In December 1999, we entered into a development, supply and license agreement
with Genentech to develop P2Y2 agonists, including INS365 Respiratory, for
respiratory diseases, including chronic bronchitis, throughout the world outside
Japan. See "--Corporate Collaborations."

     INS37217 Respiratory for Cystic Fibrosis

     INS37217 Respiratory is a second-generation P2Y2 agonist with an extended
duration of action. This product is highly stable in the mucous secretions of
cystic fibrosis patients making it an attractive product candidate for this
disease. The previous studies we have conducted with INS365 Respiratory provide
the scientific rationale for the use of INS37217 Respiratory for cystic
fibrosis. We completed all necessary preclinical studies for initial clinical
testing and in the fall of 2000 filed an IND in the United States. We initiated
and completed a Phase I clinical trial for the development of INS37217
Respiratory for cystic fibrosis in late 2000. We intend to develop INS37217
Respiratory for cystic fibrosis as a chronic use agent in an inhaled delivery
form.

                                      -7-
<PAGE>

     INS37217 Respiratory is designed to enhance the lung's innate mucosal
hydration and mucociliary clearance mechanisms, which in cystic fibrosis
patients are impaired by a genetic defect. By hydrating airways and stimulating
mucociliary clearance through stimulation of the P2Y2 receptor, we expect that
INS37217 Respiratory will help keep the lungs of cystic fibrosis patients clear
of thickened mucus, reducing infections and the damage that occurs as a
consequence of the retention of thick and tacky infected secretions. We further
believe that these effects may result in reduced frequency and length of
hospitalizations, reduced need for antibiotics and other medications, reduced
deterioration of respiratory function, and improved respiratory symptoms and
health status. In addition, this product is expected to be complementary with
the two approved products, Pulmozyme(R) and TOBI(R), neither of which affects
the underlying ion-transport defects in cystic fibrosis airways.

     We expect to receive orphan drug status and an accelerated regulatory
approval process for INS37217 Respiratory for the treatment of cystic fibrosis.
In December 1999, we entered into a co-development partnership with Genentech to
develop P2Y2 agonists for respiratory diseases, including cystic fibrosis,
throughout the world outside Japan. See "--Corporate Collaborations."

     INS37217 Respiratory for Sinusitis

     INS37217 Respiratory is also being developed to treat sinusitis, an
infectious and inflammatory condition of the nose and sinuses that often results
in painful flare-ups of the illness. We believe that increasing mucociliary
clearance in the nose and sinuses with INS37217 Respiratory may be beneficial
for treating this condition. Clinical studies with other P2Y2 agonists such as
INS316 have already shown that these agents open ion channels in the nasal
mucosa thus hydrating this surface. It is expected that INS37217 Respiratory
will also stimulate mucociliary clearance in the sinuses. We estimate that
sinusitis affects approximately 12% of the U.S. adult population, or
approximately 25 million adults. The current market consists of both
over-the-counter and prescription treatments. Our research and development of
drug candidates in this area depends on our collaboration with Genentech. See
"--Corporate Collaborations."

     INS316 for Respiratory Diagnostics

     INS316 Diagnostic, a P2Y2 agonist with a short duration of action, is being
developed as an acute-use inhaled solution to stimulate enhanced clearance of
mucus from the lungs to provide a deep-lung sputum sample for diagnosing lung
disease and infections. We have conducted four clinical trials to evaluate
INS316 Diagnostic's utility as an acute use agent. These clinical studies have
demonstrated that INS316 Diagnostic is well tolerated and appears to enhance the
ability of patients to produce rapidly an adequate deep-lung specimen. These
studies were conducted in healthy volunteers, as well as chronic smokers and
patients with chronic bronchitis who are at a high risk for developing lung
cancer and lung infections. Phase II studies in patients diagnosed with or
suspected of having lung cancer have now been completed.

     INS316 Diagnostic has been administered by inhalation to more than 325
patients, and has been well tolerated in these trials. INS316 Diagnostic's
safety profile is based on studies including non-smokers, smokers, patients with
obstructive lung diseases and patients diagnosed with or suspected of having
lung cancer, and on the results of good laboratory practice, genotoxicity and
28-day inhalation toxicology studies. We believe that INS316 Diagnostic is
rapidly degraded in blood and plasma and, so has minimal systemic absorption.
Therefore, the potential for unwanted side effects is minimized.

     These studies have demonstrated that single inhaled doses of INS316
Diagnostic significantly enhance clearing of mucus from the lungs relative to
that following administration of normal saline solution. These effects occurred
within a few minutes following dosing and were dose-related. Specimens obtained
from individuals exposed to INS316 Diagnostic were found to be highly enriched
with cell types characteristic of deep-lung secretions, including alveolar
macrophages and ciliated epithelial cells, when compared to samples from
individuals exposed to a placebo. These findings were statistically significant.
In a trial in 25 patients with chronic bronchitis who are at high risk for lung
cancer, 90% of the patients produced an adequate deep-lung specimen following
INS316 Diagnostic inhalation versus only 25% following inhalation of a placebo.
These study results were

                                      -8-
<PAGE>

statistically significant. Based on these encouraging results and the recently
completed Phase II lung cancer trials, we except to move INS316 Diagnostic into
Phase III testing in 2001.

     In September 2000, we entered into a licensing agreement with Kirin.
Pursuant to this agreement Kirin has obtained rights to develop and
commercialize INS316 Diagnostic in twenty-one Asian countries and regions,
including Japan. See "--Corporate Collaborations."

     INS365 Ophthalmic for Dry Eye Disease

     INS365 Ophthalmic is being developed as a topical eye drop for the
treatment of dry eye disease. A series of good laboratory practice ocular
toxicology studies have been completed to support the ongoing clinical program.
In preclinical testing, topically applied INS365 Ophthalmic produced a
consistent, statistically significant increase in tear secretion, relative to
that produced by normal saline controls. INS365 Ophthalmic has also enhanced
mucin secretion on the ocular surface in several preclinical models. Many of
these studies were conducted by our Asian partner, Santen. The preclinical study
results were statistically significant in multiple relevant dry eye models.

     We have completed one Phase I clinical trial in 50 healthy subjects and
demonstrated good ocular safety and tolerability. We also completed a Phase IIa
study in 35 patients with mild to moderate dry eye, which showed the product
candidate to be well tolerated in the target patient population. In the fall of
2000 we completed a multi-center Phase II clinical trial. This study enrolled
158 patients with dry eye disease. Patients were treated with multiple-daily
doses of placebo (saline drops) or INS365 Ophthalmic for up to six weeks.
Clinical efficacy measures included both objective and subjective parameters for
measuring ocular surface health. The results of this study were positive and
based on these results a large-scale Phase III program has been initiated and is
underway in the United States.

     In December 1998, we entered into a joint development, license and supply
agreement with Santen in Asia. Santen is a premier ophthalmic company and
markets the only approved prescription product for dry eye disease in Japan.
Santen has filed an IND with Japanese regulatory authorities and has begun Phase
I testing in Japan. See "--Corporate Collaborations."

     INS37217 Ophthalmic for Retinal Disease

     INS37217 Ophthalmic, a second-generation proprietary P2Y2 receptor agonist,
is being developed as a sterile intravitreal injection for the treatment of
retinal disease, including retinal detachment, a separation of the retina from
the eye. Retinal detachment occurs when fluid accumulates between the retina and
the underlying retinal epithelium. We estimate, based on an extrapolation from
United States data, that retinal detachment affects approximately 200,000 people
in the eight major international prescription pharmaceutical markets. This
condition leads to loss of vision, and when left untreated, can result in
permanent damage to the retina, a sensory organ at the back of the eye that is
responsible for vision, and irreversible blindness. Previous work conducted in
vitro has shown that the retinal pigment epithelium contains P2Y2 receptors at
the retinal-facing membrane, which can be stimulated by appropriate agonists to
enhance fluid absorption across the retinal pigment epithelium. Later work
conducted in vivo has demonstrated the ability of INS37217 Ophthalmic to
facilitate the reattachment of the retina to the retinal pigment epithelium in
two distinct animal models. Retinal disease in humans may result from several
ophthalmic diseases, ocular trauma, or side-effects from invasive intraocular
surgery. There is currently no pharmaceutical treatment for retinal detachment.

     We have completed a series of preclinical studies with INS37217 Ophthalmic
and have completed intravitreal toxicology to support initiation of clinical
trials. We filed an IND with the FDA in December 2000 and expect to initiate
clinical testing in patients in the first half of 2001.

                                      -9-
<PAGE>

Corporate Collaborations

     Genentech, Inc.

     In December 1999, we entered into a collaboration with Genentech to develop
treatments for respiratory disorders, including chronic bronchitis, cystic
fibrosis and sinusitis. Under the terms of the agreement, we granted an
exclusive license to Genentech for the use of INS365 Respiratory and our other
related P2Y2 agonists existing on the date of the agreement for all human
therapeutic uses for the treatment of respiratory tract disorders throughout the
world, excluding Japan. In addition, Genentech has an exclusive license for the
use of INS365 Respiratory and such existing P2Y2 agonists for all human
therapeutic uses for the treatment of sinusitis and middle ear infection
worldwide. Finally, Genentech has the right to use related P2Y2 agonists we
discover and develop for these uses and in these territories during the term of
the agreement upon reimbursing us for discovery costs or funding our discovery
efforts leading to those compounds. However, even if Genentech does not
reimburse or fund our discovery efforts, we have agreed not to develop any such
P2Y2 agonist for use in the therapeutic respiratory field during the term of our
agreement.

     We have established joint project teams to oversee and coordinate the joint
development programs and a joint steering committee to establish the strategy
and manage the relationship. Under the terms of the agreement, we provide bulk
active drug substance to Genentech for its requirements, at an agreed-upon
price, through the end of Phase II. After Phase II, Genentech is responsible for
obtaining or manufacturing all of its bulk active drug substance requirements.

     We received an up-front payment of $15 million, comprising a non-refundable
cash license fee, funding for the Phase II clinical trials for chronic
bronchitis and the purchase of shares of our preferred stock, which subsequently
converted to shares of our common stock. In the third quarter of 2000, we also
received a $1 million payment in the form of an equity investment for the
achievement of a technical milestone. In addition, depending on whether all
milestones in each of the chronic bronchitis, cystic fibrosis and sinusitis
development programs are met, we could receive additional payments of up to $62
million, of which $1 million would be in the form of an equity investment by
Genentech at the fair market value of the stock at the time of the investment.
Genentech is required to pay us royalties on net sales of products licensed
under the agreement.

     In the United States, we will lead the early clinical development of
INS37217 Respiratory for the treatment of cystic fibrosis through the end of
Phase II clinical trials. We then have the option to continue to co-fund the
development of the product in the United States in exchange for a share of
United States operating profits instead of royalties. In addition, we have the
option, any time before Genentech initiates pre-launch activities, to choose to
co-promote the product in the United States at our own expense.

     We are responsible for conducting, in collaboration with Genentech, the
Phase II clinical trials for INS365 Respiratory for chronic bronchitis. We will
also lead the preclinical program for INS37217 Respiratory for the treatment of
sinusitis, and will be responsible for filing the IND for such compound.

     Genentech is responsible for all other development conducted under the
agreement, including all development outside the United States and in their
territories, and for all other regulatory submissions, filings and approvals
relating to products. Genentech is required to use commercially reasonable
efforts to conduct development, seek regulatory approvals and market and sell
the products.

     The agreement will be in effect until all patents licensed under the
agreement have expired. If we exercise our option to co-fund the development of
INS37217 Respiratory for the treatment of cystic fibrosis, then the agreement
will remain in effect for those products in the United States until the products
are no longer being marketed in the United States. Either Genentech or we may
terminate the agreement if the other materially breaches the agreement. In
addition, Genentech has the right, by giving us 150 days prior notice, to
terminate the agreement at any time. If Genentech breaches the agreement or
terminates the agreement early other than for our breach, Genentech's license
will terminate. Genentech must provide us with all data and information relating
to our products, and Genentech must assign or permit us to cross-reference all
regulatory filings and approvals.

                                      -10-
<PAGE>

     Kissei Pharmaceutical Co., Ltd.

     In September 1998, we entered into a Joint Development, License and Supply
Agreement with Kissei for the development of INS365 Respiratory for all
therapeutic respiratory applications, excluding sinusitis and middle ear
infection, in Japan. We granted Kissei an exclusive license to INS365
Respiratory in the field in Japan and a first right to negotiate a license to
particular P2Y2 agonists that show utility as inhalation products for
respiratory uses in Japan.

     We established a joint development committee with Kissei to oversee the
development program, approve development plans, protocols and studies, and
review and approve all regulatory submissions and filings. In consultation with
Kissei, we are responsible for formulation of the compound and the design of the
delivery system to be used. We are also responsible, through the use of
development and manufacturing liaisons, for coordinating and facilitating
communications among our corporate partners for the worldwide development and
manufacture of INS365 Respiratory. Kissei is responsible for all development of
the compound and all regulatory filings.

     We received an up-front payment of $4.5 million, which included the
purchase of shares of our preferred stock, which subsequently converted into
shares of our common stock. In addition, depending on whether all milestones are
met, we could receive additional payments of up to $13.0 million, as well as
royalties on net sales of licensed products. To date, we have received $2.1
million in milestone payments. We also are receiving funding for development and
manufacturing liaison staff positions.

     We are obligated to supply Kissei with its requirements of INS365
Respiratory in bulk drug substance at our cost. In addition, we are obligated to
supply Kissei with its requirements of finished product contained in a vial or
nebule and in a delivery system approved by the joint development committee for
all clinical trials to be conducted by Kissei. Kissei will pay us an agreed-upon
transfer price for all such supplies. We have also agreed to negotiate a
commercial supply arrangement with Kissei at the appropriate time to supply
Kissei's requirements of finished product and the delivery system.

     The agreement will terminate when all patents licensed under the agreement
have expired. Either Kissei or we may terminate the agreement if the other
materially breaches the agreement. In addition, Kissei has the right, by giving
us three months prior notice, to terminate the agreement at any time if Kissei
determines that continued development or marketing of the product is
scientifically or economically infeasible. If Kissei breaches the agreement or
terminates the agreement early other than for our breach, Kissei's license will
terminate. Kissei will provide us with all data and information relating to our
products, and Kissei will assign or permit us to cross-reference all regulatory
filings and approvals.

     Santen Pharmaceutical Co., Ltd.

     In December 1998, we entered into a Development, License and Supply
Agreement with Santen for the development of INS365 Ophthalmic for the
therapeutic treatment of ocular surface diseases, such as dry eye disease, in
Asia. Under the agreement, we granted Santen an exclusive license to market
INS365 Ophthalmic for ocular surface diseases in Japan, China, South Korea, the
Philippines, Thailand, Vietnam, Taiwan, Singapore, Malaysia and Indonesia.

     We established a coordinating committee to review and evaluate Santen's
progress in the development and commercialization of products. Santen is
responsible for all development, regulatory submissions, filings and approvals,
and all marketing of products. We are obligated to supply Santen with its
requirements of INS365 Ophthalmic in bulk drug substance form for all
preclinical studies, clinical trials and commercial requirements at agreed-upon
prices.

     Under the terms of the agreement, we received an up-front equity investment
of $1.5 million in shares of our preferred stock, which subsequently converted
into shares of our common stock. In addition, depending on whether all
milestones are met, we could receive additional payments of up to $4.75 million,
as well as royalties on

                                      -11-
<PAGE>

net sales of licensed products. The Company has not received any milestone
payments to date under the Santen agreement.

     The agreement will terminate when all patents licensed under the agreement
have expired. Either Santen or we may terminate the agreement if the other
materially breaches the agreement. In addition, we have the right to terminate
the agreement at any time if we determine, subject to the coordinating
committee's review and arbitration, that Santen has not made reasonably
sufficient progress in the development or commercialization of products. If
Santen breaches the agreement, or if we terminate the agreement because Santen
has not made sufficient progress, Santen's license will terminate, and Santen
will provide us with all data and information relating to our products, and will
assign or permit us to cross-reference all regulatory filings and approvals.

     Kirin Brewery Co., Ltd. Pharmaceutical Division

     In September 2000, we entered into a License Agreement with Kirin for the
development and commercialization of INS316 Diagnostic. Under the agreement we
granted Kirin an exclusive license to commercialize INS316 Diagnostic in
twenty-one Asian countries and regions, including Japan.

     We established a coordinating committee to review and evaluate Kirin's
progress in the development and commercialization of a product and to provide
input and recommendations regarding development of the products Kirin is
responsible for all development regulatory submissions, filings and approvals
and all marketing of the products. We are responsible for providing to Kirin
copies of preclinical and clinical data relating to the development and
commercialization of the products. Under the terms of the agreement, we received
an upfront payment in cash and will receive milestone payments based on clinical
success and approval.

     The agreement will terminate as to a product on the later of the 10th
anniversary of the first commercial sale of the product or the date on which the
sale of the product ceases to be covered by a licensed clause under the
agreement. Either Kirin or we may terminate the agreement if the other
materially breaches the agreement. In addition, Kirin has the right, by giving
us 180 days prior notice, to terminate the agreement at any time.

Discovery

     Our scientists have specific expertise and proprietary knowledge relating
to the design and synthesis of P2Y receptor agonists, and we have invested
heavily in state-of-the-art equipment and laboratory space for performing
synthetic chemistry, determination of compound structure and receptor location
and function identification. We have acquired, by licenses and/or material
transfer agreements, rights to three of the five unique human P2Y receptors that
have been functionally expressed. We have cloned and expressed the other two
receptors in-house.

     Our discovery effort is focused on conducting studies using our proprietary
cell-based MUCOSA(TM) assay system, a cell-based scientific test that measures
biological activities caused by stimulation of P2Y receptors, to identify new
compounds that specifically and selectively bind to members of the P2Y receptor
family. The MUCOSA high-volume assay enables us to identify agonists and
antagonists that act at specific receptor subtypes and have demonstrated a level
of specificity and activity that merits further investigation. We use data from
the assays to design and synthesize compounds specific to each P2Y receptor
subtype which can be advanced to clinical trials.

     By screening against several P2Y receptor subtypes, we have been able to
identify agonists and/or antagonists that interact preferentially with a
specific receptor subtype. Several proprietary discovery compounds, including
new chemical entities, with promising stability and metabolic profiles, are
being actively explored. We intend to conduct further preclinical development
studies to advance such proprietary compounds to project status, if appropriate.
These compounds will then be targeted to the treatment of new disease areas, as
identified through our strategic planning process.

                                      -12-
<PAGE>

     We obtain access to chemical libraries through our own proprietary
combinatorial chemistry, commercial sources and corporate agreements. The
chemicals are screened for both agonist and antagonist activity. Our chemistry
department also assists in the development of analytical protocols used by
contract service organizations for analysis of a drug substance, clinical trials
material and drug stability studies which will be incorporated into IND and new
drug application (NDA) filings.

     We use sponsored research agreements to investigate specific biological
processes to augment our technology platform. We have sponsored research at
major universities, including The University of North Carolina at Chapel Hill,
Columbia University, the University of Southern California, Duke University,
Schepens Eye Research Institute, Boston University and Brigham and Women's
Hospital.

Patents and Proprietary Rights

     We believe that the proprietary protection of our product candidates,
processes and know-how is important to the success of our business. We
aggressively file and prosecute patents covering our proprietary technology,
and, if warranted, will defend our patents and proprietary technology. As of
December 31, 2000, we owned or licensed patent rights consisting of 21 issued
United States patents, none of which expire before 2011, and numerous pending
applications in the United States and corresponding patents and patent
applications in foreign jurisdictions. We seek patent protection for our
proprietary technology and products in the United States and Canada and in key
commercial European and Asia/Pacific countries and other major commercial
sectors of the world, as appropriate. We intend to seek protection in the United
States and foreign countries for trademarks from time to time. We also rely upon
trade secrets, know-how, continuing technological innovation and licensing
opportunities to develop and maintain our competitive position.

     In March 1995 and September 1998, we entered into two agreements with The
University of North Carolina at Chapel Hill ("UNC") granting us exclusive
worldwide licenses to develop, make, use and sell products based on UNC patented
technology relating to the use of P2Y2 receptor agonists for respiratory
therapeutics, such as INS365 Respiratory, and respiratory diagnostics, such as
INS316 Diagnostic. The United States government may have limited rights in some
of this UNC patented technology. We also entered into a third agreement that
granted us a non-exclusive worldwide license to use other UNC patented
technology as a research tool to identify agonists and antagonists for P2Y
receptors. The agreements require us to pay licensing fees upon the attainment
of development milestones and royalties on net sales or a share of sublicensing
income on products covered by the patents. We are also required to meet due
diligence milestones and UNC may terminate the licenses if we fail to do so. In
connection with the licenses, we issued to UNC an aggregate of 326,286 shares of
our common stock, of which 128,610 shares have been transferred to the inventors
of the licensed UNC patented technology. We have also entered into consulting
agreements with some of the inventors of these technologies, all of whom are
from The University of North Carolina at Chapel Hill, including Dr. Richard C.
Boucher, one of our founders and a member of our Board of Directors, M. Jackson
Stutts, Kendall Harden and Michael Knowles, in which they agreed to consult with
us regarding their respective fields of knowledge.

     Additional patent applications have since been filed on discoveries made in
support of such technologies, from research conducted at The University of North
Carolina at Chapel Hill or in our own laboratories. Our sponsored research
agreements, material transfer agreements, and other collaborations have the
potential to result in license agreements with universities, institutes and
businesses. We believe that our patents and licensed patents provide a
substantial proprietary base that will allow us, and our collaborative partners,
to exclude others from conducting our business as described in this prospectus
and as encompassed by our issued patents and issued patents licensed to us. We
cannot be sure, however, that pending or future applications will issue, that
the claims of any patents which do issue will provide any significant protection
of our technology or that our directed discovery research will yield compounds
and products of therapeutic and commercial value.

     Our competitors or potential competitors may have filed for or have
received U.S. and foreign patents and may obtain additional patents and
proprietary rights relating to compounds or processes which may compete with our
product candidates. Accordingly, there can be no assurance that our patent
applications will result in patents

                                      -13-
<PAGE>

being issued or that, if issued, the claims of the patents will afford
protection against competitors with similar technology, nor can we be sure that
others will not obtain patents that we would need to license or get around.

Manufacturing and Supply

     We do not engage in, and do not expect to engage in, the manufacture of
bulk active pharmaceutical ingredient for preclinical, clinical or commercial
purposes. We rely on a contract manufacturing supply agreement with a single
manufacturer for the development stage production of INS316, INS365 and
INS37217. We have identified an alternative supplier as a backup. We have
already obtained clinical trial grade material of these compounds from the lead
supplier. In addition, we expect the same lead manufacturer will supply
commercial quantities of INS316, INS365 and INS37217 for both respiratory and
ophthalmic applications. We believe this lead manufacturer is capable of
producing sufficient quantities for commercial purposes within current good
manufacturing practices. See "Risk Factors--If we are unable to contract with
third parties for synthesis and manufacturing of our product candidates for
preclinical testing and clinical trials and for large scale manufacturing of any
of our drug candidates, we may be unable to develop or commercialize products."

     We currently obtain all of our bulk active ingredient for INS316, INS365
and INS37217 from Yamasa Corporation, in Choshi, Japan, but the first two are
also available from other fine chemical manufacturers. In addition to the bulk
active ingredient, our products are made up of sodium chloride, sodium
hydrochloric acid and sterile water, all of which are readily available from
numerous sources. Our products are packaged in unit-dose vials, which we obtain
from Cardinal Health Manufacturing Services - Automatic Liquid Packaging of
Woodstock, Illinois, but these vials are also available from other commercial
filling and packing companies.

Competition

     Many drug companies engage in research and development to commercialize
products to treat chronic bronchitis, cystic fibrosis, dry eye disease and other
diseases that we are researching. We compete with these companies for funding,
access to licenses, personnel, third-party collaborators and product
development. Almost all of these companies have substantially greater financial,
marketing, sales, distribution and technical resources and more experience in
research and development, clinical trials and regulatory matters, than we do. We
are aware of existing palliative treatments that will compete with our products.

     We believe that several major pharmaceutical companies have initiated
research programs to design P2Y receptor agonists or antagonists; however, we
are not aware of any competing P2Y2 receptor agonists that have entered clinical
testing. If successfully developed and commercialized, our products will compete
with existing therapeutics and improved versions of these treatments.

     The current therapeutic approaches used in the treatment of chronic
bronchitis are palliative and are aimed at reducing airway inflammation,
respiratory infections and airflow obstruction. These approaches include
corticosteroids and other anti-inflammatory agents, bronchodilators and
antibiotics. We are aware of many anti-inflammatory agents, including
Azmacort(R), Beclovent(R) and antibiotics such as Biaxin(R) and Zithromax(R). We
believe that other anti-inflammatory agents are in development. Numerous
bronchodilators are also on the market, including among others generic
albuterol, Alupent(R), Proventil(R), Ventolin(R), Serevent(R), and Theo-Dur(R).
Outside of the United States, mucolytics, agents that liquefy or reduce the
viscoelastic consistency of mucus, are widely used even though they have shown
minimal efficacy in well-controlled trials.

     Although we believe that none of the therapeutic approaches described above
address the underlying problem of excessive retained mucus and impaired
mucociliary clearance, drugs based on other therapeutic mechanisms may be
efficacious in treating respiratory diseases. The development by others of
treatments that are not related to our mucociliary clearance approach could
render our product candidates non-competitive or obsolete.

     There are two products approved in the United States specifically for the
treatment of cystic fibrosis: Pulmozyme(R), an agent designed to break up
thickened airway secretions, and TOBI(R), an inhaled antibiotic. Pulmozyme(R) is
marketed by Genentech, which is one of our collaborative partners.

                                      -14-
<PAGE>

     The current prescription and non-prescription treatments for dry eye
disease include artificial tear replacement therapy or lubricant drops. The only
prescription pharmacological agent in late-stage clinical trials for dry eye is
Restasis(R) from Allergan. We are aware of early clinical trials with various
other potential products as possible alternative modes of therapy.

Governmental Regulation

     The research, development, testing, manufacture, promotion, marketing and
distribution of human therapeutic and diagnostic products are extensively
regulated by government authorities in the United States and other countries. In
the United States, the FDA regulates drugs and diagnostic products and similar
regulatory bodies exist in other countries. The steps ordinarily required before
a new drug may be marketed in the United States, which are similar to steps
required in most other countries, include:

     .    preclinical laboratory tests, preclinical studies in animals and
          formulation studies and the submission to the FDA of an IND for a new
          drug;

     .    adequate and well-controlled clinical trials to establish the safety
          and efficacy of the drug for each indication;

     .    the submission of an NDA to the FDA; and

     .    FDA review and approval of the NDA before any commercial sale or
          shipment of the drug.

     Preclinical tests include laboratory evaluation of product toxicity and
formulation, as well as animal studies. The results of preclinical testing are
submitted to the FDA as part of an IND. A 30-day waiting period after the filing
of each IND is required before the commencement of clinical testing in humans.
At any time during this 30-day period or later, the FDA may halt proposed or
ongoing clinical trials until the FDA authorizes trials under specified terms.
The IND process may be extremely costly and substantially delay development of
our products. Moreover, positive results of preclinical tests will not
necessarily indicate positive results in clinical trials.

     Clinical trials to support NDAs are typically conducted in three sequential
phases, but the phases may overlap. During Phase I, the initial introduction of
the drug into healthy human subjects or patients, the drug is tested to assess
metabolism, pharmacokinetics and pharmacological actions and safety, including
side effects associated with increasing doses. Phase II usually involves studies
in a limited patient population to:

     .    assess the efficacy of the drug in specific, targeted indications;

     .    assess dosage tolerance and optimal dosage; and

     .    identify possible adverse effects and safety risks.

     If a compound is found to be potentially effective and to have an
acceptable safety profile in Phase II evaluations, Phase III trials, also called
pivotal studies, major studies or advanced clinical trials, are undertaken to
further demonstrate clinical efficacy and to further test for safety within an
expanded patient population at geographically dispersed clinical study sites.

     After successful completion of the required clinical testing, generally a
NDA is submitted. The FDA may request additional information before accepting a
NDA for filing, in which case the application must be resubmitted with the
additional information. Once the submission has been accepted for filing, the
FDA has 180 days to review the application and respond to the applicant. The
review process is often significantly extended by FDA requests for additional
information or clarification. The FDA may refer the NDA to an appropriate
advisory committee for review, evaluation and recommendation as to whether the
application should be approved, but the FDA is not bound by the recommendation
of an advisory committee.

                                      -15-
<PAGE>

     If FDA evaluations of the NDA and the manufacturing facilities are
favorable, the FDA may give us either an approval letter or an approvable
letter. An approvable letter will usually contain a number of conditions that
must be met in order to secure final approval of the NDA and authorization of
commercial marketing of the drug for particular indications. The FDA may refuse
to approve the NDA or give us a non-approvable letter, outlining the
deficiencies in the submission and often requiring additional testing or
information. If regulatory approval of a product is granted, it will be limited
to particular disease states or conditions.

     We and any of our contract manufacturers are also required to comply with
the applicable FDA current good manufacturing practice regulations. Good
manufacturing practice regulations include requirements relating to quality
control and quality assurance as well as the corresponding maintenance of
records and documentation. Manufacturing facilities are subject to inspection by
the FDA. These facilities must be approved before we can use them in commercial
manufacturing of our products. Our contract manufacturers or we may not be able
to comply with the applicable good manufacturing practice requirements and other
FDA regulatory requirements.

     Outside the United States, our ability to market our products will also
depend on our receipt of marketing authorizations from the appropriate
regulatory authorities. The requirements governing the conduct of clinical
trials and marketing authorization vary widely from country to country. At
present, foreign marketing authorizations are applied for at a national level,
although within Europe procedures are available to companies wishing to market a
product in more than one European Union member state. If the regulatory
authority is satisfied that adequate evidence of safety, quality and efficacy
has been presented, a marketing authorization will be granted. This foreign
regulatory approval process, including those in Europe and Japan, involves all
of the risks associated with FDA clearance discussed above.

Employees

     As of December 31, 2000, we had 37 full-time employees, 16 of whom were
involved in our drug discovery and preclinical programs, 12 of whom were engaged
in development programs, and nine of whom were involved in administrative
activities. In addition, we utilize part-time employees and outside contractors
and consultants as needed. Employees are required to execute a confidentiality
and assignment of trade secrets agreement. Our employees are not represented by
a labor union.

Scientific Advisory Board

     We are advised by an international scientific advisory board currently
composed of eight members with expertise in the fields of statistics, molecular
biology, genetic research and medicine. We meet periodically with our scientific
advisory board to review and discuss specific projects with those members who
are experts in the subjects being discussed. In addition, we may consult
individual board members as to matters in their respective areas of expertise.
Our scientific advisory board currently is composed of the following
individuals:

          Richard Boucher, M.D. and Benjamin R. Yerxa, Ph.D. are Co-Chairmen of
     the Scientific Advisory Board. See "Management--Executive Officers and
     Directors."

          Dennis Ausiello, M.D. is Chief of Medicine at Massachusetts General
     Hospital and Professor of Medicine at Harvard Medical School. He is an
     internationally recognized expert in the cell biology of ATP receptors,
     sodium ion channels and water channels.

          Carol Basbaum, Ph.D. is Professor of Anatomy at the University of
     California at San Francisco and is an expert in lung mucin production. Her
     interests focus on both the biology of the mucin secretory cell in the lung
     and the regulation of mucin gene expression. A particular interest has been
     bacterial pathogen-mucin gene regulatory interactions.

          Geoffrey Burnstock, D.Sc. is Director, Autonomic Neuroscience
     Institute, and Professor, Department of Anatomy and Developmental Biology,
     Royal Free Hospital School of Medicine. He

                                      -16-
<PAGE>

     originally conceived the idea of purinergic nerves and receptors for
     extracellular adenine nucleotides. He is the leader of the purinergic
     receptor field. He is the recipient of many international wards and is a
     fellow of the Royal Society.

          Mark Leppert, Ph.D. is Associate Professor, Eccles Institute of Human
     Genetics, University of Utah. He is a geneticist/molecular biologist. He is
     a central figure in the internationally recognized University of Utah human
     genome effort. His particular interest is mapping human diseases to define
     the molecular basis of human disease.

          Lee Limbird, Ph.D. is Associate Vice Chancellor for Research,
     Vanderbilt University Medical Center, Professor of Pharmacology and Chair,
     Department of Pharmacology Vanderbilt University. Her research has focused
     on the structure and function of G-protein coupled receptors with
     particular emphasis on adrenergic receptors. A current interest is
     delineation of the molecular basis of membrane targeting of receptors in
     polarized cells. She was awarded the John Jacob Abel Award given to the
     most outstanding young pharmacologist in 1987.

          David Westfall, Ph.D. is Vice President, Academic Affairs, University
     of Nevada-Reno and Professor of Pharmacology, University of Nevada School
     of Medicine. He has been a leader in Physiological and pharmacological
     studies of purinergic receptors for the last two decades. His research
     includes a major interest in purinergic receptors in the nervous system and
     on smooth muscle of the urinary tract.

Risk Factors

     An investment in the shares of our common stock involves a substantial risk
of loss. You should carefully read this entire report and should give particular
attention to the following risk factors. You should recognize that other
significant risks may arise in the future, which we cannot foresee at this time.
Also, the risks that we now foresee might affect us to a greater or different
degree than expected. There are a number of important factors that could cause
our actual results to differ materially from those indicated by any forward-
looking statements in this document. These factors include, without limitation,
the risk factors listed below and other factors presented throughout this
document and any other documents filed by us with the Securities and Exchange
Commission.

IF OUR PRODUCTS FAIL IN CLINICAL STUDIES, WE WILL BE UNABLE TO OBTAIN FDA
APPROVAL AND WILL NOT BE ABLE TO SELL THOSE PRODUCTS.

     To achieve profitable operations, we must, alone or with others,
successfully identify, develop, introduce and market proprietary products. Even
if we identify potential products, we will have to conduct significant
additional development activities and preclinical and clinical tests, and obtain
regulatory approval before our products can be commercialized. Product
candidates that may appear to be promising at early stages of development may
not successfully reach the market for a number of reasons. We have not submitted
any products for marketing approval by the United States Food and Drug
Administration (FDA) or any other regulatory body.

     Generally, all of our product candidates are in research or preclinical
development, with only four, INS365 Respiratory, INS365 Ophthalmic, and INS316
Diagnostic, INS37217 Respiratory currently in clinical trials. The results of
preclinical and initial clinical testing of our products under development may
not necessarily indicate the results that will be obtained from later or more
extensive testing. Companies in the pharmaceutical and biotechnology industries
have suffered significant setbacks in advanced clinical trials, even after
obtaining promising results in earlier trials. Our ongoing clinical studies
might be delayed or halted for various reasons, including:

     .    the drug is not effective, or physicians think that the drug is not
          effective;

     .    patients experience severe side effects during treatment;

                                      -17-
<PAGE>

     .    patients die during the clinical study because their disease is too
          advanced or because they experience medical problems that may or may
          not relate to the drug being studied;

     .    patients do not enroll in the studies at the rate we expect;

     .    drug supplies are not sufficient to treat the patients in the studies;
          or

     .    we decide to modify the drug during testing.

BECAUSE OUR PRODUCT CANDIDATES UTILIZE A NEW MECHANISM OF ACTION, OBTAINING
REGULATORY APPROVAL MAY BE DIFFICULT, EXPENSIVE AND PROLONGED, WHICH WOULD DELAY
ANY MARKETING OF OUR PRODUCTS.

     We cannot apply for regulatory approval to market a product candidate until
we successfully complete pivotal clinical trials for the product. To complete
successful clinical trials, the products must meet the criteria for clinical
approval, or endpoints, which we establish for the product in the clinical
study.

     Generally, we will establish these endpoints in consultation with the
regulatory authorities, following design guidelines on the efficacy, safety and
tolerability measures required for approval of products.

     Because our existing product candidates utilize a new approach to the
treatment of respiratory and eye diseases, we may have trouble establishing
endpoints that the regulatory authorities agree sufficiently evaluate the
effectiveness of each product candidate. For this and other reasons, we could
encounter delays and increased expenses in our clinical trials if the regulatory
authorities determine that the endpoints established for a clinical trial do not
predict a clinical benefit, and the authorities will not approve the product for
marketing without further clinical trials. The regulatory authorities could
change their view on clinical trial design and establishment of appropriate
standards for efficacy, safety and tolerability and require a change in study
design, additional data or even further clinical trials before approval of a
product candidate.

     After initial regulatory approval, regulatory authorities continue to
review a marketed product and its manufacturer. They may require us to conduct
long-term safety studies after approval. Discovery of previously unknown
problems through adverse event reporting may result in restrictions on the
product, including withdrawal from the market. Additionally, we and our officers
and directors could be subject to civil and criminal penalties.

IF PHYSICIANS AND PATIENTS DO NOT ACCEPT OUR PRODUCT CANDIDATES, THEY MAY NOT BE
COMMERCIALLY SUCCESSFUL.

     Even if regulatory authorities approve our product candidates, those
products may not be commercially successful. Acceptance of and demand for our
products will depend largely on the following:

     .    acceptance by physicians and patients of our products as safe and
          effective therapies;

     .    reimbursement of drug and treatment costs by third-party payors;

     .    safety, effectiveness and pricing of alternative products; and

     .    prevalence and severity of side effects associated with our products.

     In addition, to achieve broad market acceptance of our product candidates,
in many cases we will need to develop, alone or with others, convenient methods
for administering product candidates. Physicians have administered our current
product candidates for the treatment or diagnosis of respiratory disorders,
INS365 Respiratory, INS316 Diagnostic and INS37217 Respiratory, using a jet
nebulizer, a device that generates and delivers a fine mist derived from a
liquid, which is inhaled into the lungs, in their respective clinical studies.
Although the use of a jet nebulizer is an effective and well accepted means for
administering products for inhalation

                                      -18-
<PAGE>

with respect to acute use and, to a lesser degree, chronic use, we believe more
convenient methods of delivery and administration, such as a hand-held
inhalation device, may be necessary in the case of INS365 Respiratory and
INS37217 Respiratory, to more fully address chronic use. Our testing of
prototype hand-held inhalation devices is at an early stage and we may not be
able to develop or find a convenient hand-held device that works in patients
with chronic bronchitis. Our current product candidate for the treatment of dry
eye disease, INS365 Ophthalmic, is applied from a vial containing a single dose
of medication. Patients may prefer to purchase the medication in a bottle
containing a sufficient quantity of medication for multiple doses. We have not
yet established a plan to develop a multi-dose formulation. Similar challenges
exist in identifying and perfecting convenient methods of administration for
many of our other product candidates.

WE INTEND TO RELY ON THIRD PARTIES TO DEVELOP, MARKET, DISTRIBUTE AND SELL OUR
PRODUCT CANDIDATES AND THOSE THIRD PARTIES MAY NOT PERFORM.

     We do not yet have the ability to independently market, distribute or sell
our products and intend to rely on experienced third parties to perform, or
assist us in the performance of, all of those functions. We may not identify
acceptable partners or enter into favorable agreements with them. If third
parties do not successfully carry out their contractual duties or meet expected
deadlines, we will be unable to obtain required governmental marketing approvals
and will be unable to sell our products.

OUR DEPENDENCE ON COLLABORATIVE RELATIONSHIPS MAY LEAD TO DELAYS IN PRODUCT
DEVELOPMENT AND DISPUTES OVER RIGHTS TO TECHNOLOGY.

     Our business strategy depends upon the formation of research
collaborations, licensing and/or marketing arrangements. We currently have
development collaborations with four collaborators, Genentech, Kissei, Santen
and Kirin. The termination of any collaboration may lead to delays in product
development and disputes over technology rights and may reduce our ability to
enter into collaborations with other potential partners. Genentech has the
right, by giving us 150 days prior notice, to terminate our collaboration.
Similarly, Kirin has the right to terminate our license agreement by giving us
180 days prior notice. If we do not maintain the Genentech, Kissei, Santen or
Kirin collaborations or establish additional research and development
collaborations or licensing arrangements it will be difficult to develop and
commercialize therapeutic or diagnostic products using our technology. Any
future collaborations or licensing arrangements may not be on terms favorable to
us. Our current or any future collaborations or licensing arrangements
ultimately may not be successful. Under our current strategy, and for the
foreseeable future, we do not expect to develop or market therapeutic or
diagnostic products on our own. As a result, we will continue to depend on
collaborators and contractors for the preclinical study and clinical development
of therapeutic products and for regulatory approval, manufacturing and marketing
of therapeutic and diagnostic products which result from our technology. The
agreements with collaborators typically will allow them some discretion in
electing whether to pursue such activities. If any collaborator were to breach
or terminate its agreement with us or otherwise fail to conduct collaborative
activities in a timely and successful manner, the preclinical or clinical
development or commercialization of product candidates or research programs
would be delayed or terminated. Any delay or termination in clinical development
or commercialization would delay or eliminate potential product revenues
relating to our research programs.

     We intend to rely on Genentech, Kissei, Santen, Kirin and any future
collaborators for significant funding in support of our development efforts. If
Genentech, Kissei, Santen or Kirin reduces or terminates its funding, we will
need to devote additional internal resources to product development, scale back
or terminate certain research and development programs or seek alternative
collaborators.

     Disputes may arise in the future over the ownership of rights to any
technology developed with collaborators. These and other possible disagreements
between us and our collaborators could lead to delays in the collaborative
development or commercialization of therapeutic or diagnostic products. Such
disagreement could also result in litigation or require arbitration to resolve.

                                      -19-
<PAGE>

IF WE ARE UNABLE TO CONTRACT WITH THIRD PARTIES FOR SYNTHESIS AND MANUFACTURING
OF PRODUCT CANDIDATES FOR PRECLINICAL TESTING AND CLINICAL TRIALS AND FOR LARGE
SCALE MANUFACTURING OF ANY OF OUR DRUG CANDIDATES, WE MAY BE UNABLE TO DEVELOP
OR COMMERCIALIZE PRODUCTS.

     We have no experience or capabilities in large scale commercial
manufacturing of any of our product candidates or any experience or capabilities
in the manufacturing of pharmaceutical products generally. We do not generally
expect to engage directly in the manufacturing of products, but instead intend
to contract with others for these services. We have relied upon supply
agreements with third parties for the manufacture and supply or our product
candidates for purposes of preclinical testing and clinical trials. Although we
have previously received preclinical and clinical supplies of our product
candidates from several suppliers, we presently depend upon Yamasa Corporation
as the sole supplier of our supply of product candidates. If we are unable to
retain third party manufacturing on commercially acceptable terms, we may not be
able to commercialize products as planned. Our manufacturing strategy presents
the following risks:

     .    the manufacturing processes for most of our product candidates have
          not been tested in quantities needed for commercial sales;

     .    delays in scale-up to commercial quantities and any change to a
          manufacturer other than Yamasa Corporation could delay clinical
          studies, regulatory submissions and commercialization of our products;

     .    manufacturers of our products are subject to the FDA's good
          manufacturing practices regulations and similar foreign standards, and
          we do not have control over compliance with these regulations by
          third-party manufacturers;

     .    if we need to change to manufacturers other than Yamasa Corporation,
          FDA and comparable foreign regulators would require new testing and
          compliance inspections and the new manufacturers would have to be
          educated in the processes necessary for the production of our product
          candidates;

     .    without satisfactory long-term agreements with manufacturers, we will
          not be able to develop or commercialize our product candidates as
          planned or at all; and

     .    we may not have intellectual property rights, or may have to share
          intellectual property rights, to any improvements in the manufacturing
          processes or new manufacturing processes for our product candidates.

IF WE ARE UNABLE TO SUPPLY KISSEI AND SANTEN WITH SUFFICIENT QUANTITIES OF
MATERIALS WE MAY BREACH OUR AGREEMENTS WITH SUCH PARTIES.

     We are currently a party to a development, license and supply agreement
with each of Kissei and Santen, under which we granted each a license to develop
and market INS365 Respiratory and INS365 Ophthalmic, respectively. Generally,
the agreements with Kissei and Santen will require us to supply such partners
with either sufficient quantities of materials or finished products, as
applicable, for the purpose of commercial distribution. We will need to
establish, alone or with third parties, a manufacturing process in relation to
each product. Our dependence upon third parties for the manufacture of products
may adversely affect our ability to develop and deliver products on a timely and
competitive basis.

     Our inability to successfully manufacture commercial products could result
in our breach of the terms of our agreements with Kissei and Santen. Any of
these factors could delay our preclinical studies, clinical trials or
commercialization of our product candidates, entail higher costs and result in
our inability to effectively sell our product candidates.

                                      -20-
<PAGE>

IF OUR PATENT PROTECTION IS INADEQUATE, THE DEVELOPMENT AND ANY POSSIBLE SALES
OF OUR PRODUCT CANDIDATES COULD SUFFER OR COMPETITORS COULD FORCE OUR PRODUCTS
COMPLETELY OUT OF THE MARKET.

     Our business and competitive position depends on our ability to continue to
develop and protect our products and processes, proprietary methods and
technology. Except for one patent covering new chemical compounds, most of our
patents are use patents containing claims covering methods of treating disorders
and diseases by administering therapeutic chemical compounds. Use patents, while
providing adequate protection for commercial efforts in the United States, may
afford a lesser degree of protection in European and possibly other countries
due to their particular patent laws. Besides our use patents, we have patents
covering pharmaceutical formulations of these chemical compounds. We also have
patent applications covering processes for large-scale manufacturing of these
chemical compounds. Many of the chemical compounds included in the claims of our
use patents, formulation patents and process applications were known in the
scientific community prior to our formation. None of our patents cover these
previously known chemical compounds themselves, which are in the public domain.
As a result, competitors may be able to commercialize products that use the same
chemical compounds used by us for the treatment of disorders and diseases not
covered by our use patents. In such a case, physicians, pharmacies and
wholesalers could possibly substitute these products for our products. Such
substitution would reduce any revenues received from the sale of our products.

     We believe that there may be significant litigation in the pharmaceutical
and biotechnology industry regarding patent and other intellectual property
rights. A patent does not provide the patent holder with freedom to operate in a
way that infringes the patent rights of others. While we are not aware of any
patent that we are infringing, nor have we been accused of infringement by any
other party, other companies currently have or may acquire patent rights which
we might be accused of infringing. If we must defend a patent suit, or if we
choose to initiate a suit to have a third party patent declared invalid, we may
need to make considerable expenditures of money and management time in
litigation. A judgment against us in a patent infringement action could cause us
to pay monetary damages, require us to obtain licenses, or prevent us from
manufacturing or marketing the affected products. In addition, we may need to
initiate litigation to enforce our proprietary rights against others, or we may
have to participate in interference proceedings in the United States Patent and
Trademark Office (USTPO) to determine the priority of invention of any of our
technologies.

     In general, the development of patent rights in pharmaceutical,
biopharmaceutical and biotechnology products to a degree sufficient to support
commercial efforts in these areas is typically uncertain and involves complex
legal and factual questions. For instance, while the USPTO has recently issued
guidelines addressing the requirements for demonstrating utility for
biotechnology inventions, USPTO examiners may not follow these guidelines in
examining patent applications. Such applications may have to be appealed to the
USPTO's Appeals Board for a final determination of patentability.

IF WE FAIL TO REACH MILESTONE OR OTHER OBLIGATIONS, THE UNIVERSITY OF NORTH
CAROLINA AT CHAPEL HILL AND OTHER LICENSORS MAY TERMINATE OUR AGREEMENTS WITH
THEM.

     Our current technologies, discoveries and our original patents are based in
part on two exclusive licenses and one non-exclusive license from The University
of North Carolina at Chapel Hill (UNC). Generally, if we fail to meet milestones
under the respective UNC licenses, UNC may terminate the applicable license. In
addition, it may be necessary in the future for us to obtain additional licenses
from UNC or other third parties to develop future commercial opportunities or to
avoid infringement of third party patents. We do not know the terms on which
such licenses may be available, if at all.

     Failure to license or otherwise acquire necessary technologies may reduce
or eliminate our ability to develop product candidates. Even if we acquire all
necessary licenses, if we breach any license provision, either intentionally or
unintentionally, we may lose our right to continued use of the licensed
technology.

                                      -21-
<PAGE>

BECAUSE WE RELY UPON TRADE SECRETS AND AGREEMENTS TO PROTECT SOME OF OUR
INTELLECTUAL PROPERTY, THERE IS A RISK THAT UNAUTHORIZED PARTIES MAY OBTAIN AND
USE INFORMATION THAT WE REGARD AS PROPRIETARY.

     We rely upon the laws of trade secrets and non-disclosure agreements and
other contractual arrangements to protect our proprietary compounds, methods,
processes, formulations and other information for which we are not seeking
patent protection. We have taken security measures to protect our proprietary
technologies, processes, information systems and data, and we continue to
explore ways to further enhance security. However, despite these efforts to
protect our proprietary rights, unauthorized parties may obtain and use
information that we regard as proprietary. Employees, academic collaborators and
consultants with whom we have entered confidentiality and/or non-disclosure
agreements, may improperly disclose our proprietary information. In addition,
competitors may, through a variety of proper means, independently develop
substantially the equivalent of our proprietary information and technologies,
gain access to our trade secrets, or properly design around any of our patented
technologies.

BECAUSE ALL OF OUR PRODUCT CANDIDATES USE RELATED MECHANISMS OF ACTION, WE MAY
NOT BE ABLE TO COMMERCIALIZE OUR PRODUCTS IF THE MECHANISM OF ACTION IS NOT
EFFECTIVE.

     Any products resulting from our product development efforts are not
expected to be available for sale for a number of years, if at all. Two of our
product candidates, INS365 Respiratory and INS37217 Respiratory, operate in a
similar manner. If the clinical results of one of the compounds is not
favorable, the results of the other compound may not be favorable. Moreover, we
have designed all of our product candidates to use related mechanisms of action.
If these mechanisms of action are not effective, we may not be able to
commercialize any of our product candidates. Even if all of our product
candidates prove effective, we may choose not to commercialize all of them.

IF WE CONTINUE TO INCUR OPERATING LOSSES FOR A PERIOD LONGER THAN ANTICIPATED,
OR IN AN AMOUNT GREATER THAN ANTICIPATED, WE MAY BE UNABLE TO CONTINUE OUR
OPERATIONS.

     We have experienced significant losses since inception. We incurred net
losses of $14.6 million for the year ended December 31, 2000, $9.0 million for
the year ended December 31, 1999, and $7.5 million for the year ended December
31, 1998. As of December 31, 2000 our accumulated deficit was approximately
$47.9 million. We expect to incur significant additional operating losses over
the next several years and expect cumulative losses to increase substantially in
the near-term due to expanded research and development efforts, preclinical
studies and clinical trials. We expect that losses will fluctuate from quarter
to quarter and that such fluctuations may be substantial. Such fluctuations will
be affected by the following:

     .    timing of regulatory approvals and commercial sales of our product
          candidates;

     .    the level of patient demand for our products;

     .    timing of payments to and from licensors and corporate partners; and

     .    timing of investments in new technologies.

     No regulatory authorities have approved any of our product candidates for
marketing, and therefore, we are not generating any revenues from product sales.
To achieve and sustain profitable operations, we must, alone or with others,
develop successfully, obtain regulatory approval for, manufacture, introduce,
market and sell our products. The time frame necessary to achieve market success
is long and uncertain. We do not expect to generate product revenues for at
least the next few years. We may not generate sufficient product revenues to
become profitable or to sustain profitability. If the time required to achieve
profitability is longer than we anticipate, we may not be able to continue our
business.

                                      -22-
<PAGE>

IF WE ARE NOT ABLE TO OBTAIN SUFFICIENT ADDITIONAL FUNDING TO MEET OUR EXPANDING
CAPITAL REQUIREMENTS, WE MAY BE FORCED TO REDUCE OR ELIMINATE RESEARCH PROGRAMS
AND PRODUCT DEVELOPMENT.

   We have used substantial amounts of cash to fund our research and development
activities. In the fiscal year ended December 31, 2000 our operating expenses
exceeded $20.0 million. We expect our capital and operating expenditures to
increase over the next several years as we expand our research and development
activities, address possible difficulties with clinical studies and prepare for
commercial sales. Many factors will influence our future capital needs. These
factors include:

     .    the progress of our research programs;

     .    the number and breadth of these programs;

     .    our ability to attract collaborators for our products;

     .    achievement of milestones under our existing collaborations with
          Genentech, Kissei, Santen and Kirin;

     .    our ability to establish and maintain additional collaborations;

     .    progress by our collaborators: Genentech, Kissei, Santen and Kirin;

     .    the level of activities relating to commercialization rights we retain
          in our collaborations;

     .    competing technological and market developments;

     .    the costs involved in enforcing patent claims and other intellectual
          property rights; and

     .    the costs and timing of regulatory approvals.

   We anticipate that our operating expenses will exceed $25.0 million over the
next twelve months. We also expect to purchase capital equipment at a cost of
approximately $2.0 million. Following the twelve-month period, we expect our
operating expenses to increase as we continue to develop our product candidates.
We intend to rely on Genentech, Kissei, Santen, Kirin, future collaborators and
the proceeds of our initial public offering for significant funding in support
of our development efforts. In addition, we may seek additional funding through
public or private equity offerings and debt financings. Additional financing may
not be available when needed. If available, such financing may not be on terms
favorable to us or our stockholders. Stockholders' ownership will be diluted if
we raise additional capital by issuing equity securities. If we raise funds
through collaborations and licensing arrangements, we may have to give up rights
to our technologies or product candidates which are involved in these future
collaborations and arrangements or grant licenses on unfavorable terms. If
adequate funds are not available, we would have to scale back or terminate
research programs and product development.

WE MAY NOT BE ABLE TO SUCCESSFULLY COMPETE WITH BIOTECHNOLOGY COMPANIES AND
ESTABLISHED PHARMACEUTICAL COMPANIES.

   The biotechnology and pharmaceutical industries are intensely competitive and
subject to rapid and significant technological change. Our competitors in the
United States and elsewhere are numerous and include, among others, major
multinational pharmaceutical and chemical companies, specialized biotechnology
firms and universities and other research institutions. These competitors
include Abbott, Astra Zeneca, Boehringer Ingelheim, GlaxoSmithKline, and Pfizer.
Many of these competitors employ greater financial and other resources,
including larger research and development staffs and more effective marketing
and manufacturing organizations, than we or our collaborative partners.
Acquisitions of competing companies and potential competitors by large
pharmaceutical companies or others could enhance financial, marketing and other
resources available to such competitors. As a

                                      -23-
<PAGE>

result of academic and government institutions becoming increasingly aware of
the commercial value of their research findings, such institutions are more
likely to enter into exclusive licensing agreements with commercial enterprises,
including our competitors, to market commercial products. Our competitors may
develop technologies and drugs that are safer, more effective or less costly
than any we are developing or which would render our technology and future drugs
obsolete and non-competitive. The products of our competitors marketed to treat
chronic bronchitis include anti-inflammatory products, such as Azmacort(R) and
Beclovent(R), bronchodilators such as Atrovent(R) and Proventil(R), and
antibiotics such as Biaxin(R) and Zithromax(R). Pulmozyme(R), a Genentech
product, and TOBI(R) from Chiron are examples of products used to treat cystic
fibrosis. The main current treatments for dry eye disease involve artificial
tear replacement drops. In addition, alternative approaches to treating diseases
which we have targeted, such as gene therapy, may make our product candidates
obsolete. Our competitors may also be more successful in production and
marketing.

     In addition, some of our competitors have greater experience than we do in
conducting preclinical and clinical trials and obtaining FDA and other
regulatory approvals. Accordingly, our competitors may succeed in obtaining FDA
or other regulatory approvals for drug candidates more rapidly than we do.
Companies that complete clinical trials, obtain required regulatory approvals
and commence commercial sale of their drugs before we do may achieve a
significant competitive advantage, including patent and FDA marketing
exclusivity rights that would delay our ability to market products. Drugs
resulting from our research and development efforts, or from our joint efforts
with our collaborative partners may not compete successfully with competitors'
existing products or products under development.

FAILURE TO HIRE AND RETAIN KEY PERSONNEL MAY HINDER OUR PRODUCT DEVELOPMENT
PROGRAMS AND OUR BUSINESS EFFORTS.

     We depend on the principal members of management and scientific staff,
including Christy L. Shaffer, Ph.D., our President, Chief Executive Officer and
director; and Gregory J. Mossinghoff, our Senior Vice President and Chief
Business Officer. If either of these people leave us, we may have difficulty
conducting our operations. We have not entered into agreements with any of the
above principal members of our management and scientific staff that bind any of
them to a specific period of employment. Our future success also will depend in
part on our ability to attract, hire and retain additional personnel skilled or
experienced in the pharmaceutical industry. There is intense competition for
such qualified personnel. We may not be able to continue to attract and retain
such personnel.

OUR OPERATIONS INVOLVE A RISK OF INJURY FROM HAZARDOUS MATERIALS, WHICH COULD BE
VERY EXPENSIVE TO US.

     Our research and development activities involve the controlled use of
hazardous materials and chemicals. We cannot completely eliminate the risk of
accidental contamination or injury from these materials. If such an accident
were to occur, we could be held liable for any damages that result and any such
liability could exceed our resources. In addition, we are subject to laws and
regulations governing the use, storage, handling and disposal of these materials
and waste products. The costs of compliance with these laws and regulations
could be substantial.

USE OF OUR PRODUCTS MAY RESULT IN PRODUCT LIABILITY CLAIMS FOR WHICH WE MAY NOT
HAVE ADEQUATE INSURANCE COVERAGE.

     Clinical trials or manufacturing, marketing and sale of our potential
products by our collaborative partners may expose us to liability claims from
the use of those products. Although we carry clinical trial liability insurance,
we currently do not carry product liability insurance. We or our collaborators
may not be able to obtain or maintain sufficient or even any insurance. If we
can, it may not be at a reasonable cost. If we cannot or are unable otherwise to
protect against potential product liability claims, we may find it difficult or
impossible to commercialize pharmaceutical products we or our collaborators
develop. If claims or losses exceed our liability insurance coverage, we may go
out of business.

                                      -24-
<PAGE>

IF THIRD PARTY PAYORS WILL NOT PROVIDE COVERAGE OR REIMBURSE PATIENTS FOR ANY
PRODUCTS WE DEVELOP, OUR ABILITY TO DERIVE REVENUES WILL SUFFER.

     Our success will depend in part on the extent to which government and
health administration authorities, private health insurers and other third party
payors will pay for our products. Reimbursement for newly approved health care
products is uncertain. In the United States and elsewhere, third party payors,
such as Medicare, are increasingly challenging the prices charged for medical
products and services. Government and other third party payors are increasingly
attempting to contain health care costs by limiting both coverage and the level
of reimbursement for new therapeutic products. In the United States, a number of
legislative and regulatory proposals aimed at changing the health care system
have been proposed in recent years. In addition, an increasing emphasis on
managed care in the United States has and will continue to increase pressure on
pharmaceutical pricing. While we cannot predict whether legislative or
regulatory proposals will be adopted or what effect those proposals or managed
care efforts, including those relating to Medicare payments, may have on our
business, the announcement and/or adoption of such proposals or efforts could
increase our costs and reduce or eliminate profit margins. Third party insurance
coverage may not be available to patients for any products we discover or
develop. If government and other third party payors do not provide adequate
coverage and reimbursement levels for our products, the market acceptance of
these products may be reduced. In various foreign markets, pricing or
profitability of medical products is subject to government control.

BECAUSE OUR MANAGEMENT WILL HAVE BROAD DISCRETION OVER THE USE OF THE PROCEEDS
FROM OUR INITIAL PUBLIC OFFERING, THE PROCEEDS MAY BE USED IN WAYS STOCKHOLDERS
DO NOT DEEM TO BE ADVISABLE.

     Our management will retain broad discretion as to the allocation of the
proceeds for our initial public offering, including the timing and conditions of
the use of the proceeds. Our management may allocate the proceeds to uses that
stockholders do not deem advisable. If management spends the funds unwisely, we
may not have sufficient working capital to become profitable.

OUR EXISTING DIRECTORS, EXECUTIVE OFFICERS AND PRINCIPAL STOCKHOLDERS HOLD A
SUBSTANTIAL AMOUNT OF OUR COMMON STOCK AND MAY BE ABLE TO PREVENT OTHER
STOCKHOLDERS FROM INFLUENCING SIGNIFICANT CORPORATE DECISIONS.

     Our directors, executive officers and current 5% stockholders and their
affiliates beneficially own over 45% of the common stock. These stockholders, if
they act together, may be able to direct the outcome of matters requiring
approval of the stockholders, including the election of our directors and other
corporate actions such as our merger with or into another company, a sale of
substantially all of our assets and amendments to our amended and restated
certificate of incorporation. The decisions of these stockholders may conflict
with our interests or those of our other stockholders.

ANTI-TAKEOVER PROVISIONS IN OUR AMENDED AND RESTATED CERTIFICATE OF
INCORPORATION AND BYLAWS, AND OUR RIGHT TO ISSUE PREFERRED STOCK, MAY DISCOURAGE
A THIRD PARTY FROM MAKING A TAKE-OVER OFFER THAT COULD BE BENEFICIAL TO US AND
OUR STOCKHOLDERS.

     Our amended and restated certificate of incorporation and bylaws contain
provisions which could delay or prevent a third party from acquiring shares of
our common stock or replacing members of our board of directors. Our amended and
restated certificate of incorporation allows our board of directors to issue
shares of preferred stock. The Board can determine the price, rights,
preferences and privileges of those shares without any further vote or action by
the stockholders. As a result, our board of directors could make it difficult
for a third party to acquire a majority of our outstanding voting stock.

     Our amended and restated certificate of incorporation provides that the
members of the board will be divided into three classes. Each year the terms of
approximately one-third of the directors will expire. Our bylaws will not permit
our stockholders to call a special meeting of stockholders. Under the bylaws,
only our President,

                                      -25-
<PAGE>

Chairman of the Board or a majority of the board of directors will be able to
call special meetings. The bylaws also require that stockholders give advance
notice to our Secretary of any nominations for director or other business to be
brought by stockholders at any stockholders' meeting. These provisions may delay
or prevent changes of control or management.

     Further, we are subject to the anti-takeover provisions of Section 203 of
the Delaware General Corporation Law. Under this law, if anyone becomes an
"interested stockholder" in the company, we may not enter a "business
combination" with that person for three years without special approval.

     These provisions could discourage a third party from making a take-over
offer and could delay or prevent a change of control.

OUR COMMON STOCK PRICE IS LIKELY TO BE HIGHLY VOLATILE AND YOUR INVESTMENT IN
OUR STOCK MAY DECLINE IN VALUE.

     The market price of our common stock is likely to be highly volatile.
Factors that could cause volatility and could result in declines in the market
price of our common stock include among others:

     .    announcements made by us concerning results of our clinical trials
          with INS365 Respiratory, INS365 Ophthalmic, INS316 Diagnostic,
          INS37217 and any other product candidates;

     .    changes in government regulations;

     .    regulatory actions as a result of their therapeutic approach;

     .    changes in concerns of our collaborators, in particular our
          collaborations with Genentech, Kissei, Santen and Kirin;

     .    developments concerning proprietary rights including patents by us or
          our competitors;

     .    variations in our operating results; and

     .    litigation.

     Extreme price and volume fluctuations occur in the stock market from time
to time and that can particularly affect the prices of biotechnology companies.
These extreme fluctuations are often unrelated to the actual performance of the
affected companies. These broad market fluctuations could result in significant
declines in the market price of our common stock.

FUTURE SALES BY OUR CURRENT STOCKHOLDERS MAY CAUSE OUR STOCK PRICE TO DECLINE.

     Sales of our common stock by our current stockholders in the public market
could cause the market price of our stock to fall. Sales may also make it more
difficult for us to sell equity securities or equity-related securities in the
future at a time and price that our management deems acceptable, or at all. As
of December 31, 2000, there were 25,515,087 shares of common stock outstanding.
Of these outstanding shares of common stock, all of the 6,325,000 shares sold in
our initial public offering are freely tradable, without restriction under the
Securities Act of 1933, as amended, unless purchased by our "affiliates."
Existing stockholders, who hold the remaining 19,190,087 shares of common stock,
hold "restricted shares" which may be resold in the public market only if
registered or if there is an exemption from registration, such as Rule 144 under
the Securities Act.

                                      -26-
<PAGE>

     Holders of 16,340,084 shares of common stock and options and warrants to
purchase 356,823 shares of common stock, held as of December 31, 2000, are
entitled to registration rights. Upon registration, these shares may be freely
sold in the public market.

     We may issue additional shares:

     .    to employees, directors and consultants;

     .    in connection with corporate alliances;

     .    in connection with acquisitions; and

     .    to raise capital.

     On February 28, 2001, we filed a registration statement on Form S-8, which
registered shares of common stock under our Amended and Restated 1995 Stock
Plan, as amended. The registration statement registered 3,004,220 shares of our
common stock that were issued or sold or may be issued and sold under such plan.

     As a result of these factors, a substantial number of shares of our common
stock could be sold in the public market at any time.

Item 2.    Properties.

     The Company leases facilities that comprise approximately 17,500 square
feet in Durham, North Carolina adjacent to the Research Triangle Park, through
several leases. The leases expire in August 2003, May 2003 and December 2003 and
are renewable. The Company anticipates acquiring additional space to allow for
all potential expansionary needs over the next one to two years.

Item 3.    Legal Proceedings.

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

Item 4.    Submission of Matters to a vote of Security Holders

     Not applicable.

                                     PART II

Item 5.    Market for the Company's Common Equity and Related Stockholder
           Matters.

     The Company's Common Stock has been traded on the Nasdaq National Market
under the symbol "ISPH" since August 3, 2000. The following table sets forth,
for the calendar periods indicated, the range of high and low sale prices for
the Common Stock of the Company on the Nasdaq National Market:

                            2000                          High              Low
                            ----                          ----              ---

                    Third Quarter (commencing           $30.63            $13.50
                      August 3, 2000)

                    Forth Quarter                       $31.75            $18.00

                                      -27-
<PAGE>

     As of March 15, 2001, there were 114 record holders of the Common Stock,
with beneficial stockholders in excess of 400. On March 1, 2001, the last sale
price reported on the Nasdaq National Market for the Common Stock was $9.00 per
share.

     The Company has neither paid nor declared dividends on its Common Stock
since its inception and does not plan to pay dividends in the foreseeable
future. Any earnings that the Company may realize will be retained to finance
the growth of the Company.

     On August 2, 2000, the Securities and Exchange Commission declared a
Registration Statement on Form S-1, as amended (Registration No. 333-31174)
effective, registering 6,325,000 shares of our common stock. The aggregate net
proceeds after deduction of expenses were approximately $69.3 million. Through
December 31, 2000, all of the net proceeds of the offering were being
temporarily invested in interest bearing investment grade securities and
certificates of deposit which are classified as available for sale.

     During the year ended December 31, 2000, we granted stock options to
employees, directors and consultants under our stock option plan covering an
aggregate of 748,995 shares of our common stock. The weighted average exercise
price of the stock options granted during the year ended December 31, 2000 was
$12.228 per share. During the year ended December 31, 2000, we sold 295,526
shares of our common stock to employees, directors and consultants upon the
exercise of outstanding stock options. The stock options exercised during the
year ended December 31, 2000 had exercise prices ranging from $0.1225 to $0.42
per share. In October 2000, a security holder exercised a warrant to purchase
shares of common stock. Under the terms of the warrant, the Company issued 8,197
shares of common stock to the security holder pursuant to a "net issue exercise"
in which the purchase price of the stock was paid by the cancellation of a
portion of the warrant.

     The sale and issuance of securities in the transactions described above
were deemed to be exempt from registration under the Securities Act by virtue of
Rule 701 in that they were offered and sold either pursuant to a written
compensatory benefit plan or pursuant to a written contract relating to
compensation or were deemed to be exempt from registration under the Securities
Act by virtue of Section 4(2) as a transactions not involving a public offering.
Appropriate legends were affixed to the stock certificates issued in these
transactions. The recipient either received adequate information about the
Company or had access, through employment or other relationships, to adequate
information.

                                      -28-
<PAGE>

Item 6. Selected Financial Data

The selected statement of operations data and balance sheet data with respect to
the years ended December 31, 2000, 1999, 1998, 1997 and 1996 set forth below are
derived from our financial statements which have been audited by
PricewaterhouseCoopers LLP, independent accountants. The selected financial data
set forth below should be read in conjunction with "Management's Discussion and
Analysis of Financial Condition and Results of Operations" contained in Item 7
below, and our financial statements and the notes thereto contained in Item 8
below. Historical results are not necessarily indicative of our future results.

<TABLE>
<CAPTION>
                                                         (In thousands, except share amounts)
                                         --------------------------------------------------------------------
                                                                Year Ended December 31,
                                         --------------------------------------------------------------------
                                             2000          1999          1998          1997          1996
                                         ------------  ------------  ------------  ------------  ------------
<S>                                      <C>           <C>           <C>           <C>           <C>
Statement of Operations Data:
Revenue                                   $      5,368  $      1,104  $        360  $         --  $         --
                                          ------------  ------------  ------------  ------------  ------------
Operating expenses:
  Research and development (includes
      $838, $515, $68, $0 and $0,
      respectively of stock-based
      compensation)                             16,353         7,694         5,597         6,569         4,207
  General and administrative (includes
      $678, $519, $46, $0 and $0,
      respectively of stock-based
      compensation                               3,694         2,406         1,967         1,494         1,531
                                          ------------  ------------  ------------  ------------  ------------
Total operating expenses                        20,047        10,100         7,564         8,063         5,738
                                          ------------  ------------  ------------  ------------  ------------
Operating loss                                (14,679)       (8,996)       (7,204)       (8,063)       (5,738)
Other income (expense), net                      1,089           122            36           116          (44)
                                          ------------  ------------  ------------  ------------  ------------
Loss before provision for income
      taxes                                   (13,590)       (8,874)       (7,168)       (7,947)       (5,782)
Provision for income taxes                         400            60           360            --            --
                                          ------------  ------------  ------------  ------------  ------------
Net loss                                      (13,990)       (8,934)       (7,528)       (7,947)       (5,782)
Preferred stock dividends                        (594)          (62)            --            --            --
                                          ------------  ------------  ------------  ------------  ------------
Net loss available to common
      stockholders                        $   (14,584)  $    (8,996)  $    (7,528)  $    (7,947)  $    (5,782)
                                          ============  ============  ============  ============  ============
Net loss per common share -- basic
      and diluted                         $     (1.23)  $     (3.75)  $     (3.65)  $     (4.01)  $     (3.22)
                                          ============  ============  ============  ============  ============
Weighted average common shares
      outstanding -- basic and diluted          11,871         2,401         2,061         1,981         1,798

<CAPTION>
                                                                     December 31,
                                          --------------------------------------------------------------------
                                              2000          1999          1998          1997          1996
                                          ------------  ------------  ------------  ------------  ------------
<S>                                      <C>           <C>            <C>           <C>           <C>
Balance Sheet Data:
Cash and cash equivalents                 $     35,109  $     22,728  $      4,138  $      5,826  $        843
Total assets                                    82,993        25,620         5,446         7,229         2,568
Convertible preferred stock                         --        45,895        24,467        22,067         9,100
Common stock                                        26             2             2             2             2
Total stockholders' equity                      74,505        16,034           662         5,544           507
</TABLE>

                                      -29-
<PAGE>

Item 7.    Management's Discussion and Analysis of Financial Condition and
           Results of Operations

     The discussion below contains forward-looking statements that are based on
the beliefs of management, as well as assumptions made by, and information
currently available to , our management. Our future results, performance or
achievements could differ materially from those expressed in, or implied by, any
such forward-looking statements as a result of certain factors, including, but
not limited to, those discussed in this section as well as in the section
entitled "Risk Factors."

I.   Overview

     We were founded in October 1993 under the name Innovative Pharmaceuticals,
Inc. we changed our name to Inspire Pharmaceuticals in June 1994. In March 1995,
we commenced operations following our first substantial financing. Since that
time, we have been engaged in the discovery and development of novel
pharmaceutical products that treat diseases which are characterized by
deficiencies in the body's innate defense mechanisms of mucosal hydration and
mucociliary clearance and other diseases. The Company's technologies are based
in part on exclusive license agreements with The University of North Carolina at
Chapel Hill for rights to certain developments from the founders' laboratories.

     Since inception, Inspire has primarily financed its operations through
proceeds received from the sale of equity securities including private sales of
preferred stock and the sale of common stock in its initial public offering, as
well as revenues received under corporate collaborations. The Company operates
in a single business segment and has no foreign operations.

II.  RESULTS OF OPERATIONS

     The Company's revenues for the year ended December 31, 2000 were $5.4
million compared to $1.1 million 1999 and $0.4 million in 1998. Revenues are
derived from collaborative research and development agreements with strategic
partners. The Company receives milestone payments under these collaborative
research and development agreements based both on achievement by us and our
partners of defined development milestones.

     The increase in year 2000 revenues relate to milestone payments received
from Genentech and Kissei in the fourth quarter of 1999 and milestone payments
received from Kissei, Santen and Kirin during the year ended December 31, 2000.
Milestone payments received from Genetech, Kissei and Kirin are being recognized
over the period of our ongoing research and development commitment under the
collaborative research agreements with the respective companies. The increase in
revenues during 1999 relate to recognition of a upfront payment received from
Kissei in the third quarter of 1998.

     Research and development costs for the year ended December 31, 2000 were
$16.4 million, compared to $7.7 million in 1999 and $5.6 million in 1998.
Increased expenses reflect advancement of the Company's drug candidates through
progressive clinical development phases. The Company expects to incur
significant increases in future periods as later phases of development typically
involve an increase in the scope of studies and number of patients treated.

     Increases in research and development expenses for the year ended December
31, 2000 are primarily due to increased external costs related to patent
activities, research costs, preclinical testing, toxicology studies, clinical
development activities, including intiation of Phase III clinical trials, and
increased internal costs associated with additional personnel necessary to
perform these activities.

     Increased research and development costs during 1999 relate to increased
preclinical testing, costs related to patent activities, toxicology studies,
increased clinical development activities and associated increases in personnel
costs.

     General and administrative costs were $3.7 million for the year ended
December 31, 2000, compared to $2.4 million in 1999 and $2.0 million in 1998.
The Company's general and administrative expenses consist

                                      -30-
<PAGE>

primarily of personnel and related costs for general corporate functions,
including business development, finance, accounting, legal, human resources,
facilities and information systems expenses.

     Increased general and administrative expenses for the years ended December
31, 2000 and 1999 resulted primarily from increased insurance and additional
professional services, including legal, accounting and public relations
services, to support the Company's strategic business collaborations and
operations as a publicly traded company.

     Other income (expense), net totaled $1.1 million for the year ended
December 31, 2000, compared to $0.1 million for 1999 and $36,000 for 1998. The
increase in 2000 was due to higher interest income earned from larger average
cash and investment balances partially offset by increased interest expense
related to leased equipment and amortization of debt issuance costs.

     The provision for income taxes for the year ended December 31, 2000 was
$0.4 million, compared to $60,000 in 1999 and $0.4 million in 1998. The
fluctuations in the provision for income taxes are directly attributable to
Japanese withholding taxes paid on milestone payments received from Japanese
collaborative partners.



Liquidity and Capital Resources
-------------------------------

     The Company historically has financed its operations through the sale of
equity securities, including private sales of preferred stock and the sale of
common stock in our initial public offering.

     As of December 31, 2000, cash and cash equivalents totaled $35.1 million,
an increase of $12.4 million as compared to December 31, 1999. The increase in
cash and cash equivalents resulted from approximately $70.2 million in net
proceeds our initial public offering, which was partially offset by the purchase
of net investments in investment grade securities of $44.1 million, cash used by
operations of $13.2 million, and $522,000 for the purchase of property and
equipment.

     Cash used by operations of $13.2 million for the year ended December 31,
2000, represented the net loss of $14.0 million, an increase of $554,000 in
receivables, an increase of $283,000 in prepaid expenses, and an increase of
$202,000 in accounts payable and an increase of $1.4 million in deferred
revenue, partially offset by an increase of $243,000 in accrued expenses, and
net non-cash charges of approximately $3.0 million.

     Cash used in investing activities for the year ended December 31, 2000 was
comprised of the purchase of investment grade securities, net of maturities, of
$44.0 million and the purchase of property and equipment totaling $522,000.

     Cash from financing activities for the year ended December 31, 2000 was
comprised of $70.2 million in net proceeds from our initial public offering and
the exercise of warrants and payment of lease obligations of $217,000.

     The Company will not generate revenues, other than license and milestone
payments, from the commercial sale of its products unless and until it or its
licensees receive marketing clearance from the FDA and appropriate regulatory
agencies in other countries. The Company cannot predict the timing of any
potential marketing clearance nor can assurances be given that the FDA or other
such agencies will approve any of the Company's products.

     The Company enters into contractual arrangements associated with
preclinical, toxicology and clinical studies for the development of its drug
candidates. At December 31, 2000, the Company estimates its commitments to be
approximately $15.3 million under these agreements. This estimate is dependent
upon the results of the underlying studies and certain other variable components
that may yield a result that differs from management's estimate.

                                      -31-
<PAGE>

     Additionally, the Company has entered into agreements with third parties to
provide drug substance to satisfy its drug development requirements. At December
31, 2000, the Company estimates its commitment for drug substance to
approximately $175,000. Similar to the preclinical, toxicology and clinical
studies commitment, this estimate is subject to a number of variables that may
result in the actual obligation differing from management's estimate.

Item 7A.   Quantitative and Qualitative Disclosures About Market Risk

     The Company's exposure to market risk for changes in interest rates relates
to the increase or decrease in the amount of interest income the Company can
earn on its investment portfolio and on the increase or decrease in the amount
of interest expense it must pay with respect to various outstanding debt
instruments. The Company's risk associated with fluctuating interest expense is
limited, however, to capital lease obligations. The interest rates are closely
tied to market rates and the Company's investments in interest rate sensitive
financial instruments. Under the Company's current policies, it does not use
interest rate derivative instruments to manage exposure to interest rate
changes. The Company ensures the safety and preservation of invested principal
funds by limiting default risk, market risk and reinvestment risk. The Company
reduces default risk by investing in investment grade securities. A hypothetical
100 basis point drop in interest rates along the entire interest rate yield
curve would not significantly affect the fair value of the Company's interest
sensitive financial instruments at December 31, 2000 or December 31, 2001.
Declines in interest rates over time will, however, reduce the Company's
interest income while increases in interest rates over time will increase
interest expense.

Item 8.    Financial Statements and Supplementary Data.

     The financial statements required to be filed pursuant to this Item 8 are
appended to this Annual Report on Form 10-K. A list of the financial statements
filed herewith is found at "Index to Financial Statements" on page F-1.

Item 9.    Changes in and Disagreements with Accountants on Accounting and
           Financial Disclosure.

     Not applicable.



                                    PART III

Item 10.   Directors and Executive Officers of the Company.

     For information concerning this item, see the information under "Election
of Directors," "Executive Officers" and "Section 16(a) Beneficial Ownership
Reporting Compliance" in the Company's Proxy Statement to be filed with respect
to the Annual Meeting of Stockholders to be held on June 1, 2001, which
information is incorporated herein by reference.

Item 11.   Executive Compensation.

     For information concerning this item, see the information under "Executive
Compensation" in the Company's Proxy Statement to be filed with respect to the
Annual Meeting of Stockholders to be held on June 1, 2001, which information is
incorporated herein by reference.

Item 12.   Security Ownership of Certain Beneficial Owners and Management.

     For information concerning this item, see the information under "Security
Ownership of Certain Beneficial Owners and Management" in the Company's Proxy
Statement to be filed with respect to the Annual Meeting of Stockholders to be
held on June 1, 2001, which information is incorporated herein by reference.

                                      -32-
<PAGE>

Item 13.   Certain Relationships and Related Transactions.

        For information concerning this item, see the information under "Certain
Relationships and Related Transactions" in the Company's Proxy Statement to be
filed with respect to the Annual Meeting of Stockholders to be held on June 1,
2001, which information is incorporated herein by reference.

                                    PART IV

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

(a)     The following documents are included as part of this Annual Report on
        Form 10-K:

   1.   Financial Statements:

                                                                            Page
                                                                            ----
   Report of Independent Accountants........................................ F-2
   Balance Sheets............................................................F-3
   Statements of Operations..................................................F-4
   Statements of Stockholders' Equity (Deficit)............................. F-5
   Statements of Cash Flows..................................................F-6
   Notes to Financial Statements.............................................F-7

   2.   All schedules are omitted as the information required is inapplicable
        or the information is presented in the financial statements.

   3.   Exhibits:

Exhibit
Number           Description

3.1              Amended and Restated Certificate of Incorporation.
                 (Incorporated by reference to Exhibit 3.1 to the Company's
                 registration statement on Form S-1 (Registration No. 333-31174)
                 which became effective on August 3, 2000).

3.2              Amended and Restated Certificate of Incorporation.
                 (Incorporated by reference to Exhibit 3.2 to the Company's
                 registration statement on Form S-1 (Registration No. 333-31174)
                 which became effective on August 3, 2000).

4.1              Specimen Common Stock Certificate. (Incorporated by reference
                 to Exhibit 4.1 to the Company's registration statement on Form
                 S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.1+            Amended and Restated 1995 Stock Plan, as amended. (Incorporated
                 by reference to Exhibit 10.1 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became
                 effective on August 3, 2000).

10.2+            Form of Incentive Stock Option. (Incorporated by reference to
                 Exhibit 10.2 to the Company's registration statement on Form S-
                 1 (Registration No. 333-31174) which became effective on August
                 3, 2000).

10.3+            Form of Non-statutory Stock Option. (Incorporated by reference
                 to Exhibit 10.3 to the Company's registration statement on Form
                 S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.4             Consultation and scientific Advisory Board Agreement between
                 Inspire Pharmaceuticals, Inc. and Dr. Richard Boucher, dated
                 March 10, 1995. (Incorporated by reference to Exhibit 10.4 to
                 the Company's registration statement on Form S-1 (Registration
                 No. 333-31174) which became

                                      -33-
<PAGE>

<TABLE>
<CAPTION>

Exhibit
Number           Description
                 effective on August 3, 2000).
<S>             <C>
10.5*            Sponsored Research Agreement between Inspire Pharmaceuticals, Inc. and The
                 University of North Carolina at Chapel Hill, effective March 10, 1995.
                 (Incorporated by reference to Exhibit 10.5 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.6*            Exclusive License Agreement between Inspire Pharmaceuticals, Inc. and The
                 University of North Carolina at Chapel Hill, dated March 10, 1995. (Incorporated
                 by reference to Exhibit 10.7 to the Company's registration statement on Form S-1
                 (Registration No. 333-31174) which became effective on August 3, 2000).

10.7             Lease between Inspire Pharmaceuticals, Inc. and Imperial Center, Limited
                 Partnership regarding Royal Center I, Durham, North Carolina, dated as of May 17, 1995,
                 as amended. (Incorporated by reference to Exhibit 10.8 to the Company's
                 registration statement on Form S-1 (Registration No. 333-31174) which became
                 effective on August 3, 2000).

10.8             Master Lease Agreement between Inspire Pharmaceuticals, Inc. and Comdisco,
                 Inc.., dated October 13, 1995, as amended. (Incorporated by reference to Exhibit
                 10.9 to the Company's registration statement on Form S-1 (Registration No.
                 333-31174) which became effective on August 3, 2000).

10.9             Lease Agreement between Inspire Pharmaceuticals, Inc. and Petula Associates Ltd.
                 regarding Royal Center II, Durham, North Carolina, dated as of December 30,
                 1997. (Incorporated by reference to Exhibit 10.10 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.10            Sublease Agreement between ICAgen, Inc. and Inspire Pharmaceuticals, Inc.
                 regarding premises located at 4222 Emperor Boulevard, Suite 500, Durham, North
                 Carolina, dated September 22, 1997 and extension of Sublease Agreement dated
                 February 14, 2000. (Incorporated by reference to Exhibit 10.11 to the Company's
                 registration statement on Form S-1 (Registration No. 333-31174) which became
                 effective on August 3, 2000).

10.11*           Exclusive License Agreement between Inspire Pharmaceuticals, Inc. and The
                 University of North Carolina at Chapel Hill, dated September 1, 1998.
                 (Incorporated by reference to Exhibit 10.12 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.12*           Joint Development, License and Supply Agreement between Inspire Pharmaceuticals,
                 Inc. and Kissei Pharmaceutical Co., Ltd., dated as of September 10, 1998.
                 (Incorporated by reference to Exhibit 10.13 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.13            Registration Rights Agreement between Inspire Pharmaceuticals, Inc. and Kissei
                 Pharmaceutical Co., Ltd., dated as of September 10, 1998. (Incorporated by
                 reference to Exhibit 10.14 to the Company's registration statement on Form S-1
                 (Registration No. 333-31174) which became effective on August 3, 2000).

10.14*           Development, License and Supply Agreement between Inspire Pharmaceuticals, Inc.
                 and Santen Pharmaceutical Co., Ltd., dated as of December 16, 1998.
                 (Incorporated by reference to Exhibit 10.15 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which
</TABLE>

                                      -34-
<PAGE>

<TABLE>
<CAPTION>

Exhibit
Number           Description
                 became effective on August 3, 2000).
<S>             <C>
10.15            Registration Rights Agreement between Inspire Pharmaceuticals, Inc. and Santen
                 Pharmaceutical Co., Ltd., dated as of December 16, 1998. (Incorporated by
                 reference to Exhibit 10.16 to the Company's registration statement on Form S-1
                 (Registration No. 333-31174) which became effective on August 3, 2000).

10.16*           Clinical Research Agreement between Inspire Pharmaceuticals Inc. and Simbec
                 Research Limited, dated August 30, 1999. (Incorporated by reference to Exhibit
                 10.17 to the Company's registration statement on Form S-1 (Registration No.
                 333-31174) which became effective on August 3, 2000).


10.17*           Services Agreement between Inspire Pharmaceuticals, Inc. and Pharmaceutical
                 Development Associates, Inc. (ClinSites/PDA) dated November 1, 1999.
                 (Incorporated by reference to Exhibit 10.18 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.18*           Quotation between Inspire Pharmaceuticals, Inc. and Simbec Research Limited
                 regarding research study, dated December 17, 1999. (Incorporated by reference to
                 Exhibit 10.19 to the Company's registration statement on Form S-1 (Registration
                 No. 333-31174) which became effective on August 3, 2000).

10.19*           Development, License and Supply Agreement between Inspire Pharmaceuticals, Inc.
                 and Genentech, Inc., dated as of December 17, 1999. (Incorporated by reference
                 to Exhibit 10.20 to the Company's registration statement on Form S-1
                 (Registration No. 333-31174) which became effective on August 3, 2000).

10.20*           Series G Preferred Stock and Warrant Purchase Agreement between Inspire
                 Pharmaceuticals, Inc. and Genentech, Inc., dated as of December 17, 1999.
                 (Incorporated by reference to Exhibit 10.21 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.21*           Warrant Agreement between Inspire Pharmaceuticals, Inc. and Genentech, Inc.,
                 dated as of December 17, 1999. (Incorporated by reference to Exhibit 10.22 to
                 the Company's registration statement on Form S-1 (Registration No. 333-31174)
                 which became effective on August 3, 2000).

10.22            Amended and Restated Investors' Rights Agreement among Inspire Pharmaceuticals,
                 Inc. and the holders of Series A, B, E and G Preferred Stock of the Company
                 dated as of December 17, 1999. (Incorporated by reference to Exhibit 10.23 to
                 the Company's registration statement on Form S-1 (Registration No. 333-31174)
                 which became effective on August 3, 2000).

10.23+           Employee Confidentiality, Invention Assignment and Non-Compete Agreement between
                 Inspire Pharmaceuticals, Inc. and Donald Kellerman dated February 3, 2000.
                 (Incorporated by reference to Exhibit 10.24 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.24+           Employee Confidentiality, Invention Assignment and Non-Compete Agreement between
                 Inspire Pharmaceuticals, Inc. and Gregory J. Mossinghoff dated February 4, 2000.
                 (Incorporated by reference to Exhibit 10.25 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).
</TABLE>

                                      -35-
<PAGE>

<TABLE>
<CAPTION>

Exhibit
Number           Description
<S>             <C>
10.25+           Employee Confidentiality, Invention Assignment and Non-Compete Agreement between
                 Inspire Pharmaceuticals, Inc. and Benjamin R. Yerxa dated February 4, 2000.
                 (Incorporated by reference to Exhibit 10.26 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.26+           Employee Confidentiality, Invention Assignment and Non-Compete Agreement between
                 Inspire Pharmaceuticals, Inc. and Janet L. Rideout dated February 4, 2000.
                 (Incorporated by reference to Exhibit 10.27 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.27+           Employee Confidentiality, Invention Assignment and Non-Compete Agreement between
                 Inspire Pharmaceuticals, Inc. and Christy L. Shaffer dated February 10, 2000.
                 (Incorporated by reference to Exhibit 10.28 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.28            Master Agreement between Inspire Pharmaceuticals, Inc. and ClinTrials
                 BioResearch Ltd. dated as of December 23, 1999. (Incorporated by reference to
                 Exhibit 10.29 to the Company's registration statement on Form S-1 (Registration
                 No. 333-31174) which became effective on August 3, 2000).

10.29+           Employee Confidentiality, Invention Assignment and Non-Compete Agreement between
                 Inspire Pharmaceuticals, Inc. and Richard M. Evans Dated February 10, 2000.
                 (Incorporated by reference to Exhibit 10.30 to the Company's registration
                 statement on Form S-1 (Registration No. 333-31174) which became effective on
                 August 3, 2000).

10.30*           License Agreement between Inspire Pharmaceuticals, Inc. and Kirin Brewery
                 Company, Ltd., Pharmaceutical Division, dated as of September 12, 2000.
                 (Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on
                 Form 10-Q filed on November 3, 2000).

23.1             Consent of PricewaterhouseCoopers LLP, independent public accountants
</TABLE>

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

*    Confidential treatment has been granted with respect to a portion of this
     Exhibit.

+    Denotes a management contract or compensation plan or arrangement required
     to be filed as an exhibit pursuant to Item 14(a) of this Form 10-K.

(b)  Reports on Form 8-K

     On December 1, 2000, Inspire filed a Current Report on Form 8-K, dated
     December 1, 2000, including a copy of a letter to the stockholders
     regarding the developments of the year 2000.

                                      -36-
<PAGE>

                                   SIGNATURES

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

                           Inspire Pharmaceuticals, Inc.


                           By: /s/ Christy L. Shaffer           March 19, 2000
                               -----------------------------------------------
                               Christy L. Shaffer
                               President, Chief Executive Officer and Director

     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.

<TABLE>
<CAPTION>

            Signature                                    Title                               Date

<S>                                             <C>                                    <C>
         /s/ Christy L. Shaffer                  President, Chief Executive             March 19, 2001
----------------------------------------         Officer (principal executive
         Christy L. Shaffer                      Officer) and Director



         /s/ Gregory J. Mossinghoff              Senior Vice President,                 March 19, 2001
----------------------------------------         Chief Business Officer,
         Gregory J. Mossinghoff                  Secretary and Treasurer
                                                 (principal financial officer
                                                 and principal accounting
                                                 officer)


         /s/ Terrance G. McGuire                 Chairman of the Board                  March 19, 2001
----------------------------------------
         Terrance G. McGuire


         /s/ Richard Boucher, M.D.               Director                               March 19, 2001
----------------------------------------
         Richard Boucher, M.D.


         /s/ Andre L. Lamotte, Sc.D.             Director                               March 19, 2001
----------------------------------------
         Andre L. Lamotte, Sc.D.


         /s/ H. Jefferson Leighton               Director                               March 19, 2001
----------------------------------------
         H. Jefferson Leighton


         /s/ W. Leigh Thompson                   Director                               March 19, 2001
----------------------------------------
         W. Leigh Thompson


         /s/ Jesse I. Treu                       Director                               March 19, 2001
----------------------------------------
         Jesse I. Treu
</TABLE>

                                      -37-
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                         INDEX TO FINANCIAL STATEMENTS

                                                                      Page(s)
                                                                     ---------

Report of Independent Accountants                                       F-2

Balance Sheets                                                          F-3

Statements of Operations                                                F-4

Statements of Cash Flows                                                F-5

Statements of Stockholders' Equity (Deficit)                            F-6

Notes to Financial Statements                                           F-7

                                      F-1
<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders
Inspire Pharmaceuticals, Inc.

     In our opinion, the accompanying balance sheets and the related statements
of operations, of stockholders' equity (deficit) and of cash flows present
fairly, in all material respects, the financial position of Inspire
Pharmaceuticals, Inc. (a development stage company) at December 31, 1999 and
2000 and the results of its operations and its cash flows for each of the three
years in the period ended December 31, 2000 and the period from inception
(October 28, 1993) to December 31, 2000 in conformity with accounting principles
generally accepted in the United States of America. These financial statements
are the responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statements
presentation. We believe that our audits provide a reasonable basis for our
opinion.

/s/ PricewaterhouseCoopers LLP

Raleigh, North Carolina
February 2, 2001

                                      F-2
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                                BALANCE SHEETS
              (In thousands, except share and per share amounts)

<TABLE>
<CAPTION>
                                                                                           December 31,
                                                                                  ----------------------------
                                                                                      2000           1999
                                                                                  -------------  -------------
<S>                                                                               <C>            <C>
Assets
Current assets:
    Cash and cash equivalents                                                      $    35,109    $    22,728
    Short-term investments                                                              44,026              -
    Other receivables                                                                      209             19
    Interest receivable                                                                    364              -
    Prepaid expenses                                                                       415            132
                                                                                  -------------  -------------
Total current assets                                                                    80,123         22,879

Property and equipment, net                                                              1,214            789
Other assets                                                                             1,656          1,952
                                                                                  -------------  -------------
Total assets                                                                       $    82,993    $    25,620
                                                                                  =============  =============

Liabilities and Stockholders' equity
Current liabilities:
    Accounts payable                                                               $       430    $       632
    Accrued expenses                                                                       852            651
    Notes payable, current portion                                                          26              -
    Capital leases, current portion                                                        289            210
    Deferred revenue, current portion                                                    5,618          3,868
                                                                                  -------------  -------------
Total current liabilities                                                                7,215          5,361

Notes payable, excluding current portion                                                     -             24
Capital leases, excluding current portion                                                  523            333
Deferred revenue, excluding current portion                                                750          3,868
                                                                                  -------------  -------------
Total liabilities                                                                        8,488          9,586

Commitments (Notes 10, 11 and 12)

Stockholders' equity:
    Convertible preferred stock, $0.001 par value, 2,000,000
        shares authorized; 0 and 27,892,999 shares issued and
        outstanding at December 31, 2000 and 1999, respectively                              -         45,895
    Common stock, $0.001 par value, 32,000,000 shares authorized;
        25,515,087 and 2,465,857 shares issued and outstanding at
        December 31, 2000 and 1999, respectively                                            26              2
    Additional paid-in capital                                                         126,081          8,348
    Other comprehensive income                                                              51              -
    Deferred compensation                                                              (3,782)        (4,924)
    Deficit accumulated during the development stage                                  (47,871)       (33,287)
                                                                                  -------------  -------------
Total stockholders' equity                                                              74,505         16,034
                                                                                  -------------  -------------
Total liabilities and stockholders' equity                                         $    82,993    $    25,620
                                                                                  =============  =============
</TABLE>

  The accompanying notes are an integral part of these financial statements.

                                      F-3
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                           STATEMENTS OF OPERATIONS
              (In thousands, except share and per share amounts)

<TABLE>
<CAPTION>
                                                                                                       Cumulative
                                                                                                         from
                                                                                                       Inception
                                                                                                      (October 28,
                                                                   Year Ended December 31,              1993) to
                                                       ---------------------------------------------  December 31,
                                                            2000           1999            1998          2000
                                                       --------------  -------------  --------------  -------------
<S>                                                    <C>             <C>            <C>             <C>
Revenues:
   Collaborative research agreements                   $       5,368   $      1,104   $         360   $      6,832
                                                       --------------  -------------  --------------  -------------
Operating expenses:
   Research and development (includes $838,
      $515, $68 and $1,421, of stock-based
      compensation, respectively)                             16,353          7,694           5,597         41,954
   General and administrative expenses
      (includes $678, $519, $46 and $1,243,
      of stock-based compensation,
      respectively)                                            3,694          2,406           1,967         12,477
                                                       --------------  -------------  --------------  -------------
   Total operating expenses                                   20,047         10,100           7,564         54,431
                                                       --------------  -------------  --------------  -------------
   Operating loss                                           (14,679)        (8,996)         (7,204)        (47,599)
                                                       --------------  -------------  --------------  -------------
Other income (expense), net:
   Interest income                                            2,120            238             168           3,229
   Interest expense                                            (994)          (111)           (115)         (1,659)
   Loss on disposal of property and equipment                   (37)            (5)            (17)           (366)
                                                       --------------  -------------  --------------  -------------
   Other income (expense), net                                 1,089            122              36          1,204
                                                       --------------  -------------  --------------  -------------
   Loss before provision for income taxes                   (13,590)        (8,874)         (7,168)       (46,395)
Provision for income taxes                                       400             60             360            820
                                                       --------------  -------------  --------------  -------------
   Net loss                                                 (13,990)        (8,934)         (7,528)       (47,215)
Preferred stock dividends                                      (594)           (62)               -          (656)
                                                       --------------  -------------  --------------  -------------
Net loss available to common stockholders              $    (14,584)   $    (8,996)   $     (7,528)   $   (47,871)
                                                       ==============  =============  ==============  =============

Net loss per common share - basic and
   diluted                                             $      (1.23)   $     (3.75)   $      (3.65)
                                                       ==============  =============  ==============

Weighted average common shares
   outstanding - basic and diluted                        11,870,521      2,401,028       2,061,398
                                                       ==============  =============  ==============
</TABLE>

  The accompanying notes are an integral part of these financial statements.

                                      F-4
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                           STATEMENTS OF CASH FLOWS
                                (In thousands)

<TABLE>
<CAPTION>
                                                                                                             Cumulative
                                                                                                                from
                                                                                                             Inception
                                                                                                            (October 28,
                                                                                                              1993) to
                                                                       Year Ended December 31,                December
                                                            ----------------------------------------------
                                                                2000            1999            1998          31, 2000
                                                            --------------  -------------- --------------- ----------------
<S>                                                            <C>              <C>             <C>            <C>
Cash flows from operating activities:
   Net loss                                                    $ (13,990)       $ (8,934)       $ (7,528)      $ (47,215)
   Adjustments to reconcile net loss to net cash
          used in operating activities:
      Depreciation and amortization                                 1,420             666             558           3,573
      Stock issued for exclusive license                                -               -             108             144
      Stock issued for consulting services                              -               -               -              72
      Amortization of deferred compensation                         1,544           1,035             114           2,693
      Loss on disposal of property and equipment                       37               5              17             366
      Changes in operating assets and liabilities:
         Other receivables                                          (190)            (14)             (5)           (209)
         Interest receivable                                        (364)               -               -           (364)
         Prepaid expenses                                           (283)             (9)              19           (415)
         Other assets                                                 (1)               1            (25)            (82)
         Accounts payable                                           (202)             341           (208)             430
         Accrued expenses                                             243             166             101             854
         Deferred revenue                                         (1,368)           4,496           3,240           6,368
                                                            --------------  -------------- --------------- ----------------
      Net cash used in operating activities                      (13,154)         (2,247)         (3,609)        (33,785)
                                                            --------------  -------------- --------------- ----------------
Cash flows from investing activities:
   Purchase of investments                                       (55,021)               -               -        (55,021)
   Proceeds from sale of investments                               11,046               -               -          11,046
   Purchase of property and equipment                               (522)           (151)           (170)         (1,955)
   Proceeds from sale of property and equipment                         -               -             127             127
   Sale of certificate of deposit                                       -               -               -            (78)
                                                            --------------  -------------- --------------- ----------------
      Net cash used in investing activities                      (44,497)           (151)            (43)        (45,881)
                                                            --------------  -------------- --------------- ----------------
Cash flows from financing activities:
   Proceeds from bridge loans                                           -               -               -             780
   Proceeds from issuance of notes payable                              -               1               9             408
   Payments on notes payable                                            -               -           (143)           (400)
   Issuance of common stock, net                                   70,249              38              17          70,347
   Issuance of convertible preferred stock, net                         -          21,406           2,400          45,061
   Payments on capital lease obligations                            (217)           (457)           (319)         (1,421)
                                                            --------------  -------------- --------------- ----------------
      Net cash provided by financing activities                    70,032          20,988           1,964         114,775
                                                            --------------  -------------- --------------- ----------------
      Increase (decrease) in cash and cash equivalents             12,381          18,590         (1,688)          35,109
Cash and cash equivalents, beginning of period                     22,728           4,138           5,826               -
                                                            --------------  -------------- --------------- ----------------
Cash and cash equivalents, end of period                        $  35,109       $  22,728        $  4,138       $  35,109
                                                            ==============  ============== =============== ================
</TABLE>

  The accompanying notes are an integral part of these financial statements.

                                      F-5
<PAGE>

                          INSPIRE PHARMACEUTICALS, INC.
                          (A Development Stage Company)
                  STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
      For the Period from Inception (October 28, 1993) to December 31, 2000
              (In thousands, except share and per share amounts)

<TABLE>
<CAPTION>
                                                            Preferred Stock             Common Stock             Common Stock
                                                        -------------------------------------------------------------------------
                                                           Number                    Number                   Number
                                                         of Shares     Amount      of Shares      Amount     of Shares    Amount
                                                        -----------   --------    -----------   ----------  -----------  --------
<S>                                                     <C>          <C>         <C>           <C>         <C>          <C>
Inception (October 23, 1993)                                      -   $      -              -    $       -            -    $    -
                                                        -----------   --------    -----------   ----------  -----------  --------
Balance at December 31, 1993                                      -          -              -            -            -         -
Issuance of Class A and B Common Stock                            -          -              -            -       10,000        10
Net loss                                                          -          -              -            -            -         -
                                                        -----------   --------    -----------   ----------  -----------  --------
Balance at December 31, 1994                                      -          -              -            -       10,000        10
Issuance of common stock and cancellation of
     Class A and B common stock                                   -          -        850,286            1      (10,000)      (10)
Stock issued for consulting services                              -          -        585,714            1            -         -
Stock issued in exchange for exclusive license                    -          -        297,714            -            -         -
Issuance of Series A convertible preferred stock          9,200,000      9,100              -            -            -         -
Issuance of Series A warrants                                     -          -              -            -            -         -
Net loss                                                          -          -              -            -            -         -
                                                        -----------   --------    -----------   ----------  -----------  --------
Balance at December 31, 1995                              9,200,000      9,100      1,733,714            2            -         -
Issuance of common stock                                          -          -        227,340            -            -         -
Net loss                                                          -          -              -            -            -         -
                                                        -----------   --------    -----------   ----------  -----------  --------
Balance at December 31, 1996                              9,200,000      9,100      1,961,054            2            -         -
Issuance of common stock                                          -          -         31,954            -            -         -
Issuance of Series B convertible preferred stock         10,866,014     12,966              -            -            -         -
Net loss                                                                     -              -            -            -         -
                                                        -----------   --------    -----------   ----------  -----------  --------
Balance at December 31, 1997                             20,066,014     22,066      1,993,008            2            -         -
Issuance of common stock                                          -          -        137,502            -            -         -
Stock issued in exchange for exclusive license                    -          -         28,572            -            -         -
Issuance of Series C convertible preferred stock            375,000        900              -            -            -         -
Issuance of Series D convertible preferred stock            416,667      1,500              -            -            -         -
Issuance of Series B warrants                                                -              -            -            -         -
Deferred compensation                                                        -              -            -            -         -
Amortization of deferred compensation                                        -              -            -            -         -
Net loss                                                                     -              -            -            -         -
                                                        -----------   --------    -----------   ----------  -----------  --------
Balance at December 31, 1998                             20,857,681     24,466      2,159,082            2            -         -
Issuance of common stock                                          -          -        306,775            -            -         -
Issuance of Series E convertible preferred stock          6,201,985     11,406              -            -            -         -
Issuance of Series G convertible preferred stock            833,333     10,000              -            -            -         -
Issuance of Series F warrants                                     -          -              -            -            -         -
Issuance of common stock warrants                                 -          -              -            -            -         -
Preferred stock dividends                                         -         23              -            -            -         -
Deferred compensation                                             -          -              -            -            -         -
Amortization of deferred compensation                             -          -              -            -            -         -
Net loss                                                          -          -              -            -            -         -
                                                        -----------   --------    -----------   ----------  -----------  --------
Balance at December 31, 1999                             27,892,999     45,895      2,465,857            2            -         -
Issuance of common stock                                          -          -        369,006            -            -         -
Issuance of common stock warrants                                 -          -              -            -            -         -
Preferred stock dividends                                         -          -              -            -            -         -
Issuance of common stock at initial public offering
     and exercise of over-allotment                               -          -      6,325,000            7            -         -
Conversion of preferred stock and preferred stock
     dividends into common stock at initial public
     offering                                           (27,892,999)   (45,895)    16,355,224           17            -         -
Deferred compensation                                             -          -              -            -            -         -
Amortization of deferred compensation                             -          -              -            -            -         -
Unrealized gain on investments
Net loss                                                          -          -              -            -            -         -
                                                        -----------   --------    -----------   ----------  -----------  --------
Balance at December 31, 2000                                      -   $      -     25,515,087    $      26            -    $    -
                                                        ===========   ========    ===========   ==========  ===========  ========
<CAPTION>
                                                        Additional                                      Other
                                                         Paid-In     Accumulated      Deferred      Comprehensive    Stockholders'
                                                         Capital       Deficit      Compensation   Income / (loss)      Equity
                                                       -----------   -----------    ------------   --------------    ------------
<S>                                                   <C>           <C>             <C>           <C>               <C>
Inception (October 23, 1993)                           $         -   $         -     $         -   $            -    $          -
                                                       -----------   -----------    ------------   --------------    ------------
Balance at December 31, 1993                                     -             -               -                -               -
Issuance of Class A and B Common Stock                           -             -               -                -              10
Net loss                                                         -          (330)              -                -            (330)
                                                       -----------   -----------    ------------   --------------    ------------
Balance at December 31, 1994                                     -          (330)              -                -            (320)
Issuance of common stock and cancellation of
     Class A and B common stock                                  9             -               -                -               -
Stock issued for consulting services                            71             -               -                -              72
Stock issued in exchange for exclusive license                  36             -               -                -              36
Issuance of Series A convertible preferred stock                 -             -               -                -           9,100
Issuance of Series A warrants                                   92             -               -                -              92
Net loss                                                         -        (2,704)              -                -          (2,704)
                                                       -----------   -----------    ------------   --------------    ------------
Balance at December 31, 1995                                   208        (3,034)              -                -           6,276
Issuance of common stock                                        13             -               -                -              13
Net loss                                                         -        (5,782)              -                -          (5,782)
                                                       -----------   -----------    ------------   --------------    ------------
Balance at December 31, 1996                                   221        (8,816)              -                -             507
Issuance of common stock                                        18             -               -                -              18
Issuance of Series B convertible preferred stock                 -             -               -                -          12,966
Net loss                                                         -        (7,947)              -                -          (7,947)
                                                       -----------   -----------    ------------   --------------    ------------
Balance at December 31, 1997                                   239       (16,763)              -                -           5,544
Issuance of common stock                                        17             -               -                -              17
Stock issued in exchange for exclusive license                 108             -               -                -             108
Issuance of Series C convertible preferred stock                 -             -               -                -             900
Issuance of Series D convertible preferred stock                 -             -               -                -           1,500
Issuance of Series B warrants                                    7             -               -                -               7
Deferred compensation                                        2,714             -          (2,714)               -               -
Amortization of deferred compensation                            -             -             114                -             114
Net loss                                                         -        (7,528)              -                -          (7,528)
                                                       -----------   -----------    ------------   --------------    ------------
Balance at December 31, 1998                                 3,085       (24,291)         (2,600)               -             662
Issuance of common stock                                        38             -               -                -              38
Issuance of Series E convertible preferred stock                 -             -               -                -          11,406
Issuance of Series G convertible preferred stock                 -             -               -                -          10,000
Issuance of Series F warrants                                   53             -               -                -              53
Issuance of common stock warrants                            1,813             -               -                -           1,813
Preferred stock dividends                                        -           (62)              -                -             (39)
Deferred compensation                                        3,359             -          (3,359)               -               -
Amortization of deferred compensation                            -             -           1,035                -           1,035
Net loss                                                         -        (8,934)              -                -          (8,934)
                                                       -----------   -----------    ------------   --------------    ------------
Balance at December 31, 1999                                 8,348       (33,287)         (4,924)               -          16,034
Issuance of common stock                                     1,062             -               -                -           1,062
Issuance of common stock warrants                              577             -               -                -             577
Preferred stock dividends                                        -          (594)              -                -            (594)
Issuance of common stock at initial public offering
     and exercise of over-allotment                         69,180             -               -                -          69,187
Conversion of preferred stock and preferred stock
     dividends into common stock at initial public
     offering                                               46,512             -               -                -             634
Deferred compensation                                          402             -            (402)               -               -
Amortization of deferred compensation                            -             -           1,544                -           1,544
Unrealized gain on investments                                                                                 51              51
Net loss                                                         -       (13,990)              -                -         (13,990)
                                                       -----------   -----------    ------------   --------------    ------------
Balance at December 31, 2000                            $  126,081     $ (47,871)     $   (3,782)           $  51        $ 74,505
                                                       ===========   ===========    ============   ==============    ============
</TABLE>



  The accompanying notes are an integral part of these financial statements.
                                      F-6
<PAGE>

                          INSPIRE PHARMACEUTICALS, INC.
                          (A Development Stage Company)
                          NOTES TO FINANCIAL STATEMENTS
               (In thousands, except share and per share amounts)

1. Organization

Inspire Pharmaceuticals, Inc. (the "Company") was founded on October 28, 1993 to
develop and commercialize novel pharmaceutical products that treat respiratory
and ophthalmic diseases which are characterized by deficiencies in the body's
innate defense mechanisms of mucosal hydration and mucociliary clearance. The
Company's technologies are based in part on exclusive license agreements with
The University of North Carolina at Chapel Hill for rights to certain
developments from the founders' laboratories.

The Company is considered a development stage enterprise. Since inception, the
Company has devoted substantially all of its efforts towards establishing its
business and research and development programs.

2. Summary of Significant Accounting Policies

Use of Estimates

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

Cash and 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.

Investments

Investments consist primarily of United States government agency obligations and
other fixed or variable income investments. The Company invests in high-credit
quality investments in accordance with its investment policy which minimizes the
possibility of loss. Investments with original maturities at date of purchase
beyond three months and which mature at or less than twelve months from the
balance sheet date are classified as current. Investments with a maturity beyond
twelve months from the balance sheet date are classified as long-term.
Investments are considered to be available for sale and are carried at fair
value with unrealized gains and losses recognized in other comprehensive income
(loss). Realized gains and losses are determined using the specific
identification method and transactions are recorded on a settlement date basis.

Property and Equipment

Property and equipment is primarily comprised of furniture, laboratory and
computer equipment and leasehold improvements which are recorded at cost and
depreciated using the straight-line method over their estimated useful lives
which range from three to five years. Property and equipment includes certain
equipment under capital leases. These items are depreciated over the shorter of
the lease period or the estimated useful life of the equipment.



                                       F-7
<PAGE>

                          INSPIRE PHARMACEUTICALS, INC.
                          (A Development Stage Company)
                    NOTES TO FINANCIAL STATEMENTS (Continued)
               (In thousands, except share and per share amounts)

Other Assets

Other assets are primarily comprised of deferred costs which were incurred when
the Company issued warrants in conjunction with collaborative research
agreements and capital lease arrangements. These costs are amortized using the
effective interest rate method over the life of the related collaborative
research agreement or lease.

Stock-Based Compensation

The Company accounts for stock-based compensation based on the provisions of
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25"), which states that no compensation expense is recorded for
stock options or other stock-based awards to employees that are granted with an
exercise price equal to or above the estimated fair value per share of the
Company's common stock on the grant date. In the event that stock options are
granted with an exercise price below the estimated fair value of the Company's
common stock, the difference between the estimated fair value of the Company's
common stock and the exercise price of the stock option is recorded as deferred
compensation. The Company recognized deferred compensation of $402 and $3,359
related to stock option grants during the years ended December 31, 2000 and
1999, respectively.

Deferred compensation is amortized over the vesting period of the related stock
option, which is generally four years. The Company recognized $1,544, $1,034 and
$114 of stock based compensation expense related to amortization of deferred
compensation during the years ended December 31, 2000, 1999 and 1998,
respectively. The Company has adopted the disclosure requirements of Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" which requires compensation expense to be disclosed based on the
fair value of the options granted at the date of the grant.

Income Taxes

The Company accounts for income taxes using the liability method which requires
the recognition of deferred tax assets or liabilities for the temporary
differences between financial reporting and tax bases of the Company's assets
and liabilities and for tax carryforwards at enacted statutory tax rates in
effect for the years in which the differences are expected to reverse. The
effect on deferred taxes of a change in tax rates is recognized in income in the
period that includes the enactment date. In addition, valuation allowances are
established when necessary to reduce deferred tax assets to the amounts expected
to be realized.

Revenue Recognition

Revenue is recognized under collaborative research agreements when services are
performed or when contractual obligations are met. Nonrefundable fees received
at the initiation of collaboration agreements for which the Company has an
ongoing research and development commitment are deferred and recognized ratably
over the period of the related research and development commitment. Milestone
payments under collaboration agreements and research agreements will be
recognized as revenues ratably over the remaining period of the research and
development commitment beginning on the date the Company achieves the indicated
milestone and such achievement is acknowledged by the collaborative partner,
which generally coincides with the receipt of the milestone payment.

                                       F-8
<PAGE>

                          INSPIRE PHARMACEUTICALS, INC.
                          (A Development Stage Company)
                    NOTES TO FINANCIAL STATEMENTS (Continued)
               (In thousands, except share and per share amounts)


Research and Development

Research and development costs include all direct costs, including salaries for
Company personnel, external costs of clinical trials, sponsored research
agreements and clinical trials insurance related to the development of drug
compounds. These costs have been charged to operating expense as incurred. Costs
associated with obtaining and maintaining patents on the Company's drug
compounds and license initiation and continuation fees, including milestone
payments by the Company to its licensors, are evaluated based on the stage of
development of the related drug compound and whether the underlying drug
compound has an alternative use. Costs of these types incurred for drug
compounds not yet approved by the United States Food and Drug Administration
("FDA") and for which no alternative use exists are recorded as research and
development expense. In the event the drug compound has been approved by the FDA
or an alternative use exists for the drug compound, patent costs and license
costs are capitalized and amortized over the expected life of the related drug
compound. License milestone payments to the Company's licensors are recognized
when the underlying requirement is met by the Company.

Significant Customers and Credit Risk

All revenues recognized and recorded in 2000 were from four collaborative
partners. All revenues recognized and recorded in 1999 and 1998 were from a
single collaborative partner. Financial instruments which potentially subject
the Company to concentrations of credit risk consist principally of short-term
cash investments. The Company primarily invests in short-term interest-bearing
investment-grade securities and certificates of deposits. Cash deposits are all
in financial institutions in the United States.

Cash Flows

The Company made cash payments for interest of $100, $67 and $99 for the years
ended December 31, 2000, 1999 and 1998, respectively. The Company made cash
payments for foreign withholding taxes of $400, $60 and $360 during the years
ended December 31, 2000, 1999 and 1998, respectively.

The Company acquired property and equipment through the assumption of capital
lease obligations amounting to $522 and $151 during the years ended December 31,
2000 and 1999, respectively.

Net Income (Loss) Per Common Share

Basic net income (loss) per common share ("basic EPS") is computed by dividing
net income (loss) available to common stockholders by the weighted average
number of common shares outstanding. Diluted net income (loss) per common share
("diluted EPS") is computed by dividing net income (loss) available to common
stockholders by the weighted average number of common shares and dilutive
potential common share equivalents then outstanding. Potential common shares
consist of shares issuable upon the exercise of stock options and warrants and
conversion of convertible preferred stock. The calculation of diluted EPS for
the years ended December 31, 2000, 1999 and 1998 does not include 1,526,008,
14,486,662 and 12,379,418, respectively, of potential shares of common stock
equivalents, as their impact would be antidilutive.

                                       F-9
<PAGE>

                          INSPIRE PHARMACEUTICALS, INC.
                          (A Development Stage Company)
                    NOTES TO FINANCIAL STATEMENTS (Continued)
               (In thousands, except share and per share amounts)


Segment Reporting

The Company has determined that it did not have any separately reportable
operating segments as of December 31, 2000, 1999 or 1998.

Comprehensive Income (Loss)

During 2000, the Company had $51 of unrealized gain on investments that is
classified as other comprehensive income and is disclosed as a component of
statements of stockholders' equity. The Company had no items of other
comprehensive income during the years ended December 31, 1999 or 1998.

Recent Accounting Pronouncements

In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133"). SFAS 133 establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts (collectively referred to as "derivatives"), and for hedging
activities. SFAS 133, as amended by SFAS 137, is effective for all fiscal
quarters of all fiscal years beginning after June 15, 2000, with earlier
application encouraged. The Company does not currently nor does it intend in the
future to use derivative instruments and therefore does not expect that the
adoption of SFAS 133 in fiscal 2001 will have any impact on its financial
position or results of operations.

3. Property and Equipment

Property and equipment consist of the following:

                                                               December 31,
                                                          ----------------------
                                                             2000        1999
                                                          ----------- ----------

Equipment                                                 $    1,679  $   1,326
Leasehold improvements                                           845        749
Computer hardware and software                                   742        565
Furniture and fixtures                                           384        225
                                                          ----------  ---------

                                                               3,650      2,865
Less - accumulated depreciation and amortization              (2,436)    (2,076)
                                                          ----------  ---------

Property and equipment, net                               $    1,214  $     789
                                                          ==========  =========


Depreciation expense was $546, $623 and $555 for the years ended December 31,
2000, 1999 and 1998, respectively. The Company leases certain equipment under
capital lease agreements. The book value of equipment under capital leases at
December 31, 2000 and 1999 was approximately $847 and $562, respectively.


                                      F-10
<PAGE>

                          INSPIRE PHARMACEUTICALS, INC.
                          (A Development Stage Company)
                    NOTES TO FINANCIAL STATEMENTS (Continued)
               (In thousands, except share and per share amounts)


4. Fair Value of Financial Instruments

The carrying value of cash and cash equivalents, accounts receivable and
accounts payable at December 31, 2000 and 1999 approximate their fair value due
to the short-term nature of these items.

The fair value of the Company's short-term investments at December 31, 2000 and
1999, approximate their carrying values as these investments are primarily in
short-term interest-bearing investment-grade securities.

The carrying value of the Company's notes payable and capital lease obligations
at December 31, 2000 and 1999 approximate their fair value as the interest rates
on these obligations approximate rates available in the financial market at such
dates.

5. Accrued Expenses

Accrued expenses are comprised of the following:

                                                           December 31,
                                                  -----------------------------
                                                       2000           1999
                                                  -------------- --------------

Research costs                                        $     472      $     381
Accrued payroll and benefits                                 67             32
Accrued legal and patent costs                              111             41
Accrued preferred stock dividends                             -             39
Other                                                       202            158
                                                  -------------  -------------

                                                      $     852      $     651
                                                  =============  =============

6. Income Taxes

The components of the Company's income tax expense consist of the following:

                                                Years Ended December 31,
                                          -------------------------------------
                                              2000        1999         1998
                                          -----------  -----------  -----------

Current expense (benefit):
   Federal                                 $       -    $       -    $       -
   Foreign                                       400           60          360
   State                                                        -            -
                                          ----------   ----------  -----------

   Current tax expense (benefit)                 400           60          360
                                          ----------   ----------  -----------

Deferred expense (benefit)
   Federal                                         -            -            -
   State                                           -            -            -
                                          ----------   ----------  -----------

   Deferred tax expense (benefit)                  -            -            -
                                          ----------   ----------  -----------

   Net tax expense (benefit)               $     400    $      60    $     360
                                          ==========   ==========  ===========


                                      F-11
<PAGE>

                          INSPIRE PHARMACEUTICALS, INC.
                          (A Development Stage Company)
                    NOTES TO FINANCIAL STATEMENTS (Continued)
               (In thousands, except share and per share amounts)

There was no current or deferred federal and state income tax expense for the
years ended December 31, 2000, 1999 and 1998 because the Company generated net
operating losses during such periods. The foreign tax represents foreign
withholding tax paid on amounts received from the Company's foreign
collaborative partners.

Significant components of the Company's deferred tax assets and liabilities
consist of the following:

                                                             December 31,
                                                        -----------------------
                                                           2000        1999
                                                        ----------- -----------

Current deferred tax assets:
    Compensation related items                           $      26   $      12

Noncurrent deferred tax assets:
    Domestic net operating loss carryforwards               14,105       8,598
    Deferred revenue                                         2,470       3,000
    Research and development credits                         1,575         911
    Fixed and intangible assets                                886         553
    Stock-based compensation                                 1,084         485
    Stock warrants                                               -          43
    Contributions                                              116          41
                                                        ----------  ----------

      Total deferred tax assets                             20,262      13,643
      Valuation allowance for deferred assets             (19,664)    (13,643)
                                                        ----------  ----------

Noncurrent deferred tax liabilities:
    Stock warrants                                             598           -
                                                        ----------  ----------
      Total deferred tax liabilities                           598

      Net deferred tax asset (liability)                 $       -   $       -
                                                        ==========  ==========

At December 31, 2000 and 1999 the Company has provided a full valuation
allowance against its net deferred tax assets since realization of these
benefits could not be reasonably assured. The increase in valuation allowance of
$6,021 during the year ended December 31, 2000 resulted primarily from the
generation of additional net operating loss carryforwards.

As of December 31, 2000, the Company had federal and state net operating loss
carryforwards of approximately $36,425 and $35,963, respectively. The net
operating loss carryforwards expire in various amounts starting in 2008 and 2001
for federal and state tax purposes, respectively. The utilization of the federal
net operating loss carryforwards may be subject to limitation under the rules
regarding a change in stock ownership as determined by the Internal Revenue
Code. If the Company's utilization of its net operating loss carryforwards is
limited and the Company has taxable income which exceeds the permissible yearly
net operating loss carryforward, the Company would incur a federal income tax
liability even though its net operating loss carryforwards exceed its taxable
income.

Additionally, at December 31, 2000, the Company has federal research and
development and orphan drug credit carryforwards of $1,575. The credit
carryforwards expire in varying amounts beginning in 2010.

                                      F-12
<PAGE>

                          INSPIRE PHARMACEUTICALS, INC.
                          (A Development Stage Company)
                    NOTES TO FINANCIAL STATEMENTS (Continued)
               (In thousands, except share and per share amounts)


Taxes computed at the statutory federal income tax rate of 34% are reconciled to
the provision for income taxes as follows:

<TABLE>
<CAPTION>

                                                             Years Ended December 31,
                                                    -------------------------------------------
                                                        2000           1999           1998
                                                    -------------  -------------  -------------
<S>                                                 <C>            <C>            <C>
United States federal tax at statutory federal
   income tax rate                                   $   (4,621)    $   (3,107)    $   (2,437)
State taxes (net of federal benefit)                       (642)          (439)          (367)
Change in valuation reserve                                6,021          3,713          3,196
Research and development credit                            (664)          (151)          (274)
Foreign withholding tax, net of federal
   benefit                                                   264             39            238
Other nondeductible expenses                                  42              5              4
                                                    ------------   ------------   ------------

Provision for income taxes                           $       400    $        60    $       360
                                                    ============   ============   ============
</TABLE>

7. Notes Payable

On November 13, 1996, the Company entered into a Collaborative Funding Agreement
("CFA") with the North Carolina Biotechnology Center ("NCBC") and the Kenan
Institute whereby NCBC agreed to loan the Company a total of $20. Loans made to
the Company by NCBC under the CFA are to be used for specific research
activities. All such loans are unsecured and bear interest at 8.25%, with
principal and accrued interest payable on November 7, 2001. The Company had
total borrowings from NCBC under the CFA of $20 as of December 31, 2000 and
1999. Accrued interest on these loans, which is included in notes payable,
totaled $6 and $4 at December 31, 2000 and 1999, respectively.

8. Stockholders' Equity

At December 31, 2000, the Company was authorized to issue 32,000,000 shares of
common stock with a par value of $.001 per share and 2,000,000 shares of
preferred stock. At December 31, 1999, the Company was authorized to issue
56,000,000 shares of common stock with a par value of $0.001 per share and
52,000,000 shares of preferred stock. Of the 52,000,000 shares of preferred
stock: (i) 9,365,000 shares have been designated as Series A Convertible
Preferred Stock ("Series A Preferred"); (ii) 10,881,014 shares have been
designated as Series B Convertible Preferred Stock ("Series B Preferred"); (iii)
375,000 shares have been designated as Series C Convertible Preferred Stock
("Series C Preferred"); (iv) 416,667 shares have been designated as Series D
Convertible Preferred Stock ("Series D Preferred"); (v) 8,000,000 shares have
been designated as Series E Convertible Preferred Stock ("Series E Preferred");
(vi) 1,200,000 shares have been designated as Series G Convertible Preferred
Stock ("Series G Preferred"); (vii) 9,365,000 shares have been designated as
Series AA Convertible Preferred Stock ("Series AA Preferred"); (viii) 10,881,014
shares have been designated as Series BB Convertible Preferred Stock ("Series BB
Preferred"); and (ix) 28,170 shares have been designated as Series F Convertible
Preferred Stock ("Series F Preferred").

On August 2, 2000, the Company's Registration Statement on Form S-1, as amended,
registering 6,325,000 shares of common stock was declared effective by the
Securities and Exchange Commission and permitted the Company to sell shares of
common stock in its initial public


                                      F-13
<PAGE>

                          INSPIRE PHARMACEUTICALS, INC.
                          (A Development Stage Company)
                    NOTES TO FINANCIAL STATEMENTS (Continued)
               (In thousands, except share and per share amounts)


offering ("IPO"). On August 8, 2000, the Company sold 5,500,000 shares of common
stock at the IPO for $12.00 per share which resulted in proceeds to the Company
of $66,000. On September 5, 2000, the Company sold an additional 825,000 shares
of common stock at the IPO price of $12.00 per share pursuant to the exercise by
the underwriters of their over-allotment option with respect to such shares,
generating additional gross proceeds of $9,900. Total stock issuance costs
related to the IPO and exercise of the over-allotment were $6,713.

At the IPO, all 26,684,666 shares of Series A, Series B, Series D and Series E
preferred stock converted into 15,605,504 shares of common stock at a 1-for-1.75
conversion ratio. The 375,000 Series C preferred stock converted into 214,284
shares of common stock at a 1-for-1.75 conversion ratio plus an additional 6,438
shares of common stock which were issued to the Series C preferred stockholders
as a result of their antidilution protection. Additionally, 833,333 shares of
Series G preferred stock converted into 476,190 shares of common stock plus an
additional 52,808 shares of common stock which were received by the Series G
preferred stockholders in payment of accrued dividends of $634.

Common Stock

Dividends

The holders of common stock shall be entitled to receive dividends from time to
time as may be declared by the Board of Directors. No cash dividend may be
declared or paid to common stockholders until paid on each series of outstanding
preferred stock in accordance with its terms.

Voting

The holders of shares of common stock are entitled to one vote for each share
held with respect to all matters voted on by the shareholders of the Company.

Liquidation

After payment to the preferred stockholders, holders of common stock shall be
entitled, together with holders of preferred stock, to share ratably in all
remaining assets of the Company.

Convertible Preferred Stock

Outstanding convertible preferred stock is as follows:

<TABLE>
<CAPTION>

                                           December 31, 2000            December 31, 1999
                                      ----------------------------  ---------------------------
                                        Number of                     Number of
                                         Shares         Amount         Shares        Amount
                                      -------------  -------------  ------------- -------------
<S>                                   <C>            <C>            <C>           <C>
Series A Preferred                               -   $          -      9,200,000  $      9,100
Series B Preferred                               -              -     10,866,014        12,966
Series C Preferred                               -              -        375,000           923
Series D Preferred                               -              -        416,667         1,500
Series E Preferred                               -              -      6,201,985        11,406
Series G Preferred                               -              -        833,333        10,000
                                      ------------   ------------   ------------  ------------

                                                 -   $          -     27,892,999  $     45,895
                                      ============   ============   ============  ============
</TABLE>


                                      F-14
<PAGE>

                          INSPIRE PHARMACEUTICALS, INC.
                          (A Development Stage Company)
                    NOTES TO FINANCIAL STATEMENTS (Continued)
               (In thousands, except share and per share amounts)


Dividends

The holders of Series A Preferred, Series B Preferred, Series C Preferred and
Series E Preferred were entitled to receive dividends equal to any dividends
paid on common stock. The holders of Series G Preferred were entitled to
cumulative dividends at the prime rate plus 1% of the Series G Preferred
preference amount calculated on a per share basis. Accrued dividends on the
Series G Preferred totaled $0 and $39 at December 31, 2000 and 1999,
respectively. All accrued Series G Preferred dividends for $634 were paid at the
date of the IPO in the form of 52,808 common shares.

Conversion

All outstanding shares, plus accrued dividends and shares arising from
anti-dilution provisions, of Series A, Series B, Series C, Series D, Series E
and Series G preferred stock converted into 16,355,224 shares of common stock,
at the effective conversion rate, upon the closing of the IPO.

Sales of Preferred Stock

In March 1995, the Company issued 8,388,679 shares of Series A Preferred to a
group of venture capital investors at a price per share of $1.00 which resulted
in proceeds to the Company of $8,289, net of offering costs of $100. In
addition, bridge loans from the Series A Preferred investors totaling $811,
including accrued interest, were converted into 811,321 shares of Series A
Preferred, using a conversion price of $1.00 per share.

In June and September 1997, the Company issued 10,866,014 shares of Series B
Preferred to a group of venture capital investors at a price per share of $1.20
which resulted in proceeds to the Company of $12,966, net of offering costs of
$73.

In September 1998, the Company issued 375,000 shares of Series C Preferred to a
strategic partner, Kissei Pharmaceutical Co. Ltd. ("Kissei"), at a price per
share of $2.40 which resulted in proceeds to the Company of $900, in conjunction
with entering into a collaboration agreement with Kissei relating to the
development of INS365 Respiratory (see Note 10).

In December 1998, the Company issued 416,667 shares of Series D Preferred to
Santen Pharmaceutical Company Ltd., at a price per share of $3.60 which resulted
in proceeds to the Company of $1,500, in conjunction with entering into a
collaboration agreement relating to the development of INS365 Ophthalmic (See
Note 10).

In July and October 1999, the Company issued 6,201,985 shares of Series E
Preferred to a group of venture capital investors at a price per share of $2.00
which resulted in proceeds to the Company of $11,406, net of offering costs of
$998.


                                      F-15
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                   NOTES TO FINANICAL STATEMENTS (Continued)
              (In thousands, except share and per share amounts)


In December 1999, the Company issued 833,333 shares of Series G Preferred to
Genentech, Inc. ("Genentech"), at a price per share of $12.00 which resulted in
proceeds to the Company of $10,000 in conjunction with entering into a
collaboration agreement (See Note 10). The shares automatically converted into
shares of the Company's common stock upon the initial public offering at an
exchange rate determined by dividing the total proceeds plus accrued and unpaid
dividends by the initial offering price of the Company's common stock.

9. Stock Options and Warrants

1995 Stock Incentive Plan

During 1995, the Company adopted the 1995 Stock Plan (the "Plan") which provided
for the grant of up to 1,005,714 options to directors, officers, employees and
consultants. In April 1999, the Plan was amended and restated, and is now the
Amended and Restated 1995 Stock Plan. In January 2000 the option pool was
increased to 3,428,571 shares. Under the Plan, both incentive and non-qualified
stock options, as well as restricted stock, can be granted. The Board of
Directors shall determine the term and dates of the exercise of all options at
their grant date, provided that for incentive stock options, such price shall
not be less than the fair market value of the Company's stock on the date of
grant. At December 31, 2000, there were 659,113 stock option shares available
for grant.

The maximum exercise terms for an option grant is ten years from the date of the
grant. Options granted under the plan generally vest 25% upon completion of one
full year of employment and on a monthly basis over the following three years.
Vesting begins from the date of hire for new employees and on the date of grant
for existing employees.

The following table summarizes the stock option activity for the Plan:

                                                                  Weighted
                                                   Number of      Average
                                                    Shares     Exercise Price
                                                 ------------- --------------

Options outstanding, December 31, 1997                791,774  $       0.124
   Granted                                            927,714          0.250
   Exercised                                        (137,502)        (0.124)
   Forfeited                                         (91,884)        (0.170)
                                                 ------------- --------------

Options outstanding, December 31, 1998              1,490,102          0.200
   Granted                                            395,000          0.688
   Exercised                                        (306,775)        (0.124)
   Forfeited                                        (103,809)        (0.212)
                                                 ------------- --------------

Options outstanding, December 31, 1999              1,474,518          0.345
   Granted                                            748,995         12.228
   Exercised                                        (295,526)        (0.207)
   Forfeited                                        (157,629)        (6.227)
                                                 ------------- --------------

Options outstanding, December 31, 2000              1,770,358  $       4.872
                                                 ============= ==============

                                      F-16
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                   NOTES TO FINANICAL STATEMENTS (Continued)
              (In thousands, except share and per share amounts)

The following table summarizes  information  concerning  options  outstanding at
December 31, 2000:

<TABLE>
<CAPTION>
                                                                      Weighted
                                                                       Average
                                                      Weighted        Remaining
                                                       Average       Contractual
                                       Options        Exercise          Life           Options
                                     Outstanding        Price        (in Years)      Exercisable
                                    --------------  --------------  --------------  --------------
<S>                                 <C>             <C>             <C>             <C>
Price range
   $ 0.123 - $ 0.123                      119,630    $      0.123            5.01         119,630
   $ 0.210 - $ 0.210                      502,179           0.210            7.61         341,928
   $ 0.315 - $ 0.840                      474,992           0.598            8.34         182,651
   $ 1.750 - $ 9.905                       78,568           6.495            9.32               -
   $12.000 - $12.000                      434,281          12.000            9.61               -
   $12.688 - $20.000                      160,708          15.554            9.43               -
                                    --------------  --------------  --------------  --------------
                                        1,770,358    $      4.872            8.36         644,209
                                    ==============  ==============  ==============  ==============
</TABLE>

Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123") requires the Company to disclose pro forma
information regarding option grants made and warrants issued to its employees.
SFAS 123 specifies certain valuations techniques that produce estimated
compensation charges that are included in the pro forma results below. These
amounts have not been reflected in the Company's statement of operations,
because the Company has made the election to use the provisions of APB 25 to
account for its stock based compensation.

The weighted average fair value of options granted during 2000, 1999 and 1998
was $7.04, $4.95 and $1.70, respectively.

The fair value of options granted to employees was estimated using the following
assumptions:

<TABLE>
<CAPTION>
                                                               Years Ended December 31,
                                                    ---------------------------------------------
                                                         2000           1999            1998
                                                    --------------  -------------  --------------
<S>                                                       <C>            <C>             <C>
Expected dividend yield                                        0%             0%              0%
Expected stock price volatility                            65.04%             0%              0%
Risk free interest rate                                     6.50%          5.39%           5.02%
Expected life of options                                  5 years        5 years         5 years
</TABLE>

For purposes of pro forma disclosures, the estimated fair value of equity
instruments is amortized to expense over their respective vesting period. If the
Company had elected to recognize compensation expense based on the fair value of
stock-based instruments at the grant date, as

                                      F-17
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                   NOTES TO FINANICAL STATEMENTS (Continued)
              (In thousands, except share and per share amounts)

prescribed by SFAS 123, its pro forma net loss and net loss per common share
would have been as follows:

<TABLE>
<CAPTION>
                                                                Years Ended December 31,
                                                    ------------------------------------------
                                                         2000           1999          1998
                                                    -------------  ------------  -------------
<S>                                                 <C>            <C>           <C>
Net loss available to common stockholders
        - as reported                                $   (14,584)   $   (8,996)    $   (7,528)
Net loss available to common stockholders
        - pro forma                                  $   (15,109)   $   (8,943)    $   (7,562)
Net loss per common share - as reported              $     (1.23)   $    (3.75)    $    (3.65)
Net loss per common share - pro forma                $     (1.27)   $    (3.72)    $    (3.67)
</TABLE>

Warrants

Preferred Stock Warrants

In connection with the capital lease agreement executed on October 13, 1995, the
Company issued warrants which entitle the holder to purchase 165,000 shares of
Series A Preferred with an exercise price of $1.00 per share. These warrants had
an estimated fair value of $91 at the date of issuance which was deferred and is
being amortized as an increase to interest expense over the term of the related
lease agreement using the effective interest rate method. The warrants shall be
exercisable prior to the earlier of the tenth anniversary of the grant date or
the fifth anniversary date of the Company's initial public offering.

In connection with an amendment on June 18, 1998 to increase the amount of
equipment under the capital lease agreement executed on October 13, 1995, the
Company issued warrants which entitle the holder to purchase 15,000 shares of
Series B Preferred with an exercise price of $1.20 per share. These warrants had
an estimated value of $7 at the date of issuance which was calculated using the
Black-Scholes method in accordance with SFAS 123. This amount was deferred and
is being amortized as an increase to interest expense over the term of the
related lease agreement using the effective interest rate method. The warrants
shall be exercisable prior to the earlier of the tenth anniversary of the grant
date or the fifth anniversary date of the Company's initial public offering.

In connection with additional amendments to increase the amount of equipment
under the Company's capital lease agreement which were executed on February 8,
1999 and April 15, 1999, the Company issued warrants which entitle the holder to
purchase 20,000 and 8,170 shares, respectively, of Series F Preferred with an
exercise price of $2.40 per share. These warrants had an estimated fair value of
$53 at their respective dates of issuance which was calculated using the
Black-Scholes method in accordance with SFAS 123. These amounts were deferred
and are being amortized as an increase to interest expense over the term of the
related lease agreement using the effective interest rate method. The warrants
shall be exercisable prior to the earlier of the tenth anniversary of the grant
date or the fifth anniversary date of the Company's initial public offering.

During 2000, 16,500 of the Series A Preferred stock warrants were exercised and
issued as 9,428 common stock shares based on the 1-for-1.75 IPO conversion
ratio. No preferred stock warrants had been exercised as of December 31, 1999.

                                      F-18
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                   NOTES TO FINANICAL STATEMENTS (Continued)
              (In thousands, except share and per share amounts)

Common Stock Warrants

In connection with a consulting agreement, the Company issued 11,428 warrants on
January 15, 1999 to purchase shares of the Company's common stock with an
exercise price of $4.20 per share. The warrants had an estimated value of $3 at
the date of issuance as calculated using the Black-Scholes model in accordance
with SFAS 123. The warrants shall be exercisable prior to the tenth anniversary
of the grant date.

In connection with the sale of the Series G Preferred and the collaboration
agreement entered into with Genentech on December 17, 1999, the Company issued
warrants which entitle the holder to purchase 253,968 shares of common stock
with an exercise price of $7.88 per share. The warrants had an estimated value
of $1,782 at the date of issuance as determined using the Black-Scholes model
which was deferred and recorded in other assets and will be amortized to
research and development expense over the period of the Company's research and
development commitment. The warrants shall be exercisable prior to the fifth
anniversary of the grant date.

In connection with the sale of stock to Genentech during 2000 (see Note 10), the
Company issued warrants on December 20, 2000 which entitle the holder to
purchase 25,396 shares of common stock with an exercise price of $7.88 per
share. The warrants had an estimated value of $577 at the date of issuance as
determined using the Black-Scholes model which was deferred and recorded as
other assets and will be amortized to research and development expense over the
period of the Company's research and development commitment. The warrants shall
be exercisable prior to the fifth anniversary of the grant date.

None of the common stock warrants have been exercised as of December 31, 2000
and 1999.

Subsequent to the IPO, all warrants to purchase preferred stock are now
exercisable for common stock. Outstanding warrants to purchase the Company's
common stock at December 31, 2000 are as follows:

                                      December 31, 2000
                               ------------------------------
                                  Number of         Exercise
                                  Warrants           Price
                               --------------    ------------

                                      94,285     $    1.75
                                       8,571     $    2.10
                                      16,097     $    4.20
                                      11,428     $    4.20
                                     279,364     $    7.88

10. Collaboration Agreements

On September 10, 1998, the Company entered into a Joint Development, License and
Supply Agreement (the "Kissei Agreement") with Kissei related to the development
of INS365 Respiratory for all therapeutic respiratory applications, excluding
sinusitis and middle ear infection, in Japan. INS365 Respiratory for respiratory
therapeutic uses is licensed by the Company from UNC. Under the terms of the
Kissei Agreement, Kissei will develop, commercialize, and market INS365
Respiratory in Japan. The Company maintains the right to manufacture and supply
INS365 to Kissei.

                                      F-19
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                   NOTES TO FINANICAL STATEMENTS (Continued)
              (In thousands, except share and per share amounts)

The Kissei Agreement provided that Kissei would pay the Company an up front
payment of $4,500, which included the purchase of $900 in equity in the form of
Series C Preferred Stock.

Upon the signing of the Kissei Agreement, Kissei purchased 375,000 shares of the
Company's Series C Preferred for $900 or $2.40 per share. In addition, the
Company received a non-refundable up front license fee of $3,600 million which
was initially deferred and is being recognized as license revenue ratably over
the period of the Company's ongoing research and development commitment. In
addition, depending on whether all milestones are met, the Company could receive
milestone payments of up to $13,000 over the term of the Kissei Agreement. The
Company is receiving reimbursement for liaison staff positions which totaled
$250 during each of the years ended December 31, 2000 and 1999. In addition, the
Company will receive royalties on net sales of INS365 Respiratory by Kissei.
During 1999, the Company received a milestone payment under the Kissei Agreement
of $600 based on achievement of technical milestones by Inspire. In January
2000, the Company received a milestone payment of $1,500 based on achievement of
a technical milestone by Kissei in its development of INS365 Respiratory.

During 1999, the Company contracted with a contract research organization
("CRO") to perform research and development on behalf of Kissei. The Company is
reimbursed by Kissei for the costs of this study. The total amount paid to the
CRO and reimbursement received from Kissei during 1999 totaled $813.

On December 16, 1998, the Company entered into a Development, License and Supply
Agreement (the "Santen Agreement") with Santen Pharmaceutical Company, Ltd.
("Santen") to complete the development of INS365 Ophthalmic for the therapeutic
treatment of ocular surface diseases. Santen received an exclusive license to
INS365 Ophthalmic in Japan, China, South Korea, the Philippines, Thailand,
Vietnam, Taiwan, Singapore, Malaysia and Indonesia ("the Territory") in the
field. Under the terms of the Santen Agreement, Santen will develop,
commercialize, and market INS365 Ophthalmic in the Territory. The Company
retains the right to manufacture and supply INS365 Ophthalmic in bulk drug
substance to Santen.

Upon the signing of the Santen Agreement, Santen purchased 416,667 shares of the
Company's Series D Preferred for $1,500 or $3.60 per share. In addition,
depending on whether all milestones under the Santen Agreement are met, the
Company could receive milestone payments of up to $4,750. In addition, the
Company will receive royalties on net sales on INS365 Ophthalmic by Santen.

During 2000, the Company received a milestone payment under the Santen Agreement
of $500 based on achievement of a regulatory milestone by Santen. No milestone
payments were received under the Santen Agreement during 1999 or 1998.

On December 17, 1999, the Company entered into a Development, License and Supply
Agreement (the "Genentech Agreement") with Genentech to jointly develop INS365
Respiratory and other related P2Y2 agonists existing on the date of the
Genentech Agreement for all human therapeutic uses for (a) the treatment of
respiratory tract disorders, including chronic bronchitis and cystic fibrosis,
throughout the world, excluding Japan and (b) the treatment of sinusitis and
middle ear infection worldwide. The Company will maintain the right to
manufacture and supply such compounds in bulk drug substance form to Genentech
during the research and development period and up to the end of Phase II
clinical trials for each indication. The agreement will be in effect until all
patents licensed under the agreement have expired, except that if the Company
exercises

                                      F-20
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                   NOTES TO FINANICAL STATEMENTS (Continued)
              (In thousands, except share and per share amounts)

its option to co-fund the development of INS37217 Respiratory for the treatment
of cystic fibrosis, then the agreement will remain in effect until the product
is no longer being marketed in the United States.

The Genentech Agreement provided that Genentech would pay the Company a
non-refundable, non-creditable up-front payment of $5,000 upon execution of the
Genentech Agreement, which the Company will record as license revenue over the
term of its research and development commitment, which is estimated to be
completed by December 31, 2001. In addition, the Company could receive milestone
payments of up to an additional $63,000, of which $2 million is in the form of
additional stock purchases by Genentech at the then current fair value. In
addition, the Company will receive royalties on net sales by Genentech of INS365
Respiratory and other indications represented in the collaborative research
agreement.

Upon the signing of the agreement, Genentech purchased 833,333 shares of Series
G Preferred for $12.00 a share or an aggregate purchase price of $10,000 and
Genentech was issued 253,968 warrants to purchase shares of the Company's common
stock with an exercise price of $7.88 per share. In addition, upon the
occurrence of certain milestone events, the Company is obligated to sell, and
Genentech is obligated to purchase: (i) up to $2,000 of the Company's common
stock, at a per share price determined, using the 20-day trailing average close
price of the Company's common stock as quoted on an established stock exchange,
and (ii) Genentech will be issued warrants for up to 50,792 shares of the
Company's common stock at an exercise price of $7.88 per share. In the event
these warrants are issued, the Company will be required to record a charge equal
to the fair value of the warrants.

On December 20, 2000, upon achievement of a technical milestone the Company sold
64,806 shares of common stock to Genentech at $15.40 per share and issued
warrants which entitle the holder to purchase 25,396 shares of common stock with
an exercise price of $7.88 (see Note 9).

On September 12, 2000, the Company entered into a License Agreement (the "Kirin
Agreement") with Kirin Brewery Company, Ltd., Pharmaceutical Division ("Kirin")
to complete the development and commercialization of INS316 Diagnostic to aid in
the diagnosis of lung cancer. Kirin received an exclusive license to INS316
Diagnostic in twenty-one Asian countries and regions ("the Territory") in the
field. Under the terms of the Kirin Agreement, Kirin will develop, manufacture,
commercialize, and market INS316 Diagnostic in the Territory.

Upon the signing of the Kirin Agreement, the Company received a non-refundable
up front license fee which was initially deferred and is being recognized as
license revenue ratably over the period of the Company's ongoing research and
development commitment. In addition, depending on whether all milestones under
the Kirin Agreement are met, the Company could receive milestone payments based
on clinical sucess. Upon commercialization, the Company will receive royalties
on net sales of INS316 Diagnostic by Kirin within the Territory.

                                      F-21
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                   NOTES TO FINANICAL STATEMENTS (Continued)
              (In thousands, except share and per share amounts)

11. License Agreement

On March 10, 1995, the Company licensed the rights to the patent for a Method of
Treating Lung Disease with Uridine Triphosphates which covers INS316 Diagnostic
from the University of North Carolina at Chapel Hill ("UNC"). In connection with
this license agreement, the Company paid $65 in license initiation fees and
issued 297,714 shares of common stock with an estimated value at the date of
issuance of $36 or $0.12 per share and has agreed to make milestone payments
totaling up to $1,000. The Company reached one such milestone in 1997 and made
the milestone payment of $500 in the same year. A $10 milestone payment was made
during each of 2000 and 1999.

On September 1, 1998, the Company licensed the rights to the patents for a
Method of Treating Cystic Fibrosis with Dinucleotides, a Method of Treating
Bronchitis with Uridine Triphosphates and related compounds, and a Method of
Treating Ciliary Dyskinesia with Uridine Triphosphates and related compounds,
which cover INS365 Respiratory, from UNC. In connection with this license
agreement, the Company paid $15 in license initiation fees and issued 28,572
shares of common stock with an estimated value at the date of issuance of $90 or
$3.15 per share and has agreed to pay milestone payments totaling $160. The
Company made milestone payments of $5 and $30 during 2000 and 1999,
respectively.

In connection with the license agreements with UNC, the Company has agreed to
pay royalties based on net sales of certain Licensed Products (as defined in the
license agreements).

The Company enters into sponsored research and development and clinical trial
agreements with the UNC on an annual basis whereby direct and indirect costs, as
defined, are reimbursed by the Company.

12. Commitments

The Company is obligated under a master capital lease for furniture, equipment,
and computers. Each lease term under the master lease agreement expires between
30 to 48 months from the date of inception.

The Company also has several non-cancelable operating leases, primarily for
office space and office equipment, that extend through May 2004 and are subject
to certain voluntary renewal options. Rental expense for operating leases during
2000 and 1999 for the cumulative period from inception (October 28, 1993) to
December 31, 2000 was $186 (net of sublease rentals $11), $164 (net of sublease
rentals $25), and $796 (net of sublease rentals of $108), respectively.

                                      F-22
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                   NOTES TO FINANICAL STATEMENTS (Continued)
              (In thousands, except share and per share amounts)

Future minimum lease payments under capital and non-cancelable operating leases
(net of related sublease rentals) with remaining lease payments as of December
31, 2000 are as follows:

<TABLE>
<CAPTION>
                                                              Capital        Operating
Year Ending December 31,                                       Leases          Leases
----------------------------------------------------------  ------------    -----------
<S>                                                         <C>             <C>
    2001                                                     $      358     $      231
    2002                                                            322            206
    2003                                                            193            113
    2004                                                             53              -
                                                            ------------    -----------
Total minimum lease payments                                        926     $      550
                                                                            ===========
Less amount representing interest                                   114
                                                            ------------
Present value of net minimum capital lease payments                 812
Less current portion of capital lease obligations                   289
                                                            ------------
Capital lease obligations, excluding current portion         $      523
                                                            ============
</TABLE>

The Company has contractual commitments or purchase arrangements with various
clinical research organizations, manufacturers of drug product and others. Most
of these arrangements are for a period of less than 12 months. The amount of the
Company's financial commitments under these arrangements totals approximately
$15,500 at December 31, 2000.

In June 2000, the Company entered into an equipment financing agreement under
which the Company can borrow up to $750 to finance the purchase of scientific
equipment. At December 31, 2000, $337 was outstanding under this agreement.

13. Employee Benefit Plan

The Company has adopted a 401(k) Profit Sharing Plan ("the Plan") covering all
qualified employees. The effective date of the Plan is August 1, 1995.
Participants may elect a salary reduction of 1% to 15% as a contribution to the
Plan. Modifications of salary reductions can be made quarterly.

The Plan permits employer matching of up to 8% of a participant's salary, but
the Company has elected not to match participants' contributions at this time.
If employer matching is implemented, participants will begin vesting 100%
immediately in employer contributions.

                                      F-23
<PAGE>

                         INSPIRE PHARMACEUTICALS, INC.
                         (A Development Stage Company)
                   NOTES TO FINANICAL STATEMENTS (Continued)
              (In thousands, except share and per share amounts)

14. Quarterly Financial Data (unaudited)

<TABLE>
<CAPTION>
                                      -----------  -----------  ----------- -----------  -----------
                2000                     First       Second        Third      Fourth        Total
------------------------------------- -----------  -----------  ----------- -----------  -----------
<S>                                    <C>          <C>          <C>         <C>          <C>
Revenue:
    Collaborative research
        agreements                     $   1,154    $   1,154    $   1,155   $   1,905    $   5,368

Net loss available to common
    stockholders                          (2,512)      (3,000)      (4,237)     (4,835)     (14,584)

Net loss per common
    share - basic and diluted          $   (1.01)    $  (1.15)    $  (0.25)  $   (0.19)   $   (1.23)

                1999
-------------------------------------
Revenue:
    Collaborative research
        agreements                     $     270    $     270    $     270   $     294    $   1,104

Net loss available of common
    stockholders                       $  (1,292)   $  (1,755)   $  (2,217)  $  (3,730)   $  (8,996)

Net loss per common
    share - basic and diluted          $   (0.58)   $   (0.72)   $   (0.90)  $   (1.51)   $   (3.75)
</TABLE>

Earnings per common share are computed independently for each of the quarters
presented and therefore may not sum to the total for the year.

                                      F-24