<PAGE>   1


                          SEQUUS PHARMACEUTICALS, INC.

                                   EXHIBIT 13











                     1997 ANNUAL REPORT TO SECURITY HOLDERS










                                       34
<PAGE>   2


                     MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS


    The statements in "Management's Discussion and Analysis of Financial
Condition and Results of Operations" that relate to future plans, events or
performance are forward-looking statements which involve risks and
uncertainties. Actual results, events or performance may differ materially from
those anticipated in these forward-looking statements as a result of a variety
of factors, including those set forth under "Item 1 -- Risk Factors" and
elsewhere in this Annual Report on Form 10-K. Readers are cautioned not to place
undue reliance on these forward-looking statements, which speak only as of the
date hereof. The Company undertakes no obligation to publicly release the result
of any revisions to these forward-looking statements that may be needed to
reflect events or circumstances after the date hereof or to reflect the
occurrence of unanticipated events.

OVERVIEW

    The Company is an integrated pharmaceutical company engaged in the
development of therapies for cancer and other diseases utilizing advanced drug
delivery technologies. The Company focuses on utilizing its proprietary STEALTH
liposomes to create new drug products with improved safety and efficacy
profiles. The Company has developed and is marketing DOXIL, an anticancer drug,
and AMPHOTEC, an antifungal drug, in the United States through its direct sales
organization and internationally through its marketing partners. The Company is
currently conducting Phase III clinical trials of DOXIL in patients with ovarian
cancer. A Phase II clinical trial of DOXIL is also underway in patients with
breast cancer as are numerous Phase I/II trials of DOXIL in the treatment of
patients with other solid tumors. In addition, SEQUUS is currently conducting
Phase I and II trials of its STEALTH cisplatin formulation, SPI-077, for the
treatment of cancer.

    SEQUUS developed DOXIL, a proprietary STEALTH liposome formulation
encapsulating a leading anticancer drug, doxorubicin. In November 1995, SEQUUS
received marketing clearance from the FDA for DOXIL for the treatment of KS in
people with AIDS whose KS has progressed on prior chemotherapy or in patients
who are intolerant to such therapy. In December 1995, the Company launched DOXIL
in the United States, using its own marketing and sales team, and achieved
domestic product sales of approximately $20.9 million in 1996 and $27.0 million
in 1997. In June 1996, the Company was granted marketing authorization for DOXIL
under the tradename CAELYX in the 15 member states of the EU for the treatment
of first-line and refractory KS in patients with low CD4 counts and extensive
mucocutaneous or visceral disease. The drug may be used as first-line systemic
chemotherapy, or as second-line chemotherapy, in KS patients with disease that
has progressed with, or in patients who are intolerant to, prior combination
chemotherapy comprising at least two of the following agents: a Vinca alkaloid,
bleomycin, and doxorubicin (or other anthracycline).

    The Company has entered into a distribution agreement with Schering-Plough
under which Schering-Plough has rights to market and sell CAELYX worldwide,
except for the United States, Japan and certain other countries. Schering-Plough
will conduct pricing discussions with the appropriate agencies in those European
countries where pricing approval is required. In addition, the Company and
Schering-Plough are jointly planning the clinical development of DOXIL for the
treatment of solid tumors in the United States and certain international
markets. Schering-Plough will be responsible for conducting certain of these
clinical trials. The Company received fees of $7.3 million (including a one-time
distribution rights payment of $5.3 million) in 1996 and $4.3 million in 1997
from Schering-Plough.

    The Company used another lipid-based delivery technology to develop
AMPHOTEC, a proprietary formulation of a leading antifungal drug, amphotericin
B. In November 1996, SEQUUS received marketing clearance from the FDA for
AMPHOTEC for the treatment of invasive aspergillosis, a life-threatening fungal
infection, in patients where renal impairment or unacceptable toxicity precludes
the use of conventional amphotericin B therapy in effective doses and in
patients where prior amphotericin B therapy has failed. In December 1996, the
Company launched AMPHOTEC in the United States, using its own marketing and
sales organization. AMPHOTEC has also received marketing clearance in a number
of other countries for the treatment of systemic fungal infections in patients
for whom conventional amphotericin



                                       35
<PAGE>   3

B is contraindicated due to toxicity or renal failure or for whom previous
antifungal therapy was unsuccessful. The Company's strategy is to commercialize
AMPHOTEC in international markets, under the tradename AMPHOCIL, through
distribution partners. The Company has entered into a number of distribution
agreements, including agreements with Zeneca and Bayer, in selected countries. A
liposome-based amphotericin B product which targets indications similar to those
targeted by AMPHOCIL has been first to market and captured a significant portion
of market share in many foreign markets. Another competitor introduced its
lipid-based amphotericin B product as the third entrant in the U.K. market at a
price substantially below the price of the other lipid-based antifungals and
launched the product as the first lipid-based antifungal agent in the United
States. Competition from these two competitors could have an adverse effect on
the market penetration and pricing of AMPHOTEC in both Europe and in the United
States.

    The Company recognizes product sales upon shipment of product to its
marketing partners internationally and to its customers in the United States.
The Company's quarterly operating results depend upon a variety of factors,
including the price, volume and timing of sales of the Company's approved
products; variations in payments under collaborative agreements, including
royalties, fees and other contract revenues; the availability of third-party
reimbursement; and the regulatory approvals of new products, or expanded
labeling of existing products. The Company's quarterly operating results may
also fluctuate significantly depending on other factors, including the timing of
the expansion of clinical trials for DOXIL and AMPHOTEC and the level of
clinical trials for SP1-077; changes in the Company's level of research and
development; changes in manufacturing capabilities; and variations in gross
margins of the Company's products which may be caused by cost increases from
third-party manufacturers, availability and cost of raw materials, competitive
pricing pressures and the mix between product sales in the United States and
sales to the Company's international marketing partners. In addition, sales of a
product in any given period, including the quarter in which a new product is
initially introduced to the market, may include a significant amount of orders
for inventory by distributors and wholesalers and may not necessarily be
indicative of actual demand for that product by physicians and patients. There
can be no assurance that distributors or wholesalers will be able to forecast
demand for product accurately. Fluctuations in operating results will occur to
the extent that demand by physicians and patients does not meet distributors' or
wholesalers' expectations. The Company expects quarter to quarter fluctuations
to continue in the future. In addition, the Company expects operating expenses
to increase in 1998, and there can be no assurance that the Company's revenues
will not decline or that the Company will ever achieve profitability.

    The Company has incurred losses in each year since its inception and has
accumulated approximately $174.2 million in net losses through December 31,
1997, including a net loss of approximately $23.6 million in the fiscal year
ended December 31, 1997. Although the Company and its marketing partners have
commenced marketing DOXIL in the United States and certain international markets
and AMPHOTEC in the United States and many other countries abroad, there can be
no assurance that revenues from product sales or other sources will be
sufficient to fund operations or that the Company will achieve profitability or
positive cash flow.

    The Company expects its research and development expenses to increase as a
result of expanded clinical trials of DOXIL in a variety of solid tumors and
clinical trials of SPI-077. The Company expects its marketing and sales expenses
to increase as it proceeds with the commercialization of DOXIL and AMPHOTEC
through its United States direct sales and marketing organization. As of
December 31, 1997, SEQUUS had a United States sales team of 39 individuals
experienced in the sale of pharmaceutical and biopharmaceutical products, with
particular emphasis on oncology and infectious disease.

    The Company's business is subject to significant risks, including, but not
limited to, the risks inherent in seeking market acceptance of current and
future products; managing a marketing and sales organization; depending on
third-party distributors, manufacturers and sole-source suppliers; obtaining and
enforcing patents; uncertainties relating to product development, clinical
trials and the regulatory approval process; uncertainties relating to the patent
rights of others; and uncertainties relating to pharmaceutical pricing and
reimbursement. See "Item 1 -- Risk Factors"




                                       36
<PAGE>   4


RESULTS OF OPERATIONS

Years Ended December 31, 1997 and 1996

    Revenues

    Total revenues were $40.0 million, of which $35.0 million were product
sales, during the year ended December 31, 1997 compared with total revenues of
$32.9 million during the year ended December 31, 1996. DOXIL product sales
represented 84% of total product sales in 1997 compared to 89% in 1996. For
1997, 16% of the Company's product sales represented sales of AMPHOTEC as
compared to 3% in 1996. In 1997, the Company received approximately $5.0 million
in royalyies and fees as compared $7.5 million in 1996, which included a
one-time distribution rights payment of $5.3 million from Schering-Plough in the
third quarter of 1996.

    Operating Expenses

    The Company's gross margin decreased to 80% of product sales in 1997 from
84% of product sales in 1996. This decrease in the gross margin is due to the
increase in sales through distribution partners and the mix of product sold
versus 1996. The Company generally recognizes higher margins on direct product
sales in the United States than it does on sales to the Company's international
distribution partners and agents. Direct product sales were 87% of product sales
in 1997 and were 89% of product sales in 1996. The Company anticipates that its
gross margin will continue to fluctuate depending on the mix between direct
product sales in the United States and sales to the Company's international
distribution partners and agents.

    Generally, a majority of the Company's operating expenses are incurred for
research and development ("R&D"), including preclinical testing and clinical
trials required for new pharmaceutical products. The principal items of R&D
expense are personnel costs, costs of clinical trials, clinical production and
supplies. R&D expense increased to $32.5 million in 1997, from $27.7 million in
1996. This increase in expenses resulted from higher spending in 1997 associated
with clinical trials for DOXIL, expenses associated with the regulatory approval
of AMPHOTEC and an increase in spending on R&D projects. The Company anticipates
that future clinical trial expenses will increase due to expanded clinical
trials of DOXIL in a variety of solid tumors and on clinical trials of SPI-077.

    Selling, general and administrative expenses increased to $25.2 million in
1997 from $20.3 million in 1996. The increase in selling, general and
administrative expenses was primarily due to the expanded marketing of DOXIL and
the first full year of marketing AMPHOTEC after the products' launch in December
1996.

    Interest Income & Expense

    Interest income decreased to $1.5 million in 1997 from $1.8 million in 1996,
due to the decrease in cash available for investment. Interest expense increased
to $0.2 million in 1997 relating to a $5.0 million loan obtained in June 1997.

    Net Loss

    The Company's net loss increased to $23.6 million in 1997 from $17.2 million
in 1996. The net loss per share (both basic and diluted) was $0.78 for 1997
compared to $0.59 per share for 1996. The increase in the loss was due primarily
to an increase in product marketing and sales costs for DOXIL and the first full
year of marketing AMPHOTEC after the product's launch in December 1996, an
increase in clinical and preclinical costs for additional trials, and the
absence of a similar 1996 one-time upfront payment under the Schering-Plough
distribution agreement.




                                       37
<PAGE>   5


Years Ended December 31, 1996 and 1995

    Revenues

    Total revenues, of which the majority were product sales, were $32.9
million, during the year ended December 31, 1996 compared with $2.0 million
recorded during the year ended December 31, 1995. DOXIL product sales
represented 89% of total product sales in 1996 compared to 49% in 1995. For
1996, 3% of the Company's product sales represented sales of AMPHOCIL to Zeneca
as compared to 41% for 1995. In 1996, the Company received approximately $7.5
million in upfront fees and payments, which included $7.3 million from
Schering-Plough.

    Operating Expenses

    R&D expenses increased to $27.7 million in 1996 from $22.7 million in 1995.
This increase in expenses resulted from higher spending in 1996 associated with
clinical trials for DOXIL, expenses associated with the regulatory approval of
AMPHOTEC and an increase in spending on R&D projects.

    Selling, general and administrative expenses increased to $20.3 million in
1996 from $13.9 million in 1995, principally reflecting an increase in marketing
and sale expenses in preparation of the December 1996 AMPHOTEC launch and the
first full year of marketing DOXIL. The Company hired 17 additional sales
individuals to support the launch of AMPHOTEC.

    Interest Income & Expense

    Interest income increased to $1.8 million in 1996 from $1.4 million in 1995,
due to the increase in cash available for investment resulting from
approximately $45.6 million received by the Company from a public offering of
Common Stock in the fourth quarter of 1995. Interest expense in both 1996 and
1995 was insignificant.

    Net Loss

    The Company's net loss decreased to $17.2 million in 1996 from $33.6 million
in 1995. The net loss per share (both basic and diluted) was $0.59 for 1996
compared to $1.54 in 1995. The decrease in the loss was due primarily to an
increase in product sales and receipt of a one-time upfront distribution rights
payment under the Schering-Plough distribution agreement, partially offset by an
increase in marketing and sales costs in anticipation of the December 1996
AMPHOTEC launch, the first full year of marketing of DOXIL and an increase in
clinical and preclinical costs for additional trials.

LIQUIDITY AND CAPITAL RESOURCES

    The Company's cash, cash equivalents and short-term investments at December
31, 1997 were $25.3 million, a decrease of $7.6 million from $32.9 million at
December 31, 1996. This decrease represents $14.4 million of net cash used by
operating activities and capital expenditures of $3.0 million partially offset
by $14.1 million of cash provided by financing activities and other investing
activities. In June 1997, the Company received loan proceeds of $5.0 million
from a working capital loan of $10.0 million from a bank. Payment terms for the
$5.0 million are interest only for 12 months and principal and interest over the
following 44 months. The remaining $5.0 million under the working capital loan
represents a revolving line of credit that expires June 1998. During 1997, the
Company received approximately $4.7 million from the issuance of common stock,
the exercise of warrants, and the exercise of employee stock options.




                                       38
<PAGE>   6


    The Company believes its existing cash balances, interest income and
revenues from operations will be adequate to fund its planned activities at
least through 1998. The Company may decide to raise additional financing sooner.
There can be no assurance that adequate financing will be available on
satisfactory terms, if at all.

    The Company's strategy is to fund from its own cash resources the
preclinical development of its proprietary products, DOXIL, AMPHOTEC and
SPI-077, and the continued research and development of additional STEALTH
liposome products. This strategy will require significant operating and capital
expenditures including the construction of a pilot production facility which is
currently in the planning phase.

        As of December 31, 1997, the Company had Federal and California net
operating loss carryforwards of approximately $119.5 million and $7.3 million,
respectively. The Company also has Federal and California research and
development tax credit carryforwards of approximately $6.1 million and $4.3
million, respectively. Utilization of the net operating losses and credits may
be subject to a substantial annual limitation due to the ownership change
limitations provided by the Internal Revenue Code of 1986 and similar California
provisions. The annual limitation may result in the expiration of net operating
losses and credits before utilization.

IMPACT OF YEAR 2000

Some of the Company's older computer programs were written using two digits
rather than four to define the applicable year. As a result, those computer
programs have time-sensitive software that recognize a date using "00" as the
year 1900 rather than the year 2000. This could cause a system failure or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices, or engage
in similar normal business activities. The Company has determined it has no
exposure to contingencies related to the Year 2000 issue for the products it
sells.

In 1997, the Company initiated a project to modify or replace portions of its
systems so that its computer systems will function properly with respect to
dates in the year 2000 and thereafter. The Company expects this project to be
substantially complete by the third quarter of 1999 and does not expect to incur
material costs on this project. The Company will begin to initiate formal
communications with all of its significant suppliers and large customers to
determine the extent to which the Company may be vulnerable to those third
parties failure to remediate their own Year 2000 issues.

Despite these efforts, there can be no assurance that the Company will not
encounter unforeseen problems in its own computer systems, or that the systems
of other companies on which the Company's operations rely will be upgraded or
replaced in a timely manner. Such unforeseen problems in the Company's systems,
or failures to address this issue by other companies could have an adverse
effect on the Company's operations.




                                       39
<PAGE>   7


                             SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                        YEAR ENDED DECEMBER 31,
                                                       --------------------------------------------------------
                                                         1997        1996        1995        1994        1993
                                                         ----        ----        ----        ----        ----
STATEMENT OF OPERATIONS DATA:                                    (in thousands, except per share data)
<S>                                                    <C>         <C>         <C>         <C>         <C>
Revenues:
    Product sales ..................................   $ 34,998    $ 25,462    $  1,907    $  3,664    $  1,299
    Royalties and fees(1) ..........................      4,954       7,461         109          91       5,458
                                                       --------    --------    --------    --------    --------
Total revenues .....................................     39,952      32,923       2,016       3,755       6,757

Operating expenses:
    Cost of goods sold .............................      7,119       3,990         511         916         232
    Research and development .......................     32,474      27,652      22,651      25,378      21,128
    Selling, general and administrative ............     25,181      20,302      13,856       7,622       6,653
                                                       --------    --------    --------    --------    --------
Total operating expenses ...........................     64,774      51,944      37,018      33,916      28,013
                                                       --------    --------    --------    --------    --------
Loss from operations ...............................    (24,822)    (19,021)    (35,002)    (30,161)    (21,256)
Interest income ....................................      1,477       1,844       1,406         976       1,602
Interest expense ...................................       (236)         --          --          --          --
                                                       --------    --------    --------    --------    --------
Net loss ...........................................   $(23,581)   $(17,177)   $(33,596)   $(29,185)   $(19,654)
                                                       ========    ========    ========    ========    ========
Net loss per share (basic and diluted)(2) ..........   $  (0.78)   $  (0.59)   $  (1.54)   $  (1.54)   $  (1.05)
                                                       ========    ========    ========    ========    ========
Shares used in the calculation of net loss per share
(basic and diluted)(2) .............................     30,369      28,937      21,831      18,978      18,789
                                                       ========    ========    ========    ========    ========
</TABLE>

<TABLE>
<CAPTION>
                                                                             DECEMBER 31,
                                                                             ------------
                                                         1997        1996        1995        1994       1993
                                                       ---------   ---------   ---------   --------   --------
BALANCE SHEET DATA:                                                          (in thousands)
<S>                                                    <C>         <C>         <C>         <C>        <C>     
Cash, cash equivalents and short-term
   investments......................................   $  25,295   $  32,946   $  50,276   $ 11,757   $ 34,658
Long-term investments...............................          --          --          --        500      2,520
Total assets........................................      42,228      54,968      57,808     18,198     45,179
Long-term debt......................................       4,630       --          --         --         --
Accumulated deficit.................................    (174,176)   (150,624)   (133,427)   (99,865)   (70,668)
Total stockholders' equity..........................      25,766      44,327      49,599     10,938     39,318
</TABLE>

----------
(1) Includes a signing fee and regulatory milestone fee totaling $5.3 million
    from Zeneca Limited in 1993 , a distribution rights fee of $5.3 million from
    Schering-Plough in 1996 and performance payments of $4.3 million from
    Schering-Plough in 1997.

(2) Per share and share amounts for all periods reflect the adoption of
    Statement of Financial Accounting Standards No. 128, "Earnings Per Share".







                                       40
<PAGE>   8


                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
SEQUUS Pharmaceuticals, Inc.

    We have audited the accompanying balance sheets of SEQUUS Pharmaceuticals,
Inc. as of December 31, 1997 and 1996, and the related statements of operations,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1997. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

    In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of SEQUUS Pharmaceuticals, Inc.
at December 31, 1997 and 1996, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 1997, in
conformity with generally accepted accounting principles.


                                           /S/ ERNST & YOUNG LLP

Palo Alto, California
January 28, 1998









                                       41
<PAGE>   9

                          SEQUUS PHARMACEUTICALS, INC.

                                 BALANCE SHEETS
                 (in thousands, except share and per share data)

<TABLE>
<CAPTION>
                                                                          DECEMBER 31
                                                                          -----------
                                                                       1997         1996
                                                                       ----         ----
<S>                                                                  <C>          <C>
                                     ASSETS
Current assets:
    Cash and cash equivalents ....................................   $   6,688    $   9,997
    Short-term investments .......................................      18,607       22,949
    Trade accounts receivable, net of allowance for bad debts of
      $1,501 in 1997 and $504 in 1996 ............................       4,841        8,972
    Inventories ..................................................       4,117        5,697
    Prepaid expenses and other current assets ....................       1,145        1,601
                                                                     ---------    ---------
Total current assets .............................................      35,398       49,216
Equipment and improvements, net ..................................       6,569        5,564
Other assets .....................................................         261          188
                                                                     ---------    ---------
Total assets .....................................................   $  42,228    $  54,968
                                                                     =========    =========

                      LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
    Accounts payable .............................................   $   3,848    $   4,539
    Accrued liabilities ..........................................       6,883        6,102
    Deferred revenue .............................................         731           --
    Current portion of long-term debt ............................         370           --
                                                                     ---------    ---------
Total current liabilities ........................................      11,832       10,641

Long-term debt ...................................................       4,630           --

Commitments

Stockholders' equity:
    Preferred stock, par value $0.01; 450,000 shares authorized,
      issuable in series; no shares issued and outstanding
      in 1997 and 1996 ...........................................          --           --
    Common stock, par value $0.0001; 45,000,000 shares authorized,
      shares issued and outstanding were 30,601,355 in 1997
      and 29,660,319 shares in 1996 ..............................           3            3
  Additional paid-in capital .....................................     199,939      194,948
  Accumulated deficit ............................................    (174,176)    (150,624)
                                                                     ---------    ---------
Total stockholders' equity .......................................      25,766       44,327
                                                                     ---------    ---------
Total liabilities and stockholders' equity .......................   $  42,228    $  54,968
                                                                     =========    =========
</TABLE>







                             See accompanying notes.



                                       42
<PAGE>   10
                          SEQUUS PHARMACEUTICALS, INC.

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

<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                              -----------------------
                                                           1997         1996         1995
                                                           ----         ----         ----
<S>                                                      <C>          <C>          <C>     
Revenues:
    Product sales ...................................    $ 34,998     $ 25,462     $  1,907
    Royalties and fees ..............................       4,954        7,461          109
                                                         --------     --------     --------
Total revenues ......................................      39,952       32,923        2,016

Expenses:
    Cost of goods sold ..............................       7,119        3,990          511
    Research and development ........................      32,474       27,652       22,651
    Selling, general and administrative .............      25,181       20,302       13,856
                                                         --------     --------     --------
Total expenses ......................................      64,774       51,944       37,018
                                                         --------     --------     --------
Loss from operations ................................     (24,822)     (19,021)     (35,002)

Interest income .....................................       1,477        1,844        1,406
Interest expense ....................................        (236)          --           --
                                                         --------     --------     --------
Net loss ............................................    $(23,581)    $(17,177)    $(33,596)
                                                         ========     ========     ========
Net loss per share (basic and diluted) ..............    $  (0.78)    $  (0.59)    $  (1.54)
                                                         ========     ========     ========
Common shares used in the calculation of net loss per
    share (basic diluted) ...........................      30,369       28,937       21,831
                                                         ========     ========     ========
</TABLE>















                             See accompanying notes.



                                       43
<PAGE>   11


                          SEQUUS PHARMACEUTICALS, INC.

                        STATEMENT OF STOCKHOLDERS' EQUITY
                                 (in thousands)


<TABLE>
<CAPTION>
                                                 SERIES A
                                              PREFERRED STOCK         COMMON STOCK      ADDITIONAL                     TOTAL
                                             -----------------      -----------------    PAID-IN     ACCUMULATED    STOCKHOLDERS'
                                             SHARES     AMOUNT      SHARES     AMOUNT    CAPITAL       DEFICIT        EQUITY
                                             ------     ------      ------     ------    -------       -------        ------
<S>                                            <C>       <C>        <C>          <C>    <C>           <C>            <C>      
Balance at December 31, 1994 .......            --       $--        19,096      $ 2     $ 110,801     $ (99,865)     $  10,938
Shares issued for contribution to
  401(k) Plan ......................            --        --            24       --           157            --            157
Shares issued under the Employee
  Stock Purchase Plan ..............            --        --            49       --           281            --            281
Exercise of warrants ...............            --        --            22       --            91            --             91
Exercise of stock options ..........            --        --           239       --           813            --            813
Sale of Preferred Stock in
  secondary offering, net of
  issuance costs of $986 ...........           480         4            --       --        11,010            --         11,014
Sale of Units in secondary
 offering, net of issuance costs
 of $771 ...........................            --        --         2,224       --        14,275            --         14,275
Sale of Common Stock in secondary
  offering, net of issuance costs
  of $828 ..........................            --        --         4,485        1        45,591            --         45,592
Conversion of Preferred Stock ......           (43)       --           144       --            --            --             --
Change in unrealized gains, net on
  available-for-sale securities ....            --        --            --       --            --            34             34
Net loss ...........................            --        --            --       --            --       (33,596)       (33,596)
                                              ----       ---        ------      ---     ---------     ---------      ---------
Balance at December 31, 1995 .......           437         4        26,283        3       183,019      (133,427)        49,599
Shares issued for contribution to
  401(k) Plan ......................            --        --            12       --           174            --            174
Shares issued under the Employee
  Stock Purchase Plan ..............            --        --            83       --           628            --            628
Exercise of warrants ...............            --        --         1,179       --         6,514            --          6,514
Exercise of stock options ..........            --        --           601       --         4,149            --          4,149
Common Stock issued in exchange for
  research and development license .            --        --            30       --           460            --            460
Conversion of Preferred Stock ......          (437)       (4)        1,472       --             4            --             --
Change in unrealized gains, net on
  available-for-sale securities ....            --        --            --       --            --           (20)           (20)
Net loss ...........................            --        --            --       --            --       (17,177)       (17,177)
                                              ----       ---        ------      ---     ---------     ---------      ---------
Balance at December 31, 1996 .......            --        --        29,660        3     $ 194,948      (150,624)        44,327
Shares issued for contribution to
  401(k) Plan ......................            --        --            18       --           287            --            287
Shares issued under the Employee
  Stock Purchase Plan ..............            --        --           133       --           867            --            867
Exercise of warrants ...............            --        --           507       --         2,073            --          2,073
Exercise of stock options ..........            --        --           283       --         1,764            --          1,764
Change in unrealized gains, net on
  available-for-sale securities ....            --        --            --       --            --            29             29

Net loss ...........................            --        --            --       --            --       (23,581)       (23,581)
                                              ----       ---        ------      ---     ---------     ---------      ---------
Balance at December 31, 1997 .......            --       $--        30,601      $ 3     $ 199,939     $(174,176)     $  25,766
                                              ====       ===        ======      ===     =========     =========      =========
</TABLE>


                             See accompanying notes.



                                       44
<PAGE>   12



                          SEQUUS PHARMACEUTICALS, INC.

                            STATEMENTS OF CASH FLOWS
                Increase (decrease) in cash and cash equivalents
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                       YEAR ENDED DECEMBER 31,
                                                                       -----------------------
                                                                1997           1996           1995
                                                                ----           ----           ----
<S>                                                           <C>            <C>            <C>
Cash flows from operating activities:
    Net loss ............................................     $ (23,581)     $ (17,177)     $ (33,596)
    Adjustments to reconcile net loss to net cash used in
      operating activities:
    Depreciation and amortization .......................         1,982          1,767          1,957
    Issuance of common stock to 401(k) plan .............           287            174            157
    Issuance of common stock in exchange for research and
      development technology license ....................            --            460             --
    Changes in operating assets and liabilities:
        Trade accounts receivable .......................         4,131         (7,330)        (1,578)
        Inventories .....................................         1,580         (4,592)          (547)
        Prepaid expenses and other current assets .......           456           (652)           194
        Other assets ....................................           (73)           (44)            (7)
        Accounts payable ................................          (691)         1,766          1,187
        Accrued liabilities .............................           781          1,382           (954)
        Deferred revenue ................................           731           (716)           716
                                                              ---------      ---------      ---------
    Net cash used in operating activities ...............       (14,397)       (24,962)       (32,471)
Cash flows from investing activities:
    Available-for-sale securities:
        Purchases .......................................       (64,589)       (90,207)      (106,013)
        Sales ...........................................        26,557         45,127         30,843
        Maturities ......................................        42,403         65,617         38,507
    Capital expenditures, net ...........................        (2,987)        (3,639)        (1,610)
                                                              ---------      ---------      ---------
    Net cash provided by (used in) investing activities .         1,384         16,898        (38,273)
Cash flows from financing activities:
    Issuance of common stock ............................         4,704         11,291         61,052
    Issuance of preferred stock .........................            --             --         11,014
    Proceeds from long-term debt ........................         5,000             --             --
                                                              ---------      ---------      ---------
    Net cash provided by financing activities ...........         9,704         11,291         72,066
                                                              ---------      ---------      ---------
Net increase (decrease) in cash and cash equivalents ....        (3,309)         3,227          1,322
Cash and cash equivalents, beginning of the year ........         9,997          6,770          5,448
                                                              ---------      ---------      ---------
Cash and cash equivalents, end of the year ..............     $   6,688      $   9,997      $   6,770
                                                              =========      =========      =========

 Supplemental disclosure of cash flow information:
    Cash paid during the year for interest ..............     $     236      $      --      $      --
                                                              =========      =========      =========
</TABLE>










                             See accompanying notes.


                                       45
<PAGE>   13



                          SEQUUS PHARMACEUTICALS, INC.

                          NOTES TO FINANCIAL STATEMENTS

                                DECEMBER 31, 1997

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

  Business

    SEQUUS Pharmaceuticals, Inc. ("SEQUUS", the "Company") is engaged in the
development, manufacture, marketing and sale of proprietary liposome and
lipid-based products primarily to treat cancer and certain fungal infections.
SEQUUS' strategic emphasis is on injectable pharmaceutical products designed to
improve the efficacy and reduce the toxicity of selected existing and new drugs
used to treat cancer and infectious diseases. SEQUUS distributes DOXIL and
AMPHOTEC in the United States through distributors and the same products under
the tradenames of CAELYX and AMPHOCIL, respectively, in various countries
outside the United States through corporate alliances, distribution agreements
and various agents. The Company's key raw materials are acquired from a limited
number of vendors and a single third party manufactures all of the Company's
finished goods.

  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 amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.

  Cash, Cash Equivalents and Short-Term Investments

    The Company considers all highly liquid investments with maturities of three
months or less from the date of purchase to be cash equivalents. Short-term
investments consist of investments with original maturities greater than three
months, but less than one year.

    The Company invests its excess cash principally in U.S. Treasury Bills and
high-grade investment paper. The Company maintains its cash, cash equivalents
and short-term investments in several different instruments with various banks
and brokerage houses. The diversification of risk is consistent with Company
policy to maintain liquidity and ensure the safety of principal.

    The Company accounts for its marketable investments under Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments in
Debt and Equity Securities." Management determines the appropriate
classification of debt securities at the time of purchase and reevaluates such
designation as of each balance sheet date. During 1997 and 1996, all investments
were classified as available-for-sale securities and are carried at fair value,
which is determined based on the quoted market prices of the securities, with
the unrealized gains and losses reported as a component of accumulated deficit.
The amortized cost of debt securities in this category is adjusted for
amortization of premiums and accretion of discounts to maturity. Such
amortization is included in interest income. Realized gains and losses and
declines in value judged to be other-than-temporary on available-for-sale
securities are included in interest. The cost of securities sold is based on the
specific identification method. Interest and dividends on securities are
included in interest income.



                                       46
<PAGE>   14



                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)


    The following is a summary of available-for-sale securities (in thousands):

<TABLE>
<CAPTION>
                                                           GROSS
                                                         UNREALIZED
                                                         ----------
                                                                              ESTIMATED
                                      AMORTIZED                                 FAIR
      DECEMBER 31, 1997                 COST        GAINS         LOSSES        VALUE
      -----------------                 ----        -----         ------        -----
<S>                                   <C>          <C>           <C>           <C>     
U.S. government securities ......     $  6,581     $      6      $     --      $  6,587
U.S. corporate securities .......        8,052           21            --         8,073
Foreign corporate debt securities        3,943            4            --         3,947
                                      --------     --------      --------      --------
                                      $ 18,576     $     31      $     --      $ 18,607
                                      ========     ========      ========      ========
      DECEMBER 31, 1996
      -----------------
U.S. government securities ......     $  7,434     $      1      $     (1)     $  7,434
U.S. corporate securities .......        7,399            1            --         7,400
Foreign corporate debt securities        8,114            1            --         8,115
                                      --------     --------      --------      --------
                                      $ 22,947     $      3      $     (1)     $ 22,949
                                      ========     ========      ========      ========
</TABLE>

    All of these securities mature within one year. The gross realized gains and
losses on sales of available-for-sale securities during the years ended December
31, 1997, 1996 and 1995 were not significant.

  Inventories

    Inventories are stated at the lower of cost (principally first-in,
first-out) or market. The inventory detail is as follows (in thousands):

<TABLE>
<CAPTION>
                                                            DECEMBER 31,
                                                            ------------
                                                          1997        1996
                                                         ------      ------
          <S>                                            <C>         <C>   
          Raw materials................................. $2,707      $2,801
          Work-in-process...............................     --       2,223
          Finished goods................................  1,410         673
                                                         ------      ------
                                                         $4,117      $5,697
                                                         ======      ======
</TABLE>


  Equipment and Improvements

    Equipment is recorded at cost and depreciated on a straight-line basis over
estimated useful lives of three to seven years. Leasehold improvements are
recorded at cost and amortized over the remaining term of the lease, or useful
life of the asset, whichever is less. The equipment and improvements detail is
as follows (in thousands):

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                                ------------
                                                              1997      1996
                                                            --------   -------
          <S>                                               <C>        <C>    
          Office and laboratory equipment.................  $ 12,904   $10,397
          Leasehold improvements..........................     5,584     5,104
                                                            --------   -------
                                                              18,488    15,501
          Accumulated depreciation and amortization.......   (11,919)   (9,937)
                                                            --------   -------
                                                            $  6,569   $ 5,564
                                                            ========   =======
</TABLE>






                                       47
<PAGE>   15



                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

Accrued Liabilities

        Accrued liabilities consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                               ------------
                                                              1997      1996
                                                              ----      ----
          <S>                                                <C>       <C>    
          Accrued compensation............................   $ 2,282   $ 3,149
          Accrued clinical costs..........................     1,708     1,014
          Other accrued liabilities.......................     2,893     1,939
                                                             -------   -------
                                                             $ 6,883   $ 6,102
                                                             =======   =======
</TABLE>


Revenue Recognition and Concentration of Credit Risk

    The Company recognizes product sales upon shipment to customers. The Company
defers amounts based on historical sales return experience.

    Royalties are recognized as revenue based on licensed product sales as
reported by the Company's partners. Fees and milestone payments are recognized
as earned as specified in terms set forth in the related agreements.

    The Company sells its products to distributors in the United States and
Europe. The Company performs ongoing credit evaluations of its customers and
generally does not require collateral. For the year ended December 31, 1997, two
customers each represented 19% of product sales and a third customer represented
18% of product sales. No single customer accounted for 10% or more of product
sales in 1996. For the year ended December 31, 1995, one customer represented
41% of product sales.

  Clinical Costs

    Clinical costs include costs associated with preclinical testing of
compounds for safety and efficacy, clinical trials and company-funded research
performed by third parties. Clinical trials costs are recognized as research and
development expense as the contractually-specified patient services are
performed.

  Advertising Expenses

    The Company accounts for advertising costs as an expense in the period in
which they are incurred. Advertising expenses were $2,095,000, $606,000 and
$109,000 for the years ended December 31, 1997, 1996 and 1995, respectively.

  Stock Based Compensation

    In accordance with the provisions of Statement of Financial Accounting
Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), which
the Company adopted in 1996, the Company has elected to follow Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issue to Employees" ("APB
25") and related interpretations in accounting for its employee stock option
plans. Under APB 25, if the exercise price of the Company's employee stock
options equals or exceeds the fair value of the underlying stock on the date of
grant as determined by the Company's Board of Directors, no compensation expense
is recognized. See Note 5 for pro forma disclosures required by SFAS 123.





                                       48
<PAGE>   16


                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

Per Share Data

    In 1997, the Financial Accounting Standards Board ("FASB") issued Statement
No. 128, "Earnings Per Share", according to which the calculations of primary
and fully diluted earnings per share were replaced with calculations of basic
and diluted earnings per share. Unlike primary earnings per share, basic
earnings per share excludes any dilutive effects of options, warrants and
convertible securities. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. Per share amounts for all
periods have been presented to conform to Statement 128 requirements.

The following table sets forth the computation of basic and diluted per share
data for the years ended December 31 as follows (in thousands except per share
data):

<TABLE>
<CAPTION>
                                                                          1997        1996        1995
                                                                        --------    --------    --------
<S>                                                                     <C>         <C>         <C>
Numerator used for basic and diluted loss per share- net loss           $(23,581)   $(17,177)   $(33,596)

Denominator for basic and diluted loss per share- weighted
    average shares                                                        30,369      28,937      21,831

Net loss per share (basic and diluted)                                  $  (0.78)   $  (0.59)   $  (1.54)
                                                                        ========    ========    ======== 
</TABLE>

During 1997, 1996, and 1995, options, warrants and preferred stock to purchase
3,156,472 shares, 2,219,376 shares, and 4,812,209 shares, respectively, of
common stock were outstanding but were not included in the computation of
diluted earnings per share as their effect would be antidilutive.

New Accounting Standards

In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income"
("SFAS 130"). SFAS 130 established new rules for the reporting and display of
comprehensive income and its components. Adoption is required in 1998 and will
not have an impact on the Company's net income or stockholders' equity. SFAS 130
requires unrealized gains and losses on the companies available-for-sale
securities, which currently are reported in stockholders' equity, to be included
in other comprehensive income and the disclosure of total comprehensive income.

In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS 131"). SFAS 131 establishes standarts
for the way that public business enterprises report informaton about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to shareholders. It also establishes standards for related
disclosures about products and services, geographic area, and major customers.
The adoption of SFAS 131 is required in 1998 and will have no impact on the
Company's consolidated results of operations, financial position or cash flows.

2. COLLABORATIVE AGREEMENTS

In August 1996, the Company entered into a distribution agreement with
Schering-Plough and, in partial consideration for distribution rights, received
from Schering-Plough a one-time upfront payment of $5.3 million. The Company
recognized $7.3 million in upfront fees and payments for the achievement of
certain targets and events during 1996. Under the multi-year agreement,
Schering-Plough has obtained exclusive rights to distribute, market and sell
CAELYX worldwide, except for the United States, Japan and certain other
countries. Under the terms of the agreement, SEQUUS will receive payments for
product sales to Schering-Plough. In addition, SEQUUS and Schering-Plough will
jointly develop a worldwide clinical plan for investigating the use of CAELYX in
the treatment of solid tumors. Each party will undertake clinical trials in
specific indications, coordinated by a joint development team. As part of the
agreement, Schering-Plough




                                       49
<PAGE>   17

                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)



will conduct certain clinical trials for oncology indications, will apply for
regulatory approval in the Schering-Plough territories for all new indications,
and will assist with pharmacoeconomic studies. The agreement also calls for
potential additional payments to the Company totaling $27 million based on the
achievement of certain product development milestones and events. In 1997, the
Company recognize $4.3 million in additional payments based on the achievement
of certain product development milestones and events during the year.

    In July 1996, the Company obtained an exclusive sub-license to certain
technologies held by Sheffield Medical Technologies, Inc. In return for the
sub-license the Company issued 29,798 shares of its Common Stock with a fair
market value of approximately $500,000, less issuance costs of $40,000. The fair
market value of the Common Stock was charged to research and development expense
in the accompanying statement of operations in 1996.

    In August 1993, the Company signed a distribution agreement with Zeneca
under which Zeneca was to market and sell AMPHOCIL in most European countries.
In March 1994, SEQUUS and Zeneca announced the expansion of their August 1993
agreement to cover additional markets. In July 1996, SEQUUS announced that it
had reacquired from Zeneca all international marketing and distribution rights
for AMPHOCIL except for nine European countries to which Zeneca had retained
such rights (Denmark, Finland, Iceland, Ireland, Italy, the Netherlands,
Portugal, Sweden and the U.K.). In exchange for the return to SEQUUS of
marketing and distribution rights throughout the rest of the world, SEQUUS
agreed to restructure certain future milestone payments specified in the
original agreement, adjust the pricing terms for AMPHOCIL to provide greater
competitive flexibility, and exchange certain inventory held by Zeneca. The
reacquisition of international marketing and distribution rights for AMPHOCIL is
continuing.

    The Company also has entered into various other distribution agreements with
international pharmaceutical companies to exclusively distribute AMPHOCIL in
specific countries.

3. COMMITMENTS

    The Company leases its facility and certain equipment under operating
leases. Rent expense under these leases was $2,461,000, $1,813,000, and $852,000
for the years ended December 31, 1997, 1996 and 1995, respectively. Rent expense
is being recognized on a straight-line basis over the lease term of the facility
lease which has scheduled rental payment increases.

    Minimum annual rental commitments under all operating leases at December 31,
1997 total $1,780,000 in 1998, $1,650,000 in 1999, $1,637,000 in 2000,
$1,614,000 in 2001, $1,611,000 in 2002 and $537,000 thereafter.

     During June 1997, the Company entered into a loan agreement which provides
for a revolving line of credit up to $5.0 million and a term loan facility up to
$5.0 million (the "Loan Agreement"). This Loan Agreement has various covenants
including a requirement to maintain certain financial ratios as defined.
Long-term debt of $5.0 million at December 31, 1997 represents loan proceeds
received under the term loan facility. This loan matures in December 2001 and
bears interest at a rate equal to 1% above the Prime Rate (9.5% at December 31,
1997). Payment terms are interest only for 12 months and principal and interest
over the remaining term. The revolving line of credit expires June 1998 and $5.0
million is available at December 31, 1997, subject to the terms and conditions
of the Loan Agreement. Aggregate principal maturities of long-term debt as of
December 31, 1997 are: $.04 million in 1998, $1.2 million in 1999, $1.6 million
in 2000, and $1.8 million in 2001.




                                       50
<PAGE>   18


                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

     The fair market value of the Company's long-term debt approximates the
carrying value as of December 31, 1997. Fair value was estimated using
discounted cash flow analyses, based on the Company's incremental borrowing
rates for similar types of borrowing arrangements.

    As of December 31, 1997, the Company had pledged as collateral for its Loan
Agreement all of its assets pursuant to a lien as well as all forms of
obligations owing to the Company arising out of the sale of goods and the
licensing of technology.

    The Company has entered into multiple year supply agreements with two
vendors which supply key raw materials. Under the agreements the Company is
required to purchase its forecasted three-month requirement as provided to the
vendors. The Company has agreed to indemnify these vendors for certain
liabilities.

4. STOCKHOLDERS' EQUITY

    On March 31, and April 13, 1995, the Company raised an aggregate of $11
million of equity capital with the sale of 480,000 shares of Series A
Convertible Reset Preferred Stock ("Convertible Reset Preferred Stock") together
with warrants to purchase 808,320 shares of Common Stock. Each share of
Convertible Reset Preferred Stock was convertible into Common Stock at an
initial conversion price of $7.425 per share of Common Stock (effectively 3.367
shares of common stock for each share of preferred stock). During 1995, 43,200
shares of Convertible Reset Preferred Stock were converted into 144,106 shares
of common stock. On February 2, 1996 the Company elected to convert the
remaining 437,200 shares of Convertible Reset Preferred Stock into 1,472,052
shares of Common Stock. The conversion was completed in April 1996. During 1996,
warrants to purchase 120,682 shares of Common Stock were exercised. As of
December 31, 1997, warrants to purchase 687,638 shares of Common Stock remain
outstanding and expire in April 1998.

    On May 25, 1995, the Company raised net proceeds of $14.3 million through a
private placement of Units. Each Unit consisted of one share of Common Stock and
a warrant to purchase one-half share of Common Stock at an exercise price per
share of $7.4328. The warrants are only exercisable if the Common Stock portion
of the Unit is held for one year by the initial Unit purchaser. The price per
Unit was $6.7571. Under the terms of this financing, the investors also receive
the first right to negotiate with the Company to participate in the commercial
development of the Company's anticancer product, DOXIL, in Brunei, China, Hong
Kong, Indonesia, Malaysia, Singapore, Taiwan and Thailand. The right to
negotiate has expired. During 1997 and 1996, warrants to purchase 7,399 and
352,460 shares, respectively, of Common Stock were exercised. As of December 31,
1997, warrants to purchase 751,986 shares of Common Stock remain outstanding and
expire in May 1999.

    In March 1991, the Company issued in a private placement (the "1991
Financing") 1,252,143 units (each, a "Unit," collectively, the "Units") at a
price of $7.00 per unit. Each Unit consisted of two shares of Common Stock and a
six-year warrant to purchase an additional share of Common Stock at an exercise
price of $4.25 per share. Gross proceeds to the Company were $8,750,000. In
addition to the sale of the Units, the Company paid a fee and issued a six year
warrant to purchase 125,000 shares of Common Stock to Oppenheimer & Co., Inc.
for its role as placement agent in connection with the 1991 Financing. During
1996, warrants to purchase 705,714 shares of Common Stock were exercised. During
March 1997, the remaining warrants to purchase shares of Common Stock under the
1991 Financing were exercised.

    As of December 31, 1997, approximately 9,900,000 shares of Common Stock were
reserved for future issuance under the Company's 401(k) Plan, stock option
plans, employee stock purchase plan and for the exercise of warrants.

    During April 1997, the Board of Directors adopted a Stockholder Rights Plan
(the "Rights Plan") to protect the Company and its shareholders against coercive
takeover tactics. Under the Rights Plan, a dividend of one Share Purchase Right
("Right") was declared for each share of Common Stock outstanding on April 28,
1997. The Rights generally will not be exercisable until ten business days after
a person or group acquires 15% or more of the Company's Common Stock



                                       51
<PAGE>   19

                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)


in a transaction that is not approved in advance by the Board of Directors or
announces a tender offer, which could result in a person or group owning 15% or
more of the Common Stock. In the event a person or group were to acquire more
than 15% of the Company's Common Stock without the prior approval of the Board
of Directors, each Right will entitle the holder, other than the acquirer, to
buy Common Stock equal to a market value of twice the Right's then current
exercise price. In addition, if the Company were to be acquired in a merger,
stockholders with unexercised Rights could purchase common stock of the acquirer
with a value of twice the then current exercise price of the Rights. The
Company's Board of Directors may redeem the Rights for a nominal amount at any
time prior to the tenth business day following the event that causes the Rights
to become exercisable. The Rights will expire on April 17, 2007.

    Preferred shares may be issued from time to time in one or more series. The
Board of Directors is authorized to provide for the rights, privileges and
restrictions of the shares of such series.

5. STOCK OPTION PLANS AND STOCK PURCHASE PLAN

  401(k) Plan

    The Company has a 401(k) Plan under which it may make employer contributions
at the discretion of the Board of Directors, but no such contributions are
required. The Board also has the discretion to determine the amount of any
employer contribution. The Company has reserved 138,000 shares for issuance
under the Plan. For the years ended December 31, 1997, 1996 and 1995, the
Company contributed Common Stock to the 401(k) Plan valued at approximately
$287,000, $174,000 and $157,000, respectively.

  Stock Compensation Plans

    Under the 1987 Employee Stock Option Plan, as amended, and 1987 Consultant
Stock Plan, as amended, (the "Plans"), both of which expired in December 1997,
the Company was authorized to issue either incentive or non-qualified stock
options to its employees and consultants to purchase up to 5,000,000 shares of
common stock. Generally, options granted under the Plans become exercisable over
periods of six months to four years and for a period ranging from three to seven
months after termination of employment or consulting arrangement, and all expire
ten years from the date of grant. The stock delivered upon exercise of any
option under these Plans may be subject to repurchase (subject to determination
by the Board of Directors) upon ceasing employment or consulting relationship
with the Company. The Company's right of repurchase generally expires over a
period of three to five years. The exercise price of non-qualified stock options
may not be less than 85 percent of the fair market value of the stock on the
date of grant. The Company granted options to purchase 12,000, 30,000 and 16,000
shares of Common Stock under the 1987 Consultant Stock Plan during 1997, 1996
and 1995, respectively. The fair value of these options is immaterial.

    Under the 1990 Director Stock Option Plan (the "Director Plan"), the Company
is authorized to grant non-qualified options to its non-employee directors for
up to 600,000 shares of Common Stock. Each eligible director is entitled to
receive an initial grant to purchase 25,000 shares; and, on the first
anniversary of the initial grant, each eligible director then in office is
entitled to receive a grant to purchase 12,500 shares. Upon each annual grant
date, an option to purchase an additional 5,000 shares of Common Stock will be
granted to each non-employee director plus an option to purchase an additional
2,500 shares to each such director who also serves on one or more committees of
the Board. All options under the Director Plan have an exercise price not less
than the fair market value on the date of grant. Options granted before March 8,
1996 were immediately exercisable upon the grant, and initial options granted on
or after March 8, 1996 vest ratably over four years. Each annual grant granted
on or after March 8, 1996 vest ratably one year from the date of grant. The
right to exercise generally expires upon the earlier of ten years from the date
of grant or one year after a non-employee director's termination as a
non-employee director. The Company granted options to purchase 22,500 and 37,500
shares of Common Stock under the Director Stock Option Plan in 1997 and 1996,
respectively. No shares were granted puruant to this plan in 1995.




                                       52
<PAGE>   20

                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)


    In June 1997, the stockholders approved an Equity Incentive Plan (the
"Incentive Plan"), under which the Company is authorized to issue a total of
2,000,000 shares of Common Stock. The Incentive Plan provides for the
discretionary award of options, restricted stock, stock purchase rights,
performance shares,or any combination of these (collectively, the "awards") to
eligible employees, including executive officers, directors and consultants. The
Incentive Plan may be administered by the Board of Directors or the Board of
Directors may delegate its authority to a committee (in either case, the
"Committee"). As of December 31, 1997, the Board of Directors had made awards of
stock options under the Incentive Plan. Stock options under the Incentive Plan
may be incentive stock options ("ISOs") or non-qualified stock options ("NQOs").
The exercise price of the ISOs may not be less than the fair market value of the
shares subject to option on the date of grant. The exercise price of NQOs must
be at least 85 percent of the fair market value of the shares subject to the
option on the date of grant. The term on any ISO granted under the plan may not
exceed ten years and the term of any NQO may not exceed fifteen years. As of
December 31, 1997, the Board of Directors had granted to certain employees of
the Company ISOs to purchase a total of 252,325 shares of Common Stock. These
options have a ten-year term and generally become exercisable over the period of
one to four years from the date of grant.



                                       53
<PAGE>   21



                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)


    Activities under the above mentioned stock option plans are as follows
(amounts in thousands, except per share information):

<TABLE>
<CAPTION>
                                                  OUTSTANDING                  EXERCISABLE
                                          ---------------------------  ---------------------------
                               OPTIONS               WEIGHTED AVERAGE             WEIGHTED AVERAGE   WEIGHTED
                              AVAILABLE   NUMBER OF   EXERCISE PRICE    NUMBER     EXERCISE PRICE    AVERAGE
                              FOR GRANT    SHARES       PER SHARE      OF SHARES     PER SHARE      FAIR VALUE
                              ---------    ------       ---------      ---------     ---------      ----------
<S>                           <C>         <C>            <C>             <C>          <C>             <C>
  Balance, December 31, 1994.    390       3,012          $6.73          1,124        $ 5.86
  Additional authorized......  2,150          --             --
  Granted.................... (1,427)      1,427          $8.95                                       $5.08
  Forfeited and cancelled....    230        (230)         $7.84
  Exercised..................     --        (239)         $3.67
                              ------      ------
  Balance, December 31, 1995.  1,343       3,970          $7.73          1,971        $ 6.98
  Granted....................   (927)        927         $16.26                                       $9.15
  Forfeited and cancelled....    210        (210)        $10.92
  Exercised..................     --        (601)         $6.39
                              ------      ------
  Balance, December 31, 1996.    626       4,086          $9.67          2,052        $ 7.36
  Additional authorized......  2,000          --             --
  Plan shares expired........   (377)         --             --
  Granted.................... (1,272)      1,272          $7.37                                       $4.16
  Forfeited and cancelled....  1,008      (1,008)        $11.05
  Exercised..................     --        (283)         $5.81
                              ------      ------
  Balance, December 31, 1997.  1,985       4,067         $ 8.87          2,172        $ 8.24
                              ======      ======
</TABLE>

No shares purchased under the option plans are subject to repurchase at December
31, 1997. All options were granted at fair market value.








                                       54
<PAGE>   22



                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

    The options outstanding at December 31, 1997 have been segregated into
ranges for additional disclosure as follows (options amounts are recorded in
thousands):

<TABLE>
<CAPTION>
                                           OPTIONS OUTSTANDING             OPTIONS EXERCISABLE
                                           -------------------             -------------------
                                                 WEIGHTED-
                                                  AVERAGE                         OPTIONS
                                    OPTIONS      REMAINING                       CURRENTLY
                                 OUTSTANDING AT  CONTRACTUAL    WEIGHTED-      EXERCISABLE AT     WEIGHTED-
  RANGE OF                        DECEMBER 31,      LIFE         AVERAGE         DECEMBER 31,      AVERAGE
 EXERCISE PRICES                      1997       (IN YEARS)   EXERCISE PRICE        1997        EXERCISE PRICE
 ---------------                      ----       ----------   --------------        ----        --------------
<S>                                   <C>            <C>           <C>              <C>              <C>   
$ 1.13 - $ 6.63 ..................     954          7.79          $ 5.44             233            $ 2.75
$ 6.75 - $ 7.38 ..................     898          6.31          $ 6.84             763            $ 6.78
$ 7.44 - $ 8.56 ..................   1,090          7.41          $ 8.12             754            $ 8.19
$ 8.75 - $15.63 ..................     815          8.05          $12.57             290            $12.08
$15.75 - $21.75 ..................     311          7.90          $18.22             133            $18.22
                                     -----                                         -----
                                     4,067          7.42          $ 8.87           2,172            $ 8.24
                                     =====                                         =====
</TABLE>


  Employee Stock Purchase Plan

    The Company's Employee Stock Purchase Plan is administered by the Board of
Directors, subject to shareholder approval, and the Company has reserved for
sale under the plan 778,000 shares of Common Stock. Employees who own less than
5% of the total outstanding Common Stock of the Company are eligible to
participate in the plan, which provides for the option to purchase a defined
number of shares at 85% of the lower of the fair market value of the stock at
the enrollment or purchase date. At December 31, 1997, approximately 345,000
shares of Common Stock had been issued under this plan.

  Pro Forma Information

    Relating to the Company's stock-based compensation plans described above,
the Company has elected to follow APB 25 and related interpretations in
accounting for its employee stock options because, as discussed below, the
alternative fair value accounting provided for under SFAS 123 requires use of
option valuation models that were not developed for use in valuing employee
stock options and employee stock purchase plans. Under APB 25, because the
exercise price of the Company's employee stock options equals the market price
of the underlying stock on the date of the grant, no compensation expense is
recognized.

    Pro forma information regarding net loss and net loss per share is required
by SFAS 123, and has been determined as if the Company had accounted for its
employer stock purchase plan and employee stock options granted subsequent to
December 31, 1994 under the fair value method of SFAS 123. The fair value for
these options was estimated at the date of grant using a Black-Scholes option
pricing model with a multiple option approach and the following weighted-average
assumptions:

<TABLE>
<CAPTION>
                                                        1997    1996    1995
                                                        ----    ----    ----
             <S>                                        <C>     <C>     <C> 
             Weighted average risk-free interest rate   6.2%    6.2%    5.9%
             Volatility                                  .79     .74     .74
             Weighted average expected life (in years)  3.3     3.7     3.7
             Dividend yield                               0%      0%      0%
</TABLE>





                                       55
<PAGE>   23


                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)


    The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's employee stock options and employee stock purchase plan
have characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of the Company's
employee stock options and the employee stock purchase plan. For purposes of pro
forma disclosures, the estimated fair value of the options is amortized to pro
forma net loss over the options' vesting period. The Company's historical and
pro forma information follows (in thousands, except for net loss per share
information):

<TABLE>
<CAPTION>
                                                            YEARS ENDED
                                                           DECEMBER 31,
                                                           ------------
                                                     1997       1996      1995
                                                     ----       ----      ----
          <S>                                      <C>        <C>       <C>    
          Net loss
              Historical.........................  $23,581    $17,177   $33,596
              Pro Forma..........................  $26,119    $22,121   $35,849

          Net loss per share
              Historical.........................  $ (0.78)   $ (0.59)  $ (1.54)
              Pro Forma..........................  $ (0.86)   $ (0.76)  $ (1.64)
</TABLE>


    Because SFAS 123 is applicable only to options granted subsequent to
December 31, 1994, its pro forma effect will not be fully realized until 1998.













                                       56
<PAGE>   24



                          SEQUUS PHARMACEUTICALS, INC.

                   NOTES TO FINANCIAL STATEMENTS--(CONTINUED)


6. INCOME TAXES

    The Company accounts for income taxes under Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes."

    As of December 31, 1997, the Company has Federal and California net
operating loss carryforwards ("NOLs") of approximately $119.5 million and $7.3
million, respectively. The Company also has Federal and California research and
development tax credit carryforwards of approximately $6.1 million and $4.3
million, respectively. The Federal NOLs expire as follows (in thousands):

<TABLE>
        YEAR(S) ENDING                                        FEDERAL NOL
        DECEMBER 31                                            EXPIRING
        -----------                                            --------
         <S>                                                   <C>
         1998-2000......................................       $  2,300
         2001-2012......................................        117,200
                                                               --------
                                                               $119,500
                                                               ========
</TABLE>

    Utilization of the net operating losses and credits may be subject to a
substantial annual limitation due to the ownership change limitations provided
by the Internal Revenue Code of 1986 and similar California provisions. The
annual limitation may result in the expiration of net operating losses and
credits before utilization.

    The Federal net operating loss carryforward differs from the accumulated
deficit principally due to timing differences in the recognition of certain
revenue and expense items for financial and federal tax reporting purposes,
consisting primarily of capitalized research and development costs and stock
option deductions. Significant components of the Company's current deferred tax
assets for federal and state income taxes are as follows (in thousands):

<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                             ------------
                                                           1997          1996
                                                           ----          ----
     <S>                                                 <C>          <C>     
     Net operating loss carryforwards................    $ 41,100     $ 33,200
     Capitalized research and development............      22,100       19,800
     Research credits................................       9,000        7,200
     Other, net......................................       2,800        2,400
     Valuation allowance.............................     (75,000)     (62,600)
                                                         --------     --------
             Total...................................    $     --     $     --
                                                         ========     ========
</TABLE>

    The valuation allowance increased by approximately $12,400,000 in 1997,
$7,530,000 in 1996, and $15,250,000 in 1995. Approximately $4,100,000 of the
valuation allowance for deferred tax assets relates to benefits of stock option
deductions which, when recognized, will be allocated directly to contributed
capital.






                                       57
<PAGE>   25



                 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS

                          SEQUUS PHARMACEUTICALS, INC.


<TABLE>
<CAPTION>
                COL. A                        COL. B          COL. C              COL. D        COL. E
                ------                        ------          ------              ------        ------
                                                             ADDITIONS
                                                             ---------
                                                          CHARGED    CHARGED
                                             BALANCE AT   TO COSTS   TO OTHER
                                             BEGINNING      AND      ACCOUNTS-   DEDUCTIONS-  BALANCE AT END
              DESCRIPTION                    OF PERIOD    EXPENSES   DESCRIBE     DESCRIBE      OF PERIOD
              -----------                    ---------    --------   --------     --------      ---------
<S>                                          <C>          <C>           <C>      <C>            <C>     
YEAR ENDED DECEMBER 31, 1995:
    Reserves and allowances deducted from
      asset accounts:
        Allowance for uncollectible
          accounts.....................      $258,000     $266,000      $--      $346,000(1)    $178,000
YEAR ENDED DECEMBER 31, 1996:
    Reserves and allowances deducted from
      asset accounts:
        Allowance for uncollectible
          accounts.....................      $178,000     $656,000      $--      $330,000(1)    $504,000
YEAR ENDED DECEMBER 31, 1997:
    Reserves and allowances deducted from
      asset accounts:
        Allowance for uncollectible
          accounts.....................      $504,000   $1,218,000      $--      $221,000(1)  $1,501,000
</TABLE>

----------
(1) Uncollectible accounts written off, net of recoveries.







                                       58