<PAGE>
 
                          SEQUUS PHARMACEUTICALS, INC.

                                   EXHIBIT 13

                     1997 ANNUAL REPORT TO SECURITY HOLDERS

<PAGE>
 
                    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 distribution agreement with Schering-Plough also
provides for milestone payments of up to an aggregate of $27 million, subject to
the satisfaction of certain conditions at specified times.  There can be no
assurance that any of these conditions will be satisfied or that the Company
will ever receive such payments.

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 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 


                                       2
<PAGE>
 
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"

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 royalties 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 

                                       3
<PAGE>
 
$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.

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

                                       4
<PAGE>
 
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 expired June 1998.  The loan provided
for an initial interest rate of 9.5% for the period of July 1997 through June
1998 and has an interest rate of 8.98% for the remaining term of the loan which
expires in December 2001.  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.

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.

                                       5
<PAGE>
 
                            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 good 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".


                                      6
<PAGE>
 
               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



                                       7
<PAGE>
 
                          SEQUUS PHARMACEUTICALS, INC.

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

<TABLE>
<CAPTION>
                                                                                               DECEMBER 31
                                                                                          ----------------------
                                                                                             1997        1996
                                                                                          ----------  ----------
                                                     ASSETS
<S>                                                                                       <C>         <C>
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                                                                                         4,512       8,757
Inventories                                                                                   4,117       5,697
Related Party Receivables                                                                       329         215
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                  3           3
 outstanding were 30,601,355 in 1997 and 29,660,319 shares in 1996
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.

                                       8
<PAGE>
 
                          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.

                                       9
<PAGE>
 
                          SEQUUS PHARMACEUTICALS, INC.

                       STATEMENT OF STOCKHOLDERS' EQUITY
                                 (in thousands)

<TABLE>
<CAPTION>
                                          STOCK
                                     PREFERRED STOCK    COMMON STOCK   ADDIITONAL                    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 of 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.


                                      10
<PAGE>
 
                          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                 --        460          --
 technology license
Changes in operating assets and liabilities:
Trade accounts receivable                                                      4,245     (7,413)     (1,280)
Inventories                                                                    1,580     (4,592)       (547)
Related Party Receivables                                                       (114)        83        (298)
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.

                                      11
<PAGE>
 
                          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.


                                      12
<PAGE>
 
                          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>

                                      13
<PAGE>
 
                          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.  Milestone payments recognized pursuant to
collaborative agreements are recognized as revenue upon the achievement of the
specified milestone, where no future obligation to perform exists for that
milestone.  Upfront fees related to work previously performed, under which no
future obligation to perform exists, are recognized as revenue upon execution of
the agreement as these amounts are not contingent on future performance or the
passage of time.

Export sales to unaffiliated European customers were 10%, 9% and 65%  for the
years ended December 31, 1997, 1996 and 1995, respectively.

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.

                                      14
<PAGE>
 
                          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.

Related Party Receivables

The Company holds notes receivables from certain officers and employees, which
amounted to an aggregate of $329,000 and $215,000 at December 31, 1997 and 1996,
respectively.

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 standards
for the way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to 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, received a fee of $5.3 million for recognition of work previously
performed by the Company to obtain marketing authority approval for CAELYX in
the European Union, and in partial consideration for distribution rights. 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 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, and 

                                      15
<PAGE>
 
the Company is obligated to supply the CAELYX product to Schering-Plough,
provide data from studies and assist Schering-Plough in obtaining governmental
approvals. 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 recognized $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.  This agreement provides that the
Company shall develop, market and sell products incorporating certain technology
relating to liposomes with CD4 protein incorporated into their bilayers and
their method of use as a therapeutic agent in the treatment of HIV infection and
AIDS.  The Company has all rights to any new invention or discovery that it
develops in connection with this collaboration.

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 agreement provides that SEQUUS shall supply the product, obtain
import licenses and relevant documents, and jointly with Zeneca, maintain
regulatory approvals for the product.

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.

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

                                      16
<PAGE>
 
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 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 

                                      17
<PAGE>
 
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 pursuant to this plan in 1995.

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.


                                      18
<PAGE>
 
                          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.


                                      19
<PAGE>
 
                          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>

                                      20
<PAGE>
 
                          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.


                                      21
<PAGE>
 
                          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):

     YEAR(S) ENDING                        FEDERAL NOL
     DECEMBER 31                            EXPIRING
     -----------                            --------

     1998-2000.......................       $  2,300
     2001-2012.......................        117,200
     ---------                              --------

                                            $119,500
                                            ========

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.


                                      22
<PAGE>
 
                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:           $258,000  $  266,000  $      --     $345,000(1)      $  178,000
Reserves and allowances deducted
 from asset accounts:
     Allowances for uncollectible
      accounts......................
YEAR END DECEMBER 31, 1996:             $179,000  $ 6565,000  $      --     $330,000(1)      $  504,000
Reserves and allowances deducted
 from asset accounts:
     Allowance for uncollectible
      accounts......................
YEAR ENDED DECEMBER 31, 1997:           $504,000  $1,218,000  $      --     $221,000(1)      $1,501,000
Reserves and allowances deducted
 from asset accounts:
     Allowance for uncollectible
      accounts......................
</TABLE>
(1) Uncollectible accounts written off, net of recoveries.


                                      23