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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-K

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

                  For the fiscal year ended SEPTEMBER 30, 1996

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

              For the transition period from ________ to ________


                           Commission File No. 0-18734

                              LIDAK Pharmaceuticals
             (Exact name of registrant as specified in its charter)


              CALIFORNIA                                33-0314804
    (State or other jurisdiction of           (IRS Employer Identification No).
    incorporation or organization)

      11077 N. TORREY PINES ROAD
        LA JOLLA, CALIFORNIA                             92037
(Address of principal executive office)                (Zip Code)


                                 (619) 558-0364
              (Registrant's telephone number, including area code)

        Securities registered pursuant to Section 12(b) of the Act: None

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

                       Class A Common Stock, no par value

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934
during the preceding 12 months (or for such shorter periods that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]

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

The aggregate market value of the Registrant's voting stock, held by
non-affiliates, computed by reference to the average of the closing bid and
asked prices of the Class A Common Stock as reported by NASDAQ on December 20,
1996: $62,261,953

The number of shares of Common Stock of the Registrant issued and outstanding as
of December 20, 1996:

    Class A common stock, no par value             36,225,136
    Class B common stock, no par value                283,000

                       DOCUMENTS INCORPORATED BY REFERENCE
Registrant's definitive Proxy Statement which will be filed with the Securities
and Exchange Commission on or before January 28, 1997 in connection with
Registrant's annual meeting of stockholders to be held on March 15, 1997 is
incorporated by reference into Part III of this Report.



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                                     PART I

ITEM 1.      BUSINESS

            This Form 10-K contains certain statements of a forward-looking
nature relating to future events or the future performance of the Company.
Prospective investors are cautioned that such statements are only predictions
and that actual events or results may differ materially. In evaluating such
statements, prospective investors should specifically consider various factors
identified in this Form 10-K, including the matters set forth under the caption
"Risk Factors," below, which could cause actual results to differ materially
from those indicated by such forward-looking statements.

GENERAL

            LIDAK Pharmaceuticals ("LIDAK" or the "Company") is a development
stage company organized to engage in research, development and commercialization
of innovative pharmaceutical products. The Company was incorporated in
California in 1988 and since inception has operated in one business segment --
research and development of pharmaceutical products. See "Item 6.--Selected
Financial Data." The Company is currently focusing on the development and
commercialization of two proprietary products/technologies 1) n-docosanol 10%
cream (LIDAKOL(R)) as a topical treatment for oral herpes (cold sores or fever
blisters); and 2) Large Multivalent Immunogen ("LMI") technology as a potential
immunotherapeutic vaccine treatment for malignant melanoma and other human
cancers.

            In Spring 1996, the Company reported preliminary results from three
Phase 3 clinical trials comparing LIDAKOL cream to a placebo cream as a
treatment of recurrent oral herpes episodes. In these trials, LIDAKOL
demonstrated clinical effectiveness compared to historical episode features
experienced by the patients in the study, including reduced healing times,
episode abortion and shortening of pain symptoms. However, similar results were
obtained with the cream used as the intended placebo in the trials. If these
trials had shown a statistically and clinically significant advantage of LIDAKOL
versus placebo, the Company could have filed a New Drug Application ("NDA") with
the U.S. Food and Drug Administration ("FDA") for marketing approval of LIDAKOL
as a treatment of recurrent oral herpes. As a result of the inconclusive
outcome, the Company obtained FDA approval to use an alternative placebo and to
conduct additional Phase 3 clinical trials to prove the efficacy of LIDAKOL
versus the alternative placebo. In July and September 1996, the Company
initiated two additional Phase 3 clinical trials of LIDAKOL in the United
States. The Company anticipates completion of these studies, including data
availability, around the summer of 1997. If successful, these trials will
complete the final requirements to file an NDA for marketing approval. If FDA
approval is obtained in a timely manner thereafter, the Company believes that it
is possible that commercial sales could commence sometime in 1998. See "Research
and Development - LIDAKOL".

            To date, the Company has entered into five licensing agreements
relating to marketing certain topical indications of LIDAKOL. These agreements
are with : 1) Yamanouchi Europe, b.v., of the Netherlands ("Yamanouchi"), for
rights in certain European and other countries (November, 1991); 2) CTS Chemical
Industries, Ltd. ("CTS"), for rights in Israel (July, 1993); 3) Boryung
Pharmaceuticals Company, Ltd. ("Boryung"), of Seoul, Korea, for rights in the
Republic of Korea (July, 1994); 4) Grelan Pharmaceutical Co., Ltd. ("Grelan"),
of Tokyo, Japan, for rights in Japan (October, 1994); and 5) Bristol-Myers
Squibb Company ("BMS"), headquartered in the U.S., for rights in the United
States, Canada and all remaining major territories throughout the world which
were not licensed to other parties (February, 1996). In November 1996, LIDAK
reacquired from BMS the rights to market LIDAKOL in all territories covered in
the LIDAK/BMS agreement except the U.S., Canada and Mexico and is now free to
engage new licensing partners in these reacquired territories which include
China, South America, Central America, Australia, India and portions of the Far
East. In each of the territories covered by the above agreements, and other
territories not covered by these agreements, marketing of LIDAKOL is subject to
obtaining appropriate government approvals.



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            The Company's second current area of clinical development uses the
LMI technology as a new therapeutic approach to cancer. This technology involves
the use of antigen-containing artificial cell membranes to stimulate the immune
system's defense against cancer cells. Under an Investigational New Drug
Application ("IND"), approved by the FDA, the Company is currently conducting a
Phase 1/Phase 2 clinical trial of LMI in patients with malignant melanoma. The
Company anticipates completion of this trial in early 1997. The Company's rights
to the LMI technology, and certain other technologies, derive from a licensing
agreement with Medical Biology Institute ("MBI"), a non-profit research
organization founded in 1981 by Dr. David H. Katz, the founder, President and
Chief Executive Officer of the Company.

            The Company has experienced significant losses since inception and
its business is subject to significant risks. (See "Risk Factors"). Except as
noted above with respect to LIDAKOL, the Company does not expect any other of
its proposed products, including LMI, to be available for commercial sale for
several years, if at all. There is no assurance that the ongoing U.S. Phase 3
clinical trials of LIDAKOL or the current and/or future clinical trials of LMI
will demonstrate satisfactory efficacy to support the filing of NDA's with the
FDA in the U.S. or with regulatory agencies outside the U.S. Moreover, filing of
any such NDA's does not assure that marketing approvals will be granted for
these products in the U.S. or elsewhere. There is no assurance that pre-clinical
and clinical testing of the Company's earlier-stage technologies will
demonstrate appropriate safety and efficacy requirements to warrant further
development and/or to achieve the requirements of regulatory marketing approvals
in the U.S. or elsewhere.

            Even if the Company obtains applicable regulatory marketing
approvals for LIDAKOL, LMI or any of its other products, it will still be
necessary for the Company to make appropriate arrangements, for which no
assurance can be made, to finance the ultimate commercialization of such
products. These arrangements could include obtaining additional licensing
agreements or other collaborative interactions with outside parties which have
sufficient financial resources and expertise and/or raising additional financing
to support completion of any remaining non-clinical and clinical development,
regulatory approval filings and, if approved, eventual marketing of such
products.

RESEARCH AND DEVELOPMENT

            LIDAKOL: Company scientists have developed a therapeutic compound,
n-docosanol, trademarked under the name LIDAKOL, which has demonstrated
anti-viral and anti-inflammatory properties. The Company has been focusing on
approval for LIDAKOL as a topical treatment for oral herpes infections. During
fiscal 1995, a Phase 3 clinical trial of LIDAKOL as a topical treatment for oral
herpes was completed in Europe by Yamanouchi, the Company's licensing partner in
Europe. In this double blind study, LIDAKOL was compared to acyclovir
(Zovirax(R)) 5% cream in approximately 400 patients initiating treatment at
early stages of a recurrent herpes episode. Results of this trial demonstrated
that LIDAKOL showed statistically comparable therapeutic efficacy to Zovirax 5%
cream, a product approved for marketing in Europe as a treatment for recurrent
oral herpes, but which is not available in the U.S., (Zovirax ointment, which is
available in the U.S., has not been approved by the FDA for use as a treatment
for recurrent oral herpes). Demonstrating comparable efficacy to an approved
product is a requirement for obtaining regulatory approval in most major
European countries, but is not a requirement for approval in the U.S. Results
of this trial will be used by Yamanouchi, along with results from the Phase 3
U.S./Canadian placebo-controlled trials described below, for submission to the
appropriate regulatory agencies for marketing approval in Europe.

            In Spring 1996, the Company obtained the results of three
double-blind placebo-controlled Phase 3 U.S. and Canadian clinical trials of
LIDAKOL 10% cream as a topical treatment for recurrent oral herpes. Two of these
studies focused on early treatment and the third focused on late treatment of
oral herpes. In the two early treatment studies, in which 648 patients were
treated early in the course of oral herpes episodes, LIDAKOL had a very good
safety profile and was well-tolerated. With regard to healing time, the average
duration of oral herpes episodes averaged 5.5 days in both the LIDAKOL and
placebo-treated groups, compared to an average duration of 8.9 days in prior
untreated episodes experienced by these patients. This represents a 35%
reduction (P  0.0001) in time to healing. Furthermore, in one of these
studies, both LIDAKOL and placebo treatment resulted in significant benefit (73%
and 50%, respectively) in aborting the progression of oral herpes to the
vesicle, or blister, stage in patients who initiated treatment 




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at the early sign of an outbreak., Moreover, complete elimination of pain was
observed by the patients in 2.6 and 4.0 days, respectively, compared to 6.0 days
when the disease is left untreated, as published in the scientific literature.
The absence of a difference between LIDAKOL and placebo treatment was
unexpected. The Company believes that this result was due to unanticipated
anti-herpes activity of the cream used as the intended placebo in the trials.

            The third Phase 3 U.S./Canadian late treatment study of LIDAKOL was
conducted in 544 oral herpes patients initiating treatment in the late stage of
a recurrent episode. This study demonstrated that late-stage treatment was
ineffective in altering overall healing times. This outcome was expected in view
of the Company's understanding of the mode of action of LIDAKOL, in which
interference with viral infection occurs early when infecting herpes viruses
begin to enter target cells, rather than after the virus has entered the cell
and begun to multiply.

            If these trials had shown a statistically and clinically significant
advantage of LIDAKOL versus placebo, the Company could have filed an NDA with
the FDA for marketing approval of LIDAKOL as a treatment of recurrent oral
herpes. However, LIDAKOL did not show a statistically significant difference in
healing times versus the cream used as the intended placebo in the trials. As a
result of this outcome and because the Company believes that the cream used as
the intended placebo displayed unexpected anti-herpes activity, the Company is
conducting additional clinical trials to prove the efficacy of LIDAKOL compared
to what it believes to be an alternative, inert placebo.

            In July 1996 and September 1996, the Company initiated two
additional Phase 3 clinical trials in the United States of LIDAKOL as an early
treatment of recurrent oral herpes. A minimum of 500 patients will be evaluated
in the two double-blind, placebo-controlled studies using a totally different
placebo than was used in the original studies. The alternative placebo cream
being used in these additional studies has been shown in previous human clinical
trials to be inactive as a treatment for oral herpes. Consequently, the Company
believes that these trials should provide the Company with a more valid
comparison of LIDAKOL activity versus an inert placebo. The primary endpoint of
these studies will be overall time-to-healing, with secondary endpoints
including percentage of aborted outbreaks and relief of pain symptoms. The
studies will be conducted at many of the same sites used in previous Phase 3
studies of LIDAKOL. The Company anticipates completion of these studies around
the summer of 1997. If successful, the Company will use these results in support
of filing an NDA.

            In January 1996, the Company initiated two separate Phase 2 clinical
trials of LIDAKOL in AIDS patients as a topical treatment for Kaposi's Sarcoma
cutaneous lesions (KS) and Molluscum Contagiosum (MC) under the Company's IND
with the FDA. Each of these conditions occurs in increased frequency with
patients infected with human immunodeficiency virus (HIV). KS is a malignant
vascular tumor typified by purplish skin lesions which may appear anywhere on
the body. Recently published studies suggest that a new herpes virus, human
herpes virus 8 (HHV-8), may be the causative agent of KS. MC is a viral
infection resulting in raised skin lesions, or warts, currently treatable only
by surgical removal. Each of the trials involve adult male HIV-infected patients
(18 in the KS and 10 in the MC studies, respectively) in an open label, single
center study in which patients apply LIDAKOL five times daily over a 14 to 28
day period. Clinical endpoints of both trials will include reduction in the size
of lesions and time-to-heal responses. The Company anticipates results from
these studies in early 1997.

            In late fiscal 1997 the Company plans to initiate a Phase 2 clinical
trial using LIDAKOL as a topical therapeutic treatment for burns and wound
healing. The Company is also investigating the possibility of initiating
additional clinical trials for other topical indications of LIDAKOL which may
include therapeutic use in genital herpes, shingles, fungal infections and other
skin conditions, although no specific plan has been established for initiation
of such trials. In addition, the Company has preliminary data indicating that a
topical formulation of LIDAKOL might be beneficial in preventing sexually
transmitted HIV.

            The Company is also developing LIDAKOL for systemic (internally
administered) anti-viral and anti-inflammatory use. Preclinical studies indicate
that systemically formulated LIDAKOL inhibits viral replication of certain
lipid-enveloped viruses. Several medically significant diseases are caused by
these viruses which, besides herpes, include shingles, cytomegalovirus,
influenza, respiratory syncytial virus, hepatitis and HIV.



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            Patents covering medical and veterinary uses of the topical and
systemic formulations of LIDAKOL have been issued to LIDAK in the U.S. and
Europe. The Company has additional foreign patent applications pending covering
topical and systemic uses of LIDAKOL and has been granted rights under certain
United States and foreign patents and patent applications relating to LIDAKOL
held by a third party. See "Patents and Proprietary Rights."

            LARGE MULTIVALENT IMMUNOGEN (LMI): Utilizing LMI technology acquired
through its license agreement with MBI, the Company is attempting to develop
anti-cancer and anti-viral therapeutic products. See "Relationship with Medical
Biology Institute". This technology incorporates homogeneous cell-sized beads
coated with purified cell membranes containing cancer or virus antigens. These
coated beads are injected into patients' skin to stimulate the immune system, in
particular cytotoxic T lymphocytes ("CTL") or "killer cells", to attack and kill
the cancer cells or virus infected cells. CTL's play a major role in the immune
system's defense against diseases. Provided they are effectively stimulated into
their killing action, CTL's can recognize foreign antigens on cancer or
virus-infected cells and kill such cells. In experimental animals, the LMI
approach has been shown to effectively stimulate and enhance cancer-specific CTL
responses against a variety of mouse tumors and, when combined with traditional
chemotherapy, has been shown to significantly improve survival rates of
cancer-bearing mice.

            In August 1993, the Company entered into an agreement with Ribi
Immunochem Research, Inc. ("Ribi") under which Ribi granted the Company a
license to use Ribi's melanoma cell lines in the clinical development of LMI
technology for use in malignant melanoma. The Company granted Ribi an option for
an exclusive license to commercialize the Company's LMI technology with Ribi's
melanoma cell lines for the treatment of melanoma. This agreement does not
restrict the Company from using its LMI technology for the treatment of melanoma
using melanoma antigens from other sources.

            In December 1995, the Company began a Phase 1/Phase 2 clinical trial
of LMI in patients with malignant melanoma under its IND with the FDA. This
clinical trial is investigating the safety of LP 2307 Injectable LMI Suspension
("LP 2307") in 18 patients with late stage disease. LP 2307 is created by
attaching high concentrations of isolated melanoma antigens derived from
melanoma cell lines onto cell-sized microspheres. The study will also evaluate
varying doses of the LP 2307, and its ability to elicit melanoma-specific immune
responses and possible stabilization of the disease and prolongation of patient
life. The Company anticipates completion of this study in early 1997.

            Although research efforts are still at an early stage, Company
scientists believe that the LMI approach may also be effective for stimulating
enhanced virus-specific CTL responses, thereby providing the opportunity to also
develop improved therapies and vaccines for viral diseases.

            Patents covering the use of LMI to treat human tumors have been
issued to MBI in the U.S. and Europe. The rights to these patents belong to the
Company through the license agreement with MBI described under "Relationship
with Medical Biology Institute" below (the "MBI" Agreement). Both U.S. and
foreign patents are pending for use of LMI as a treatment for viral diseases.
See "Patents and Proprietary Rights." The Company intends to obtain outside
funding for any future development of the LMI technology.

            ADIFAB TECHNOLOGY : Using technology acquired through its license
agreement with MBI, Company scientists have developed an assay which rapidly
measures, with high precision, levels of unbound Free Fatty Acids ("FFA") in
blood plasma and other tissue fluids. See "Relationship with Medical Biology
Institute". Modest but statistically significant increases in blood plasma
levels of unbound FFA were found to be associated with cancer and diabetes.
However, major increases in unbound FFA, (14 fold), were found in patients
undergoing balloon angioplasty for coronary artery disease. Thus, in preliminary
clinical studies, this assay appears to be an extremely sensitive detector of
ischemia in heart disease and may prove to be a simple, rapid and cost-effective
early diagnostic tool to identify individuals with ischemia caused by coronary
artery disease or stroke. The Company is currently seeking outside parties to
further develop this technology into a new clinically important diagnostic tool.
The ADIFAB assay is currently available for sale to the medical research
community through a non-exclusive distribution agreement with Molecular Probes,
Inc. of Eugene, Oregon, although such sales have not and 




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are not expected to result in significant revenues to the Company. Both U.S. and
foreign patents have been issued for the ADIFAB technology. The rights to these
patents belong to the Company through the MBI Agreement. See "Patents and
Proprietary Rights."

            HUMAN IMMUNE SYSTEM-RECONSTITUTED SCID MOUSE TECHNOLOGY: The human
immune system-reconstituted SCID mouse technology (hu-PBL-SCID), which the
Company acquired through its license agreement with MBI, creates a functional
human immune system in mice which have a genetic defect known as Severe Combined
ImmunoDeficiency ("SCID") by reconstituting such mice with human blood cells.
See "Relationship with Medical Biology Institute". Certain aspects of the human
immune system are thereby created to function in laboratory animals. Both U.S.
and foreign patents have been issued for the hu-PBL-SCID technology. The rights
to these patents belong to the Company through the MBI Agreement. See "Patents
and Proprietary Rights". The Company believes there may be both commercial and
scientific applications of the hu-PBL-SCID mouse technology. The focus of work
with this model has been diseases of the human immune system, including AIDS.
This model permits basic studies on the infection of human cells with human
viruses, such as Human Immunodeficiency Virus ("HIV"), without risk to human
life and efficacy testing of possible vaccines for prevention of disease or
drugs for therapy. The Company is currently investigating the use of this
technology in the production of human monoclonal antibodies.

            To date, the Company has completed work under twelve contract
research agreements pursuant to which the Company used hu-PBL-SCID mice infected
with HIV to screen compounds developed by other pharmaceutical and biotechnology
companies for potential therapeutic efficacy in human AIDS and other
virus-induced diseases. The Company does not expect that long term future
revenue from contract research agreements to test compounds in hu-PBL-SCID mice
will be significant. Therefore, the Company does not intend to continue to
perform this research service to other pharmaceutical and biotechnology
companies.

            In August, 1996, the Company entered into a five-year license
agreement with Southern Research Institute ("SRI") under which the Company
granted SRI a non-exclusive license to use its hu-PBL-SCID technology in
performing certain contract research testing. The Company does not anticipate
significant revenues under this agreement. The Company will continue to offer
non-exclusive licenses to the research community for the use of this technology.

OTHER RESEARCH & DEVELOPMENT

            GENE SEQUENCE ANALYSIS (INDEL) TECHNOLOGY: Using a new drug
discovery method based on gene sequence analysis which the Company acquired
through its license agreement with MBI, Company scientists have identified
several new potential anti-inflammatory compounds which the Company believes may
inhibit very early stages of inflammation caused by activation of the complement
system. See "Relationship with Medical Biology Institute". The Company believes
that there are no currently available therapeutic products which specifically
inhibit complement activation involved in a variety of human diseases including
autoimmune diseases, such as rheumatoid arthritis and lupus, adult respiratory
distress syndrome, certain neurological disorders, reperfusion injury following
heart attacks, and organ transplant rejection. Complement inhibitors can
potentially suppress inflammatory responses at earlier stages than other
anti-inflammatory drugs by blocking interactions between complement proteins.
Identifying potential peptide inhibitors capable of blocking interaction among
complement system proteins requires knowledge of the proteins' structures,
especially the location of binding sites involved in protein-protein
interactions. In the past, scientists have relied on time-intensive
three-dimensional techniques such as X-ray crystallography to determine
structures and possible binding sites. The INDEL technology appears to rapidly
identify potential interactive binding sites on proteins based on analysis of
gene and protein sequences. Although research efforts are at an early stage,
Company scientists believe that the INDEL technology has the potential to reduce
the drug discovery process from years to months. The Company is also using the
INDEL technology to discover active sites on a variety of clinically important
proteins. Both U.S. and foreign patent applications have been filed for the
INDEL technology. The rights to these patent applications belong to the Company
through the MBI Agreement. See "Patents and Proprietary Rights."





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            The Company is also supporting research and development efforts on
other technologies developed at MBI including work related to IgE receptor
modulation, dendritic cell-based vaccines and hematopoietic stem cell
development . See "Relationship with Medical Biology Institute".

            Research and development efforts relating to the FFA, hu-PBL-SCID,
INDEL and other technologies are at an early stage. There can be no assurance
that efforts to develop commercial applications of these technologies will be
continued. In the event that the Company proceeds with efforts to develop
commercial applications of these technologies, it may require additional
financing either from collaborative arrangements with pharmaceutical or
biotechnology companies or from other sources to commercialize any such
applications. There can be no assurance that the required development and
testing will be successfully completed and result in safe and effective products
for human use, that the Company will be able to raise additional financing, or
that the Company will be able to enter into licensing or other collaborative
arrangements on favorable terms, if at all.

RELATIONSHIP WITH MEDICAL BIOLOGY INSTITUTE

            In October 1988, the Company entered into an exclusive license
agreement with Medical Biology Institute, a non-profit research organization
founded by David H. Katz, M.D. Dr. Katz serves as President, Chief Executive
Officer and a director of MBI. MBI was incorporated in California in 1981 to
conduct interdisciplinary basic research in biological sciences. MBI currently
conducts research on a variety of projects funded predominantly by Federal
grants. Certain of the founders, scientific consultants, staff scientists and
administrative personnel of the Company are affiliated with and/or employed by
MBI. See "Human Resources." The MBI Agreement was amended in 1993 and 1994.

            Under the MBI Agreement, as amended, the Company has been granted an
exclusive worldwide license to all technology and know-how of MBI which had been
developed or which was under development as of the original date of the MBI
Agreement and a right of first preference to license future technology of MBI
through the year 2013 subject to restrictions, if any, in the funding agreements
by which MBI develops the technology. The Company expects that, if rights to
additional technologies developed at MBI are acquired pursuant to right of first
preference under the MBI Agreement, the Company will assume responsibility
including funding, for the commercial development efforts including remaining
research and development, clinical testing and regulatory approvals.

            MBI currently leases office and laboratory facilities in La Jolla,
California. The lease expires in 1997. MBI intends to renew its lease under a 5
year renewal option which it exercised on May 31, 1996. MBI's laboratories are
designed for all phases of biological, biochemical, molecular biology and
immunochemical studies, including tissue culture facilities, walk-in
environmental rooms, facilities for recombinant DNA experimentation and modern
computer equipment. MBI maintains a modern vivarium for breeding and housing of
certain rodents in ample numbers to meet the needs of its researchers. The
Company entered into a sublease agreement with MBI for laboratory and
administrative facilities, equipment and services. The MBI Agreement provides
that MBI will perform research services for the Company at its request on a
fee-for-service basis not to exceed MBI's cost of providing such services,
including reasonable overhead and administrative costs. Excluded from the
computation of such fees are salaries of scientists also employed by the
Company, as well as the costs of facilities, equipment and administrative
services already included in the sublease agreement. See "Human Resources," and
"Item 2.--Properties. "

            There can be no assurance that the Company will have the ability to
satisfy all of its obligations under the MBI Agreement, that the MBI Agreement
will result in the development of any additional products or technologies, that
MBI will be able to continue to receive adequate research funding, or that MBI
will be able to attract and/or maintain qualified scientific or administrative
personnel. Modification or termination of the MBI Agreement could have a
material adverse effect on the Company.




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GOVERNMENT REGULATIONS

            The manufacture and sale of pharmaceutical products under
development by the Company are subject to extensive regulation by the FDA in the
United States and by comparable regulatory agencies in certain foreign
countries. The FDA has established guidelines and safety standards which are
applicable to the preclinical evaluation and clinical investigation of
therapeutic products and stringent regulations which govern the manufacture and
sale of such products.

            The process of obtaining FDA approval for a new therapeutic product,
such as LIDAKOL or LMI, usually takes a significant amount of time and
substantial resources. The steps typically required before such a product can be
produced and marketed for human use include preclinical evaluation in vitro and
in animal models, the filing of an IND, the conduct of human clinical
investigations and the filing of an NDA which must be approved by the FDA.

            Preclinical studies are conducted in vitro and in animal models in
order to gain preliminary information on the safety and efficacy of a drug. The
results of such preclinical studies are submitted to the FDA as part of the IND
application. After the sponsor files an IND, the sponsor may commence
investigating the drug in humans within 30 days unless otherwise notified by the
FDA.

            The human clinical testing program for a drug generally involves
three phases. Phase 1 investigations are conducted on volunteers or, in the case
of certain anti-tumor agents, on volunteers with a terminal disease to determine
the maximum tolerated doses and any side effects of the product. Phase 2 studies
are conducted on a small number of patients with the disease or condition to be
studied, in order to determine whether the product demonstrates some level of
effectiveness against the disease and to determine the most effective doses and
schedule of administration. Phase 3 studies involve wide-scale, well controlled
investigations on patients who have the disease or condition for the purpose of
determining whether the drug is safe and effective in a rigorously controlled
trial. Data from Phase 1, Phase 2 and Phase 3 trials are submitted to the FDA in
an NDA. The NDA involves considerable data collection, verification and
analysis, as well as the preparation of summaries of the manufacturing and
testing processes, preclinical studies and clinical trials. The FDA's Center for
Drug Evaluation and Research must approve an NDA for a drug before the drug may
be marketed in the United States.

            The Company is currently conducting Phase 3 clinical trials of
LIDAKOL as a topical treatment of oral herpes infections and two Phase 2
clinical trials of LIDAKOL as a topical treatment for KS lesions and MC under an
IND with the FDA. See "Research and Development - LIDAKOL". In addition, the
Company is conducting a Phase 1/Phase 2 human clinical trial of its LMI
technology as a treatment for late stage melanoma under an IND with the FDA. See
"Research and Development - LMI". A Phase 1/Phase 2 trial combines the safety
and efficacy testing, described above, into one trial. No other IND applications
have been filed with the FDA or any other agency with respect to any of the
Company's other products or technologies.

            At such time, if ever, that the Company begins marketing its
products for commercial sale in the United States, any manufacturing operations
which may be established within or outside the United States will be subject to
rigorous regulation, including the need to comply with Federal Good
Manufacturing Practice Regulations. See "Manufacturing and Marketing." The
Company may also be subject to regulation under the Occupational Safety and
Health Act, the Environmental Protection Act, the Toxic Substance Control Act,
Export Control Act and other present and future laws of general application.

            Additionally, the handling, care and use of laboratory mice, such as
the hu-PBL-SCID mice, and rats is subject to the Guidelines for the Humane Use
and Care of Laboratory Animals published by the NIH.

            The Company intends to seek approval to market its products in
foreign countries which may have regulatory processes that materially differ
from that of the FDA. The Company anticipates that it will rely upon the
pharmaceutical or biotechnology companies to which it has licensed or may
license its products, or independent consultants, to seek approvals to market
its products in foreign countries. There can be no assurance that approvals to
market any of the Company's products can be obtained in any country. Approval to
market a product in any one foreign country does not necessarily indicate that
approval can be obtained in other countries.one foreign country does not
necessarily indicate that approval can be obtained in other countries.





                                       8
<PAGE>   9

PATENTS AND PROPRIETARY RIGHTS

            The Company owns six United States and three European patents and
has additional foreign patent applications pending relating to the topical and
systemic uses of LIDAKOL and has been granted rights under certain United States
and foreign patents and patent applications relating to LIDAKOL held by a third
party. In addition, the Company has been granted rights to certain United States
and foreign patents and patent applications related to LMI, FFA, hu-PBL-SCID
technologies pursuant to the MBI Agreement. United States and Foreign patent
applications have been filed related to INDEL and other technologies pursuant to
the MBI Agreement. The MBI Agreement requires the Company to pay the costs of
pursuing and obtaining patents on the licensed technology and any improvements
thereto. See "Research and Development" and "Relationship with Medical Biology
Institute".

            There can be no assurance that the claims in the pending patent
applications will issue as patents, that any issued patents will provide the
Company with significant competitive advantages, or that challenges will not be
instituted against the validity or enforceability of any patent owned by the
Company or, if instituted, that such challenges will not be successful. The cost
of litigation to uphold the validity and prevent infringement of the Company's
patents could be substantial. Furthermore, there can be no assurance that others
will not independently develop similar technologies or duplicate the Company's
technologies or design around the patented aspects of the Company's
technologies. There is no assurance that the Company's proposed technologies
will not infringe patents or other rights owned by others, licenses to which may
not be available to the Company. Finally, NIH regulations provide that if
federally-funded institutions do not timely pursue patent applications for
patentable inventions, the government can exercise its right to own such
inventions. Accordingly, the Company must monitor MBI's filing of patent
applications in order to protect the value of its license agreement with MBI.

            The process for the approval of patent applications in foreign
countries may differ significantly from the process in the United States.
Approval in one country does not necessarily indicate that approval can be
obtained in other countries. The patent authorities in each country administer
that country's laws and regulations relating to patents independently of the
laws and regulations of any other country and the patents must be sought and
obtained separately.

            In some cases, the Company may rely on trade secrets and
confidentiality agreements to protect its innovations. There can be no assurance
that trade secrets will be established, or that secrecy obligations will be
honored, or that others will not independently develop similar or superior
technology. To the extent that consultants, key employees or other third parties
apply technological information independently developed by them or by others to
Company projects, disputes may arise as to the proprietary rights to such
information which may not be resolved in favor of the Company.

PRODUCT LIABILITY

            The testing, marketing and sale of pharmaceutical products entails a
risk of product liability claims by consumers and others. Claims may be asserted
against the Company by end users of any of the Company's proposed products which
may be developed. The Company has obtained product liability insurance coverage
in the amount of $2,000,000 per incident and in aggregate for its clinical
trials. There is no assurance that such insurance will be sufficient to cover
all possible liabilities. In the event of a successful suit against the Company,
lack or insufficiency of insurance coverage could have a material adverse effect
on the Company. Further, certain distributors of pharmaceutical products require
minimum product liability insurance coverage as a condition precedent to
purchasing or accepting products for distribution. Failure to satisfy such
insurance requirements could impede the ability of the Company to achieve broad
distribution of its proposed products, which would have a material adverse
effect upon the business and financial condition of the Company.




                                       9
<PAGE>   10
MANUFACTURING AND MARKETING

            The Company has established certain contractual manufacturing
relationships with respect to the manufacturing of LIDAKOL and LMI. The Company
does not have the resources to directly manufacture or directly market LIDAKOL
or any other products which it may develop on a large commercial scale. To
successfully commercialize LIDAKOL or any other products, it will be necessary
for the Company to enter into collaborative and licensing arrangements with
pharmaceutical or biotechnology companies to assist in funding development
costs, including the costs of clinical testing necessary to obtain regulatory
approvals, and costs of manufacturing and marketing. The Company believes that
these arrangements will be more effective in promoting and distributing its
products in view of the Company's limited resources and the extensive marketing
networks and large advertising budgets of established companies. Such
third-party arrangements, however, will reduce the Company's profit margin on
its products.

            In November 1991, the Company entered into a licensing agreement
with Yamanouchi for the clinical development, manufacturing, marketing and
distribution of LIDAKOL in certain European and other countries. Pursuant to
this agreement the Company and Yamanouchi have jointly designed clinical
trials of LIDAKOL which were conducted by Yamanouchi to confirm clinical
efficacy and generate data to support regulatory approval for market
introduction of LIDAKOL for topical treatment of herpes in covered territories.
See "Research and Development-LIDAKOL".

            In July 1993, the Company entered into a licensing agreement with
CTS Chemical Industries, Ltd. ("CTS"), a subsidiary of CTS Ltd., located in
Kiryat Malachi, Israel, for the promotion of LIDAKOL in Israel, including
obtaining governmental approvals for its manufacture and distribution. Separate
clinical trials in Israel are not required for marketing approval. Accordingly,
CTS will be able to file for marketing approval based on the data generated in
U.S. and Canadian clinical trials, if successful, and European clinical trials.
See "Research and Development-LIDAKOL".

            In July 1994, the Company entered into a licensing agreement with
Boryung Pharmaceuticals Company, Ltd. located in Seoul, Korea, for the promotion
of LIDAKOL in the Republic of Korea, including obtaining governmental approvals
for its manufacture and distribution. In Korea, certain local clinical trials,
in addition to clinical data generated in the U.S., Canada and Europe, are
required in order to apply for marketing approval. To date, local clinical
trials have not been initiated. See "Research and Development-LIDAKOL".

            In October 1994, the Company entered into a licensing agreement with
Grelan Pharmaceutical Company, Ltd. located in Tokyo, Japan, for the promotion
of LIDAKOL in Japan, including obtaining governmental approvals for its
manufacture and distribution. In Japan complete Phase 1, 2 and 3 clinical
trials, conducted in Japan, are required in order to apply for marketing
approval.

            In February 1996, the Company entered into an exclusive license and
distribution agreement with Bristol-Myers Squibb Company ("BMS"), underwhich BMS
received the rights to manufacture, market and distribute LIDAKOL as a topical
treatment for oral herpes in the United States, Canada and all remaining major
territories throughout the world which were not licensed to other parties. In
November 1996, the Company reacquired the rights to market LIDAKOL in all
territories except the U.S., Canada, and Mexico and is now free to engage new
licensing partners in these reacquired territories, which include China, South
and Central America, Australia and India, and portions of the Far East.

            The Company is currently discussing licensing agreements for LIDAKOL
in the territories not covered by the above agreements with other pharmaceutical
companies. The Company may ultimately decide to establish its own manufacturing
and/or marketing capability, at least for certain products or certain
applications related thereto, in which case it would require substantial
additional funds and personnel. There can be no assurances, however, that the
Company will be able to finalize any substantial additional licensing
arrangements on favorable terms, if at all, or that the Company will be able to
raise additional financing necessary to develop and market LIDAKOL and any of
its other products.




                                       10
<PAGE>   11
COMPETITION

            The pharmaceutical industry is characterized by rapidly evolving
technology and intense competition. Many companies of all sizes, including major
pharmaceutical companies and specialized biotechnology companies, are engaged in
activities similar to those of the Company. Many of the Company's competitors
have substantially greater financial and other resources, larger research and
development staffs and, unlike the Company, have significant experience in
pre-clinical testing, human clinical trials and other regulatory approval
procedures. In addition, colleges, universities, governmental agencies and other
public and private research organizations will continue to conduct research and
are becoming more active in seeking patent protection and licensing arrangements
to collect royalties for use of technology that they have developed, some of
which may be directly competitive with that of the Company. In addition, these
institutions compete with commercial firms, such as the Company, in recruiting
highly qualified scientific personnel. The Company does not have the resources
and does not intend to compete with major pharmaceutical companies on a wide
scale basis in the areas of clinical testing, regulatory approvals,
manufacturing and marketing. See "Manufacturing and Marketing" and "Government
Regulations."

            The Company's first proposed product, LIDAKOL, if successfully
developed and approved for commercialization for the treatment of oral herpes,
will compete with acyclovir (Zovirax(R)), a product marketed by Glaxo-Wellcome
Corp., and famciclovir (Famvir(R)) and penciclovir (Denavir(R)), products
marketed by SmithKline Beecham, and over-the-counter preparations. In addition,
there are products and compounds being developed by other pharmaceutical and
biotechnology companies for treatment of oral herpes, including the
Glaxo-Wellcome product Valtrex(TM) (valaciclovir). There can be no assurance
that LIDAKOL, if successfully developed and approved for sale by the FDA, will
gain widespread acceptance by the medical community or consumer market.

            The Company's LMI technology will compete with technologies being
developed by other companies and academic institutions which attempt to
stimulate an immune response. There can be no assurance that these competing
technologies will be less efficacious than LMI or that LMI will gain widespread
acceptance by the medical community.

HUMAN RESOURCES

            At December 20, 1996, the Company employed 44 persons, of whom 26
were engaged in research and development activities and 18 in finance, business
development and administrative functions. The Company's staff includes 16
employees with Ph.D. or M.D. degrees. Eight of the Company's employees are also
employed by MBI (including Dr. Katz, the Company's President and Chief Executive
Officer). In addition the Company has consulting agreements with four senior
scientists at MBI. Pursuant to its arrangement with MBI, MBI may perform
research services at the request of the Company on a fee-for-service basis. See
"Relationship with the Medical Biology Institute."

EXECUTIVE OFFICERS

The Executive Officers of the Company and their ages as of December 20, 1996 are
as follows:

DAVID H. KATZ, M.D....53
President and Chief Executive Officer; Acting Chief Financial Officer

            Dr. Katz, M.D., has served as Chief Executive Officer and as a
director of the Company since its inception in 1988 and as its President from
inception through October 8, 1989 and from March 14, 1992 to the present. Since
October, 1996, Dr. Katz has served as Vice President, Chief Financial Officer
and Secretary. Dr. Katz is the founder of MBI and has served as its President
and Chief Executive Officer since its inception in 1981 and as a director since
August 1990. He was also founder of QUIDEL Corporation, a San Diego based
biotechnology company ("QUIDEL"), serving as its Chairman of the 





                                       11
<PAGE>   12

Board and Chief Executive Officer from inception in 1981 through March 1985, and
as its Chairman of the Board and Chief Scientific Officer through March 1988.
Prior to founding MBI and QUIDEL, Dr. Katz was Chairman of the Department of
Cellular and Developmental Immunology at Scripps Clinic and Research Foundation
from 1976. From 1971 to 1976, Dr. Katz was on the Faculty of Medicine at Harvard
Medical School. Dr. Katz has authored over 300 scientific publications, a
comprehensive textbook on Immunology and edited a half-dozen other books in his
field. Dr. Katz has served on the editorial boards of six major scientific
journals, and was elected to membership in the American Society for Clinical
Investigation in 1977. He has been an advisor to the National Institutes of
Health ("NIH"), and served as Member of the Cancer Preclinical Program Project
Research Committee of the National Cancer Institute at the NIH, and on the
Medical and Scientific Advisory Board and the National Board of Trustees of the
Leukemia Society of America. Dr. Katz received his B.A. in Biology from the
University of Virginia in 1965 and his M.D. degree from Duke University Medical
School in 1968. He trained in Internal Medicine at Johns Hopkins and then served
on the staff of NIH.

TIMOTHY R. RUSSELL....54
Vice President of Business Development and Licensing

            Mr. Russell has served as Vice President of Business Development and
Licensing since September, 1992. Mr. Russell also serves as President of
Carlsson-Rensselaer Corporation, a licensing and development consulting company
which he founded in 1990. Mr. Russell currently devotes less than 5% of his time
to the Carlsson-Rensselaer Corporation. Prior to 1990, Mr. Russell held various
positions in McNeil Pharmaceuticals, a subsidiary of Johnson & Johnson,
including serving as a board member (1983-1990), Vice President of Corporate
Relations (1986-1990), Vice President of Business Development (1983-1986) and
other business development and planning functions (1975-1983). Mr. Russell also
serves as a director of Scandipharm, Inc., a privately held pharmaceutical
company based in Birmingham, Alabama. Mr. Russell received a B.S. degree in
Engineering in 1964 from Rensselaer-Polytechnic Institute and an M.B.A. in 1987
from the Wharton School of the University of Pennsylvania.

GERALD J. YAKATAN...54
Vice President of Drug Development

            Dr. Yakatan has served the Company on a half-time basis as Vice
President of Drug Development since July, 1995. Dr. Yakatan also currently
serves as an independent consultant to other biotechnology companies. From 1990
until 1995, Dr. Yakatan served as President and Chief Executive Officer of San
Diego based Tanabe Research Laboratories, USA, Inc., an inflammation drug
discovery research and development company. From 1987 until 1990, Dr. Yakatan
was Executive Vice President for Research and Development, and Vice President of
Pharmaceutical Development at Immunetech Pharmaceuticals, the predecessor
company to Tanabe Research. From 1980 to 1987, Dr. Yakatan held various
positions at Warner-Lambert Co., initially joining the
Warner-Lambert/Parke-Davis Pharmaceutical Research Division as Director,
Pharmokinetics/Drug Metabolism and later serving as Vice President of Product
Development for the Pharmaceutical Research Division. From 1972 to 1980, Dr.
Yakatan was on the faculty of the University of Texas at Austin and Assistant
Director of the Drug Dynamics Institute at the College of Pharmacy. Dr. Yakatan
has over 60 scientific and professional publications in the areas of
pharmokinetics, biopharmaceutics, analysis of drugs in biological fluids and
drug stability. He is a Fellow of the American Association of Pharmaceutical
Scientists and the American College of Clinical Pharmacology. Dr. Yakatan
received his B.S. in Pharmacy in 1963 and M.S. in Pharmaceutical Chemistry in
1965 from Temple University. In 1971, Dr. Yakatan received his Ph.D. in
Pharmaceutical Sciences from the University of Florida.

SENIOR MANAGEMENT

The following sets forth information with respect to other members of Management
of the Company:

            James E. Berg, has been Director of Clinical Affairs and Product
Development since August, 1992. Prior to joining the Company, Mr. Berg was
employed by QUIDEL Corporation, since 1984, where he held positions as Regional
Manager, Autoimmune Products, National Accounts Manager, Director of 




                                       12
<PAGE>   13

Materials, Materials Manager and Product Manager. From 1979 to 1984, Mr. Berg
was the Sales Manager, Eastern Region at Bilstein Corporation. Mr. Berg received
his B.A. degree from the University of Wisconsin in 1973.

            Carol O. Cowing, Ph.D., has a been Director of Biological Sciences
since May 1996. Prior to joining the Company as a full-time employee, Dr. Cowing
served as a consultant to the Company since 1989. Dr. Cowing has been on the
scientific staff of the Medical Biology Institute since 1985, serving as an
Associate Member from 1985 to 1993 and as Member from 1993 to 1996. From 1979 to
1985, Dr. Cowing was an Assistant Professor of Pathology and a Member of the
Immunology Graduate Group at the University of Pennsylvania School of Medicine.
Prior to 1979, Dr. Cowing performed postdoctoral research in the Department of
Genetics at Washington University Medical School and the National Cancer
Institute of the National Institutes of Health. Dr. Cowing has over 40
publications in the field of Immunology and has served on several national
advisory committees of the National Institutes of Health, the National Science
Foundation and the U.S. Army Medical Research Breast Cancer Program. Dr. Cowing
received her B.A. from Stanford University in 1963 and a Ph.D. in Medical
Microbiology from Stanford University School of Medicine in 1973.

            Laura E. Pope, Ph.D., has been Director of Preclinical Development
since May, 1996. Prior to May, 1996, Dr. Pope was Manager of Drug Metabolism and
Pharmacokinetics from October, 1994 and a Senior Scientist Company since
September, 1990. From 1987 to 1990, Dr. Pope served as a Research Associate in
the Division of Biochemistry, Department of Molecular and Experimental Medicine
at the Research Institute of Scripps Clinic. From 1984 to 1987, Dr. Pope was the
recipient of Postdoctoral Fellowship awards from the American Cancer Society and
National Cancer Institute while at Scripps. Dr. Pope received her B.A. degree
from the University of Kansas in 1978, and her Ph.D. in Biological Chemistry
from the University of California, Los Angeles, in 1983.

            Jagadish Sircar, Ph.D., has been Director of Biological Chemistry
since May 1996. Dr. Sircar served as a full-time consultant to the Company from
November 1995. Prior to joining the Company, Dr. Sircar was Senior Vice
President of Research and Discovery at Biofor, Inc. from 1992 to 1995. From 1969
to 1991, Dr. Sircar held various positions at Warner Lambert/Parke Davis,
including the position of Research Fellow and Chairman of the
Immuno-Inflammatory Project Team. During his 22 years at Parke-Davis, Dr. Sircar
was responsible for the design and implementation of two significant
inflammation research programs and the discovery and preclinical development of
six compounds. Dr. Sircar is also responsible for the discovery of PNP
inhibitors, under development by Parke-Davis and BioCryst Pharmaceuticals, Inc.
Dr. Sircar holds in excess of 70 patents and has in excess of 74 scientific
publications relating to inflammation, asthma/allergy, cardiovascular diseases
and fungal infections. Dr. Sircar received his B.Sc., in 1956, his M.S. in 1958
and Ph.D. in Chemistry in 1964 from the University of Calcutta.

SENIOR SCIENTIFIC & REGULATORY PERSONNEL

The following sets forth information with respect to other Senior Scientists,
and Medical and Regulatory Staff of the Company:

            Naghmana Z. Bajwa, M.D., has been Associate Medical Director since
October 1996. Prior to joining the Company, Dr. Bajwa was the Primary Clinical
Data Manager In Parexel International Corporation's Biostatistics and Data
Management Division since 1995. From 1994 to 1995, Dr. Bajwa was a Project
Coordinator and Medical Consultant at VRG International. Prior to that, Dr.
Bajwa was the Supervising Medical Officer at the Rural Health Center in Girjat,
Pakistan from 1992 until 1994 and Medical Officer/Surgery at the Mayo Hospital
in Lahore, Pakistan from 1991 until 1992. Dr. Bajwa received her Pre-Medical
Degree at Lahore College in Lahore, Pakistan in 1983 and her M.B., B.S. degree
from Fatima Jinnah Medical College in Lahore, Pakistan in 1990.

            Robert C. Davis, Ph.D., has been a Senior Scientist of the Company
since May, 1992. Before joining the Company, Dr. Davis was an independent
consultant from 1988. From 1976 to 1988 he was employed by the Battelle Columbus
Div. of Columbus, Ohio, concluding as a Senior Research Scientist at 




                                       13
<PAGE>   14

Battelle. From 1969 to 1976, Dr. Davis was an Assistant Professor of Chemistry
at the University of Pennsylvania in Philadelphia. Dr. Davis received his B.A.
from University of Rochester in 1962 and his Ph.D. in Chemistry from the
University of California at Berkeley in 1967.

            M.H. Khalil, Ph.D., has served as a Senior Scientist at the Company
since inception. From 1985 to 1989, Dr. Khalil was Associate Director of
Diagnostic R & D at QUIDEL Corporation where he managed the research and
development of rapid, solid phase enzymatic and nonenzymatic visual
immunoassays. From 1979 through 1985, Dr. Khalil was Manager and Senior
Scientist at International Diagnostic Technology ("IDT") where he was involved
in the research and development of immunofluorescence instrumentation and
reagents. From 1978 through 1979, Dr. Khalil was a Research Scientist at SYVA
Diagnostics working on the research and development of diagnostic equipment and
reagents for therapeutic drug monitoring. From 1975 through 1978, Dr. Khalil did
his postdoctoral training at North Dakota State University and California State
University of Long Beach. Dr. Khalil received a Ph.D. in Organic Chemistry from
the University of North Dakota.

            John F. Marcelletti, Ph.D., has been a Senior Scientist at the
Company since inception and since July, 1993, has been Head of Experimental
Medicine. Before joining the Company, Dr. Marcelletti served as an Assistant
Member at the Medical Biology Institute from 1982. During that period, he was
involved in the study of the role of IgE antibodies in allergic and arthritic
diseases. Also during this time period, he was employed as a scientific
consultant to the therapeutics group of QUIDEL. Dr. Marcelletti received his
Ph.D. from Wayne State University School of Medicine, Department of Immunology
and Microbiology, in 1979. He received his M.B.A from Western Michigan
University in 1981.

            Phillip R. Morrow, Ph.D., has been a Senior Scientist at the Company
since July 1991. Prior to joining the Company, Dr. Morrow was the Director of
Research and Technical Services at Imdyne, Inc., where he was responsible for
research and technical support involving commercial and scientific applications
of immunodeficient rodents. From 1989 to 1990, Dr. Morrow was Project Manager
and Senior Scientist at QUIDEL Corporation where he supervised the development
of two in vitro diagnostic tests for antibodies to H. pylori, an infectious
organism involved in gastric ulcer pathogenesis. From 1987 to 1989, Dr. Morrow
was Manager, Clinical Trials and Manager, Hybridoma Facility at Cytotech, Inc.,
where he supervised production and purification of monoclonal antibodies and the
procurement and testing of patient samples for FDA submission. From 1981 to
1986, Dr. Morrow was a Research Fellow and Senior Research Associate in the
Department of Immunology at the Research Institute of Scripps Clinic. Dr. Morrow
received a B.A. degree in Mathematics in 1971 from the University of California,
Riverside; his M.S. degree and his Ph.D. degree in Genetics in 1974 and 1979,
respectively, from the University of California, Davis, where he also completed
his postdoctoral training from 1979 to 1981.

RISK FACTORS

            Development Stage Company; Explanatory Paragraph in Independent
Auditors' Report for the Fiscal Year Ended September 30, 1996; History of
Continuing Losses. The Company's independent auditors have included an
explanatory paragraph in their report issued in connection with their audit of
the Company's financial statements as of and for the fiscal year ended September
30, 1996 that refers to the Company's activities as those of a development stage
enterprise. Through September 30, 1996 the Company has generated only limited
revenues. Primarily as a result of expenses incurred in organizational and
research and development activities, the Company has incurred net losses
aggregating approximately $34.3 million from its inception through September 30,
1996. Since September 30, 1996, the Company has incurred operating losses, and
anticipates that it will continue to incur substantial operating losses until
such time, if ever, that the Company achieves significant revenue from its
products. There can be no assurance that the Company will be able to
successfully implement its marketing strategy or achieve significant revenues or
profitable operations. Potential investors should be aware of the problems,
delays, expense, and difficulties encountered by any company in the development
stage, many of which may be beyond the Company's control. These include, but are
not limited to, unanticipated problems relating to product development and
formulation, clinical testing, regulatory compliance, production and marketing
additional costs and competition. There can be no assurance that the 




                                       14
<PAGE>   15

Company's proposed products, if fully developed and if required regulatory
approvals are obtained, can be successfully marketed or that the Company will
ever achieve significant revenues or profitable operations.

            Significant Capital Requirements; Need for Working Capital and
Additional Financing. The commercialization of LIDAKOL or any of the Company's
other products will require capital reserves substantially greater than those
currently available to the Company. Accordingly, the Company will be required to
raise additional capital and, with the exception of LIDAKOL for oral herpes,
will be required to collaborate with one or more large pharmaceutical companies
which will provide the necessary financing and expertise to obtain regulatory
approvals, complete clinical development, manufacture and market other
indications of LIDAKOL and other proposed products. To date, the Company has
entered into five such agreements relating to LIDAKOL for herpes. (See
"Manufacturing and Marketing"). There can be no assurance that the Company will
be able to raise additional capital or to enter into other collaborative
arrangements necessary to further develop or commercialize LIDAKOL or any of its
other proposed products on acceptable terms. Failure to obtain required
additional financing, or to enter into additional collaborative and licensing
arrangements for the continued development, manufacturing and distribution of
the Company's products, would materially limit the Company's ability to finance
or undertake its proposed operations. In such event, if the Company were unable
to obtain from alternative sources the substantial financing necessary on
acceptable terms, it would be unable to commercialize any products.

            In additon, the Company is obligated to repay the outstanding
principal balance of the Convertible Note (the "Note"), issued in January, 1996,
two years from the date of issuance to the extent the Note is not converted into
Class A Common Stock. (See "Management's Discussion and Anaylsis of Financial
Condition -- Liquidity and Capital Resources"). At December 20, 1996, the
remaining principal balance of the Note is $1.3 million. In the event the
noteholder requests conversion of the remaining principal amount, the Company is
immediately obligated to repay the principal of that portion of the Note which
is presented for conversion which cannot be converted plus a premium equal to
25% of such principal plus any accrued and unpaid interest. At December 20,
1996, the Company would be required to pay the noteholder approximately $1.6
million as repayment of principal plus premium and any accrued interest. At its
option, the noteholder can require the Company to seek shareholder approval to
issue shares of Class A Common Stock at the then fair market value in exchange
for the above-referenced principal and premium payment.

            Early Stage of Research Development; Unproven Products; Possible
Loss of Product Development Costs. There can be no assurance that LIDAKOL or any
of the Company's other proposed products will be successfully developed, prove
to be safe and efficacious in clinical trials, prove to be more effective than
formulated products based on existing or newly developed technologies, meet
applicable regulatory standards, demonstrate substantial therapeutic benefits in
the treatment of any disease, be capable of being produced in commercial
quantities at reasonable costs or be successfully marketed. There can be no
assurance that effectiveness of these technologies in preclinical studies
performed in vitro or in animal models will be pertinent to the development of,
or indicative of the efficacy of, a product for human use. The continued
development of the Company's products, including LIDAKOL, remain subject to all
the risks inherent in the development of products based on innovative
technologies, including unanticipated development problems and the possible
insufficiency of funds which could result in the abandonment or substantial
change in the development of a specific product. The development of medical
products is a lengthy and capital intensive process. The risk of failure to
complete development of the Company's proposed products is substantial.
Unsuccessful Phase 3 clinical trial results for proposed products or the
inability to successfully complete development, or a determination by the
Company, for economic or other reasons, not to undertake to complete development
of a particular product, could have a material adverse effect on the Company.
Such material adverse effect with respect to unsuccessful clinical trial results
for LIDAKOL for oral herpes would be virtually assured.

            Uncertainty of Market Acceptance; Limited Marketing Arrangements for
Proposed Products. Except for its arrangement with Molecular Probes, Inc., the
Company has not commenced marketing of any products to date, and at the present
time, has limited marketing capabilities. Achieving market acceptance will
require substantial marketing efforts and the expenditure of significant funds
to inform potential customers of the perceived benefits of the Company's
proposed products. The Company has no experience in the marketing or
distribution of its proposed products. Moreover, the Company does not 




                                       15
<PAGE>   16

have the financial and other resources to undertake extensive marketing and
advertising activities. Accordingly, the Company intends generally to rely on
marketing arrangements, including possible joint ventures, license or
distribution arrangements with third parties. To date, the Company has entered
into marketing agreements with Yamanouchi, CTS, Boryung, Grelan, BMS and
Molecular Probes, Inc. (See "Manufacturing and Marketing" and "Research and
Development-ADIFAB") There can be no assurance that it will be successful in
entering into similar agreements with other parties in the future or that its
products can be successfully marketed.

            Government Regulation. The development, production, testing,
manufacturing and marketing of pharmaceutical products is subject to significant
regulation by governmental authorities in the United States, including the FDA,
and other countries. The clinical testing and regulatory approval process can
take a number of years and require the expenditure of substantial resources.
There can be no assurance that regulatory approval will be obtained for any of
the Company's proposed products. A significant portion of the proceeds of the
Company's financings are being used for research and development and clinical
trials necessary for seeking such approvals for the Company's products. There is
no assurance that the Company will be able to enter into additional
collaborative arrangements with large pharmaceutical companies to provide the
financing necessary to complete the required testing and regulatory review
process for the Company's products. Further, the expenditures by the Company
will be made without any assurance that approvals will be obtained and before it
can be ascertained whether the Company's products can be commercialized. The
inability to obtain, or delays in obtaining, such approval would adversely
affect the Company's ability to commence marketing such products and could have
a material adverse effect on the Company. The Company is unable to predict the
extent of adverse governmental regulation which might arise from future United
States or foreign legislative or administrative action.

            Moreover, the Company cannot predict with accuracy the effect of
unspecified, but possible, future changes in the regulatory approval process and
in the domestic health care system. Possible future changes could affect the
time frame required for regulatory review and the sale prices of the Company's
products, if approved for sale.

            Technological Change and Competition. The pharmaceutical industry is
subject to rapid, unpredictable and significant technological change.
Competition from universities, research institutions and pharmaceutical,
chemical and bio-engineering companies may be intense. There can be no assurance
that developments by the Company's competitors or potential competitors will not
render the Company's proposed products obsolete. Most of such competitors have
greater financial resources, research and development facilities and
manufacturing and marketing experience than the Company. If the Company's first
proposed product, LIDAKOL, is successfully developed, it will compete with
prescription products for oral herpes known to the Company currently on the
market in the United States and other over-the-counter preparations, as well as
other products or potential products which are or may be under development or
undergoing the FDA regulatory approval process. (See "Competition").

            Relationship With and Dependence on Medical Biology Institute. With
the exception of LIDAKOL, the Company's technologies have been obtained by
license from MBI, a non-profit research organization founded by Dr. Katz and
principally funded by research grants awarded by the National Institutes of
Health. Dr. Katz serves as President and Chief Executive Officer of MBI. Under
the MBI Agreement, as amended, the Company was granted a twenty-year exclusive
worldwide license to all technology and know-how which MBI developed or had
under development as of October 10, 1988, the date of the MBI Agreement, and a
right of first preference to license future technology subject to restrictions,
if any, in the funding agreements by which MBI develops the technology. In
consideration of these rights, MBI received 2,000,000 shares of the Company's
nonvoting Series A Preferred Stock, licensing fees in the amount of $900,000, 10
percent of all net license fees obtained by the Company based on licensed
technology, 20 percent of all royalties paid to the Company by any sublicensee
and 6% percent royalties (for patented inventions) or 3 percent royalties (for
nonpatented inventions) on net sales of products based on licensed technology
manufactured and marketed directly by the Company or any of its subsidiaries. In
addition, if the Company failed to market on a product scale at least one
product derived from a licensed technology or pay a royalty of at least $100,000
per year for the calendar year ending December 31, 1995, or any calendar year
thereafter, MBI had the right to convert the license to a nonexclusive license
upon six 




                                       16
<PAGE>   17

months' notice. MBI may terminate the MBI Agreement upon 180 days'
notice in the event of default thereunder by the Company which remains uncured
in 90 days.

            In July 1993, the MBI Agreement was amended, and pursuant to the
terms of the amendment, the Company issued 1,500,000 shares of Class A Common
Stock to MBI in consideration for a 5-year extension of their exclusive
technology rights (until October 10, 2013) and a 5-year postponement (until
December 31, 2000) of the Company's obligation to pay minimum royalties to MBI.
The shares granted to MBI pursuant to the amendment are restricted stock under
federal securities laws and do not enjoy any registration rights. Additionally,
in connection with the issuance of the new shares, MBI waived all rights to
1,500,000 of its Series A Preferred Shares which were then held in escrow.

            In July 1994, the MBI Agreement was further amended to provide for
future research funding and support for projects outside the realm of the
initial license agreement. This amendment provides for the transfer of ownership
rights for each specific project during the time it is being funded by the
Company.

            There can be no assurance that the Company will have the ability to
satisfy all of its obligations under the MBI Agreement, that the MBI Agreement
will result in the development of any additional products or technologies, that
the Company will be able to maintain its exclusivity to the MBI technology, that
MBI will be able to continue to receive additional research funding, or that MBI
will be able to attract and/or maintain qualified scientific or administrative
personnel. Modification or termination of the MBI Agreement could have a
material adverse effect on the Company.

            Dependence Upon Key Personnel. The Company is dependent on its
executive management and scientific staff, particularly Dr. David H. Katz, its
President and Chief Executive Officer. Dr. Katz also serves as President, Chief
Executive Officer and a Director of MBI and devotes a portion of his time to
MBI. A reduction in the amount of time Dr. Katz or other key personnel devote to
the Company or the loss of any key person could have a material adverse effect
upon the Company's business. The Company has entered into an employment
agreement with Dr. Katz and has obtained "key-man" life insurance on the life of
Dr. Katz in the amount of $1,000,000. In addition, in order to carry out its
business plan, the Company will be required to retain additional qualified
scientific, technical and administrative personnel. There can be no assurance
the Company will be able to attract or maintain such additional personnel.

            Patents and Proprietary Rights. The Company owns six United States
and three European patents and has additional foreign patent applications
pending relating to the topical and systemic uses of LIDAKOL and has been
granted rights under certain United States and foreign patents and patent
applications relating to LIDAKOL held by a third party. In addition, the Company
has been granted rights to certain United States and foreign patents and patent
applications related to LMI, and other technologies pursuant to the MBI
Agreement. There can be no assurance that the claims in the pending patent
applications will issue as patents, that any issued patents will provide the
Company with significant competitive advantages, or that challenges will not be
instituted against the validity or enforceability of any patent owned by the
Company or, if instituted, that such challenges will not be successful. The cost
of litigation to uphold the validity and prevent infringement of the Company's
patents could be substantial. Furthermore, there can be no assurance that others
will not independently develop similar technologies or duplicate the Company's
technologies or design around the patented aspects of the Company's
technologies. There is no assurance that the Company's proposed technologies
will not infringe patents or other rights owned by others, licenses to which may
not be available to the Company. In this regard, the Company was at one time
negotiating to acquire another company working on an anti-viral topical
therapeutic product, but such negotiations were terminated. Although there can
be no assurance that this other company will not assert rights with respect to
LIDAKOL in the future, the Company believes it will have meritorious defenses to
such assertions. Finally, federal NIH regulations provide that if
federally-funded institutions do not timely pursue patent applications for
patentable inventions, the government can exercise its right to own such
inventions. Accordingly, the Company must monitor MBI's filing of patent
applications in order to protect the value of its license agreement with MBI.
The MBI Agreement requires the Company to pay the costs of pursuing and
obtaining patents on the licensed technologies and improvements thereto.



                                       17
<PAGE>   18

            In some cases, the Company may rely on trade secrets and
confidentiality agreements to protect its innovations. There can be no assurance
that trade secrets will be established, that secrecy obligations will be honored
or that others will not independently develop similar or superior technology. To
the extent that consultants, key employees or other third parties apply
technological information independently developed by them or by others to
Company projects, disputes may arise as to the proprietary rights to such
information which may not be resolved in favor of the Company.

            Dependence Upon a Limited Number of Proposed Products. The Company's
principal efforts to date have been devoted to the development of LIDAKOL, LMI,
ADIFAB and hu-PBL-SCID mouse technologies. Of these products and technologies,
the Company believes LIDAKOL, for the treatment of oral herpes, is the product
most likely to be first available for commercial distribution. However, the
Company does not expect LIDAKOL to be available for commercial sale or use in
the United States and certain foreign markets until sometime in 1998, if at all.
The ADIFAB assay is currently available for sale to the research community and
the Company has entered into a distribution agreement with an independent,
third-party distributor. The Company does not believe that revenues from the
distribution of the ADIFAB assay will materially add to the revenues of the
Company for several years, if ever. Accordingly, it is not anticipated that the
Company will generate any significant revenues from sales for several years.

            The failure of these products to achieve commercial viability would
have a material adverse effect upon the business and financial condition of the
Company.

            Potential Conflicts of Interest. The Company's President and Chief
Executive Officer is also employed by MBI and serves on the board of directors
of MBI. Other than LIDAKOL, it is hoped that a large part of the Company's
business activities will relate to development of technologies licensed from
MBI. However, conflicts could arise with respect to, among other things, the
funding for development of licensed projects between the Company and MBI, as
well as the terms of licenses to future developments at MBI pursuant to the
Company's right of first preference to such developments. Although the decisions
with respect to such matters must be approved by a majority of the members of
the Board of Directors not employed by MBI, there can be no assurance that
effective transactions between the Company and MBI will be advantageous to the
Company, that conflicts of interest will not arise with respect to such
transactions or that, if conflicts of interest do arise, they will be resolved
in a manner favorable to the Company.

            Control by Insiders. As of December 20, 1996, the officers and
directors of the Company own approximately 4% of the outstanding capital stock
of the Company and possess approximately 6% of the voting power. At that date,
the officers and directors of the Company also held options and warrants to
purchase an additional 3,488,006 shares of Class A Common Stock and 407,000
shares of Class B Common Stock. Assuming exercise of these options and warrants,
the officers and directors of the Company would be able, as a practical matter,
to influence considerably the election of directors and thereby select
management and direct the policies of the Company.

            Dependence Upon Third-Party Arrangements. The Company does not have
and does not expect to have in the foreseeable future the resources to
manufacture or directly market on a large commercial scale LIDAKOL or any other
products which it may develop. To successfully commercialize LIDAKOL or any
other products it will be necessary for the Company to enter into collaborative
arrangements with pharmaceutical or biotechnology companies to assist in funding
development costs, including the costs of clinical testing necessary to obtain
regulatory approvals, and costs of manufacturing and marketing. The Company
believes that these arrangements will be more effective in promoting and
distributing its products in view of the Company's limited resources and the
extensive marketing networks and large promotional and advertising budgets of
established pharmaceutical companies. The Company has entered into several
licensing agreements to cover the clinical development, manufacturing and
marketing of LIDAKOL. There can be no assurance, however, that the Company will
be able to finalize any licensing or distributorship arrangements for
territories not covered by existing agreements on favorable terms or at all. The
Company may ultimately determine to establish its own manufacturing and/or
marketing capability, at least for certain products, in which case it will
require substantial additional funds and personnel.





                                       18
<PAGE>   19

            Risks Related to Foreign Sales. The Company is subject to various
risks inherent in foreign trade in connection with the continued development of
LIDAKOL by foreign licensees, and the manufacture, marketing and distribution of
LIDAKOL, if ever, overseas by foreign licensees. Such risks could include
economic or political instability, shipping delays, fluctuations in foreign
currency exchange rates, customs duties and export quotas and other trade
restrictions, all of which could have a significant impact on the Company's
ability to deliver its products.

            Possible Volatility of Stock Price. Recent history relating to the
market prices of the shares of biotechnology companies in general, and the
historical fluctuations in the market price of the Company's Class A Common
Stock, indicates the market price of the Company's Class A Common Stock may be
highly volatile. Factors such as fluctuations in the Company's operating
results, developments relating to the progress of clinical trials for the
Company's products and the Company's relationships with present and potential
licensees and distributors, announcements of technological innovations or new
products by the Company or its competitors, and changes in market conditions and
in the economy generally, may have a significant impact in the market price of
the Company's Class A Common Stock. Further, the market price for securities of
many biotechnology companies have experienced wide fluctuations which were not
necessarily related to the operating performance of such companies.

            Product Liability; Absence of Insurance Coverage. The testing,
marketing and sale of pharmaceutical products entails a risk of product
liability claims by consumers and others. Claims may be asserted against the
Company by end users of any of the Company's proposed products which may be
developed. The Company has obtained product liability insurance coverage for its
clinical trials in the amount of $2,000,000 per incident, and aggregate. There
is no assurance that such insurance will be sufficient to cover all possible
liabilities. In the event of a successful suit against the Company, lack or
insufficiency of insurance coverage could have a material adverse effect on the
Company. Further, certain distributors of pharmaceutical products require
minimum product liability insurance coverage as a condition precedent to
purchasing or accepting products for distribution. Failure to satisfy such
insurance requirements could impede the ability of the Company to achieve broad
distribution of its proposed products, which would have a material adverse
effect upon the business and financial condition of the Company.

            Future Sales of Common Stock. All of the Company's shares of Class B
Common Stock currently outstanding are "restricted securities" as the term is
defined in Rule 144 promulgated under the Securities Act of 1933, as amended
(the "Act") and under certain circumstances may be sold without registration
pursuant to such Rule. The outstanding shares of Class B Common Stock, which
will convert into Class A Common Stock upon certain sales or transfers, are
eligible for sale under Rule 144. Additionally, 1,338 shares are potentially
issuable upon conversion of the Convertible Note. (See "Effect of Outstanding
Convertible Stock, Options, Warrants and Notes" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations-Liquidity and Capital
Resources"). The Company is unable to predict the effect that sales made under
Rule 144, or otherwise, may have on the then prevailing market price of the
Class A Common Stock although any substantial sale of restricted securities
pursuant to Rule 144 may have an adverse effect.

            Effect of Outstanding Convertible Stock, Options, Warrants and
Notes: As of December 20, 1996, there were outstanding stock options to purchase
an aggregate of 5,214,827 shares of Class A Common Stock, which have exercise
prices ranging between $0.9375 to $6.4375 per share, and 429,000 shares of Class
B Common Stock which have exercise prices ranging between $0.0125 to $0.50 per
share. In addition, the Company had outstanding 283,000 shares of Class B Common
Stock at that date, each share of which is convertible into one share of Class A
Common Stock. In addition, the Company had outstanding at December 20, 1996,
Class D Warrants with an exercise price of $1.50 per share, which, if exercised,
would result in the issuance of 1,728,354 shares of Class A Common Stock.
Finally, at December 20, 1996, there were 1,338 shares of Class A Common Stock
issuable upon the conversion of the Notes. (See "Significant Capital
Requirements: Need for Working Capital and Additional Financing" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources").




                                       19
<PAGE>   20

            To the extent that these outstanding securities are exercised or
converted, dilution of the percentage of ownership of the Company's Shareholders
will occur. Sales in the public market of the Class A Common Stock underlying
options and warrants and the Notes may adversely affect prevailing market prices
for the Class A Common Stock. This, in turn, might adversely affect the terms
upon which the Company will be able to obtain additional equity capital.

            Dividends Unlikely. The Company does not intend to declare or pay
cash dividends in the foreseeable future. Earnings are expected to be retained
to finance its business.

            Lack of Trading Market in Certain Jurisdictions. Although securities
of the Company have been qualified for sale only in certain jurisdictions, the
Company's Listed Securities are exempted from the qualification requirements for
offers in the secondary market of most states because of their listing on the
NMS/NASDAQ. However, the Company has not qualified the secondary offering of its
securities in the state of Hawaii and Nebraska and NMS/NASDAQ exemption is not
available in Hawaii. Consequently, the secondary trading of securities of the
Company in Hawaii and Nebraska can only be conducted through unsolicited buy and
sell orders, privately negotiated transactions, or through other exempt
transactions. Similar restrictions may apply in other jurisdictions.

ITEM 2.       PROPERTIES

            The Company currently subleases approximately 13,549 square feet of
laboratory and office space at MBI's La Jolla facility for a base annual rent of
approximately $410,000. In addition, the sublease provides for the use of
certain equipment, excess utility usage and laboratory and administrative
services for an estimated annual fee of $219,000. Such costs represent the
pro-rata portion of MBI's costs attributable to the Company.
See "Item 1.--Business--Relationship with the Medical Biology Institute."

ITEM 3.       LEGAL PROCEEDINGS

            There are no pending legal proceedings to which the Company is a
party.


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

            There were no matters submitted to a vote of stockholders, through
the solicitation of proxies or otherwise, during the fourth quarter of the
fiscal year covered by this Report.





                                       20
<PAGE>   21
                                     PART II


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

            The Company's shares of Class A Common Stock have traded on the
NASDAQ National Market System under the symbols LDAKA since September 30, 1993.
Previous to that date, these securities were traded on the NASDAQ Small-Cap
Market since May 8, 1990. The prices set forth below represent quotes between
dealers and do not include commissions, mark-ups or mark-downs, and may not
necessarily represent actual transactions.

<TABLE>
<CAPTION>
                                       Class A Common Stock
                                       --------------------
                                      High              Low
                                      ----              ---
<S>                                   <C>               <C>  
     1995
     ----
First Quarter                         $2.50             $1.50
Second Quarter                        $4.0625           $1.5625
Third Quarter                         $4.75             $3.0625
Fourth Quarter                        $7.0625           $3.75

     1996
     ----
First Quarter                         $4.8125           $3.5625
Second Quarter                        $5.9375           $2.50
Third Quarter                         $3.3125           $2.1875
Fourth Quarter                        $2.5625           $1.6875
</TABLE>

            On December 20, 1996, the closing bid and ask prices of Class A
Common Stock were $1.6875 and $1.75, respectively.

            As of December 20, 1996, there were 1,042 holders of record and in
excess of 17,000 beneficial owners of the Company's Class A Common Stock. The
Company has not paid any dividends since its inception and does not contemplate
payment of dividends in the foreseeable future.


ITEM 6.       SELECTED FINANCIAL DATA

            The selected financial data presented below at September 30, 1995
and 1996, for the years ended September 30, 1994, 1995, and 1996 and the period
from August 31, 1988 (Inception) to September 30, 1996 are derived from,
and are qualified by reference to, the audited financial statements of the
Company included elsewhere herein and should be read in conjunction with those
financial statements and notes thereto and with "Item 7.--Management's
Discussion and Analysis of Financial Condition and Results of Operations." The
selected financial data presented below at September 30, 1992, 1993 and 1994,
and for the years ended September 30, 1992 and 1993, are derived from audited
financial statements not included herein.



                                       21
<PAGE>   22

<TABLE>
<CAPTION>
                                                                                                                From
                                                      Years Ended September 30,                            August 31, 1988 
                                -------------------------------------------------------------------         (Inception) to
                                1992            1993            1994            1995           1996       September 30, 1996
                                ----            ----            ----            ----           ----       ------------------
<S>                         <C>             <C>             <C>             <C>             <C>             <C>
Statement of
Operations Data:
   Revenues .............   $    427,086    $    590,822    $  1,016,719    $    884,589    $  4,158,038    $  8,001,016
   Net loss .............     (2,361,855)     (6,139,223)     (4,813,341)    (10,173,001)     (6,130,241)    (34,296,198)
   Net loss per share(1)    $       (.26)   $       (.35)   $       (.19)   $       (.35)   $       (.19)
   Weighted average
     number of common
     outstanding(1) ....       9,150,776      17,310,231      25,166,958      29,338,418      32,072,944
</TABLE>

<TABLE>
<CAPTION>
                                                        September 30,
                              --------------------------------------------------------------------
                                  1992          1993          1994          1995         1996
                                  ----          ----          ----          ----         ----
<S>                           <C>           <C>           <C>           <C>           <C>
Balance Sheet Data:

Cash, cash equivalents and
  short-term investments ..   $10,460,558   $10,256,445   $17,402,896   $10,035,727   $20,374,010
  Working capital .........    10,164,854    10,063,769    16,837,299     8,567,966    13,759,577
  Total assets ............    10,874,448    10,877,700    18,244,299    10,954,043    22,846,879
  Convertible notes payable                                                             5,721,087
  Total liabilities .......       430,474       378,529       847,904     1,705,443     7,778,760
  Stockholders' equity ....    10,443,974    10,499,171    17,396,395     9,248,600    15,068,119
</TABLE>

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

(1)  The Escrow Shares outstanding in fiscal years ended 1992 through 1994 are
     excluded from the computation of net loss per share, See Note 1 of Notes to
     Financial Statements.


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

            This Form 10-K contains certain statements of a forward-looking
nature relating to future events or the future performance of the Company.
Prospective investors are cautioned that such statements are only predictions
and that actual events or results may differ materially. In evaluating such
statements, prospective investors should specifically consider various factors
identified in this Form 10-K, including the matters set forth under the caption
"Risk Factors," which could cause actual results to differ materially from those
indicated by such forward-looking statements.

OVERVIEW

            The Company is a development stage company. Since inception in
August 1988, the Company has been engaged primarily in the research, development
and commercialization of innovative pharmaceutical products. The Company is
currently focusing its efforts primarily on the commercialization of n-docosanol
10% cream (LIDAKOL (R)) and its Large Multivalent Immunogen (LMI) technology.
The Company has not generated any significant product revenues and has been
unprofitable since inception in August 1988. For the period from inception to
September 30, 1996, the Company incurred a cumulative net loss of $34.3 million.
The Company's research and development, clinical trial and general and
administrative expenses will continue to be substantial and the Company expects
to continue to incur operating losses during the next several years.

            In Spring 1996, the Company reported preliminary results from three
Phase 3 clinical trials comparing LIDAKOL cream to placebo cream as a treatment
of recurrent oral herpes episodes. In these trials, LIDAKOL demonstrated
clinical effectiveness compared to historical episode features reported by the
patients in the study, including reduced healing times, episode abortion and
shortening of pain symptoms. However, similar results were obtained with the
cream used as the intended placebo in the 




                                       22
<PAGE>   23
            trials. If these trials had shown statistically significant
advantage of LIDAKOL versus placebo, the Company could have filed a New Drug
Application ("NDA") with the U.S. Food and Drug Administration ("FDA") for
marketing approval of LIDAKOL as a treatment of recurrent oral herpes. As a
result of the inconclusive outcome, the Company obtained FDA approval to use an
alternative placebo to conduct additional Phase 3 clinical trials to prove the
efficacy of LIDAKOL versus an alternative placebo in order to complete final
requirements to file an NDA for marketing approval. In July and September 1996,
the Company initiated two additional Phase 3 clinical trials of LIDAKOL in the
United States. The Company estimates that during fiscal 1997, it will incur
direct costs for these two studies of approximately $2.5 to $3.0 million. The
Company anticipates completion of these studies including data availability,
around the summer of 1997. See "Business-General" and "Research and Development
- LIDAKOL".

            The Company's business is subject to significant risks including,
but not limited to, the success of its research and development efforts,
uncertainties associated with obtaining and enforcing patents important to the
Company's business and lengthy and expensive regulatory approval processes and
competition from pharmaceutical and biotechnology companies, increasing pressure
on pharmaceutical pricing from payors, patients, and government agencies and
limitations on the availability of capital. Even if the Company's products
appear promising at an early stage of development, they may not reach the market
for a number of reasons. Such reasons include, but are not limited to, the
possibilities that the potential products will be found ineffective or toxic
during clinical trials, fail to receive the necessary regulatory approvals, be
difficult to manufacture on a large scale, be uneconomical to market, or be
precluded from commercialization by proprietary rights of third parties, or that
the Company may not have sufficient financial resources. Additional expenses,
delays and losses of opportunities that may arise out of these and other risks
could have a material adverse effect on the Company's financial condition and
results of operations.

RESULTS OF OPERATIONS

COMPARISON OF FISCAL 1995 AND 1996

NET LOSSES - 1996 VS. 1995

            During the fiscal year ended September 30, 1996, ("fiscal 1996") the
Company incurred a net loss of $6.1 million compared to a net loss of $10.2
million in the fiscal year ended September 30, 1995 ("fiscal 1995").

REVENUES - 1996 VS. 1995

            Revenues totaled $4.2 million for fiscal 1996 compared to $885,000
for fiscal 1995. Revenues for fiscal 1996 consisted of license fee/contract
research income of $3.0 million, interest and other income of $1.1 million and
federal research grant income of $58,000.

            The increase in revenues during fiscal 1996 was attributable
primarily to license fee revenues in the amount of $3.0 million earned in
connection with certain licensing agreements, most of which was derived from the
Company's agreement with Bristol-Myers Squibb Company. Interest and other income
increased in fiscal 1996 to $1.0 million compared to $885,000 in fiscal 1995.
This increase is primarily attributable to higher cash balances available for
investment during fiscal 1996. See "Liquidity and Capital Resources". Federal
research grant income increased to $58,000 during fiscal 1996 related to income
earned from research grants issued by the National Institutes of Health which
were not in place during fiscal 1995.

EXPENSES - 1996 VS. 1995

            Research and development expenses decreased by $3.1 million to $4.6
million during fiscal 1996 as compared to fiscal 1995. This decrease in expenses
is primarily attributable to decreased activities related to toxicology testing
and the completion of certain U.S./Canadian Phase 3 clinical trials of LIDAKOL
in fiscal 1996.



                                       23
<PAGE>   24

            General and administrative expenses decreased to $2.7 million during
fiscal 1996 from $3.3 million during fiscal 1995. This decrease in expenses
during fiscal 1996 is primarily attributable to a one-time payment of fees
related to a consulting agreement which was no longer in effect in fiscal 1996
and non-recurring expenses incurred in fiscal 1995 of investment banking fees
paid in connection with the Company's license agreement for LIDAKOL in Japan,
and for legal and investment banking services related to a proposed acquisition
which is no longer being pursued by the Company.

            Interest expenses recorded during fiscal 1996 represents interest
associated with the convertible notes issued during the fiscal year. Of the $2.9
million in interest expense, $2.7 million represents non-cash interest expense
from the recognition of the conversion discount on the convertible notes. (See
"Liquidity and Capital Resources" and Note 6 to the Financial Statements).

COMPARISON OF FISCAL 1994 AND 1995

NET LOSSES - 1995 VS. 1994

            During the fiscal year ended September 30, 1995, ("fiscal 1995") the
Company incurred a net loss of $10.2 million compared to a net loss of $4.8
million in the fiscal year ended September 30, 1994 ("fiscal 1994").

REVENUES - 1995 VS. 1994

            Revenues totaled $885,000 for fiscal 1995 as compared to $1.0
million for fiscal 1994. The entire amount of fiscal 1995 revenue is
attributable to interest and other income representing an increase of $402,000
over the fiscal 1994 amount. No revenue was earned during fiscal 1995 from
contract research and federal grant revenue as compared to an aggregate of
$534,000 from these categories in fiscal 1994. The increase in interest and
other income during fiscal 1995 is attributable primarily to higher average cash
balances available for investment and higher interest rates during the year. See
"Liquidity and Capital Resources." The decrease in contract research and federal
grant revenue during fiscal 1995 is due to the completion of all such agreements
prior to the beginning of fiscal 1995.

EXPENSES - 1995 VS. 1994

            Research and development expenses increased by $4.6 million to $7.7
million during fiscal 1995 as compared to fiscal 1994. This increase is
attributable primarily to expenditures associated with the Phase 3 clinical
trials in the United States and Canada, the non-clinical toxicology program for
LIDAKOL for the topical treatment of oral herpes which began in fiscal 1995, and
the continued preclinical development of LMI.

            General and administrative expenses increased to $3.3 million during
fiscal 1995 from $2.6 million in fiscal 1994. The increase in fiscal 1995
expenses is attributable primarily to the one-time payment of fees in connection
with the completion of a two-year consulting agreement in February 1995, and
investment banking fees associated with the Company's license agreement with
Grelan Pharmaceutical Co., Ltd. of Japan. General and administrative expenses
also increased during the year due to personnel costs related to staff
additions, market research expenditures, and occupancy costs related to an
expansion of office space. In addition, consulting, legal and other costs
increased as a consequence of a proposed acquisition during the year.

            Contract research expenses decreased during fiscal 1995 by $155,000
as compared to fiscal 1994 as a direct result of decreased contract research
revenue as noted above.




                                       24
<PAGE>   25
LIQUIDITY AND CAPITAL RESOURCES

            Since inception, the Company has financed its operations primarily
through the sale of equity and debt securities and stockholder loans. Net cash
provided from financing activities through September 30, 1996 was $47.5 million.

            At September 30, 1996, the Company had cash, cash equivalents and
short-term investments totaling $20.4 million and working capital of $13.8
million, as compared to $10.0 million and $8.6 million, respectively, at
September 30, 1995. The increases in cash and working capital during fiscal 1996
are attributable primarily to net proceeds of approximately $14.5 million
received by the Company through the sale of $1.5 million of Class A Common Stock
and $13.5 million of convertible notes in a private financing and $386,000 
from the exercise of certain options and warrants during fiscal 1996. Cash
utilized by the Company to fund operating activities for fiscal 1996 and from
inception to September 30, 1996, was $4.1 million and $26.7 million,
respectively, as a result of net losses incurred during these periods. In
addition, $122,000 and $543,000 of cash was utilized for capital expenditures
during fiscal 1996 and from inception to September 30, 1996, respectively.
Offsetting such cash utilization during fiscal 1996 was the receipt of $500,000
in connection with a licensing agreement which has been recorded as deferred
revenue.

            The Company does not believe that the net cash used to fund
operating activities during fiscal 1996 is representative of future cash
requirements. Net cash requirements during fiscal 1997 are expected to increase
to levels more consistent with net cash used in the 1995 period as a result of
continuing research and development, clinical trial and general and
administrative expenses.

            As discussed above, the results of the clinical studies reported in
the Spring of 1996 of the Company's lead drug candidate, LIDAKOL, do not support
the filing of an NDA at this time. The Company has recently initiated two
additional clinical studies to prove the efficacy of LIDAKOL versus an
alternative placebo which, if successful, would enable it to file an NDA. The
Company estimates that during fiscal 1997, it will incur direct costs for these
two additional clinical studies of approximately $2.5 to $3.0 million.

            In November 1995, December 1995 and January 1996, the Company issued
an aggregate $13.5 million in principal amount of Convertible Notes (the
"Notes"). The Notes accrue interest at an annual rate of 7% beginning six months
from the date of issue, with the principal due and payable two-years from the
date of issue if, and to the extent that the Notes are not previously converted.
The Notes are convertible into Class A Common Stock at a price equal to 80% of
the average closing bid price of the Company's Class A Common Stock on the
NASDAQ for seven trading days prior to the date of conversion. The $13.5 million
original principal amount of Notes was convertible into an aggregate maximum of
5,513,018 shares of the Company's Class A Common Stock at the option of the
holders, with each individual note limited to a pro-rata amount of such number
of shares. In the event that shares of Class A Common Stock underlying a
particular note cannot be issued upon request for conversion due to the above
referenced maximum share limitations, the Company is immediately obligated to
repay the principal of that portion of the note which is presented for
conversion which cannot be converted plus a premium equal to 25% of such
principal plus any accrued and unpaid interest. Through December 20, 1996 a
total of 5,511,680 shares of Class A Common Stock had been issued in connection
with the conversion of $10,824,461 principal amount of the Notes. As a result of
these events, two of the noteholders reached their pro-rata portion of the
maximum share limitation described above. On December 19, 1996, the Company
repaid $1,728,393 representing $1,375,539 of original principal, and $352,854 of
premium and accrued interest to such noteholders pursuant to the terms of the
Notes thus retiring the entire balance of principal and interest on these notes.

            As of December 20, 1996, there remains one note outstanding in the
principal amount of $1.3 million. This note was issued in January 1996
with an original principal amount of $3.0 million. In the event the noteholder
requests conversion of the remaining principal amount, the Company is
immediately obligated to repay the principal of that portion of the note which
is presented for conversion which cannot be converted plus a premium equal to
25% of such principal plus any accrued and unpaid 




                                       25
<PAGE>   26

interest. At December 20, 1996, the Company would be required to pay
approximately $1.6 million as repayment of remaining principal plus premium and
any accrued and unpaid interest. At its option, the noteholder can require the
Company to seek shareholder approval to issue shares of Class A Common Stock at
the then fair market value in exchange for the above-referenced principal and
premium payment.

            At December 20, 1996 the Company had additional exercisable warrants
and options outstanding which, if fully exercised, would result in the aggregate
issuance of approximately 7.4 million shares of the Company's Class A Common
Stock and would result in approximate gross proceeds to the Company of $17.0
million. Included in such warrants and options are Class D Warrants, exercisable
on or before February 26, 1997 into approximately 1.8 million shares of the
Company's Class A Common Stock at an exercise price of $1.50 per share. Such
warrants are redeemable by the Company, at a price of $.05 per warrant, upon 30
days notice if the average closing bid price of the Company's Class A Common
Stock for the 30 days prior to the notice exceeds $3.45 per share. In the event
the Company does call the Class D Warrants for redemption, there can be no
assurance regarding the number of warrants which would be exercised or the
amount of proceeds which the Company would receive. The remaining exercisable
options and warrants are not redeemable by the Company and can be exercised by
the holders at various times through 2006. The average exercise price of the
remaining exercisable options and warrants is approximately $2.52 per share
which is higher than the market price of the Company's Class A Common Stock on
December 20, 1996. There can be no assurance that voluntary option and warrant
exercises will continue to occur in the future.

            The Company had available cash, cash equivalents and short term
investments of approximately $18 million at November 30, 1996. The Company
expects to continue to incur substantial operating losses for the foreseeable
future. The Company's available funds may not be sufficient to permit the
Company to successfully complete development or commercialize any of its
proposed products. Accordingly, the Company may be required to raise substantial
additional capital or to collaborate with one or more large pharmaceutical or
biotechnology companies which could provide the necessary financing and
expertise to complete clinical development, manufacture and package finished
product and obtain regulatory approvals to market its products. There can be no
assurance that the Company can successfully obtain such additional capital or
enter into the collaborative arrangements necessary to fully develop or
commercialize any of its proposed products on acceptable terms.



                                       26
<PAGE>   27




ITEM 8.                 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

            The financial statements of the Company are annexed to
            this Report as pages F-1 through F-22 

<TABLE>
<CAPTION>
                                                                            Page
                                                                            ----


               <S>                                                           <C>
               Independent Auditors' Report                                  F-2
               Balance Sheets at September 30, 1995 and 1996                 F-3
               Statements of Operations for the years ended
                  September 30, 1994, 1995 and 1996, and the period
                August 31, 1988 (inception) to September 30, 1996            F-4
               Statements of Stockholders' Equity (Deficit) for the
                  period August 31, 1988 (inception) to
                  September 30, 1996                                         F-5
               Statements of Cash Flows for the years
                  ended September 30, 1994, 1995 and 1996, and the period
                  August 31, 1988 (inception) to September 30, 1996          F-9
               Notes to Financial Statements                                 F-11
</TABLE>

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

            None.

                                    PART III


ITEM 10.      DIRECTORS AND EXECUTIVE OFFICERS

            The information required by this item (with respect to Directors) is
incorporated by reference from the information under the caption "Election of
Directors" contained in the Company's Definitive Proxy Statement which will be
filed with the Securities and Exchange Commission in connection with the
solicitation of proxies for the Company's Annual Meeting of Stockholders to be
held March 15, 1997 (the "Proxy Statement").

            The required information concerning Executive Officers of the
Company is contained in Part 1, Item 1, of this Report under "Executive
Officers".

ITEM 11.      EXECUTIVE COMPENSATION

            The information required by this item is incorporated by reference
to the information under the caption "Executive Compensation" contained in the
Proxy Statement.

ITEM 12.      SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

            The information required by this item is incorporated by reference
to the information under the caption "Security Ownership of Certain Beneficial
Owners and Management" contained in the Proxy Statement.

ITEM 13.      CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

            The information required by this item is incorporated by reference
to the information under the caption "Certain Transactions" contained in the
Proxy Statement.



                                       27
<PAGE>   28
                                     PART IV



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



 (a)        Financial Statements and Schedule

            (i)         Index to financial statements appears on page F-1.

 (b)        Current Reports on Form 8-K

            Report on Form 8-K was filed on July 8, 1996 reporting under Item 5
            issuance of 306,576 shares of Class A Common Stock in connection
            with the conversion of $600,000 in principal amount of Convertible
            Notes.

            Report on Form 8-K was filed on July 11, 1996 reporting under Item 5
            issuance of 100,720 shares of Class A Common Stock in connection
            with the conversion of $200,000 in principal amount of Convertible
            Notes.

            Report on Form 8-K was filed on September 3, 1996 reporting under
            Item 5 issuance of 270,970 shares of Class A Common Stock in
            connection with the conversion of $450,000 in principal amount of
            Convertible Notes.

            Report on Form 8-K was filed on September 30, 1996 reporting under
            Item 5 the resignation of Michael H. Lorber from the position of
            vice president and chief financial officer effective October 11,
            1996.

(c)         Exhibits

           1.1  -  Underwriting Agreement(1)
           3.1  -  Restated Articles of Incorporation of the Registrant(6)
           3.2  -  Bylaws of the Registrant(4)
           3.3  -  First and Second Amendment to Bylaws(6)
           4.1  -  Forms of Class A and Class B Common Stock Certificates(3)
           4.2  -  Class D Warrant Agreement (including form of Class D Warrant 
                   Certificate)(4)
           4.3  -  Warrant Agreement (including form of Class E Warrant 
                   Certificate)(4)
           4.7  -  Form of Unit Purchase Option issued to D.H. Blair & Co., Inc.
                   and its designees regarding Series B Preferred Stock and
                   Class D Warrants(4)
           4.8  -  Registration Rights Agreement(4)
           4.9  -  Convertible Note issued to GFL Advantage Fund Limited(8)
           4.10    Convertible Note issued to Capital Ventures International(9)
          10.1  -  1989 Stock Option Plan(3)
          10.2  -  License Agreement with Medical Biology Institute(3)
          10.3  -  Amendment to License Agreement with Medical Biology Institute
                   dated July 19935
          10.4  -  Employment Agreement with David H. Katz, as amended(3)
          10.5  -  Amendment to Employment Agreement with David H. Katz dated 
                   April 1993(5)
          10.6  -  Sublease Agreement with Medical Biology Institute(3)
          10.7  -  First, Second and Third Amendments to Sublease Agreement with
                   Medical Biology Institute(4)
          10.8  -  Fourth and Fifth Amendments to the Sublease Agreement with 
                   Medical Biology Institute(7)
          10.9  -  Licensing Agreement with Yamanouchi Europe b.v.(2)
          10.10 -  1994 Stock Option Plan(7)
          10.11 -  Supplemental Agreement with Yamanouchi Europe b.v.(7)
          10.12 -  Licensing Agreement with Grelan Pharmaceutical Company 
                   Limited(7)
          10.13 -  Sixth Amendment to the Sublease Agreement with Medical 
                   Biology Institute(8)





                                       28
<PAGE>   29

          10.14 -  Subscription Agreement(8)
          10.15 -  Note Purchase Agreement issued to GFL Advantage Fund 
                   Limited(8)
          10.16 -  Registration Rights Agreement issued to GFL Advantage Fund 
                   Limited(8)
          10.17    License and Development Agreement with Bristol-Myers Squibb 
                   Company(9)
          10.18    Registration Rights Agreement issued to Capital Ventures 
                   International(9)
          10.19    Note Purchase Agreement issued to Capital Ventures 
                   International(9)
          10.20    Seventh Amendment to the Sublease Agreement with Medical
                   Biology Institute(9)
          11.1  -  Statement Re Computation of Net Loss Per Share
          23.1  -  Independent Auditors' Consent
          27.1  -  Financial Data Schedule


1           Incorporated by reference to the similarly described exhibits filed
            in connection with the Registrant's Registration Statement on Form
            S-1, File No. 33-37166, declared effective by the Securities and
            Exchange Commission on November 9, 1990.

2           Incorporated by reference to the similarly described exhibits
            included with the Registrant's Annual Report on Form 10-K for the
            fiscal year ended September 30, 1991, filed January 11, 1992.

3           Incorporated by reference to the similarly described exhibit filed
            in connection with the Registrant's Registration Statement on Form
            S-1, File No. 33-32742, declared effective by the Commission on May
            8, 1990.

4           Incorporated by reference to the similarly described exhibit filed
            in connection with the Registrant's Registration Statement on Form
            S-1, File No. 33-49082, declared effective by the Commission on
            October 26, 1992.

5           Incorporated by reference to the similarly described exhibits
            included with the Registrant's Annual Report on Form 10-K for the
            fiscal year ended September 30, 1993, filed December 29, 1993.


6           Incorporated by reference to the similarly described exhibit filed
            in connection with the Registrant's Amendment #4 to the Registration
            Statement on Form S-1, File No. 33-32742, declared effective by the
            Commission on April 13, 1994.

7           Incorporated by reference to the similarily described exhibit
            included with the Registrant's Annual Report on Form 10-K for the
            fiscal year ended September 30, 1994, filed December 29, 1994.

8           Incorporated by reference to the similarily described exhibit
            included with the Registrant's Annual Report on Form 10-K for the
            fiscal year ended September 30, 1995, filed December 15, 1995.

9           Incorporated by reference to the similarily described exhibit
            included with the Registrant's Quarterly Report on Form 10-Q for the
            quarter ended March 31, 1996, filed Filed May 15, 1996.





                                       29
<PAGE>   30
                                   SIGNATURES

                        Pursuant to the requirements of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

Date:             December 20, 1996


                                       LIDAK PHARMACEUTICALS
                                       By: /s/David H. Katz
                                          ---------------------------------
                                          David H. Katz, M.D.
                                          President and Chief Executive Officer


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

<TABLE>
<CAPTION>
Signature                                            Title                                  Date
---------                                            -----                                  ----

<S>                                      <C>                                                <C> 
/s/David H. Katz                         President and Chief                                December 20, 1996
----------------------------             Executive Officer
David H. Katz, M.D.                      (Principal Executive Officer and 
                                         Principal Financial and Accounting Officer)


/s/Daniel J. Paracka                     Chairman of the Board                              December 20, 1996
-----------------------------
Daniel J. Paracka


/s/Helmer P.K. Agersborg, Jr.            Director                                           December 20, 1996
-----------------------------
Helmer P.K. Agersborg, Jr.


/s/William N. Jenkins                    Director                                           December 20, 1996
-----------------------------
William N. Jenkins


/s/Kenneth E. Olson                      Director                                           December 20, 1996
-----------------------------
Kenneth E. Olson


/s/Stuart A. Samuels                     Director                                           December 20, 1996
-----------------------------
Stuart A. Samuels


/s/Sidney N. Towle, Jr.                  Director                                           December 20, 1996
-----------------------------
Sidney N. Towle, Jr.
</TABLE>





                                       30
<PAGE>   31
LIDAK PHARMACEUTICALS


INDEX TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>

                                                                    PAGE


<S>                                                                 <C>
INDEPENDENT AUDITORS' REPORT                                        F-2

FINANCIAL STATEMENTS

Balance Sheets at September 30, 1995 and 1996                       F-3

Statements of Operations for the years ended
  September 30, 1994, 1995 and 1996, and the period
  August 31, 1988 (inception) to September 30, 1996                 F-4

Statements of Stockholders' Equity (Deficit) for the
  period August 31, 1988 (inception) to
  September 30, 1996                                                F-5

Statements of Cash Flows for the years
  ended September 30, 1994, 1995 and 1996, and the period
  August 31, 1988 (inception) to September 30, 1996                 F-9

Notes to Financial Statements                                       F-11
</TABLE>


                                      F-1
<PAGE>   32
INDEPENDENT AUDITORS' REPORT


To the Board of Directors and Stockholders of LIDAK Pharmaceuticals:

We have audited the accompanying balance sheets of LIDAK Pharmaceuticals (a
development stage enterprise) as of September 30, 1995 and 1996, and the related
statements of operations, stockholders' equity (deficit), and cash flows for
each of the three years in the period ended September 30, 1996 and for the
period August 31, 1988 (inception) to September 30, 1996. 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, such financial statements present fairly, in all material
respects, the financial position of LIDAK Pharmaceuticals at September 30, 1995
and 1996, and the results of its operations and its cash flows for each of the
three years in the period ended September 30, 1996 and the period August 31,
1988 (inception) to September 30, 1996 in conformity with generally accepted
accounting principles.

The Company is in the development stage as of September 30, 1996. As discussed
in Note 1 to the financial statements, the Company has not yet completed product
development, obtained required regulatory approvals or verified the market
acceptance and demand for its products.



DELOITTE & TOUCHE LLP


San Diego, California
November 6, 1996, (December 20, 1996 as to Note 6)




                                      F-2
<PAGE>   33

LIDAK PHARMACEUTICALS
(A DEVELOPMENT STAGE ENTERPRISE)

BALANCE SHEETS
SEPTEMBER 30, 1995 AND 1996
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>

ASSETS                                                                             1995              1996
<S>                                                                            <C>              <C>         
CURRENT ASSETS:
  Cash and cash equivalents                                                    $  4,244,575     $ 13,347,508
  Short-term investments                                                          5,791,152        7,026,502
  Interest receivable                                                                54,751          338,403
  Prepaid and other                                                                 182,931          825,924
                                                                               ------------     ------------

           Total current assets                                                  10,273,409       21,538,337

PROPERTY - at cost (less accumulated depreciation of $178,729 and $266,668)         241,486          275,972

PATENT COSTS (less accumulated amortization of $18,719 and $39,654)                 438,883          581,770

DEBT ISSUE COSTS                                                                                     185,015

OTHER ASSETS                                                                            265          265,785
                                                                               ------------     ------------

TOTAL                                                                          $ 10,954,043     $ 22,846,879
                                                                               ============     ============


LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
  Convertible notes payable                                                                     $  5,721,087
  Accounts payable                                                             $  1,520,231        1,329,418
  Accrued compensation and payroll taxes                                            168,885          206,445
  Due to MBI                                                                         16,327           21,810
  Deferred revenue                                                                                   500,000
                                                                               ------------     ------------

           Total current liabilities                                              1,705,443        7,778,760
                                                                               ------------     ------------

COMMITMENTS AND CONTINGENCIES (Notes 2, 5, 6, 7, and 10)

STOCKHOLDERS' EQUITY:
  Common stock - no par value:
    Class A - 99,490,000 shares authorized;
      29,847,064 and 34,054,022 shares issued and outstanding                    37,235,484       49,216,569
    Class B -  510,000 shares authorized;  343,000 and 283,000 shares
     issued and outstanding (convertible to Class A Common Stock)                   179,073          147,748
  Deficit accumulated during the development stage                              (28,165,957)     (34,296,198)
                                                                               ------------     ------------

           Total stockholders' equity                                             9,248,600       15,068,119
                                                                               ------------     ------------

TOTAL                                                                          $ 10,954,043     $ 22,846,879
                                                                               ============     ============
</TABLE>



See notes to financial statements.

                                      F-3
<PAGE>   34

LIDAK PHARMACEUTICALS
(A DEVELOPMENT STAGE ENTERPRISE)


STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED SEPTEMBER 30, 1994, 1995 AND 1996, AND THE PERIOD
AUGUST 31, 1988 (INCEPTION) TO SEPTEMBER 30, 1996
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                                     AUGUST 31, 1988
                                               YEARS ENDED SEPTEMBER 30,              (INCEPTION) TO
                                    --------------------------------------------       SEPTEMBER 30,
                                         1994              1995           1996             1996
<S>                                 <C>              <C>              <C>              <C>          
REVENUES:
  License fees/Contract research    $    322,000                      $  3,016,800     $  3,982,625
  Federal SBIR grants                    211,875                            58,000          798,777
  Interest and other                     482,844     $    884,589        1,083,238        3,219,614
                                    ------------     ------------     ------------     ------------

           Total revenues              1,016,719          884,589        4,158,038        8,001,016
                                    ------------     ------------     ------------     ------------

EXPENSES:
  Research and development             3,115,602        7,715,807        4,576,426       24,388,809
  General and administrative           2,559,781        3,341,783        2,745,166       14,276,342
  Cost of contract research              154,677                                            533,270
  Interest                                                               2,966,687        3,098,793
                                    ------------     ------------     ------------     ------------

           Total expenses              5,830,060       11,057,590       10,288,279       42,297,214
                                    ------------     ------------     ------------     ------------

NET LOSS                            $ (4,813,341)    $(10,173,001)    $ (6,130,241)    $(34,296,198)
                                    ============     ============     ============     ============

NET LOSS PER SHARE                  $      (0.19)    $      (0.35)    $      (0.19)
                                    ============     ============     ============

WEIGHTED AVERAGE NUMBER
  OF COMMON SHARES
  OUTSTANDING                         25,166,958       29,338,418       32,072,944
                                    ============     ============     ============
</TABLE>


See notes to financial statements.



                                      F-4

<PAGE>   35

LIDAK PHARMACEUTICALS

(A DEVELOPMENT STAGE ENTERPRISE)

STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
AUGUST 31, 1988 (INCEPTION) TO SEPTEMBER 30, 1996
--------------------------------------------------------------------------------


<TABLE>
<CAPTION>
                                               CONVERTIBLE PREFERRED STOCK                           COMMON
                                                                                                      STOCK           
                                           -----------------------------------    -----------------------------------------------
                                                SERIES A           SERIES B               CLASS A                   CLASS B   
                                            ------    ------    ------   ------   --------    ----------        ------     ------  
                                            SHARES    AMOUNT    SHARES   AMOUNT    SHARES        AMOUNT         SHARES     AMOUNT 
                                            ------    ------    ------   ------   --------    ----------        ------     ------  
<S>                                        <C>         <C>     <C>       <C>      <C>         <C>             <C>        <C>
BALANCE, AUGUST 31, 1988 (INCEPTION)

Issuance of common stock for notes
  receivable and cash in September 1988
  at $.0125 per share                                                                                        4,235,000   $ 52,937
Issuance of preferred stock in October                                                              
  1988 for license and other rights         2,000,000     $1
Issuance of common stock for cash in       
  October 1988 at $.05 per share                                                                                80,000      4,000 
Issuance of common stock for cash in
  January 1989 at $.05 per share                                                                                80,000      4,000
Issuance of stock options effective in
  August 1989 to purchase 600,000 shares
  of Class B common stock at $.0125
  per share (with an estimated fair market
  value of $.05 per share)                                                                                                 22,500
Issuance of common stock for cash in
  September 1989 at $.0125 per share
  (with an estimated fair market value
  of $.05 per share)                                                                                           400,000     20,000
Collection on notes receivable                                                        
Net loss                                                                             
                                           ---------     --    ------   ------    ---------   ----------     ---------    -------

BALANCE, SEPTEMBER 30, 1989                2,000,000      1                                                  4,795,000    103,437

Conversion of advances to common stock in
  October 1989 at $.50 per share                                                                               250,000    125,000 
Issuance of common stock for cash in May
  1990 at $1.00 per share (net of stock
  issue costs totalling $1,033,280)                                               5,000,000   $3,966,820
Issuance of common stock for cash in June
  1990 at $1.00 per share (net of stock
  issue costs totalling $97,500)                                                    750,000      652,500 
Exercise of stock options in July and
August 1990 at $.50 per share                                                                                   21,500     10,750 
Forgiveness of compensation obligation                                                                                     66,923
Collection on notes receivable                                                                                                  
Net loss                                                                                                                        
                                           ---------     --    ------   ------    ---------     --------    ----------   --------

BALANCE, SEPTEMBER 30, 1990                2,000,000      1                       5,750,000    4,619,320      5,066,500   306,110
</TABLE>                                                 




<TABLE>
<CAPTION>
                                                         
                                                                  DEFICIT
                                                                ACCUMULATED         NOTES
                                                                 DURING THE       RECEIVABLE
                                                                DEVELOPMENT          FROM
                                                                    STAGE        STOCKHOLDERS    TOTAL
                                                                -----------      ------------    -----
                                                                <C>               <C>             <C>
BALANCE, AUGUST 31, 1988 (INCEPTION)

Issuance of common stock for notes
  receivable and cash in September 1988
  at $.0125 per share                                                       $ (14,525)       $ 38,412
Issuance of preferred stock in October
  1988 for license and other rights                                                                 1
Issuance of common stock for cash in
  October 1988 at $.05 per share                                                                4,000
Issuance of common stock for cash in
  January 1989 at $.05 per share                                                                4,000
Issuance of stock options effective in
  August 1989 to purchase 600,000 shares
  of Class B common stock at $.0125
  per share (with an estimated fair market
  value of $.05 per share)                                                                     22,500
Issuance of common stock for cash in
  September 1989 at $.0125 per share
  (with an estimated fair market value
  of $.05 per share)                                                                           20,000
Collection on notes receivable                                                  1,635           1,635
Net loss                                                    $(409,718)                       (409,718)
                                                            ---------        --------        --------

BALANCE, SEPTEMBER 30, 1989                                  (409,718)        (12,890)       (319,170)

Conversion of advances to common stock in
  October 1989 at $.50 per share                                                              125,000
Issuance of common stock for cash in May
  1990 at $1.00 per share (net of stock
  issue costs totalling $1,033,280)                                                         3,966,820
Issuance of common stock for cash in June
  1990 at $1.00 per share (net of stock
  issue costs totalling $97,500)                         
Exercise of stock options in July and
August 1990 at $.50 per share                                                                  10,750
Forgiveness of compensation obligation                                                         66,923
Collection on notes receivable                                                12,890           12,890
Net loss                                                                  (2,319,231)      (2,319,231)
                                                          ----------      -----------      ----------
BALANCE, SEPTEMBER 30, 1990                               (2,728,949)               -       2,196,482
</TABLE>                                                 
                                                      

                                                                F-5
<PAGE>   36



LIDAK PHARMACEUTICALS
(A DEVELOPMENT STAGE ENTERPRISE)
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
AUGUST 31, 1988 (INCEPTION) TO SEPTEMBER 30, 1996
--------------------------------------------------------------------------------


<TABLE>
<CAPTION>
                                                                            CONVERTIBLE PREFERRED STOCK                         
                                                            ------------------------------------------------------------        
                                                                      SERIES A                         SERIES B                 
                                                            ----------------------------    ----------------------------        
                                                               SHARES          AMOUNT        SHARES            AMOUNT           
                                                               ------          ------        ------            ------           
<S>                                                           <C>                 <C>       <C>                  <C>
      BALANCE, SEPTEMBER 30, 1990                             2,000,000         $ 1

      Exercise of stock options in November
        1990 at $.50 per share
      Issuance of preferred stock in July 1991
        for cash (net of stock issue costs
        totalling $130,339)                                                                    960,003        $  769,670
      Conversion of common stock
      Net loss
                                                       ----------------         ---  -----------------        ----------

      BALANCE, SEPTEMBER 30, 1991                             2,000,000           1            960,003           769,670

      Issuance of preferred stock in February 1992
        for cash (net of stock issue costs
        totalling $428,605)                                                                  4,266,680         3,571,395
      Exercise of stock options in March 1992 at
        $.50 per share
      Exercise of Class A warrants in May 1992 at
        $1.50 per share for cash (net of stock issue
        costs totalling $317,930)
      Conversion of common stock
      Net loss
                                                       ----------------         ---  -----------------        ----------

      BALANCE, SEPTEMBER 30, 1992                             2,000,000           1          5,226,683         4,341,065

      Exercise of Unit Purchase Options between October
        1992 and September 1993 for cash
      Exercise of Class A Warrants between October 1992
        and September 1993 at $.9450 per share for cash
      Exercise of Class B Warrants between October 1992
        and September 1993 at $2.25 per share for cash
        (net of stock issue costs totalling $8,720)
      Exercise of Class C Warrants between October 1992
        and September 1993 at $1.00 per share for cash
        (net of stock issue costs totalling $4,122)
      Exercise of Class D Warrants between October 1992
        and September 1993 at $1.50 per share for cash
        (net of stock issue costs totalling $42,125)
      Exercise of Class E Warrants between October 1992
        and September 1993 at $.20 per share for cash
      Exercise of Class F Warrants between October 1992
        and September 1993 at $100,000 per warrant for
        cash                                                                                   320,000           300,000
</TABLE>




<TABLE>
<CAPTION>
                                                                                        COMMON STOCK                      
                                                                --------------------------------------------------------- 
                                                                           CLASS A                       CLASS B          
                                                                -----------------------------   ------------------------- 
                                                                  SHARES          AMOUNT            SHARES        AMOUNT  
                                                                  ------          ------            ------        ------  
<S>                                                               <C>             <C>            <C>              <C>
      BALANCE, SEPTEMBER 30, 1990                                 5,750,000    $  4,619,320      5,066,500      $ 306,110

      Exercise of stock options in November
        1990 at $.50 per share                                                                       2,000          1,000
      Issuance of preferred stock in July 1991
        for cash (net of stock issue costs
        totalling $130,339)
      Conversion of common stock                                    115,000           5,750       (115,000)        (5,750)
      Net loss
                                                               ------------    ------------      ---------      ---------

      BALANCE, SEPTEMBER 30, 1991                                 5,865,000       4,625,070      4,953,500        301,360

      Issuance of preferred stock in February 1992
        for cash (net of stock issue costs
        totalling $428,605)
      Exercise of stock options in March 1992 at
        $.50 per share                                                                             119,000         59,500
      Exercise of Class A warrants in May 1992 at
        $1.50 per share for cash (net of stock issue
        costs totalling $317,930)                                 5,650,200       8,157,370
      Conversion of common stock                                    395,000           6,250       (395,000)        (6,250)
      Net loss 
                                                               ------------    ------------      ---------      ---------

      BALANCE, SEPTEMBER 30, 1992                                11,910,200      12,788,690      4,677,500        354,610

      Exercise of Unit Purchase Options between October
        1992 and September 1993 for cash                            793,645         600,010
      Exercise of Class A Warrants between October 1992
        and September 1993 at $.9450 per share for cash             793,645         749,995
      Exercise of Class B Warrants between October 1992
        and September 1993 at $2.25 per share for cash
        (net of stock issue costs totalling $8,720)                  96,897         209,298
      Exercise of Class C Warrants between October 1992
        and September 1993 at $1.00 per share for cash
        (net of stock issue costs totalling $4,122)                 103,050          98,928
      Exercise of Class D Warrants between October 1992
        and September 1993 at $1.50 per share for cash
        (net of stock issue costs totalling $42,125)                836,335       1,212,376
      Exercise of Class E Warrants between October 1992
        and September 1993 at $.20 per share for cash               315,000          63,000
      Exercise of Class F Warrants between October 1992
        and September 1993 at $100,000 per warrant for
        cash
</TABLE>

<TABLE>
<CAPTION>
                                                                    DEFICIT
                                                                  ACCUMULATED           NOTES
                                                                  DURING THE         RECEIVABLE
                                                                  DEVELOPMENT           FROM
                                                                     STAGE          STOCKHOLDERS          TOTAL
                                                                     -----          ------------          -----
<S>                                                                 <C>                  <C>           <C>
      BALANCE, SEPTEMBER 30, 1990                                $  (2,728,949)          -           $  2,196,482

      Exercise of stock options in November
        1990 at $.50 per share                                                                              1,000
      Issuance of preferred stock in July 1991
        for cash (net of stock issue costs
        totalling $130,339)                                                                               769,670
      Conversion of common stock
      Net loss                                                      (1,949,588)                        (1,949,588)
                                                                 -------------         ---           ------------

      BALANCE, SEPTEMBER 30, 1991                                   (4,678,537)          -              1,017,564

      Issuance of preferred stock in February 1992
        for cash (net of stock issue costs
        totalling $428,605)                                                                             3,571,395
      Exercise of stock options in March 1992 at
        $.50 per share                                                                                     59,500
      Exercise of Class A warrants in May 1992 at
        $1.50 per share for cash (net of stock issue
        costs totalling $317,930)                                                                       8,157,370
      Conversion of common stock
      Net loss                                                      (2,361,855)                        (2,361,855)
                                                                  ------------         ---           ------------

      BALANCE, SEPTEMBER 30, 1992                                   (7,040,392)            -           10,443,974

      Exercise of Unit Purchase Options between October
        1992 and September 1993 for cash                                                                  600,010
      Exercise of Class A Warrants between October 1992
        and September 1993 at $.9450 per share for cash                                                   749,995
      Exercise of Class B Warrants between October 1992
        and September 1993 at $2.25 per share for cash
        (net of stock issue costs totalling $8,720)                                                       209,298
      Exercise of Class C Warrants between October 1992
        and September 1993 at $1.00 per share for cash
        (net of stock issue costs totalling $4,122)                                                        98,928
      Exercise of Class D Warrants between October 1992
        and September 1993 at $1.50 per share for cash
        (net of stock issue costs totalling $42,125)                                                    1,212,376
      Exercise of Class E Warrants between October 1992
        and September 1993 at $.20 per share for cash                                                      63,000
      Exercise of Class F Warrants between October 1992
        and September 1993 at $100,000 per warrant for
        cash                                                                                              300,000
</TABLE>
                                         
                       

                                      F-6
<PAGE>   37



LIDAK PHARMACEUTICALS
(A DEVELOPMENT STAGE ENTERPRISE)
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
AUGUST 31, 1988 (INCEPTION) TO SEPTEMBER 30, 1996

<TABLE>
<CAPTION>
                                                                     CONVERTIBLE PREFERRED STOCK
                                                           --------------------------------------------------------
                                                                    SERIES A                     SERIES B          
                                                           --------------------------    --------------------------
                                                             SHARES          AMOUNT        SHARES          AMOUNT  
                                                             ------          ------        ------          ------  
<S>                                                          <C>             <C>           <C>             <C>       
Exercise of Preferred Stock Units between October 1992
  and September 1993 for cash                                                                 96,000    $    90,000     
Exercise of stock options in August 1993 and
  September 1993 at exercise prices ranging from
  $0.81 to $1.53 per share                                                                                        
Compensation expense related to stock options
  granted at an exercise price below fair market
  value                                                                                                           
Cancellation of Series A Preferred and Class B
  Common Stock in July 1993                                 (1,500,000)                                            
Issuance of Class A Common Stock in July 1993 in
   connection with amendment to a license agreement                                                               
Conversion of preferred and common stock                      (100,000)                   (5,642,653)    (4,731,065)    
Cancellation of partial shares                                                                   (30)
Net loss                                                                                                          
                                                           -----------       ----        -----------    -----------

BALANCE, SEPTEMBER 30, 1993                                    400,000       $  1                  -              -     
Exercise of non-redeemable Class B Warrants in
  April 1994 at $1.4175 per share for cash                                                                        
Exercise of redeemable Class B Warrants between
  October 1993 and June 1994 at $2.25 per share for
  cash (net of stock issue costs totalling $541,340)                                                              
Exercise of Class C Warrants between October 1993
  and September 1994 at $1.00 per share for cash
  (net of commissions totalling $4,414)                                                                           
Exercise of Class D Warrants between October 1993
  and September 1994 at $1.50 per share for cash
  (net of commissions totalling $2,875)                                                                           
Exercise of Class F Warrants between October 1993
  and November 1993 at $100,000 per warrant for cash                                         106,666        100,000
Exercise of stock options between October 1993 and
  September 1994 at exercise prices ranging from
  $0.50 to $2.4375 per share                                                                                      
Compensation expense related to stock options granted
  at an exercise price below fair market value                                                                    
Issuance of Class A Common Stock in connection with
  Stock Purchase Agreement in September 1994 (net
  of issue costs of $192,215)                                                                                     
Conversion of preferred and common stock                      (400,000)            (1)      (106,666)      (100,000)
Cancellation of Class A Common and Class B Common
  Stock between January 1994 and May 1994                                                                         
Cancellation of partial shares                                                                                    
Net loss                                                                                                          
                                                           -----------       ----        -----------    -----------

BALANCE, SEPTEMBER 30, 1994                                          -          -                  -              -
                                                           -----------       ----        -----------    -----------
</TABLE>

<TABLE>
                                                                                  COMMON STOCK                     
                                                           -------------------------------------------------------- 
                                                                    CLASS A                       CLASS B           
                                                           --------------------------    -------------------------- 
                                                             SHARES          AMOUNT        SHARES          AMOUNT   
                                                             ------          ------        ------          ------   
<S>                                                           <C>            <C>           <C>             <C>      
Exercise of Preferred Stock Units between October 1992
  and September 1993 for cash                                                                                       
Exercise of stock options in August 1993 and
  September 1993 at exercise prices ranging from
  $0.81 to $1.53 per share                                      27,480    $    37,480                               
Compensation expense related to stock options
  granted at an exercise price below fair market
  value                                                                       163,333                               
Cancellation of Series A Preferred and Class B
  Common Stock in July 1993                                                    28,003     (2,240,250)   $   (28,003)
Issuance of Class A Common Stock in July 1993 in
   connection with amendment to a license agreement          1,500,000      2,670,000                               
Conversion of preferred and common stock                     6,040,653      4,790,121       (298,000)       (59,056)
Cancellation of partial shares                                                           
Net loss                                                                                                            
                                                           -----------    -----------    -----------    -----------

BALANCE, SEPTEMBER 30, 1993                                 22,416,905     23,411,234      2,139,250        267,551
Exercise of non-redeemable Class B Warrants in
  April 1994 at $1.4175 per share for cash                      17,202         24,384
Exercise of redeemable Class B Warrants between
  October 1993 and June 1994 at $2.25 per share for
  cash (net of stock issue costs totalling $541,340)         4,312,060      9,160,795
Exercise of Class C Warrants between October 1993
  and September 1994 at $1.00 per share for cash
  (net of commissions totalling $4,414)                        106,340        101,926
Exercise of Class D Warrants between October 1993
  and September 1994 at $1.50 per share for cash
  (net of commissions totalling $2,875)                         78,335        114,627
Exercise of Class F Warrants between October 1993
  and November 1993 at $100,000 per warrant for cash           
Exercise of stock options between October 1993 and
  September 1994 at exercise prices ranging from
  $0.50 to $2.4375 per share                                   113,267        156,048
Compensation expense related to stock options granted
  at an exercise price below fair market value                                245,000
Issuance of Class A Common Stock in connection with
  Stock Purchase Agreement in September 1994 (net
  of issue costs of $192,215)                                  522,449      1,807,785                 
Conversion of preferred and common stock                       653,416        113,911       (146,750)       (13,910)
Cancellation of Class A Common and Class B Common
  Stock between January 1994 and May 1994                      (70,000)        20,794     (1,546,500)       (20,794)
Cancellation of partial shares                                      (3)
Net loss                                               
                                                           -----------    -----------    -----------    -----------

BALANCE, SEPTEMBER 30, 1994                                 28,149,971     35,156,504        446,000        232,847
                                                           -----------    -----------    -----------    -----------
</TABLE>

<TABLE>
                                                             DEFICIT
                                                           ACCUMULATED           NOTES
                                                            DURING THE         RECEIVABLE
                                                           DEVELOPMENT            FROM
                                                              STAGE           STOCKHOLDERS          TOTAL
                                                              -----           ------------          -----
<S>                                                           <C>             <C>                   <C> 
Exercise of Preferred Stock Units between October 1992
  and September 1993 for cash                                                                    $    90,000
Exercise of stock options in August 1993 and
  September 1993 at exercise prices ranging from
  $0.81 to $1.53 per share                                                                            37,480
Compensation expense related to stock options
  granted at an exercise price below fair market
  value                                                                                              163,333
Cancellation of Series A Preferred and Class B
  Common Stock in July 1993                               
Issuance of Class A Common Stock in July 1993 in
   connection with amendment to a license agreement                                                2,670,000
Conversion of preferred and common stock                     
Cancellation of partial shares                               
Net loss                                                   $(6,139,223)                           (6,139,223)
                                                           -----------         -----------       -----------

BALANCE, SEPTEMBER 30, 1993                                (13,179,615)                  -        10,499,171
Exercise of non-redeemable Class B Warrants in
  April 1994 at $1.4175 per share for cash                                                            24,384
Exercise of redeemable Class B Warrants between
  October 1993 and June 1994 at $2.25 per share for
  cash (net of stock issue costs totalling $541,340)                                               9,160,795
Exercise of Class C Warrants between October 1993
  and September 1994 at $1.00 per share for cash
  (net of commissions totalling $4,414)                                                              101,926
Exercise of Class D Warrants between October 1993
  and September 1994 at $1.50 per share for cash
  (net of commissions totalling $2,875)                                                              114,627
Exercise of Class F Warrants between October 1993
  and November 1993 at $100,000 per warrant for cash                                                 100,000
Exercise of stock options between October 1993 and
  September 1994 at exercise prices ranging from
  $0.50 to $2.4375 per share                                                                         156,048
Compensation expense related to stock options granted
  at an exercise price below fair market value                                                       245,000
Issuance of Class A Common Stock in connection with
  Stock Purchase Agreement in September 1994 (net
  of issue costs of $192,215)                                                                      1,807,785
Conversion of preferred and common stock                      
Cancellation of Class A Common and Class B Common
  Stock between January 1994 and May 1994                   
Cancellation of partial shares                                                 
Net loss                                                    (4,813,341)                           (4,813,341)
                                                           -----------         -----------       -----------

BALANCE, SEPTEMBER 30, 1994                                (17,992,956)                  -        17,396,395
                                                           -----------         -----------       -----------
</TABLE>




                                      F-7


<PAGE>   38
LIDAK PHARMACEUTICALS
(A DEVELOPMENT STAGE ENTERPRISE)
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
AUGUST 31, 1988 (INCEPTION) TO SEPTEMBER 30, 1996

<TABLE>
<CAPTION>
                                                                            CONVERTIBLE PREFERRED STOCK
                                                            ------------------------------------------------------------  
                                                                      SERIES A                         SERIES B           
                                                            ----------------------------    ----------------------------  
                                                               SHARES          AMOUNT        SHARES            AMOUNT     
                                                               ------          ------        ------            ------     
<S>                                                         <C>                  <C>        <C>                <C>        
      OCTOBER 1, 1994 TO SEPTEMBER 30, 1995 
      Exercise of non-redeemable Class B
        Warrants in January and February, 1995 at
         $1.4175 per share for cash                                                                                         
      Exercise of Class C Warrants between October,
        1994 and June, 1995 at $1.00 per share for
        cash (net of commissions totaling $26,743)                                                                        
      Exercise of Class D Warrants between April, 1995
        and September, 1995 at $1.50 per share for cash                                                                   
      Exercise of Class E Warrants in April and August,
        1995 at $0.20 per share for cash                                                                                  
      Exercise of stock options between October, 1994
        and September, 1995 at exercise prices ranging
        from $0.50 per share to $3.56 per share                                                                           
      Compensation expense related to stock options
        granted at an exercise price below fair market
        value                                                                                                             
      Conversion of common stock                                                                                          
      Net loss                                                                                                            
                                                            -----------         --------    ----------        ----------  

      BALANCE, SEPTEMBER 30, 1995                            -                     -         -                         -  
                                                            -----------         --------    ----------        ----------  

      OCTOBER 1, 1995 TO SEPTEMBER 30, 1996
      Exercise of Class D Warrants between October, 1995
        and September, 1996 at $1.50 per share for cash                                                                   
      Exercise of Class E Warrants in March, 1996
        at $0.20 per share for cash                                                                                       
      Issuance of Class A Common Stock in connection with
        Stock Purchase Agreement in November 1995 (net
        of issue costs of $83,495)                                                                                        
      Conversion of Convertible Notes to Class A Common
        Stock between February and September, 1996
        (including interest and discount applied of
        $2,263,276 and net of issue costs of $402,268)                                                                    
       Exercise of stock options between October, 1995
        and September, 1996 at exercise prices ranging
        from $0.50 per share to $3.56 per share                                                                           
      Conversion of common stock                                                                                          
      Net loss                                                                                                            
                                                            ----------          -------    -----------        ----------  

      BALANCE, SEPTEMBER 30, 1996                            -                     -        -                          -   
                                                            ==========          =======    ===========        ==========  


<CAPTION>
                                                                                    COMMON STOCK                      
                                                            --------------------------------------------------------- 
                                                                       CLASS A                       CLASS B          
                                                            -----------------------------   ------------------------- 
                                                              SHARES          AMOUNT            SHARES        AMOUNT  
                                                              ------          ------            ------        ------  
<S>                                                          <C>            <C>                 <C>           <C>     
      OCTOBER 1, 1994 TO SEPTEMBER 30, 1995 
      Exercise of non-redeemable Class B
        Warrants in January and February, 1995 at 
        $1.4175 per share for cash                               97,202         137,783                               
      Exercise of Class C Warrants between October,
        1994 and June, 1995 at $1.00 per share for
        cash (net of commissions totaling $26,743)              415,600         388,857                               
      Exercise of Class D Warrants between April, 1995
        and September, 1995 at $1.50 per share for cash         153,335         230,003                               
      Exercise of Class E Warrants in April and August,
        1995 at $0.20 per share for cash                         85,000          17,000                               
      Exercise of stock options between October, 1994
        and September, 1995 at exercise prices ranging
        from $0.50 per share to $3.56 per share                 842,956       1,121,771                               
      Compensation expense related to stock options
        granted at an exercise price below fair market
        value                                                                   129,792                               
      Conversion of common stock                                103,000          53,774        (103,000)      (53,774)
      Net loss                                                                                                        
                                                            -----------    ------------      ----------     --------- 

      BALANCE, SEPTEMBER 30, 1995                            29,847,064      37,235,484         343,000       179,073 
                                                            -----------    ------------      ----------     --------- 

      OCTOBER 1, 1995 TO SEPTEMBER 30, 1996
      Exercise of Class D Warrants between October, 1995
        and September, 1996 at $1.50 per share for cash          78,334         117,500                               
      Exercise of Class E Warrants in March, 1996
        at $0.20 per share for cash                              25,000           5,000                               
      Issuance of Class A Common Stock in connection with
        Stock Purchase Agreement in November 1995 (net
        of issue costs of $83,495)                              481,651       1,416,505                               
      Conversion of Convertible Notes to Class A Common
        Stock between February and September, 1996
        (including interest and discount applied of
        $2,263,276 and net of issue costs of $402,268)        3,419,166      10,147,676                               
       Exercise of stock options between October, 1995
        and September, 1996 at exercise prices ranging
        from $0.50 per share to $3.56 per share                 142,807         263,079                               
      Conversion of common stock                                 60,000          31,325          (60,000)     (31,325)
      Net loss                                                                                                        
                                                            -----------    ------------     ------------    --------- 

      BALANCE, SEPTEMBER 30, 1996                            34,054,022    $49,216,569           283,000     $147,748  
                                                            ===========    ===========      ============    ========= 

<CAPTION>
                                                               DEFICIT
                                                             ACCUMULATED
                                                              DURING THE       RECEIVABLE
                                                             DEVELOPMENT           FROM
                                                                STAGE          STOCKHOLDERS          TOTAL
                                                             -----------       ------------          -----
<S>                                                             <C>                <C>           <C>
      OCTOBER 1, 1994 TO SEPTEMBER 30, 1995 
      Exercise of non-redeemable Class B
        Warrants in January and February, 1995 at
        $1.4175 per  share for cash                                                                137,783
      Exercise of Class C Warrants between October,
        1994 and June, 1995 at $1.00 per share for
        cash (net of commissions totaling $26,743)                                                 388,857
      Exercise of Class D Warrants between April, 1995
        and September, 1995 at $1.50 per share for cash                                            230,003
      Exercise of Class E Warrants in April and August,
        1995 at $0.20 per share for cash                                                            17,000
      Exercise of stock options between October, 1994
        and September, 1995 at exercise prices ranging
        from $0.50 per share to $3.56 per share                                                  1,121,771
      Compensation expense related to stock options
        granted at an exercise price below fair market
        value                                                                                      129,792
      Conversion of common stock                            
      Net loss                                                  (10,173,001)                   (10,173,001)
                                                             ---------------    -------        ----------- 

      BALANCE, SEPTEMBER 30, 1995                               (28,165,957)       -             9,248,600
                                                             ---------------    -------        -----------

      OCTOBER 1, 1995 TO SEPTEMBER 30, 1996
      Exercise of Class D Warrants between October, 1995
        and September, 1996 at $1.50 per share for cash                                            117,500
      Exercise of Class E Warrants in March, 1996
        at $0.20 per share for cash                                                                  5,000
      Issuance of Class A Common Stock in connection with
        Stock Purchase Agreement in November 1995 (net
        of issue costs of $83,495)                                                               1,416,505
      Conversion of Convertible Notes to Class A Common
        Stock between February and September, 1996
        (including interest and discount applied of
        $2,263,276 and net of issue costs of $402,268)                                          10,147,676
       Exercise of stock options between October, 1995
        and September, 1996 at exercise prices ranging
        from $0.50 per share to $3.56 per share                                                    263,079
      Conversion of common stock                            
      Net loss                                                   (6,130,241)                    (6,130,241)
                                                             ---------------      -------      ----------- 

      BALANCE, SEPTEMBER 30, 1996                              $(34,296,198)         -         $15,068,119 
                                                             ==============       =======      =========== 
</TABLE>



See notes to financial statements.   




                                      F-8



<PAGE>   39
LIDAK PHARMACEUTICALS
(A DEVELOPMENT STAGE ENTERPRISE)

STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED SEPTEMBER 30, 1994, 1995 AND 1996 AND THE PERIOD
AUGUST 31, 1988 (INCEPTION) TO SEPTEMBER 30, 1996
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                                                       AUGUST 31, 1988
                                                              YEARS ENDED SEPTEMBER 30,                 (INCEPTION) TO
                                                     -------------------------------------------         SEPTEMBER 30,
                                                           1994            1995             1996            1996
<S>                                                  <C>              <C>              <C>              <C>          
OPERATING ACTIVITIES:
  Net loss                                           $ (4,813,341)    $(10,173,001)    $ (6,130,241)    $(34,296,198)
  Adjustments to reconcile net loss to
    net cash used for operating activities:
    Technology license fee                                                                                 3,545,713
    Depreciation and amortization                          61,399           84,867          292,943          596,883
    Non-cash interest expense                                                             2,771,030        2,771,030
    Compensation paid with common stock
      and stock options                                   245,000          129,792                           575,625
    Compensation forgiven by stockholder                                                                      66,923
    Imputed interest under technology
      license fee                                                                                             82,613
    Changes in assets and liabilities:
      Interest receivable                                  (3,070)         (16,913)        (283,652)        (338,403)
      Prepaid and other                                    51,946          (77,111)        (908,513)      (1,091,709)
      Patent costs                                        (83,073)        (113,535)        (163,822)        (621,424)
      Organizational costs                                                                                   (20,242)
      Accounts payable                                    493,360          812,040         (190,813)       1,329,418
      Accrued compensation and payroll taxes              (22,975)          44,436           37,560          206,445
      Due to MBI                                           (1,010)           1,064            5,483           21,810
      Deferred revenue                                                                      500,000          500,000
                                                     ------------     ------------     ------------     ------------

           Net cash used for operating activities      (4,071,764)      (9,308,361)      (4,070,025)     (26,671,516)

INVESTING ACTIVITIES:
  Short-term investments                               (6,599,940)       7,115,856       (1,235,350)      (7,026,502)
  Capital expenditures                                   (108,701)         (92,871)        (122,425)        (542,640)
  Note receivable - employee                             (138,649)         138,649
                                                     ------------     ------------     ------------     ------------

           Net cash provided by (used for)
             investing activities                      (6,847,290)       7,161,634       (1,357,775)      (7,569,142)
                                                     ------------     ------------     ------------     ------------

FINANCING ACTIVITIES:
  Proceeds from issuance of common
    and preferred stock                                12,206,408        1,922,157        1,885,579       38,678,271
  Stock issue costs                                      (740,843)         (26,743)         (83,495)      (2,913,703)
  Advances for purchase of common stock                                                                      125,000
</TABLE>


                                      F-9



<PAGE>   40
LIDAK PHARMACEUTICALS
(A DEVELOPMENT STAGE ENTERPRISE)


STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED SEPTEMBER 30, 1994, 1995 AND 1996 AND THE PERIOD
AUGUST 31, 1988 (INCEPTION) TO SEPTEMBER 30, 1996
--------------------------------------------------------------------------------


<TABLE>
<CAPTION>
                                                                                                           AUGUST 31, 1988
                                                                  YEARS ENDED SEPTEMBER 30,                 (INCEPTION) TO
                                                        ------------------------------------------           SEPTEMBER 30,
                                                              1994           1995             1996              1996
<S>                                                     <C>              <C>              <C>             <C>         
FINANCING ACTIVITIES (Continued):
  Collection of notes receivable for
    common stock                                                                                                14,525
  Proceeds from stockholder loans                                                                              322,788
  Repayment of stockholder loans                                                                              (322,788)
  Proceeds from the issuance of
    convertible notes payable                                                               13,500,000      13,500,000
  Debt issue costs                                                                            (771,351)       (771,351)
  Proceeds from issuance of
    subordinated notes payable -
    net of issue costs                                                                                         538,750
  Repayment of subordinated notes payable                                                                     (625,000)
  Payment on technology license fee                                                                           (958,326)
                                                        ------------     ------------     ------------    ------------

           Net cash provided by financing activities      11,465,565        1,895,414       14,530,733      47,588,166
                                                        ------------     ------------     ------------    ------------

NET INCREASE (DECREASE)
  IN CASH AND CASH EQUIVALENTS                               546,511         (251,313)       9,102,933      13,347,508

CASH AND CASH EQUIVALENTS
  AT BEGINNING OF PERIOD                                   3,949,377        4,495,888        4,244,575
                                                        ------------     ------------     ------------    ------------

CASH AND CASH EQUIVALENTS
  AT END OF PERIOD                                      $  4,495,888     $  4,244,575     $ 13,347,508    $ 13,347,508
                                                        ============     ============     ============    ============

SUPPLEMENTAL DISCLOSURES
  OF CASH FLOW INFORMATION:
  Interest paid                                                                           $     77,433    $    209,539
                                                                                          ============    ============
</TABLE>

SUPPLEMENTAL DISCLOSURES OF NON-CASH OPERATING AND FINANCING ACTIVITIES:

In October 1989, advances of $125,000 were converted into 250,000 shares of
Class B Common Stock.  In May 1990 and September 1992, the Company recorded an
expense and a liability in the amount of $817,387 and $58,326, respectively,
related to the technology license agreement and the grant-in-aid agreement with
MBI (see Note 2). 

During 1993, the Company recorded expense and equity in the amount of $2,670,000
related to the amendment of the technology license agreement with MBI (see Note
2).

During 1993, 1994 and 1995, the Company recorded expense and equity in the
amount of $163,333, $245,000 and $81,666, respectively, related to the issuance
of stock options (below fair market value) as compensation for services provided
under a consulting agreement, and $48,126 in 1995 related to compensation to an
employee.

See notes to financial statements.    


                                      F-10
<PAGE>   41
LIDAK PHARMACEUTICALS
(A DEVELOPMENT STAGE ENTERPRISE)
--------------------------------------------------------------------------------

NOTES TO FINANCIAL STATEMENTS

1.          NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

            NATURE OF OPERATIONS - LIDAK Pharmaceuticals (the "Company") was
incorporated in the state of California on August 31, 1988. The Company is
organized to engage in research, development, and commercialization of
innovative pharmaceutical products.

            BASIS OF ACCOUNTING - The Company has not yet completed product
development, obtained required regulatory approvals or verified the market
acceptance and demand for its products. The Company has completed certain
clinical trials on one of its products and is currently undergoing clinical
trials on two of its products under Investigational New Drug ("IND")
applications filed with the United States Food & Drug Administration ("FDA").
The Company is also currently performing research in connection with other
technologies. Accordingly, the Company's activities have been accounted for as
those of a "development stage enterprise" as set forth in Financial Accounting
Standards Board Statement No. 7 ("FAS 7"). Among the disclosures required by FAS
7 are that the Company's financial statements be identified as those of a
"development stage enterprise" and that the Statements of Operations,
Stockholders' Equity (Deficit) and Cash Flows disclose activities since the date
of the Company's inception.

            CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS - Cash equivalents
consist of highly liquid investments purchased with original maturities of three
months or less, or other investments which provide for liquidity within three
months. Short-term investments represent certificates of deposit, U.S.
government securities, commercial paper, and other money market instruments with
maturities of approximately one year or less. Cash equivalents and short-term
investments are carried at cost, which approximates market value. At October 1,
1995, the Company adopted Statement of Financial Standards No. ("SFAS") 115,
"Accounting for Certain Investments in Debt and Equity Securities". In
accordance with SFAS 115, management determined that the appropriate
classification of its investments is "held-to-maturity". (See Note 4).

            CONCENTRATION OF CREDIT RISK - The Company invests its excess cash
in certificates of deposit, U.S. government securities, commercial paper, and
other money market instruments and has established guidelines relative to
diversification and maturities in an effort to maintain safety and liquidity.
These guidelines are periodically reviewed and modified to take advantage of
trends in yields and interest rates. The Company has not experienced any
significant losses on its cash equivalents or short-term investments.

            PROPERTY - Property is recorded at cost and represents primarily
scientific equipment. Depreciation is provided over the estimated useful lives
of the property (generally five years) on the straight-line method. Depreciation
expense for the years ended September 30, 1994, 1995 and 1996 and the period
from inception to September 30, 1996 was $56,818, $74,799, and $87,939 and
$266,668, respectively.

            PATENT COSTS - Legal expenses incurred in connection with
applications for patents are capitalized. Amortization of the costs of approved
patent applications is provided over the useful lives 




                                      F-11
<PAGE>   42

of the patents. For patent applications that are abandoned, accumulated costs
are charged to expense.

            DEBT ISSUE COSTS - Debt issue costs represent costs related to the
issuance of the Convertible Notes Payable (the "Notes") which will be amortized
over the life of the Notes, for a maximum of two-years from the date of
issuance. As of September 30, 1996, $184,068 of the debt issue costs have been
amortized and $402,268 have been reclassified to stock issue costs in connection
with the conversion of the Notes into common stock. In the event the Notes are
converted prior to their due date, any remaining unamortized costs will be
charged to the equity resulting from the conversion of the Notes. (See Note 6).

            DEFERRED REVENUE - Deferred Revenue represents payments received
under licensing agreements that require additional performance by the Company
prior to recognition of such amounts as revenue.

            REVENUES - Revenues from license fees are recognized when the
performance requirements of the license agreements are met. Revenues from
federal research grants and contracts are recognized during the period in which
related expenditures are incurred. Revenues from research contracts are
recognized on the percentage of completion method. Under this method, revenues
and costs are recognized as the work is performed based on the ratio that
incurred costs bear to the estimated total costs. Provisions for anticipated
losses on such contracts would be made in the period in which they first become
determinable.

            RESEARCH AND DEVELOPMENT - Research and development costs are
expensed as incurred.

            NET LOSS PER SHARE - Net loss per share is computed using the
weighted average number of common shares outstanding during the period. Certain
shares of common stock which were outstanding during the fiscal year ended
September 30, 1994 were excluded from the number of shares used in the
calculation of weighted average number of common shares outstanding during that
period as these shares had been placed in escrow and were subject to forfeiture.
All shares which had been placed in escrow were subsequently cancelled (see Note
5). Common equivalent shares have been excluded from the number of shares used
in the calculation of weighted average number of common shares outstanding as
their inclusion would be antidilutive.

            ACCOUNTING FOR STOCK-BASED COMPENSATION - In October 1995, the
Financial Accounting Standards Board issued Statement of Financial Accounting
Standards ("SFAS") No. 123, "Accounting for Stock-based Compensation," which
requires the Company to adopt disclosure provisions for stock based compensation
effective January 1, 1996. The standard defines a fair value method of
accounting for stock options and other equity instruments. Under the fair value
method, compensation is measured at the grant date based on the fair value of
the award and is recognized over the service period, which is usually the
vesting period. This standard encourages rather than requires companies to adopt
the fair value method of accounting for employee stock-based transactions.
Companies are permitted to continue to account for such transactions under
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued
to Employees," but will be required to disclose in a note to the financial
statements pro forma net income and net income per share as if the new method of
accounting had been applied. The Company has elected to continue to apply APB
Opinion No. 25 in its financial statements and will disclose in future reports
the required pro forma information in a footnote.

            ESTIMATES - The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the 




                                      F-12
<PAGE>   43

reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities as of the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from those estimates.

            RECLASSIFICATIONS - Certain reclassifications have been made to the
1994 and 1995 balances to confrom with the 1996 presentation.

2.          MBI AND THE LICENSE AGREEMENT

            Medical Biology Institute ("MBI"), is a non-profit research
organization incorporated in 1981 to conduct interdisciplinary basic research in
biological sciences. The President, Chief Executive Officer and director of the
Company is also President, Chief Executive Officer and a director of MBI.

            The Company and MBI entered into a twenty year licensing agreement
("Agreement") as of October 10, 1988 which granted the Company an exclusive,
worldwide license to all existing technology of MBI and a right of first
preference to license future technology arising from the research and
development efforts of MBI. As consideration for entering into the agreement,
MBI was granted 2,000,000 shares of the Company's preferred stock, which was
recorded at the nominal value of $1. Upon completion by the Company of its
initial capitalization in May 1990, the Company became obligated to MBI for
$900,000 payable in three equal annual installments. The payments were made in
May 1990, 1991 and 1992, respectively. The present value of the obligation
(approximately $818,000) as of May 1990 was reflected in the financial
statements as a charge to research and development expense in May 1990. In
addition, MBI shall receive 10% of all net license fees and 20% of royalties
relating to sub licenses of the licensed technology. For products manufactured
and sold by the Company, MBI will receive royalties of 6% and 3% of sales
relating to patented (issued or pending) and non patented licensed technology,
respectively.

            Prior to the amendment of the Agreement, if the annual fees and
royalties paid to MBI failed to exceed $100,000 for the calendar year ending
December 31, 1995 or any calendar year thereafter then MBI had the right to
convert the license to a non-exclusive license upon six months notice. Fees and
royalties on future technology are subject to negotiation.

            In July 1993 the Agreement was amended. Pursuant to the terms of the
amendment, the Company issued 1,500,000 shares of Class A common stock to MBI as
consideration for a 5-year extension to its exclusive technology rights (until
October 10, 2013) and a 5-year postponement (until December 31, 2000) of the
Company's obligation to pay minimum royalties to MBI. Additionally, MBI waived
its rights to 1,500,000 shares of the Company's Series A preferred stock which
were being held in escrow (See Note 5). The value of the common stock issued
($2,670,000) was reflected in the financial statements as a charge to research
and development expense in July 1993.

            In November 1993 the Company and MBI entered into a Grant-in-Aid
agreement as an addendum to the October 10, 1988 license agreement. Under this
grant the Company agreed to provide direct laboratory support to fund a specific
research program. Such grant will automatically renew for additional one year
periods until terminated in writing by the Company.

            In July 1994 the Agreement was further amended to provide for future
research funding and support for projects not included in the initial license
agreement. This amendment provides for the transfer of ownership rights for each
specific project during the time it is being funded by the Company.





                                      F-13
<PAGE>   44





3.          CONTRACT ARRANGEMENTS

            CONTRACT RESEARCH AGREEMENTS - During 1994, the Company recognized
revenue from a contract research agreement with a third party whereby the
Company performed research related to the screening of certain compounds.

            FEDERAL GRANTS & CONTRACTS - During fiscal 1994 and 1996, the
Company recognized revenues from Small Business Innovation Research ("SBIR")
grants and contracts issued by the National Institutes of Health related to
research on specific technologies.

4.          SHORT-TERM INVESTMENTS

    Short-term investments include the following (at cost which approximates
fair value):


<TABLE>
<CAPTION>
                                        September 30,
                                   1995             1996
                                ----------      ----------
<S>                             <C>             <C>       
Corporate Debt Securities       $4,204,841      $7,026,502
U.S. Government Securities         495,967
Commercial Paper                   991,344
Certificates of Deposit             99,000
                                ----------      ----------

                                $5,791,152      $7,026,502
                                ==========      ==========
</TABLE>

            The marketable securities held by the Company at September 30, 1996,
have contractual maturities of approximately one year.

5.  STOCKHOLDERS' EQUITY (DEFICIT)

Common Stock
     Common stock consists of Class A and B. Each share of Class A and B common
stock (i) participates equally in dividends, (ii) is entitled to one and five
votes, respectively, (iii) upon liquidation of the Company, shares ratably in
the net assets available for distribution, subject to the rights of Preferred
Stock. Class B common stock automatically converts into Class A common stock at
the option of the holder or upon sale or transfer to someone other than a holder
of Class B common stock.

     Stock Purchase Agreement In September 1994 the Company entered into a stock
purchase agreement with Grelan Pharmaceutical Co. Ltd. of Japan ("Grelan").
Pursuant to the agreement, Grelan purchased 522,449 shares of the Company's
Class A common stock for $2,000,000.

Warrants
  Class B Warrants - Each Class B warrant entitled the holder to purchase one
share of Class A common stock at an exercise price of $2.25. In May 1994,
1,920,489 Class B warrants were redeemed at a total cost to the Company of
$94,577. The Class B Warrants outstanding at September 30, 1994 were
non-redeemable warrants issued as a result of the exercise of certain Class A
Warrants. All such Class B Warrants were exercised at a price of $1.4175 per
warrant into one share of Class A Common Stock prior to their May 8, 1995
expiration date.



                                      F-14
<PAGE>   45

  Class C Warrants - Each Class C warrant entitled the holder to purchase one
share of Class A common stock at an exercise price of $1.00 per share through
May 26, 1995.

  Class D Warrants- Each Class D warrant entitles the holder to purchase one
share of Class A common stock at an exercise price of $1.50 per share. Such
warrants are redeemable by the Company, upon 30 days written notice, at a price
of $.05 per warrant, if the average closing price of the Company's Class A
common stock for the 30 days prior to notice exceeds $3.45 per share. If the
Company exercises it's redemption right, it is are obligated to redeem all
outstanding Class D warrants. Such warrants expire at various dates through
February 26, 1997.

  Class E Warrants- Each Class E warrant entitles the holder to purchase one
share of Class A common stock at an exercise price of $.20 per share. All such
warrants expire on January 7, 1997.



<TABLE>
<CAPTION>
                                   CLASS A        CLASS B        CLASS C        CLASS D        CLASS E
                                  WARRANTS       WARRANTS        WARRANTS       WARRANTS       WARRANTS
<S>                                <C>             <C>           <C>            <C>             <C>      
Balance at August 31,
  1988 (Inception) and
  September 30, 1989
Issued                            5,750,000                       625,000
                                 ----------     ----------     ----------     ----------     -----------

Balance at September 30, 1990     5,750,000                       625,000
Issued                                                                           480,006
                                 ----------     ----------     ----------     ----------     -----------

Balance at September 30, 1991     5,750,000                       625,000        480,006
Issued                                           5,650,200                     2,133,360        500,000
Exercised                        (5,650,200)
Redeemed                            (99,800)
                                 ----------     ----------     ----------     ----------     -----------

Balance at September 30, 1992                    5,650,200        625,000      2,613,366         500,000
Issued                              793,650        793,650                       207,995
Exercised                          (793,650)       (96,897)      (103,050)      (836,335)       (315,000)
                                 ----------     ----------     ----------     ----------     -----------

Balance at September 30, 1993                    6,346,953        521,950      1,985,026        185,000
Issued                                                                            53,334
Exercised                                       (4,329,262)      (106,340)       (78,337)
Redeemed                                        (1,920,489)
                                 ----------     ----------     ----------     ----------     ----------

Balance at September 30, 1994                       97,202        415,610      1,960,023        185,000
Exercised                                          (97,202)      (415,600)      (153,335)       (85,000)
Canceled                                                              (10)
                                 ----------     ----------     ----------     ----------     ----------

Balance at September 30, 1995                                                  1,806,688        100,000
                                 ----------     ----------     ----------     ----------     ----------

Exercised                                                                        (78,334)       (25,000)
                                 ----------     ----------     ----------     ----------     ----------

Balance at September 30, 1996                                                  1,728,354         75,000
                                 ----------     ----------     ----------     ----------     ----------

Exercise Price per Warrant              -              -              -       $     1.50     $      0.20
                                 ==========     ==========     ==========     ==========     ===========
</TABLE>


Underwriter Agreements
            On May 8, 1990, the Company entered into an agreement with an
underwriter for the sale of common stock units. Among other things, the
agreement provides for: (i) underwriter shall have a right of first refusal to
act as underwriter on any offerings of securities for a period of five years,
(ii) upon the exercise of any warrants after May 8, 1991 the Company shall pay
underwriter a fee of 4% of the aggregate exercise price if the market price of
the Company's common stock exceeds the exercise price on the date of exercise,
and (iii) certain anti-dilution rights.



                                      F-15
<PAGE>   46

            On November 3, 1993, the Company entered into an agreement whereby
the underwriter waived its right of first refusal and any and all rights under a
merger and acquisition agreement dated May 15, 1990. As compensation for such
waivers, the Company paid the underwriter $40,000 and issued non-qualified
options exercisable until November 3, 1996 into 50,000 shares of the Company's
Class A common stock at an exercise price of $6.75 per share.

Escrow Agreement
            Pursuant to an agreement between the Company and the underwriter of
the Company's initial public offering, 3,783,750 shares of Class B common stock,
1,500,000 shares of Series A convertible preferred stock, and options to
purchase 2,216,250 shares of Class B common stock were placed in an escrow
account to be held until January 1994. During fiscal 1992, 70,000 of these
options were exercised resulting in 70,000 shares of Class A common stock being
placed in the escrow account. In July 1993, certain holders of the shares and
options placed in escrow waived all rights to their respective shares and
options, resulting in the cancellation of 2,240,250 shares of Class B common
stock, 1,500,000 shares of Series A convertible preferred stock and options to
purchase 1,603,500 shares of Class B common stock. At September 30, 1993, there
were 70,000 shares and 1,546,500 shares, respectively, of Class A common and
Class B common stock remaining in escrow which were cancelled during fiscal
1994.

Stock Options
            In March 1994 the Company's shareholders approved the adoption of
the 1994 Stock Option Plan ("the 1994 Plan") pursuant to which an aggregate of
750,000 shares of Class A Common Stock were reserved for issuance. Such options
may be granted to officers, directors, employees and consultants of the Company.
The options are to be granted at an exercise price of at least fair market value
on the date of grant and generally vest over a three year period. The 1994 Plan
provides for an automatic annual grant of an option to purchase 10,000 shares to
each director who is not also an employee of the Company. The 1994 Plan shall
terminate on January 14, 2004. In March, 1995 and March, 1996 the Company's
shareholders voted to increase the shares reserved for issuance under the plan
to an aggregate of 1,100,000 and 1,350,000 shares, respectively. At September
30, 1996, there were 527,558 shares of Class A Common Stock remaining available
for grant under the 1994 Plan.

            Prior to the adoption of the 1994 Plan, the Company had other stock
option plans which provided for the grant of options to purchase up to 1,200,000
and 1,500,000 shares of Class A and Class B common stock, respectively, to key
employees and others at an option price of at least fair market value at date of
grant. In March 1994 and November 1989, respectively, the Company terminated
these plans as to the issuance of new options.

            In September 1988, under an employment agreement with its President
and Chief Executive Officer, the Company issued options to purchase 900,000
shares of Class B common stock at an option price of $.0125 per share
representing the estimated fair market value on the date of grant. Effective in
August 1990, the employment agreement was amended to provide for the grant of
options to purchase an additional 600,000 shares of Class B common stock at an
option price of $.0125 per share (which was below the estimated fair market
value of $.05 per share on the date of grant resulting in the recording of
related compensation expense) in return for the cancellation of certain
anti-dilution rights. The options were fully exercisable when issued and expire
on September 9, 2003. In July 1993 options to purchase 1,125,000 shares were
canceled and replaced pursuant to certain of the July 1993 grants discussed
below. As of September 30, 1996, fully vested options to purchase 375,000 shares
of Class B common stock remained outstanding.





                                      F-16
<PAGE>   47

            In February 1993 the Company granted options to purchase 500,000
shares of Class A common stock to a consultant at an option price of $0.50 per
share (which was below the estimated fair market value of $1.48 on the date of
grant). In June 1994 the Company issued additional options to purchase 100,000
shares of Class A common stock at an exercise price of $2.25 per share pursuant
to the consulting agreement. In February 1995, the consultant exercised options
to purchase 500,000 shares of the Company's Class A Common Stock at the option
price of $0.50 per share.

            In July 1993 the Company granted options to purchase an aggregate of
3,843,750 shares of Class A common stock to certain current employees,
consultants, directors and original investors of the Company at an option price
of $3.56 per share. Recipients of these options waived all of their respective
rights to an aggregate of 3,843,750 shares of Class B common stock and options
to purchase Class B common stock held in an escrow account. These options were
fully exercisable when issued and expire on July 17, 2003.

            In September 1994 the Company reduced the exercise price on options
granted to certain employees, officers and consultants to purchase 3,285,250
shares of Class A and Class B common stock to $2.75 per share.




                                      F-17
<PAGE>   48




The following summarizes all common stock option activity for the period August
31, 1988 (inception) to September 30, 1996:



<TABLE>
<CAPTION>
                                                                NUMBER OF SHARES
                                                      -------------------------------------               OPTION PRICE
                                                      CLASS A                     CLASS B                  PER SHARE
<S>                                                     <C>                      <C>                     <C>  
   Granted in September 1988                                                        900,000                  $0.0125
                                                                                    -------

   Outstanding September 30, 1988                                                   900,000                  $.0125
       Granted                                                                       28,000                  $0.025
                                                                                    -------

   Outstanding September 30, 1989                                                   928,000              $0.0125-$0.025
       Granted                                          133,500                   2,027,000               $.0125-$1.53
       Exercised                                                                    (21,500)                  $0.50
       Canceled                                                                     (72,500)                  $0.50
                                                      ---------                     -------

   Outstanding at September 30, 1990                    133,500                   2,861,000               $0.0125-$1.53
       Granted                                          120,100                                           $0.9375-$1.00
       Exercised                                                                     (2,000)                  $0.50
       Canceled                                         (60,000)                   (104,000)              $0.050-$1.53
                                                      ---------                     -------

   Outstanding at September 30, 1991                    193,600                   2,755,000               $0.0125-$1.53
       Granted                                          365,000                                          $1.3125-$2.4375
       Exercised                                                                   (119,000)                  $0.50
       Canceled                                         (89,100)                   (498,000)               $0.50-$1.53
                                                      ---------                     -------

   Outstanding at September 30, 1992                    469,500                   2,138,000              $0.0125-$2.4375
       Granted                                        4,865,250                                           $0.50-$6.8755
       Exercised                                        (27,480)                                           $0.81-$1.53
       Canceled                                          (7,420)                 (1,603,500)              $0.0125-$2.25
                                                      ---------                     -------

   Outstanding at September 30, 1993                  5,299,850                     534,500              $0.0125-$6.8755
       Granted                                          619,000                                           $2.00 - $6.75
       Exercised                                        (70,767)                    (42,500)             $0.025-$2.4375
       Canceled                                        (180,966)                                         $0.9375-$6.8750
                                                      ---------                     -------

   Outstanding at September 30, 1994                  5,667,117                     492,000
       Granted                                          319,500                                           $0.0125-$6.75
       Exercised                                       (795,956)                    (47,000)             $2.9375-$6.4375
       Canceled                                        (168,746)                                         $1.0625-$2.9375
                                                      ---------                     -------

   Outstanding at September 30, 1995                  5,021,915                     445,000
       Granted                                          243,500                                           $2.50 - $3.00
       Exercised                                       (126,807)                    (16,000)              $0.50 - $3.56
       Canceled                                         (18,586)                                         $1.0625-$6.4375
                                                      ---------                     -------

   Outstanding at September 30, 1996                  5,120,002                     429,000
                                                      =========                     =======
   Exercisable at September 30, 1996                  5,077,943                     429,000               $0.0125-$6.75
                                                      =========                     =======
</TABLE>





                                      F-18
<PAGE>   49

6.  CONVERTIBLE NOTES PAYABLE

            In November 1995, December 1995 and January 1996, the Company sold a
total of $13.5 million of Convertible Notes Payable (the "Notes") to
institutional investors as part of a private placement. The Notes accrue
interest at an annual rate of 7%, beginning six months from the date of issue,
with the principal due and payable two years from the date of issue if and to
the extent that the Notes are not previously converted. The Notes are
convertible at the option of the holder (subject to the maximum share
limitations set forth below) into Class A Common Stock at a price equal to 80%
of the average closing bid price for the Class A Common Stock on the NASDAQ for
the seven trading days prior to the date of conversion.

            The conversion of the Notes at 80% of the average closing bid price
of the Company's Class A Common Stock results in the Notes being issued at a 25%
discount (the "Conversion Discount"). The Conversion Discount is being
recognized by the Company as non-cash interest expense over the term of the
Notes with a corresponding increase to the original principal amount of the
Notes. Any portion of the Conversion Discount not recognized upon conversion of
the Notes is recorded as interest expense on that date. In addition, the stated
7% annual interest is being recognized ratably over the term of the Notes.
During the fiscal year ended September 30, 1996, a total of $2,966,687 was
recorded as interest expense relating to the Notes, including $2,579,442
relating to the Conversion Discount.

            The $13.5 million original principal amount of the Notes is
convertible into an aggregate maximum of 5,513,018 shares of the Company's Class
A Common Stock, with each individual note limited to a pro-rata amount of such
number of shares. As of September 30, 1996, the $5,721,087 outstanding balance
of the Notes consisted of $5,213,333 of the original principal amount of the
Notes and $507,754 of Conversion Discount. During fiscal 1996, an aggregate of
$8,286,668 of the original principal amount of Notes had been converted into
3,419,166 shares of Class A Common Stock.

            In the event that the shares of Class A Common Stock underlying a
particular Note cannot be issued upon request for conversion due to the above
referenced maximum share limitations, the Company is immediately obligated to
repay the original principal of that portion of the Note which is presented for
conversion which cannot be converted plus a premium equal to 25% of such
principal plus any accrued and unpaid interest. At its option, the holder(s) of
the $1.3 million of principal amount of the Notes sold in January, 1996 can
require the Company to issue shares of Class A Common Stock based on a
conversion price equal to 100% of the average closing bid price for the Class A
Common Stock for the seven trading days prior to the date of conversion in lieu
of the above-referenced principal and premium payment.

            From October 1, 1996 to December 20, 1996, the Company issued a
total of 2,092,514 shares of its Class A Common Stock in connection with the
conversion of $2,537,794 of the original principal amount of the Notes.
Including these issuances, a total of 5,511,680 shares of Class A Common Stock
have been issued through December 20, 1996 in connection with the conversion of
the Notes. On December 19, 1996, the Company repaid certain noteholders a total
of $1,728,393 representing $1,375,539 of original principal and $352,854 of
premium and accrued interest in accordance with the provisions of these notes.
After these events, the original principal amount outstanding on the notes was
$1,300,000.

            At December 20, 1996, the Company would be required to pay
approximately $1.6 million as repayment of remaining principal plus premium and
any accrued and unpaid interest. At its option, the noteholder can require the
Company to issue shares of Class A Common Stock at the then fair market value in
exchange for the above-referenced principal and premium payment.




                                      F-19
<PAGE>   50
7.  LICENSE AGREEMENTS

            YAMANOUCHI EUROPE, b.v. (formerly Brocades Pharma, b.v.) - In
November 1991 the Company entered into a licensing agreement with Yamanouchi
Europe, b.v. of the Netherlands ("Yamanouchi") for clinical development,
manufacturing, marketing and distribution of n-docosanol 10% cream (LIDAKOL(R)),
as a topical anti-herpes compound in certain European and other countries. Under
terms of the agreement, Yamanouchi will be responsible for obtaining the
necessary regulatory approvals and for the subsequent manufacturing, marketing
and distribution of LIDAKOL in certain European and other countries. Under the
agreement, the Company may receive payments based on the attainment of certain
milestones and will receive royalties on sales in the subject territories after
market introduction.

            CTS - In July 1993, the Company entered into a 5 year license/supply
and distribution agreement with CTS Chemical Industries, Ltd. ("CTS"), for the
manufacturing, marketing and distribution of LIDAKOL as a topical anti-herpes
compound in Israel. Under the terms of the agreement, CTS will be responsible
for obtaining the necessary regulatory approvals and for the subsequent
manufacturing, marketing and distribution of LIDAKOL in Israel. The agreement
includes a supply provision under which CTS will purchase its entire requirement
of active ingredients for use in the manufacture of topical LIDAKOL from the
Company or the Company's designee.

            BORYUNG - In July 1994, the Company entered into a 12 year exclusive
license and supply agreement with Boryung Pharmaceuticals Company Ltd.
("Boryung"), for the manufacture and sale of LIDAKOL in the Republic of Korea.
Under the terms of the agreement, Boryung will be responsible for obtaining the
necessary regulatory approvals and for the subsequent manufacturing, marketing
and distribution of LIDAKOL in Korea. The agreement includes a supply provision
under which Boryung will purchase its entire requirement of active ingredient
for use in the manufacture of topical LIDAKOL from the Company or the Company's
designee, and after market introduction the Company will receive royalties on
sales in the subject territory. The Company may terminate the agreement if
market introduction in Korea does not occur by December 31, 1998.
            GRELAN - In October 1994 the Company entered into an exclusive
license agreement with Grelan Pharmaceutical Co., Ltd. ("Grelan") for the
manufacturing, marketing and distribution of LIDAKOL in Japan. Under the terms
of the agreement, Grelan will be responsible for obtaining the necessary
regulatory approvals and for the subsequent manufacturing, marketing and
distribution of LIDAKOL in Japan. Under the agreement, the Company may receive
payments on the attainment of certain milestones, and will receive royalties on
sales in the subject territory after market introduction.

            BRISTOL-MYERS SQUIBB -In February 1996, the Company entered into an
exclusive license agreement with Bristol-Myers Squibb Company ("BMS") for the
manufacture, marketing and distribution of LIDAKOL as a topical treatment for
oral herpes in the U.S. and Canada and all remaining major territories
throughout the world which are not currently licensed to other parties,
including Mexico, China, South and Central America, Australia and India, and
portions of the Far East. In connection with this agreement, the Company
received an initial license fee with a portion recorded as revenue in the year
ended September 30, 1996 and the remainder recorded as deferred revenue at
September 30, 1996. Recognition of the deferred revenue is subject to the
completion of certain Phase 3 clinical trials of LIDAKOL and to BMS' continued
participation in a joint development program. Under the agreement, the Company
may receive additional license fees based on the attainment of certain
milestones and will receive royalties on sales in subject territories.

            In November 1996, the Company reacquired from BMS the rights to
market LIDAKOL in all territories covered in the license agreement, except the
United States, Canada and Mexico.



                                      F-20
<PAGE>   51

8.  INCOME TAXES

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


<TABLE>
<CAPTION>
                                                      September 30,
                                                   1995           1996
                                              -----------     ------------
<S>                                           <C>             <C>         
Net operating loss carryforwards                9,392,873      11,894,762
Capitalized license fees                        1,200,039       1,136,879
Research credit carryforwards                   1,302,745       1,359,517
Capitalized research and development costs        590,000         663,639
Other                                             (72,482)       (138,077)
                                              -----------     -----------

Net deferred tax assets                        12,413,175      14,916,720
Valuation allowance for net deferred
  tax assets                                  (12,413,175)    (14,916,720)
                                              -----------     -----------
                                                      -                -
                                              ===========     ===========
</TABLE>

            The Company has provided a valuation allowance against the net
deferred tax assets recorded as of September 30, 1995 and 1996 due to
uncertainties as to their ultimate realization. The net operating loss and
research credit carryforwards expire through 2010. In the event of certain
ownership changes, the Tax Reform Act of 1986 imposes certain restrictions on
the amount of net operating loss carryforwards which may be used in any year by
the Company. As of September 30, 1996, the Company had $33,062,561 and
$10,646,641 of federal and California net operating loss carryforwards,
respectively.

9.  RELATED PARTY TRANSACTIONS

            Private Placement - In July 1991 the Company's President and Chief
Executive Officer purchased nine preferred stock units in a private placement
offering (see Note 5).

            MBI - The President and Chief Executive Officer of the Company is
also an officer of MBI, a non-profit research organization. The Company has
agreements with MBI for the licensing of technology (see Note 2) and for the
leasing of facilities (see Note 10). In addition, the Company has incurred
charges relating to certain administrative and research services and facilities
provided by MBI and the use of certain of MBI's facilities and equipment. Such
charges to the Company are based on the usage of personnel and facilities and
totaled $206,241, $216,439 and $218,867 and $1,390,465 for the years ended
September 30, 1994, 1995 and 1996 and for the period from inception to September
30, 1996, respectively.

            H.C. Wainwright - In October 1995, the Company engaged H.C.
Wainwright Asset Management to provide cash management services of the Company's
investment portfolio. One of the Company's directors, is a Vice President at
Wainwright and will receive a portion of the fee earned by Wainwright for such
cash management services.

10.  COMMITMENTS

            OPERATING LEASES - The Company leases its facilities from MBI under
a non-cancelable operating lease which expires January 31, 1997. The Company
also leases certain equipment under non-cancelable operating leases. Lease
expense for the years ended September 30, 1994, 1995 and 1996 and the period
from inception to September 30, 1996 was $266,012, $372,201, and $410,391 


                                      F-21
<PAGE>   52

and $1,976,545, respectively. Future minimum payments under non-cancelable
operating leases for the year ending September 30, 1997 are $147,496.

            CLINICAL RESEARCH AGREEMENT - In August 1996, the Company entered
into a clinical research services agreement with a third party related to Phase
3 clinical trials of LIDAKOL in the United States. During fiscal 1997, the
Company anticipates making payments of approximately $2.0 million under this
agreement.

11.  EMPLOYEE SAVINGS PLAN

The Company has an employee savings plan established pursuant to Section 401(k)
of the Internal Revenue Code. The plan allows participating employees to deposit
into tax deferred investment accounts 2% to 15% of their salary, subject to
annual limits. The Company is not required to make matching contributions. The
Company did not make any such contributions in fiscal years 1994, 1995, and
1996.

12.  SELECTED QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

<TABLE>
<CAPTION>
                                                Year ended September 30, 1995:
                                         First         Second         Third           Fourth
-----------------------------------------------------------------------------------------------
<S>                                 <C>             <C>             <C>             <C>        
REVENUES:
      Interest and other            $   212,958     $   210,173     $   300,580     $   160,878
                                    -----------------------------------------------------------
          Total revenues                212,958         210,173         300,580         160,878
                                    -----------------------------------------------------------
EXPENSES:
      Research and development        1,092,288       1,875,163       2,223,857       2,524,499
      General and administrative        872,081         983,823         835,126         650,753
                                    -----------------------------------------------------------
          Total expenses              1,964,369       2,858,986       3,058,983       3,175,252
                                    -----------------------------------------------------------
NET LOSS                            $(1,751,411)    $(2,648,813)    $(2,758,403)    $(3,014,374)
                                    =========================================================== 
NET LOSS PER SHARE                  $     (0.06)    $     (0.09)    $     (0.09)    $     (0.11)
</TABLE>

<TABLE>
<CAPTION>
                                                       Year ended September 30, 1996:
                                           First (1)     Second (1)     Third (1)       Fourth
--------------------------------------------------------------------------------------------------
<S>                                     <C>             <C>            <C>             <C>         
REVENUES:
      License fees/Contract research                    $ 3,000,000                    $    16,800
      Federal SBIR grants               $     6,500          11,332    $    25,168          15,000
      Interest and other                    190,035         279,336        306,050         307,817
                                        ----------------------------------------------------------
          Total revenues                    196,535       3,290,668        331,218         339,617
                                        ----------------------------------------------------------
EXPENSES:
      Research and development            1,441,423       1,115,346        920,336       1,099,321
      General and administrative            650,143         901,709        636,654         556,660
      Interest (1)                          175,374       1,214,630      1,115,124         461,559
                                        ----------------------------------------------------------
          Total expenses                  2,266,940       3,231,685      2,672,114       2,117,540
                                        ----------------------------------------------------------
NET INCOME (LOSS) (1)                   $(2,070,405)    $    58,983    $(2,340,896)    $(1,777,923)
                                        ========================================================== 

NET INCOME (LOSS) PER SHARE (1)         $     (0.07)    $      0.00    $     (0.07)    $     (0.05)
</TABLE>



(1)  Interest expense, net income (loss) and net income (loss) per share for the
     first, second, and third quarters of the year ended September 30, 1996 have
     been restated from amounts previously disclosed by the Company in its
     quarterly reports on Form 10-Q to reflect the impact on those amounts of a
     fourth quarter adjustment recorded by the Company to properly recognize
     non-cash interest expense associated with the Convertible Notes (see Note
     6). The effect of this adjustment on amounts previously disclosed was to
     increase interest expense and net loss for the first quarter by $175,374
     (.01 per share), increase interest expense and reduce net income for the
     second quarter by $1,214,630 (.04 per share), and increase interest expense
     and net loss for the third quarter by $1,083,340 (.03 per share).

                                   * * * * * *


                                      F-22

<PAGE>   53
                              LIDAK PHARMACEUTICALS

                                INDEX TO EXHIBITS


           1.1    -  Underwriting Agreement(1)
           3.1    -  Restated Articles of Incorporation of the Registrant(6)
           3.2    -  Bylaws of the Registrant(4)
           3.3    -  First and Second Amendment to Bylaws(6)
           4.1    -  Forms of Class A and Class B Common Stock Certificates(3)
           4.2    -  Class D Warrant Agreement (including form of Class D 
                     Warrant Certificate)(4)
           4.3    -  Warrant Agreement (including form of Class E Warrant 
                     Certificate)(4)
           4.7    -  Form of Unit Purchase Option issued to D.H. Blair & Co., 
                     Inc. and its designees regarding Series B Preferred Stock 
                     and Class D Warrants(4)
           4.8    -  Registration Rights Agreement(4)
           4.9    -  Convertible Note issued to GFL Advantage Fund Limited(8)
           4.10      Convertible Note issued to Capital Ventures 
                     International(9)
          10.1    -  1989 Stock Option Plan(3)
          10.2    -  License Agreement with Medical Biology Institute(3)
          10.3    -  Amendment to License Agreement with Medical Biology 
                     Institute dated July 1993(5)
          10.4    -  Employment Agreement with David H. Katz, as amended(3)
          10.5    -  Amendment to Employment Agreement with David H. Katz dated 
                     April 1993(5)
          10.6    -  Sublease Agreement with Medical Biology Institute(3)
          10.7    -  First, Second and Third Amendments to Sublease Agreement 
                     with Medical Biology Institute(4)
          10.8    -  Fourth and Fifth Amendments to the Sublease Agreement with
                     Medical Biology Institute(7)
          10.9    -  Licensing Agreement with Yamanouchi Europe b.v.(2)
          10.10   -  1994 Stock Option Plan(7)
          10.11   -  Supplemental Agreement with Yamanouchi Europe b.v.(7)
          10.12   -  Licensing Agreement with Grelan Pharmaceutical Company 
                     Limited(7)
          10.13   -  Sixth Amendment to the Sublease Agreement with Medical 
                     Biology Institute(8)
          10.14   -  Subscription Agreement(8)
          10.15   -  Note Purchase Agreement issued to GFL Advantage Fund
                     Limited(8)
          10.16   -  Registration Rights Agreement issued to GFL Advantage Fund
                     Limited(8)
          10.17      License and Development Agreement with Bristol-Myers Squibb
                     Company(9)
          10.18      Registration Rights Agreement issued to Capital Ventures 
                     International(9)
          10.19      Note Purchase Agreement issued to Capital Ventures 
                     International(9)
          10.20      Seventh Amendment to the Sublease Agreement with Medical 
                     Biology Institute(9)
          11.1    -  Statement Re Computation of Net Loss Per Share
          23.1    -  Independent Auditors' Consent
          27.1    -  Financial Data Schedule

1    Incorporated by reference to the similarly described exhibits filed in
     connection with the Registrant's Registration Statement on Form S-1, File
     No. 33-37166, declared effective by the Securities and Exchange Commission
     on November 9, 1990.

2    Incorporated by reference to the similarly described exhibits included with
     the Registrant's Annual Report on Form 10-K for the fiscal year ended
     September 30, 1991, filed January 11, 1992.

3    Incorporated by reference to the similarly described exhibit filed in
     connection with the Registrant's Registration Statement on Form S-1, File
     No. 33-32742, declared effective by the Commission on May 8, 1990.

4    Incorporated by reference to the similarly described exhibit filed in
     connection with the Registrant's Registration Statement on Form S-1, File
     No. 33-49082, declared effective by the Commission on October 26, 1992.

5    Incorporated by reference to the similarly described exhibits included with
     the Registrant's Annual Report on Form 10-K for the fiscal year ended
     September 30, 1993, filed December 29, 1993.


6    Incorporated by reference to the similarly described exhibit filed in
     connection with the Registrant's Amendment #4 to the Registration Statement
     on Form S-1, File No. 33-32742, declared effective by the Commission on
     April 13, 1994.

7    Incorporated by reference to the similarily described exhibit included with
     the Registrant's Annual Report on Form 10-K for the fiscal year ended
     September 30, 1994, filed December 29, 1994.

8    Incorporated by reference to the similarily described exhibit included with
     the Registrant's Annual Report on Form 10-K for the fiscal year ended
     September 30, 1995, filed December 15, 1995.

9    Incorporated by reference to the similarily described exhibit included with
     the Registrant's Quarterly Report on Form 10-Q for the quarter ended March
     31, 1996, filed Filed May 15, 1996.