<PAGE>   1
                       SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549

                                    FORM 10-K

(Mark one)

[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
    of 1934
For the fiscal year ended December 31, 1996

                                       or

[  ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934
For the transition period from                       to

Commission File Number:  0-22314

                              PENEDERM INCORPORATED
             (Exact name of registrant as specified in its charter)

          California                                      77-0146116
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
incorporation or organization)

        320 Lakeside Drive, Foster City, California          94404
        (Address of principal executive offices)           (Zip Code)

<TABLE>
<S>                                                            <C>
Registrant's telephone number, including area code:            (415) 358-0100
Securities registered pursuant to Section 12(b) of the Act:    None
Securities registered pursuant to Section 12(g) of the Act:    Common Stock, no par value
                                                               Rights to purchase Common Stock
                                                               (Title of class)
</TABLE>

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                            Yes   X             No
                                 ---                 ---

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

The aggregate market value of the voting stock held by non-affiliates of the
registrant on February 28, 1997, based upon the closing price of the Common
Stock on the Nasdaq National Market for such date, was approximately
$91,552,000.

The number of outstanding shares of the registrant's Common Stock on February
28, 1997 was 7,324,195.

DOCUMENTS INCORPORATED BY REFERENCE

None.

<PAGE>   2

                              PENEDERM INCORPORATED
                              1996 FORM 10-K REPORT


                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                                                                       PAGE
                                                                                                                       ----
<S>               <C>                                                                                                    <C>
PART I
         ITEM 1.  BUSINESS..............................................................................................  1
         ITEM 2.  PROPERTIES............................................................................................ 30
         ITEM 3.  LEGAL PROCEEDINGS..................................................................................... 31
         ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS................................................... 31

PART II
         ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS............................. 31
         ITEM 6.  SELECTED FINANCIAL DATA............................................................................... 32
         ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS................. 33
         ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA........................................................... 36
         ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.................. 52

PART III
         ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.................................................... 53
         ITEM 11. EXECUTIVE COMPENSATION................................................................................ 55
         ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT........................................ 58
         ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS........................................................ 59

PART IV
         ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K...................................... 60
</TABLE>

<PAGE>   3

    THE STATEMENTS IN THIS ANNUAL REPORT ON FORM 10-K AND OTHER STATEMENTS MADE
BY THE COMPANY FROM TIME TO TIME THAT RELATE TO FUTURE PLANS, EVENTS OR
PERFORMANCE ARE FORWARD-LOOKING STATEMENTS WHICH INVOLVE RISKS AND
UNCERTAINTIES. ACTUAL RESULTS, EVENTS OR PERFORMANCE MAY DIFFER MATERIALLY FROM
THOSE ANTICIPATED IN ANY FORWARD-LOOKING STATEMENTS AS A RESULT OF A VARIETY OF
FACTORS, INCLUDING THOSE SET FORTH UNDER "RISK FACTORS" AND ELSEWHERE IN THIS
ANNUAL REPORT ON FORM 10-K. READERS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON
THESE FORWARD-LOOKING STATEMENTS WHICH SPEAK ONLY AS OF THE DATE HEREOF. THE
COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY RELEASE THE RESULT OF ANY REVISIONS
TO THESE FORWARD-LOOKING STATEMENTS THAT MAY BE MADE TO REFLECT EVENTS OR
CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCE OF
UNANTICIPATED EVENTS.


                                     PART I

ITEM 1.  BUSINESS

COMPANY OVERVIEW

    Penederm is developing and commercializing topically administered
prescription dermatology products that use the Company's proprietary drug
delivery technology or drug compounds to achieve enhanced patient safety or
clinical efficacy. In the fourth quarter of 1996, Penederm received clearance
from the United States Food and Drug Administration ("FDA") to market Mentax, a
once-a-day prescription topical treatment for the treatment of three skin fungal
conditions: tinea pedis (athletes' foot), tinea corporis (ringworm) and tinea
cruris (groin fungus). In January 1997, Penederm received FDA clearance to begin
marketing its Avita cream prescription product for the treatment of acne.
Penederm also received clearance to market the gel formulation of Avita
contingent upon the expiration of a patent held by a third party in January
1998. In January 1997, Penederm entered into an arrangement with The Merck KGaA
Group/Center Laboratories to co-promote in the United States Akne-Mycin, a
topical cream ointment containing erythromycin, and Cloderm, a mid-potency
topical steroid. Penederm has several other pharmaceutical products for
psoriasis, nail fungus and Mentax skin treatment line extensions in Phase II
human clinical trials. The Company also sells its patented TopiCare Delivery
Compounds for use in cosmetics and personal care products, and markets its own
over-the counter (OTC) skin care products through corporate partners. The
Company's goal is to become a leader in the United States prescription
dermatology market and compete in other skin care markets by creating safer and
more efficacious topical formulations using its versatile drug delivery
technology with selected licensed and off-patent drug compounds addressing niche
markets and by successfully commercializing these formulations.

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

         The following trademarks of Penederm are used in this Annual Report on
Form 10-K: TopiCare Delivery Compounds(R), Avita(TM), Mentax(TM), Penederm(R),
Vitinoin(R) and DuraScreen(R) (licensed to Pierre Fabre Inc. in the United
States).


                                       3
<PAGE>   4

MARKET OVERVIEW

    Prescription Products

    The market for prescription treatments for dermatologic disorders, or
diseases of the skin, is estimated to be in excess of $2 billion annually in the
United States at the manufacturer level. In the United States, dermatological
diseases are treated primarily by 7,000 high-prescribing dermatologists and
general practitioners. It is estimated that dermatologists prescribe drug
therapies in approximately 65 percent of patient visits. In many instances, the
dermatological disease being treated is chronic, requiring continued use of
prescribed products.

         Dermatological treatments may be delivered topically, in the form of
creams, ointments, gels, liquids or patches, or orally, primarily in the form of
tablets and gelatin capsules. Dermatologists often prefer topical administration
of drugs to oral drug delivery for the treatment of many dermatological
conditions, since topical drug delivery may reduce the amount of drug required
and because targeted topical pharmaceutical application is often safer and less
expensive. In addition, topical administration may avoid side effects associated
with systemic ingestion of drug agents. The primary clinical approaches to
topical drug delivery include:

         Traditional Penetrating Agents. Typically, formulating agents,
    including ethanol, propylene glycol, surfactants and other agents are used
    to aid in the penetration into the skin of active pharmaceutical compounds.
    Although these formulating agents often initially provide enhanced
    penetration of active ingredients, they may not provide long-term
    penetration enhancement, and often cause irritation when used in doses
    concentrated enough to provide clinical efficacy.

         Specialized Delivery Technologies. A variety of topical drug delivery
    technologies, including liposomes, microspheres, injectable matrices,
    transdermal patches, electroporation and iontophoresis, have been developed
    to enhance or enable the topical delivery of pharmaceuticals. Although many
    of these technologies have demonstrated clinical efficacy for certain drugs
    and disease indications, these technologies have generally not been
    successfully developed for dermatological indications due to product
    instability, side effects, toxicity, cost or difficulty of administration.

    Although topical delivery is preferred by many dermatologists, the
development of new products and the market acceptance of topically delivered
dermatological therapies in many instances has been limited by side effects or
by the limited efficacy of existing topical formulations. Many effective active
ingredients may be irritating to the skin in traditional topical delivery
formulations. In addition, effective topical drug delivery is often difficult
because the skin provides a natural barrier to foreign substances, and because
topical therapies may be diluted or washed off by natural secretions or contact
with other liquids or may be rubbed off by contact with clothing.

    Although the aggregate market for prescription dermatological products is
large, the markets for pharmaceuticals to treat specific dermatological diseases
are smaller and fragmented. Large pharmaceutical companies have historically
focused on the drug discovery process, including preclinical and clinical
development, regulatory approvals, and marketing of therapeutics to treat
diseases affecting large patient populations. The clinical focus on enhancing
the delivery of existing pharmaceuticals is a relatively new field, and may
provide opportunities for companies developing novel drug delivery technologies
or new formulations of existing therapeutics targeted to niche markets.


                                       4
<PAGE>   5

    Nonprescription Products

    Technologies used for the delivery of drugs to treat dermatologic
indications may be applied to the nonprescription skin care market. Cosmetics
and skin and hair care products are primarily sold through mass merchandisers,
food and drug chains, department stores, independent specialty and convenience
stores, pharmacies, mail order and door-to-door sales. New product introductions
are frequent, with market acceptance based on such factors as breadth of
distribution, cost, product efficacy, safety and appealing use characteristics.
Important attributes of delivery agents used for such products include safety,
emolliency, duration of action, stability and ease of formulation.

PENEDERM DRUG DELIVERY TECHNOLOGY

    The Company's TopiCare Delivery Compounds represent a patented skin-loading
technology designed to target delivery to layers in the skin or other epithelial
tissue. TopiCare Delivery Compounds consist of a broad portfolio of liquid
polymers that can be designed to deposit an active ingredient and optimize
penetration at targeted levels of skin tissue where particular disease
conditions can be effectively treated. For example, formulations currently in
development containing TopiCare Delivery Compounds deliver an antifungal agent
to the upper epidermis, a skin layer where fungus predominates. Penederm has
developed another formula containing TopiCare Delivery Compounds which moderates
the delivery of retinoic acid into the follicular area for effective treatment
of acne. Laboratory, clinical or marketplace studies conducted by the Company
have indicated that products containing TopiCare Delivery Compounds possess one
or more of the following benefits:

         Longer duration of action. Due to their unique chemistry, TopiCare
    Delivery Compounds are resistant to accidental removal, causing them to
    remain on and in the upper layers of the skin for an extended period,
    thereby improving the duration of drug effects or delivery. Laboratory
    studies conducted by the Company have indicated that TopiCare Delivery
    Compounds upon application remain at or near the surface of the skin and
    penetrate only in very low levels beyond the stratum corneum.

         Reduced dosage requirements; improved safety profile. The Company
    believes that its technology provides for more effective topical deposition
    of certain drugs, thereby enabling the Company to develop topical treatments
    that contain smaller doses of active drug agent than existing topical
    treatments or that contain agents which previously have only been
    administered orally. Under typical usage conditions, the reduction in
    topical dosage and the administration topically of agents previously
    administered orally result in a reduction in the systemic exposure to the
    agent and, accordingly, a reduction in the potential for systemic toxicity
    and adverse reactions with other drugs taken by the patient.

         Fewer local adverse side effects. Clinical trials have shown the
    TopiCare Delivery Compounds to be non-irritating and non-sensitizing to the
    skin. In addition, the compounds have been shown to reduce the irritation
    caused by certain drug and skin care agents currently delivered topically.

    By tailoring the compound to the active agent and the skin condition, the
Company believes that its drug delivery system may more effectively target the
drug to the site of the disease and provide the benefits described above. These
benefits may thereby contribute to improved patient compliance and clinical
outcomes.


                                       5
<PAGE>   6

    The Company also believes that its TopiCare Delivery Compounds provide the
Company with the following strategic advantages in developing and
commercializing a broad spectrum of dermatological treatments and skin care
products:

         Broad application. The Company believes the properties of the TopiCare
    Delivery Compounds make them excellent candidates for inclusion in drugs,
    skin and hair care products and cosmetics. Clinical trials and laboratory
    studies have indicated that the TopiCare polymers hold to the skin, are
    moisturizing, are non-occlusive and do not clog pores. The Company has
    synthesized and evaluated numerous polymeric compounds, both water- and
    oil-compatible, as a basis for further development. The Company believes
    that the demonstrated flexibility and compatibility of the TopiCare Delivery
    Compounds will allow them to meet the varying delivery needs of many
    different drug compounds, skin care agents and cosmetics.

         Ease of formulation. The TopiCare Delivery Compounds, along with other
    product ingredients, are blended into the drug formulation during
    manufacture. This procedure may be less costly and time-consuming than
    delivery systems relying upon drug entrapment, such as liposome and
    microsphere technologies.

         Streamlined development. The ability of TopiCare Delivery Compounds to
    be combined with existing drug compounds or agents may involve less cost,
    time and risk than do the discovery, development and commercialization of
    new drug compounds or skin care agents. The Company has compiled
    considerable pre-clinical, clinical and market data which it believes may be
    helpful in shortening the development time of products incorporating
    TopiCare Delivery Compounds. To date, the Company has completed two
    in-licensing arrangements for compounds with existing preclinical data
    packages, enabling the Company to initiate clinical development.

         New topical treatments. TopiCare Delivery Compounds may make possible
    topical treatments with drugs that previously have not been effectively used
    topically, such as antifungal agents for treatment of nail fungal
    infections, chemotherapeutic agents for psoriasis and new Vitamin D
    treatments for psoriasis.

         New and expanded product markets. The attributes of TopiCare Delivery
    Compounds may create new product markets or may expand existing prescription
    and consumer markets by increasing the number of indications for which an
    existing drug or skin care agent can be used, by providing potential
    additional patent protection for off-patent drugs, by extending patent
    protection for patented drugs or by increasing patient use of treatments.

PRODUCTS

    The Company's marketed products and products under development include
prescription and nonprescription dermatology and skin care products. The
following charts summarize certain information regarding the products that the
Company currently is actively marketing or developing and should be read
together with the more detailed discussion of these products that follows.


                                       6
<PAGE>   7

<TABLE>
<CAPTION>
                                                     PRESCRIPTION PRODUCTS

        PRODUCT               INDICATION                     STATUS                            MARKETING RIGHTS
-------------------------- ------------------ -------------------------------------- --------------------------------------
<S>                        <C>                <C>                                    <C>
Avita (retinoic acid)      Acne               U.S.:  Cream approved for marketing    U.S.:  Penederm
cream and gel                                 (gel approval contingent upon
                                              expiration of a third party patent     Canada:  Pharmascience Inc.
                                              in January 1998)                       ("Pharmascience")
                                              Canada:  Approved for marketing        
                                              Europe: Approved for marketing in      Europe:  Penederm
                                              the U.K.; filed as European
                                              Marketing Authorization Application
                                              ("MAA")

-------------------------- ------------------ -------------------------------------- --------------------------------------
Mentax                     Skin fungus        U.S.:  Approved for tinea pedis;       U.S.:  Schering-Plough HealthCare
(butenafine) cream                            tinea corporis and tinea cruris        Products, Inc. ("Schering-Plough")
                                                                                     (podiatrists) and Penederm
                                              Canada:  submitted New Drug           
                                              Submission for tinea pedis             Canada:  Schering-Plough and Penederm

-------------------------- ------------------ -------------------------------------- --------------------------------------
Butenafine nail fungus     Nail fungus        U.S.:  Phase II human clinical         U.S.:  Schering-Plough and Penederm
formulation                                   testing in progress
                                                                                     Canada:  Schering-Plough and Penederm
                                                                                    
                                                                                     Europe, Africa and the Middle East:
                                                                                     UCB Group of Belgium ("UCB")

-------------------------- ------------------ -------------------------------------- --------------------------------------
Vitamin D analogs cream    Psoriasis          U.S.:  preclinical testing;            U.S.:  Penederm
and ointment                                  Investigational New Drug  ("IND")
                                              opened; Phase II human clinical        Canada:  Penederm
                                              testing in progress

                                                     NONPRESCRIPTION PRODUCTS

        PRODUCT               INDICATION                     STATUS                            MARKETING RIGHTS
-------------------------- ------------------ -------------------------------------- --------------------------------------
DuraScreen SPF15 and       Prevention of      Marketed in U.S. and Canada            U.S.:  Pierre Fabre, Inc. ("Pierre
SPF 30 sunscreen           photo-damage                                              Fabre")

                                                                                     Canada:  Pharmascience

-------------------------- ------------------ -------------------------------------- --------------------------------------
Penederm Cream and         Severe dry skin    Marketed in U.S. and Canada            U.S.:  Penederm
Penederm Lotion
                                                                                     Canada: Pharmascience

-------------------------- ------------------ -------------------------------------- --------------------------------------
Warner's Lubriderm Alpha   Severe dry skin    Marketed in U.S. and Canada            U.S. and Canada:  Warner
Hydroxy Moisture
Recovery Creme and Lotion
-------------------------- ------------------ -------------------------------------- --------------------------------------
OTC Product (Europe)       Severe dry skin    Marketed in Europe                     Europe: SmithKline Beecham
                                                                                     ("SmithKline")
-------------------------- ------------------ -------------------------------------- --------------------------------------
TopiCare Delivery          Sunscreens,        Marketed worldwide                     U.S.:  Barnet Products Corporation
Compounds (used with       color cosmetics                                           Asia:  Nikko Chemicals Co. Ltd.
various agents)            and skin                                                  Europe and South Africa:
                           treatment                                                 Sederma, S.A.
                           products                                                  Australia and New Zealand:  Bronson
                                                                                     & Jacobs, Pty. Ltd.
</TABLE>

    There can be no assurance that the Company can successfully develop any
potential products or technologies or, if successfully developed, that they will
obtain regulatory approval or be successfully commercialized. See "Risk
Factors."


                                       7
<PAGE>   8

    PRESCRIPTION PRODUCTS

    Avita. The Company has developed Avita gel and cream as prescription
retinoic acid acne treatments that incorporate TopiCare Delivery Compounds.
According to industry sources, approximately 35 million people in the United
States are affected by acne each year. The Company estimates the United States
prescription acne market to be approximately $400 million. Retinoic acid
formulations are the leading prescription products for the topical treatment of
acne, and until recently only Ortho Pharmaceutical Company, a subsidiary of
Johnson & Johnson, marketed topical retinoic acid products for the treatment of
acne in the United States. The Company is aware of other companies that have
developed prescription acne treatments formulated with retinoids that are
newly-approved and that may also present substantial competition for Avita,
including one product developed by Galderma that has been launched in the United
States and a second Johnson & Johnson tretinoin gel product with a reduced
irritation claim. Studies indicate that a significant number of users experience
skin irritation (dryness, peeling and redness) from the current leading retinoic
acid products. The Company has completed human clinical studies which the
Company believes indicate that Avita retinoic acid gel and cream treatments,
which are formulated with TopiCare Delivery Compounds, provide comparable
effectiveness and less irritation than the current leading retinoic acid
products. The Company does not have data comparing the efficacy and irritation
of Avita with that of the recently approved acne treatments with retinoids and
there can be no assurance that Avita will be as efficacious and less irritating
than those products or will achieve market acceptance.

    In January 1997, the FDA notified the Company that Avita cream was approved
for marketing and that, contingent upon expiration of a third party patent in
January 1998, Avita gel was also approved for marketing. The Company has
initiated human clinical studies to support marketing claims related to the
products. The FDA has completed its inspection of the contract manufacturing
facilities that the Company would use to produce retinoic acid products and has
granted an export license to ship these products out of the United States. The
Company has retained United States marketing rights to Avita and intends to
market the product in the United States through a pharmaceutical specialty
contract sales force. Penederm will pay a modest royalty on the sales of Avita,
subject to a specified maximum amount, pursuant to a 1995 termination agreement
with a company that originally had distribution rights to Avita. See "Risk
Factors -- Uncertainty of Commercial Launch and Market Acceptance of
Prescription Products," "--Government Regulation; No Assurance of Product
Approvals" and "-- Uncertainty of Future Product Development."

    The Company has also received approval to market Avita in Canada under the
trade name Vitinoin. The Company has licensed its rights to market the products
in Canada to Pharmascience. Pharmascience launched Vitinoin in June 1995 and is
promoting it as a "less irritating" retinoic acid product. In February 1997, the
Company received approval in the United Kingdom for this product. The U.K. will
be Penederm's sponsor country to seek approval in other European nations through
the European Mutual Recognition Process. See "Collaborative Arrangements."

    Mentax. The Company has licensed Mentax, a formulation of butenafine, from
Kaken Pharmaceutical Company, Ltd. ("Kaken") for sale as a topical treatment for
fungus. The Company estimates that the annual United States market for skin
fungus products is $400 million, of which approximately $300 million consists of
treatments for tinea pedis (athlete's foot). In the United States, the Company
believes that 18 million people experience skin fungus infections each year, and
that approximately 12 million of these indications are tinea pedis. Most
commercially available skin fungus treatments arrest the growth of fungus,
rather than result in cell death directly, and do not result in the complete
treatment of the disease. Mentax is a patented butenafine that has been shown to
result in the death of skin fungus cells. Kaken and a second Japanese partner
are marketing


                                       8
<PAGE>   9

two brands of butenafine in Japan, having received approval of the Japanese
Ministry of Health and Welfare in 1992. The Company licensed from Kaken
exclusive rights to its butenafine compound in the United States and Canada for
topical administration of butenafine. See "Collaborative Arrangements."

    In the fourth quarter of 1996, Penederm received clearance from the FDA to
market Mentax, a once-a-day prescription topical treatment for three skin fungal
conditions: tinea pedis (athletes' foot), tinea corporis (ringworm) and tinea
cruris (groin fungus). The Company also has submitted a New Drug Submission to
the Canadian Health Protection Branch for approval for tinea pedis in Canada.
The Company plans to provide the FDA and the Canadian Health Protection Branch
with supplemental data to support certain marketing claims after approval. In
addition, the Company plans to pursue the development of Mentax formulated with
TopiCare Delivery Compounds as an extension of its skin antifungal product line.
See "Risk Factors -- Uncertainty of Commercial Launch and Market Acceptance of
Prescription Products," "-- Government Regulation; No Assurance of Product
Approvals" and "--Uncertainty of Future Product Development."

    The Company has commenced marketing Mentax in the United States through a
pharmaceutical specialty contract sales force and has entered into an agreement
with Schering-Plough for the marketing and sale in the United States and Canada
of certain skin antifungal products. See "Sales and Marketing" and
"Collaborative Arrangements."

    Butenafine nail fungus formulation. The Company has under development a
topical formulation of the licensed butenafine compound that incorporates
TopiCare Delivery Compounds for the treatment of nail fungus. The Company
believes that approximately ten million patients experience nail fungal
infections, a condition in which the nails become unsightly, malformed and, in
some cases, require removal. There currently are no FDA-approved topical drug
products for the treatment of nail fungus. The condition is generally treated
with oral medication prescribed over many months. The Company believes that some
people with fungus in the nail area do not receive treatment because of the
potential side effects and costs associated with available oral dosage forms or
the difficulty of an extended treatment program.

    The Company licensed from Kaken exclusive rights to its butenafine compound
for nail fungus treatments in the United States, Canada, Western Europe,
Scandinavia, Australia and New Zealand. The Company is developing a topical nail
antifungal treatment that is designed to use the TopiCare Delivery Compounds to
hold the butenafine agent in the nail and surrounding skin for a period of time
sufficient to achieve significant clinical cure rates. The Company has completed
two Phase II human clinical trials of its butenafine nail formulation. The
Company entered into an agreement with Schering-Plough involving the development
and, upon regulatory approval, the manufacturing, marketing and sale in the
United States of certain nail antifungal products. The Company has also entered
into a licensing agreement with a subsidiary of UCB, a multinational
pharmaceutical and chemical company, to market certain topical prescription
butenafine nail antifungal formulations in Europe, Africa and the Middle East.
See "Collaborative Arrangements."

    Vitamin D analogs. The Company is developing psoriasis therapies using
proprietary Vitamin D analogs and TopiCare Delivery Compounds. Psoriasis is a
chronic skin condition characterized by inflammation and an abnormally rapid
growth of skin cells that leads to dry, flaky, red, itchy skin. Industry sources
indicate that approximately four million people in the United States suffer from
psoriasis. Present treatments such as emollients and steroids either are
ineffective or are not indicated for long-term use because of safety problems or
because the skin stops responding to the treatment. Topical steroids, which are
currently prescribed to two-thirds of patients with moderate to severe
psoriasis, can cause side effects such as skin thinning and "rebound effect"
(condition worsening after cessation of treatment as compared


                                       9
<PAGE>   10

to before treatment) that limit long-term use of these products. A new promising
area of psoriasis therapies are Vitamin D analogs, certain of which have
demonstrated efficacy without the adverse side effects of steroids. One Vitamin
D derivative treatment is currently on the market. However, this treatment does
not cause total clearing of the psoriasis in most cases and should not be used
on certain parts of the body because it can cause irritation. The Company is
exploring the development of a therapy from a family of Vitamin D compounds
which, when formulated with TopiCare Delivery Compounds, may provide increased
potency, enhanced activity or duration of action, and better local safety than
the currently available Vitamin D treatment. The Company is currently conducting
preclinical and clinical testing of certain of these compounds in cream and
ointment formulations. The Company has licensed rights to the Vitamin D analogs
from Wisconsin Alumni Research Foundation ("WARF") and Renaissance Corporation
("Renaissance"). See "Collaborative Arrangements."

    NONPRESCRIPTION PRODUCTS

    DuraScreen. The Company has developed DuraScreen SPF15 and SPF30 sunscreens
formulated with TopiCare Delivery Compounds, ultraviolet ("UV") absorbers and an
infrared blocker. The Company estimates the market for physician promoted
sunscreen in the United States to be approximately $100 million. Sunscreens with
an SPF of 15 or higher are frequently recommended by dermatologists. Tanning,
burning and skin damage, such as precancerous lesions, skin cancers, and
accelerated skin aging, are a result of exposure to the sun's UV light rays.
More than 600,000 new cases of skin cancer are diagnosed each year, and more
than 90 percent of skin cancers are caused by sun exposure. Sun protection
products that contain UV-absorbing chemical sunscreens can be very effective if
they stay on the skin. However, many tend to wash off with perspiration, contact
with water, or rubbing and therefore require frequent reapplication.

    The Company's DuraScreen products provide all-day waterproof protection with
one application in a formula that is cosmetically appealing. DuraScreen is
marketed in the United States by Pierre Fabre under an exclusive license. The
Company has licensed the rights to market DuraScreen in Canada to Pharmascience.
See "Collaborative Arrangements."

    Penederm Cream and Penederm Lotion; Lubriderm; and other OTC products. The
Company has developed different treatments for severe dry skin that incorporate
TopiCare Delivery Compounds. Industry sources estimate that skin lotions are
used by approximately 80 percent of households in the United States. Lactic acid
(an alpha-hydroxy acid) is known to be effective in the treatment of severe dry
skin. The Company believes that the tendency of lactic acid and its salts to be
irritating to sensitive dry skin and the lack of cosmetic appeal of certain
existing formulations have generally limited their use.

    The Company has developed Penederm Cream and Penederm Lotion, formulations
containing lactic acid and TopiCare Delivery Compounds. These products have
demonstrated clinically effective relief of severe dry skin. In addition, these
products indicated statistically superior protection against the irritation
caused by detergents as compared to two leading over-the-counter products, as
measured by erythema (redness) and dryness. Penederm Cream and Penederm Lotion
have also been shown to be effective in treating dry skin associated with
psoriasis and atopic dermatitis. The Company uses brokers to sell these products
in the United States. The Company licenses to Warner proprietary product
formulations containing TopiCare Delivery Compounds, which Warner markets under
the trade names Lubriderm Moisture Recovery Alpha Hydroxy Formula Creme and
Lotion, and has entered into an agreement with SmithKline whereby SmithKline
will market in Europe other formulations containing TopiCare Delivery Compounds.


                                       10
<PAGE>   11

See "Risk Factors -- Marketing and Sales Uncertainties; Dependence on
Collaborative Partners," "Sales and Marketing" and "Collaborative Arrangements."

    TopiCare Delivery Compounds. TopiCare Delivery Compounds can be designed in
formulations to provide effective moisturization of the skin, to bind to the
hair and skin, to be waterproof, non-occlusive and compatible with a broad range
of cosmetic formulations and not to clog pores. The Company believes these
advantages make the compounds candidates for use in cosmetics and skin care
products, such as sunscreens, makeups, mascara, moisturizers, lipsticks, nail
lacquers, soaps, shampoos and other hair care products. The Company has engaged
exclusive distributors in the Americas and in Europe for the sale of its
patented polymeric materials to the cosmetic and toiletry industries. Estee
Lauder, Inc., Mary Kay Cosmetics, Inc., Maybelline, Inc., and Clinique
Laboratories, Inc., among others, have purchased TopiCare Delivery Compounds for
commercial use in certain cosmetic products. A global distribution network is
comprised of Barnet Products Corporation, Nikko Chemicals Co., Ltd.,
Sederma S.A., and Bronson and Jacobs, Pty. Ltd., acting as distributors of
TopiCare Delivery Compounds in the United States, Asia, Europe and South Africa,
and Australia/New Zealand, respectively. The Company is discussing additional
collaborative arrangements to commercialize TopiCare Delivery Compounds in
additional cosmetic and consumer skin care and hair care products worldwide.

PRECLINICAL RESEARCH AND EARLY CLINICAL RESEARCH AND DEVELOPMENT

    The Company continues to evaluate new compound and product opportunities
utilizing its TopiCare Delivery Compounds. The Company is conducting research to
develop new types of butenafine formulations as line extensions to Mentax for
treatment of skin fungus. Laboratory and Phase II human clinical studies
conducted by the Company with corticosteroids, which are used for the topical
treatment of psoriasis and other inflammatory disorders have demonstrated
effective delivery of corticosteroids from TopiCare-containing formulations,
with the potential for reduced systemic absorption. The Company is also
conducting preclinical research on formulating TopiCare Delivery Compounds with
Vitamin D analogs, other anti-oxidants and UV blockers to develop products which
may prevent sun damage or reduce wrinkles.

    Although the Company has focused its research efforts on dermatology and
skin care, the Company believes that there may be future opportunities for the
application of the TopiCare Delivery Compounds for treatment of disorders in
tissues other than skin. The Company has conducted preclinical research to
determine whether its TopiCare Delivery Compounds have utility in other
epithelial tissues, such as vaginal, oral or ophthalmic tissues. Laboratory
studies have indicated that TopiCare Delivery Compounds may be useful in holding
drugs in the eye for extended periods without being cleared by the natural
tearing of the eye. Additionally, laboratory work has indicated that TopiCare
Delivery Compounds may be used to deliver antifungal agents in a manner to
reduce the recurrence of yeast infections in vaginal tissue. Preclinical studies
are also ongoing to define the opportunities for TopiCare Delivery Compounds to
deliver and hold agents to hair and hair follicles to determine ways to enhance
the activity of those agents at targeted sites.

SALES AND MARKETING

    The Company's product commercialization strategy is to market prescription
dermatologic drug products worldwide through a pharmaceutical specialty contract
sales force in the United States and through licensing and other collaborative
relationships in the United States and in geographies outside of the United
States. For nonprescription skin and hair care markets, the Company plans to
license out its technology worldwide.


                                       11
<PAGE>   12

    PRESCRIPTION PRODUCTS

    In the United States, the Company's strategy is to market its prescription
products directly to the approximately 7,000 high prescribers of dermatologic
products through a pharmaceutical specialty contract sales force of
approximately 47 sales representatives specializing in pharmaceuticals and
solely dedicated to Penederm products. The sales force commenced detailing to
physicians in February 1997. The use of contract sales representatives as an
alternative to an internal sales force is an emerging practice in the
pharmaceutical industry and the Company believes that this approach will provide
it with high quality sales representatives and a lower startup cost than if it
hired and trained its own internal sales force. Each sales representative
promotes the Company's products to an average of 150 high prescribing physicians
of dermatologic products. In addition to promoting directly to high prescribing
physicians of dermatologic products, the Company engages in an active
advertising campaign geared towards these physicians through medical journals,
medical publications, direct mail, conventions, electronic media and sampling of
its products. The Company believes that its market penetration will be
determined by its success in gaining high awareness and successful usage among
these targeted customers. Sales and marketing expenditures are expected to
increase significantly as a result of retaining the contract sales force and
engaging in promotional activities related to product launch.

    In addition, the Company has entered into arrangements with collaborative
partners for the marketing of certain pharmaceutical products in the United
States. In June 1994, the Company entered into an agreement with Schering-Plough
for the development, prescription product co-promotion, OTC product marketing
and sale, and manufacture by Schering-Plough of certain Penederm nail antifungal
and skin antifungal products in the United States and Canada. Schering-Plough
has rights for promotion of the Mentax product to podiatrists in the U.S. In
January 1997, Penederm entered into an arrangement with The Merck KGaA
Group/Center Laboratories to co-promote in the United States Akne-Mycin and
Cloderm. See "Collaborative Arrangements."

    NONPRESCRIPTION PRODUCTS

    The Company intends to compete in nonprescription markets in the United
States through corporate partners and distributors. The Company currently has
arrangements with Warner, Pierre Fabre, Schering-Plough and Barnet Products
Limited for the sale of nonprescription products and TopiCare Delivery Compounds
in the United States and is actively pursuing other arrangements in the United
States. See "Collaborative Arrangements."

    MARKETS OUTSIDE OF THE UNITED STATES

    The Company intends to use distribution partners to market its products in
geographies outside of the United States. The Company has agreements with
Pharmascience for the distribution of Avita (trade named Vitinoin in Canada),
Penederm Cream, Penederm Lotion and DuraScreen in Canada, with UCB for the
distribution of nail antifungal products in Europe and the Middle East and with
SmithKline to market certain OTC skin care products containing the Company's
patented TopiCare Delivery Compounds in Europe. In addition, Nikko Chemicals
Co., Ltd., Sederma S.A., and Bronson and Jacobs, Pty. Ltd. distribute TopiCare
Delivery Compounds in Asia, Europe and South Africa, and Australia/New Zealand,
respectively. See "Products -- Prescription Products ,-- Avita" and "-- Mentax,"
and "Products -- Nonprescription Products."


                                       12
<PAGE>   13

    In November 1995, certain TopiCare Delivery Compounds were approved by the
Japanese Ministry of Health and Welfare for use in skin care products. This
approval is important to the commercialization of the Company's TopiCare
Delivery Compounds because they now may gain broader use as an ingredient in
products whose formulations are made uniform for distribution worldwide.

COLLABORATIVE ARRANGEMENTS

    The Company's strategy for the research, development and commercialization
of certain of its products requires entering into various arrangements with
corporate collaborators, licensors, licensees and others. Set forth below is a
description of the Company's significant collaborative arrangements. The Company
is discussing additional collaborative arrangements to develop and commercialize
certain products and as part of its strategy expects to continue to pursue such
arrangements in the future. The Company believes that the establishment and
success of such arrangements is an important element in the long term success of
the Company. There can be no assurance that the Company will be able to maintain
its current collaborative relationships or establish new relationships on
acceptable terms, that the Company's current or future collaborative partners
will perform their obligations under such relationships, or that such
relationships will be commercially successful. See "Risk Factors -- Marketing
and Sales Uncertainties; Dependence Upon Collaborative Partners," "--
Uncertainty of Future Product Development."

    IN-LICENSING AND CO-PROMOTION ARRANGEMENTS

    University of California. The Company has licensed from the University of
California on a worldwide exclusive basis three United States and six foreign
patents providing coverage in 17 counties outside of the U.S. for the technology
underlying the TopiCare Delivery Compounds for the life of the patents. These
patents will expire during 2007 and 2008. Under the license arrangement, the
University of California is required to file, prosecute and maintain foreign
patent applications as requested by the Company at the Company's expense. The
University of California is entitled to royalties based on the revenues received
by the Company from the TopiCare Delivery Compounds and products that
incorporate the compounds. In general, these royalties range from 1.5 to 2.5
percent of net sales of the delivery technology component, as defined in the
license agreement.

    Kaken. The Company has licensed from Kaken exclusive rights to develop skin,
nail, and other topical antifungal products incorporating Kaken's proprietary
butenafine compound in the United States, Canada, Mexico, and Central and South
America. In addition, the Company has the exclusive right to develop and market
nail antifungal products in additional territories, including Western Europe,
Scandinavia, Australia and New Zealand. The Company made a payment of
approximately $500,000 to Kaken in the first quarter of 1995 and an additional
payment of approximately $500,000 in the fourth quarter of 1996. Additional
future payments of approximately $1,200,000 would become due upon the
achievement of certain other regulatory milestones related to the nail products.
The Company believes that the achievement of these additional milestones would
occur, if at all, over several years. In addition, the Company has agreed to
purchase butenafine raw material from Kaken.

    WARF and Renaissance. The Company has entered into an exclusive license with
WARF for the North American rights to develop topical and oral therapies for a
variety of skin diseases using Vitamin D metabolites and synthetic compounds and
to use a database of information regarding these metabolites and compounds. The
Company has licensed from WARF and Renaissance certain patents awarded to two
leading Vitamin D scientists. The Company's first disease target for these
Vitamin D analogs is psoriasis. The Company paid initial licensing fees to WARF
and certain patent licensing fees to Renaissance and will


                                       13
<PAGE>   14

make payments contingent upon achievement of product development and regulatory
milestones and will pay royalties upon any future product sales.

    The Merck KGaA Group/Center Laboratories. The Company has entered into an
arrangement with The Merck KGaA Group/Center Laboratories to co-promote in the
Unites States Akne-Mycin, a topical cream ointment containing erythromycin, and
Cloderm, a mid-potency topical steroid. Under this arrangement, the parties will
share profits in relation to their relative contributions to the marketing
effort.



    DEVELOPMENT AND DISTRIBUTION

    Schering-Plough. The Company has entered into an agreement with
Schering-Plough for the development, prescription product co-promotion, OTC
product marketing and sale, and manufacture by Schering-Plough of certain
Penederm nail antifungal and, at Schering-Plough's option, skin antifungal
products in the United States and Canada. Pursuant to the agreement,
Schering-Plough and the Company will collaborate in the development of, and the
regulatory filing related to, the antifungal products, and Schering-Plough will
have co-promotion and marketing rights with respect to podiatrists and the
Company will maintain exclusive rights to promote and market the products to all
other prescription audiences. The Company and Schering-Plough currently
contemplate co-promoting the products as one brand. The agreement provides for
Schering-Plough to pay the Company upfront fees, development support and
milestone payments if certain conditions are met, including, but not limited to,
clinical development and regulatory approval of, and option payments for, the
antifungal products. In addition, the Company would receive royalties upon
product sales and the exclusive right to supply certain raw materials. The
agreement may be terminated by Schering-Plough at any time. In that event, the
marketing rights would revert to the Company, including the right to sublicense
to another development partner.

    UCB. The Company has entered into a licensing agreement with a subsidiary of
UCB to market certain topical prescription butenafine antifungal formulations in
Europe, Africa and the Middle East. UCB will complete clinical development and
seek regulatory approval in the countries under the agreement. The agreement
provides the Company with upfront and milestone payments, a royalty on sales and
a supply agreement for its TopiCare Delivery Compounds.

    Pharmascience. The Company has entered into an agreement with Pharmascience
to market retinoic acid prescription products, DuraScreen and Penederm Lotion
and Penederm Cream in Canada. Pharmascience launched these products in 1995.
Terms of the license include supply arrangements and royalties payable to the
Company based on net product sales.

    Warner. The Company has licensed to Warner proprietary formulations
containing TopiCare Delivery Compounds to create Lubriderm Moisture Recovery
Alpha Hydroxy Acid Creme and Lotion products. Warner launched these products
nationally in August 1994 and is marketing these products in the United States
and Canada. Terms of the license include supply arrangements, fees and royalties
payable to the Company based on net product sales. The agreement with Warner in
the United States is expected to terminate at the end of 1997, but continue with
respect to Canada.

    SmithKline. The Company has entered into an agreement with SmithKline
whereby SmithKline will market in Europe certain OTC products containing
TopiCare Delivery Compounds. The Company will


                                       14
<PAGE>   15

receive certain milestone payments and royalties on sales of these SmithKline
products, in addition to sales from the supply of TopiCare Delivery Compounds.

    Pierre Fabre. Pierre Fabre acquired from Schwarz Pharma Inc. the U.S.
marketing rights to the DuraScreen product line in 1996, and will continue to
pay the Company royalties based on annual net sales of DuraScreen and purchase
TopiCare Delivery Compounds from the Company on the same terms as the original
distributor.

    TopiCare Delivery Compound Distributors. The Company has established a
global distribution network for the sale of its TopiCare Delivery Compounds for
use in cosmetics and skin care products. Barnet Products Corporation Limited,
Nikko Chemicals Co., Ltd., Sederma S.A., and Bronson and Jacobs, Pty. Ltd. act
as distributors of TopiCare Delivery Compounds in the United States, Asia,
Europe and South Africa, and Australia/New Zealand, respectively. TopiCare is
sold through these distributors on a purchase order basis.

RESEARCH AND DEVELOPMENT EXPENDITURES

    Penederm charges research and development expenses to operations as
incurred. Such expenses for 1996, 1995 and 1994 were $5,292,000, $5,713,000, and
$4,509,000, respectively.

MANUFACTURING AND RAW MATERIALS

    The Company contracts with third parties to manufacture its finished
products and the TopiCare Delivery Compounds, subject to strict industry and
governmental standards. By using contract manufacturers, the Company has avoided
the need to invest in substantial production equipment or hire a manufacturing
labor force to make its products. The Company currently has no plans to
establish internal manufacturing facilities, but does intend to continue
qualifying multiple contract manufacturers. The Company currently has two
qualified manufacturing sites for TopiCare Delivery Compounds, one qualified
manufacturing site for Avita and Mentax and two qualified manufacturing sites
for Penederm Cream, Penederm Lotion, DuraScreen and Lubriderm. The Company
intends to maintain rights to the manufacture of certain finished products and
TopiCare Delivery Compounds.

    The Company is dependent upon third parties for the supply of raw materials
used to produce TopiCare Delivery Compounds and finished products. One of the
materials used in the compounds is currently available from only one supplier,
Bayer Corporation ("Bayer"). Bayer is a major worldwide chemical company, and it
supplies this ingredient as a commodity to the Company on a purchase order basis
and to many other users in much larger quantities than it supplies to the
Company. The Company currently obtains certain other raw materials, including
butenafine and retinoic acid, from other sole sources. The Company currently
secures many of these supplies pursuant to contracts that are terminable on
short notice or purchase orders. In the event of termination or breach by a
supplier or other failure to continue to supply materials, the Company would be
required to secure and qualify an alternate supplier. Although the Company has
not experienced difficulty acquiring raw materials necessary for the production
of commercial quantities of its compounds, maintains significant inventory of
the necessary raw materials and believes it could qualify alternate suppliers
for these materials, the Company continues to attempt to identify an alternate
supplier for the material now available only from Bayer. There can be no
assurance that the Company would not experience a disruption in manufacturing if
it experienced a disruption in supply from any sole source. Any significant
interruption of supply or significant increase in the cost of raw materials


                                       15
<PAGE>   16

could have a material adverse effect on the Company's ability to produce its
compounds and finished products.

PATENTS AND PROPRIETARY TECHNOLOGY

    The basic technology underlying the TopiCare Delivery Compounds was
originally discovered by researchers at the University of California, Irvine and
has been patented by the University of California. In 1987, the University of
California granted the Company an exclusive worldwide license for the life of
the applicable patents to use and develop this technology. Under this license,
the University of California is required to maintain, at the Company's expense,
all United States patent rights with respect to the licensed technology and to
file and prosecute patent applications in foreign countries when requested by
the Company. The University of California is entitled to royalties based on the
revenues received by the Company from the TopiCare Delivery Compounds and
products that incorporate the compounds. In general, these royalties range from
1.5 to 2.5 percent of net sales of the delivery technology component, as defined
in the license agreement.

    To date, the Company has exclusive rights to three United States patents and
six foreign patents covering 17 countries outside of the U.S. obtained by the
University of California and relating to the uses of the TopiCare Delivery
Compounds. These patents will expire in 2007 and 2008. In addition, the Company
has applied for four patents in Japan for cosmetic applications and one U.S and
one foreign patent covering 19 countries outside of the U.S.

    The Company's policy is to protect its technology by, among other things,
filing, or requiring the University of California to file, patent applications
for technology that it considers important to the development of its business.
The Company has filed one United States patent application and a corresponding
Patent Cooperation Treaty application and also has four foreign patent
applications pending. The Company intends to file additional patent
applications, when appropriate, relating to its technology, improvements to its
technology and to specific products that it develops. There can be no assurance
that any additional patents will be issued, or, if issued, that they will be of
commercial benefit to the Company. In addition, it is impossible to anticipate
the breadth or degree of protection that any such patents will afford.
Furthermore, there can be no assurance that litigation seeking to challenge such
patent protection will not be brought against the Company or the University of
California or that the Company's or the University of California's patents will
not be successfully challenged. The expenses involved in any patent litigation
can be significant and cannot be estimated by the Company. In addition, there
can be no assurance that the Company will be successful in the current
proceeding or that the scope and validity of the Company's or the University of
California's existing or future patents, if any, will prevent third parties from
developing similar or competing products.

    The Company has also licensed certain composition of matter, process and use
patents from WARF and Renaissance related to various Vitamin D compounds.

    A substantial number of patents have been issued to other pharmaceutical and
drug delivery companies. Pharmaceutical companies, drug delivery system
companies and others, including competitors, may have filed applications for, or
may have been issued patents or may obtain additional patents and proprietary
rights relating to, products or processes competitive with those of the Company.
Accordingly, there can be no assurance that the Company's or the University of
California's future patent applications will result in issued patents or that
any patents will afford significant protection against competitors with similar
technology. There can be no assurance that any patents issued to the Company,
the University of California


                                       16
<PAGE>   17

or other licensors of drug compounds or skin care agents to the Company, such as
Kaken, WARF and Renaissance, will not be infringed or circumvented by others, or
that others will not obtain patents that the Company would need to license or
circumvent. There can be no assurance that licenses that might be required for
the Company's processes or products would be available on reasonable terms, or
at all. In addition, there can be no assurance that the Company's, the
University of California's or other licensors' existing or future patents, if
any, would be held valid by a court of competent jurisdiction.

    Third parties may hold or be issued patents which the Company's technology
may infringe. The Company could incur substantial costs in defending itself and
its partners against any resulting claims. Furthermore, parties making such
claims may be able to obtain injunctive or other equitable relief which could
effectively block the Company's ability to further develop or commercialize its
products in the United States and abroad, and could result in the award of
substantial damages. In the event of a claim of infringement, the Company may be
required to obtain one or more licenses from third parties. There can be no
assurance that the Company will be able to obtain such licenses at a reasonable
cost, if at all. Defense of any lawsuit or failure to obtain any such license
could have a material adverse effect on the Company.

    The Company also relies upon unpatented trade secrets and know-how, and
there can be no assurance that others will not independently develop
substantially equivalent proprietary information and techniques, or otherwise
gain access to the Company's trade secrets or disclose such technology, or that
the Company can meaningfully protect its rights to its unpatented trade secrets.

    The United States Patent and Trademark Office ("PTO") has recently adopted
changes to United States patent law which changed the term of issued patents,
subject to certain transition periods, to 20 years from the date of filing
rather than 17 years from date of issuance. For applications filed after June 7,
1995, the patent term will be 20 years from the earliest effective filing date
of the priority patent application. Such change may reduce the effective term of
protection for patents that are pending for more than three years in the PTO.
While the Company cannot predict the effect that such changes may have on its
business, the adoption of such changes could have a material adverse effect on
the Company's ability to protect its proprietary information and sustain the
commercial viability of its products. Furthermore, the possibility of shorter
terms of patent protection, combined with the lengthy FDA review process and
possibility of extensive delays in such process, could effectively further
reduce the term during which a marketed product could be protected by patents.
These changes in the patent law do not, however, affect the existing patents for
the technology underlying the TopiCare Delivery Compounds, for Mentax licensed
from Kaken, or for the Vitamin D analogs licensed from WARF and Renaissance.

    It is the Company's policy to require its employees and consultants to
execute a confidentiality agreement upon the commencement of employment by or
consultancy to the Company. Each agreement provides that all confidential
information developed or made known to the employee or consultant during the
course of employment or consultancy will be kept confidential and not disclosed
to third parties except in specified circumstances and that all inventions
conceived by the employee or consultant shall be the exclusive property of the
Company. In addition, the Company enters into confidentiality agreements with
all collaborators and potential collaborators. There can be no assurance,
however, that these agreements will provide meaningful protection for the
Company's trade secrets in the event of unauthorized use or disclosure of such
information.


                                       17
<PAGE>   18

GOVERNMENT REGULATION

    FDA Requirements for Drug Compounds. The research, testing, manufacture and
marketing of drug products are extensively regulated by numerous governmental
authorities in the United States and other countries. In the United States,
drugs are subject to rigorous regulation by the FDA. The federal Food, Drug and
Cosmetic Act, as amended (the "FDC Act"), and the regulations promulgated
thereunder, and other federal and state statutes and regulations, govern, among
other things, the research, development, testing, manufacture, storage,
recordkeeping, labeling, promotion and marketing and distribution of
pharmaceutical products. Failure to comply with applicable regulatory
requirements may subject a company to administrative or judicially imposed
sanctions such as civil penalties, criminal prosecution, injunctions, product
seizure or detention, product recalls, total or partial suspension of
production, and FDA refusal to approve pending premarket approval applications
or supplements to approved applications.

    Investigational New Drug Applications. The steps ordinarily required before
a new pharmaceutical product may be marketed in the United States include: (i)
preclinical laboratory tests, in vivo preclinical studies and formulation
studies; (ii) the submission to the FDA of an IND, which must become effective
before clinical testing may commence; (iii) adequate and well-controlled
clinical trials to establish the safety and effectiveness of the drug; (iv) the
submission of a New Drug Application ("NDA") to the FDA and (v) FDA review and
approval of the NDA prior to any commercial sale or shipment of the drug.
Preclinical tests include laboratory evaluation of product chemistry and
formulation, as well as animal studies to assess the potential safety and
efficacy of the product. Compounds must be formulated according to current Good
Manufacturing Practice ("cGMP") requirements, and preclinical tests must be
conducted in compliance with Good Laboratory Practice regulations. The results
of preclinical testing are submitted to the FDA as part of an IND. A 30-day
waiting period after the filing of each IND is required prior to the
commencement of clinical testing in humans. If the FDA has not commented on or
questioned the IND within this 30-day period, clinical studies may begin. If the
FDA has comments or questions, the questions must be answered to the
satisfaction of the FDA before initial clinical testing can begin. In addition,
the FDA may, at any time, impose a clinical hold on ongoing clinical trials. If
the FDA imposes a clinical hold, clinical trials cannot commence or recommence
without FDA authorization and then only under terms authorized by the FDA. In
some instances, the IND application process can result in substantial delay and
expense. The Company has filed INDs for retinoic acid and Mentax skin and nail
antifungal formulations and a Vitamin D analog formulation and has conducted
clinical testing of those formulations and other formulations incorporating
other drugs under IND submissions filed by others.

    New and Abbreviated New Drug Applications. Clinical trials involve the
administration of the investigational new drug to healthy volunteers or patients
under the supervision of a qualified principal investigator. Clinical trials are
conducted in accordance with good clinical practices under protocols detailing
the objectives of the study, the parameters to be used in monitoring safety and
the effectiveness criteria to be evaluated. Each protocol must be submitted to
the FDA as part of the IND. Further, each clinical study must be conducted under
the auspices of an independent Institutional Review Board ("IRB") at the
institution at which the study will be conducted. The IRB will consider, among
other things, ethical factors, the safety of human subjects and the possible
liability of the institution. Clinical trials to support NDAs are typically
conducted in three sequential phases, but the phases may overlap. In Phase I,
the initial introduction of the drug into healthy human subjects or patients,
the drug is tested to assess metabolism, pharmacokinetics and pharmacological
actions and safety, including side effects associated with increasing doses.
Phase II usually involves studies in a limited patient population to (i)
determine the efficacy of the drug for specific, targeted indications, (ii)
determine dosage tolerance and optimal dosage and (iii) identify


                                       18
<PAGE>   19

possible adverse effects and safety risks. If a compound is found to be
effective and to have an acceptable safety profile in Phase II evaluations,
Phase III trials are undertaken to further evaluate clinical efficacy and to
further test for safety within an expanded patient population at geographically
dispersed clinical study sites. There can be no assurance that Phase I, Phase II
or Phase III testing will be completed successfully within any specified time
period, if at all, with respect to any of the Company's products subject to such
testing.

    After completion of the required clinical testing, generally an NDA is
submitted. FDA approval of the NDA (or, in the alternative an Abbreviated New
Drug Applications ("ANDA"), as described below) is required before marketing may
begin in the United States. The NDA must include the results of extensive
clinical and other testing and the compilation of data relating to the product's
chemistry, pharmacology and manufacture, the cost of all of which is
substantial. The FDA reviews all NDAs submitted before it accepts them for
filing and may request additional information rather than accepting an NDA for
filing. In such an event, the NDA must be resubmitted with the additional
information and, again, is subject to review before filing. Once the submission
is accepted for filing, the FDA begins an in-depth review of the NDA. Under the
FDC Act, the FDA has 12 months in which to review the NDA and respond to the
applicant. The review process is often significantly extended by FDA requests
for additional information or clarification regarding information already
provided in the submission. The FDA may refer the application to the appropriate
advisory committee typically a panel of clinicians for review, evaluation and a
recommendation as to whether the application should be approved. The FDA is not
bound by the recommendation of an advisory committee. During the review process,
the FDA generally will conduct an inspection of the relevant drug manufacturing
facilities to ensure that the facilities are in compliance with applicable cGMP
requirements. If FDA evaluations of the NDA application and the manufacturing
facilities are favorable, the FDA may issue either an approval letter or an
approvable letter, which usually contains a number of conditions that must be
met in order to secure final approval of the NDA. When and if those conditions
have been met to the FDA's satisfaction, the FDA will issue an approval letter,
authorizing commercial marketing of the drug for certain indications. As a
condition of NDA approval, the FDA may require postmarketing testing and
surveillance to monitor the drug's safety or efficacy. If the FDA's evaluation
of the NDA submission or manufacturing facilities is not favorable, the FDA may
refuse to approve the NDA or issue a not approvable letter, outlining the
deficiencies in the submission and often requiring additional testing or
information. Notwithstanding the submission of any requested additional data or
information in response to an approvable or not approvable letter, the FDA
ultimately may decide that the application does not satisfy the regulatory
criteria for approval. Once granted, product approvals may be withdrawn if
compliance with regulatory standards is not maintained or problems occur
following initial marketing.

    In circumstances where a company submits an NDA for a novel formulation of
an active drug ingredient already approved by the FDA, clinical and preclinical
testing requirements may not be as extensive. Limited additional data about the
safety and/or effectiveness of the proposed new drug formulation, along with
chemistry and manufacturing information and public information about the active
ingredient, may be satisfactory for product approval. Consequently, the new
product formulation may receive marketing approval more rapidly than a
traditional full NDA, although there can be no assurance that a product will be
granted such treatment by the FDA or, if granted, will result in an approval.

    Once patent and other statutory protections covering a drug approved under
an NDA have expired or have been demonstrated not to apply, a generic equivalent
to that drug may be approved under an ANDA. An ANDA usually is based upon
bioequivalence data that demonstrate that the rate and extent of absorption of
the active drug ingredient of the generic drug, usually measured in the blood
stream, is equivalent to that


                                       19
<PAGE>   20

of the drug approved under an NDA. The demonstration of bioequivalence and,
therefore, ANDA approval generally requires less time than safety and efficacy
studies and NDA approval.

    Although ANDAs are not available for the Company's retinoic acid products
because these products contain excipients not included in the marketed retinoic
acid products, the Company believes ANDAs may be available for the Company's
future topical formulations of drugs that have already been approved by the FDA.
Nevertheless, because there can be no assurance that other drugs utilizing the
TopiCare Delivery Compounds will be eligible for ANDAs, and because standard
bioequivalence studies may be of questionable utility in dermatologics, which
are generally non-systemically absorbed, the Company intends to perform clinical
studies to establish the safety, effectiveness, and therapeutic equivalence of
its new drugs to listed drugs in order to support the ANDAs it expects to file
for future products.

    Premarket approval under section 505(b)(2) of the FDC Act may be appropriate
for certain future drugs developed by the Company. Section 505(b)(2) allows the
FDA to approve an NDA using shortened procedures, usually for drugs that have
proven safety profiles because of the market place performance among a large
population. In a 505(b)(2) application, a company may rely on clinical
investigations conducted by others to which it does not hold a right of
reference. In general, a 505(b)(2) application is supported by two or three
clinical studies among the target population group designed to verify the safety
and efficacy of the drug product in that population using that target dose and
dose sequence. The cost of this approach is typically much less than a standard
NDA.

    Until an NDA, ANDA or Section 505(b)(2) application is actually approved,
there can be no assurance that the information requested and submitted will be
considered adequate by the FDA to justify approval. It is impossible to
anticipate the amount of time that will be required to obtain approval from the
FDA to market any product.

    OTC Drug Products. Most OTC drug products marketed in the United States are
exempt from the FDA's premarketing approval requirements. In 1972, the FDA
instituted the ongoing OTC Drug Review to evaluate the safety and effectiveness
of OTC drugs then on the market. Through this process, the FDA issues monographs
that set forth the specific active ingredients, dosages, indications and
labeling statements for OTC drugs that the FDA will consider generally
recognized as safe and effective and therefore not subject to premarket
approval. For certain categories of OTC drug products not yet subject to a final
monograph, the FDA usually will not take regulatory action against such a
product unless failure to do so poses a potential health hazard to consumers.
The active ingredients in DuraScreen are covered by the FDA tentative final
monograph for OTC sunscreen drug products issued May 12, 1993, and the Company
believes that it has formulated and labeled DuraScreen in accordance with that
proposed regulation. Changes in that monograph may require changes to the
product and its labeling. OTC drug products and manufacturing facilities are
subject to FDA inspection, and failure to comply with applicable regulatory
requirements may lead to administrative or judicially imposed penalties.

    Manufacturing. Each domestic drug manufacturing facility must be registered
with FDA. Domestic drug manufacturing establishments are subject to inspection
by the FDA and must comply with cGMP. To supply products for use in the United
States, foreign manufacturing establishments must comply with cGMP and are
subject to periodic inspection by the FDA or corresponding regulatory agencies
in countries under reciprocal agreements with the FDA. Drug product
manufacturing establishments located in California must be licensed by the State
of California in compliance with local regulatory requirements. The Company uses
and will continue to use contract manufacturers to produce its products in
commercial quantities. The Company will audit its contract manufacturers
periodically to monitor their compliance with cGMP,


                                       20
<PAGE>   21

although there can be no guarantee that future FDA inspections will proceed
without any compliance issues requiring the expenditure of money or other
resources.

    Foreign Regulation of Drug Compounds. Whether or not FDA approval has been
obtained, approval of a product by comparable regulatory authorities may be
necessary in foreign countries prior to the commencement of marketing of the
product in such countries. The approval procedure varies among countries, can
involve additional testing, and the time required may differ from that required
for FDA approval. Although there are some procedures for unified filings for
certain European countries with the sponsorship of the country which first
granted marketing approval, in general each country has its own procedures and
requirements, many of which are time consuming and expensive. Thus, there can be
substantial delays in obtaining required approvals from foreign regulatory
authorities after the relevant applications are filed. The Company expects to
rely on corporate partners and licensees, external consultants, and Company
expertise to obtain governmental approval in foreign countries of drug
formulations utilizing its compounds.

    Cosmetics. Cosmetics do not require approval by the FDA for marketing in the
United States. Cosmetic products must be safe under normal conditions of use and
must comply with FDA labeling regulations.

COMPETITION

    In the development and marketing of dermatologic drugs, skin care products
and drug delivery systems, the Company faces significant competition from, among
others, large pharmaceutical companies with established dermatology divisions,
such as Ortho Pharmaceutical Company, a subsidiary of Johnson & Johnson,
Schering-Plough, Upjohn Co. and Westwood Pharmaceuticals Inc., a subsidiary of
Bristol-Myers. The Company expects that its principal competition with respect
to Avita will be the retinoic acid products marketed by Johnson & Johnson. The
Johnson & Johnson products have been on the market for many years and have
substantially all of the market share for prescription acne treatments. The
Company is aware of other companies that have developed prescription acne
treatments formulated with retinoids that are newly-approved and that may also
present substantial competition for Avita, including one product developed by
Galderma that has been launched in the United States and a second product from
Johnson & Johnson tretinoin gel product with a reduced irritation claim. The
Company expects that its principal competition with respect to Mentax will be
products marketed by Allergan Inc., Johnson & Johnson, Novartis (formerly Sandoz
Pharmaceuticals) and Glaxo Wellcome plc. Most of the Company's competitors have
substantially greater financial, technical, production, marketing and regulatory
experience and resources, larger sales and marketing forces and more experience
than the Company in developing, commercializing and marketing drug and skin care
products. The Company also competes with several smaller companies which have
been formed to develop unique delivery systems or to produce competing drug or
skin care products. In recent years, several other companies have been formed
and, in certain instances, are collaborating with large pharmaceutical
companies, to develop specific drug delivery systems or drug or skin care
products that might compete directly with the Company's technologies and
products. Drug delivery systems and products developed by the Company's
competitors may be superior to, or gain greater or faster market acceptance
than, the Company's drug delivery systems and products. The Company also faces
competition from universities and related entities seeking to develop drug
delivery technologies and to earn revenues from technology and patent licensing.
In addition, these companies and academic and research institutions compete with
the Company in recruiting and retaining highly qualified scientific and
management personnel.


                                       21
<PAGE>   22

    Competition in the dermatology market is generally based on performance
characteristics and, to a somewhat lesser extent, price. Acceptance by doctors
and patients, of which there can be no assurance, is crucial to the success of a
product. There can be no assurance that the Company's current products and
products under development will be able to compete successfully with existing
products or that other companies, universities and other institutions will not
be able to develop products that compete effectively with the Company's current
products and products under development.

    In licensing its compounds for use in cosmetics and consumer skin care
products, the Company faces strong competition both from specialty chemical
companies and from cosmetic companies with substantially greater resources that
develop their own formulating agents. The Company expects technological
developments to occur at a rapid rate and believes that competition may
intensify as technological advances in the field are made and become more widely
known.


SCIENTIFIC ADVISORY BOARD

         The Company has established a Scientific Advisory Board composed of
individuals with expertise in the fields of dermatology, topical drug delivery
and non-prescription skin care. The Scientific Advisory Board was formed to
assist in establishing strategic research and development policy. The members of
the Scientific Advisory Board meet as a group periodically. In addition, members
of the Scientific Advisory Board also meet from time to time on an individual
basis with scientists and management of the Company to review projects and
programs. Individual members of the Scientific Advisory Board help guide the
Company's clinical and scientific evaluation programs. If appropriate, certain
members of the Scientific Advisory Board conduct clinical studies of the
Company's formulations as investigators and conduct experiments on behalf of the
Company. The Company intends to expand the Scientific Advisory Board and
continue to use other external research consultants as the number of its
products increases.

         As of December 31, 1996, the members of Penederm's Scientific Advisory
Board were as follows:

<TABLE>
<CAPTION>
             NAME                 AFFILIATION
             ----                 -----------
<S>                               <C>
Albert M.  Kligman, M.D., Ph.D.   Professor of Dermatology, University of Pennsylvania
                                  School of Medicine
Gerald G. Krueger, M.D.           Professor of Medicine, University of Utah School of
                                  Medicine
James Leyden, M.D.                Professor of Dermatology, University of Pennsylvania
                                  School of Medicine
Nicholas J. Lowe, M.D.            Clinical Professor of Dermatology, University of California,
                                  Los Angeles, School of Medicine
Gerald D. Weinstein, M.D.         Professor and Chairman, Department of Dermatology, University
                                  of California, Irvine, College of Medicine
</TABLE>


                                       22
<PAGE>   23

HUMAN RESOURCES

    As of December 31, 1996, the Company had 39 employees, 27 of whom were
engaged in research and development, three in marketing and sales activities,
and nine in finance, administration and operations. The Company believes that
its future success will depend upon its ability to continue to attract and
retain a team of highly motivated and skilled individuals. None of the Company's
employees is represented by a labor organization. The Company believes that its
employee relations are good.



RISK FACTORS

         The statements in this Annual Report on Form 10-K and other statements
made by the company from time to time that relate to future plans, events or
performance are forward-looking statements which involve risks and
uncertainties. Actual results, events or performance may differ materially from
those anticipated in any forward-looking statements as a result of a variety of
factors, including those set forth below and elsewhere in this Annual Report on
Form 10-K. The following risk factors should be considered carefully in
evaluating the Company and its business by he company's shareholders and by
prospective investors in the Company.

         Uncertainty of Commercial Launch and Market Acceptance of Prescription
Products. Although the FDA has notified the Company that certain Avita and
Mentax products have been cleared for marketing, these products will face
manufacturing, sales and marketing, market acceptance and other risks associated
with the market launch and commercialization of prescription pharmaceutical
products. The Company relies on third-party contract manufacturers for
commercial production of all of its products. There can be no assurance that the
Company will be able to obtain contract manufacturing of adequate quantities on
a timely basis or on commercially acceptable terms, if at all, for its products.
The Company has commenced marketing in the United States prescription products
through a pharmaceutical specialty contract sales force. The Company has no
experience using a contract sales force or promoting prescription products, and
there can be no assurance that the Company will be able to establish and
maintain a successful marketing and sales effort. A number of factors may limit
the market acceptance of the Company's products, including the timing of market
entry, the availability of alternative products, the price of the Company's
products relative to alternative products, the availability of third-party
reimbursement, acceptance by prescribing physicians, managed care providers and
patients, the nature of publicity regarding the products (if any), and the
extent of marketing efforts by the Company's collaborators or partners (if any).
The Company's products will be subject to continued post-market review which may
result in restrictions on marketing or withdrawal of any such products from the
market. There can be no assurance that prescribing physicians, managed care
providers or patients will demand the products in quantities consistent with
expectations of public market analysts and investors. The failure of such
products to receive regulatory approval or market acceptance could have a
material adverse effect on the Company's operating results or the market price
of the Company's Common Stock.

         Competition and Technological Change. The Company faces significant
competition from, among others, large pharmaceutical companies with established
dermatology divisions. The Company expects that its principal competition with
respect to Mentax will be products marketed by Allergan Inc., Johnson & Johnson,
Novartis (formerly Sandoz Pharmaceuticals) and Glaxo Wellcome plc. The Company
expects that


                                       23
<PAGE>   24

its principal competition with respect to Avita initially will be the retinoic
acid products marketed by Johnson & Johnson. Such Johnson & Johnson products
have been on the market for many years and have substantially all of the market
share for prescription acne treatments. The Company is aware of other
newly-approved novel acne treatments that may present substantial competition
for Avita, including another Johnson & Johnson tretinoin gel product that has a
reduced irritation claim. Most of the Company's competitors have substantially
greater financial, technical, production, marketing and regulatory experience
and resources, larger sales and marketing forces and more experience than the
Company in developing, commercializing and marketing drug and skin care
products. There can be no assurance that the Company's existing and proposed
products, including Avita and Mentax, will compete successfully with the
existing and proposed products of the Company's competitors, and the failure of
the Company's products to do so would have a material adverse effect on the
Company's operating results.

         The Company's current products and those under development are based on
relatively new technologies. The Company expects technological developments in
its business to occur at a rapid rate and believes that competition may
intensify as technological advances in the field are made and become more widely
known. In recent years, several other companies have been formed and, in certain
instances, are collaborating with large pharmaceutical companies, to develop
specific drug delivery systems or drug or skin care products that might compete
directly with the Company's technologies and products. Delivery systems and
products developed by the Company's competitors may be superior to, or gain
greater or faster market acceptance than, the Company's drug delivery systems
and products. There can be no assurance that the Company's competitors will not
succeed in developing technologies and products that are more effective than any
which have been or are being developed by the Company or that would render the
Company's products and technologies obsolete or noncompetitive. See "Business --
Competition."

         Dependence on Sole Suppliers and Third Party Manufacturers. The Company
is dependent on third parties for both the supply of raw materials used to
produce TopiCare Delivery Compounds and finished products and the manufacturing
of these compounds and products. One of the materials used in TopiCare Delivery
Compounds is currently available from only one supplier, Bayer. The Company
currently obtains certain other raw materials, including butenafine and retinoic
acid, from other sole sources. The Company currently secures many of these
supplies pursuant to purchase orders or contracts that are terminable on short
notice. In the event of termination or breach by a supplier or other failure to
continue to supply materials, the Company would be required to secure and
qualify an alternate supplier. Although the Company has not experienced
difficulty acquiring raw materials, maintains significant inventories of these
materials and believes it could qualify alternate suppliers for these materials,
there can be no assurance that interruptions in supplies will not occur in the
future or that the Company would be able to timely secure the materials
necessary to produce its products so as to not experience a disruption in
manufacturing if a supplier breached or terminated its contract and the Company
experienced a disruption in supply. Any significant interruption in the supply
of raw materials could have a material adverse effect on the Company's ability
to produce its compounds and finished products and its operating results.

         The Company neither has nor plans to acquire the equipment and
facilities necessary to manufacture its current and future products and is and
will be dependent upon third-party contract manufacturers for commercial
production of all of its existing and proposed products. The Company currently
secures the manufacture of its products pursuant to contracts or purchase
orders. In the event of breach by a manufacturer or other failure to provide
manufacturing services, the Company would be required to secure and qualify an
alternate manufacturer, which could delay production and sale of the Company's
products. In addition, because the Company must contract for the manufacture of
its products,


                                       24
<PAGE>   25

the Company has little control over the production of finished products and the
associated raw materials costs. There can be no assurance that the Company will
continue to be able to obtain contract manufacturing on commercially acceptable
terms, if at all, for its products in the quantities required. Quality control
and manufacturing problems have arisen from time to time, and there can be no
assurance that future manufacturing or quality control problems will not arise
at the plants of the Company's contract manufacturers or that such manufacturers
will be able to maintain the necessary licenses from governmental authorities to
continue or to commence manufacturing the Company's products. For example, in
1994 one of the Company's contract manufacturers had certain regulatory
deficiencies which led to the Company removing the manufacturer from its drug
application and qualifying a new manufacturing site. There can be no assurance
that the Company will be able to secure the timely and cost-efficient
manufacture of its products in accordance with FDA requirements from these
independent parties, and the inability of the Company to do so could have a
material adverse effect on the Company's operating results. See "Business --
Manufacturing and Raw Materials."

         Marketing and Sales Uncertainties; Dependence on Collaborative Partners
for Product Distribution. The Company has commenced marketing in the United
States prescription products through a pharmaceutical specialty contract sales
force of approximately 47 sales representatives specializing in pharmaceuticals
and solely dedicated to Penederm products. Although the pharmaceutical specialty
contract sales force consists of personnel with experience promoting
dermatological or other pharmaceutical products, none of the sales
representatives has experience working under the direction of the Company or
promoting its products and some do not have experience promoting dermatological
products. Accordingly, the ongoing training and management of the sales force
will require significant management attention and cost. The Company has no
experience establishing, training or managing a contract sales force or
promoting prescription products. In addition, the sales representatives are not
directly employed by the Company, and the Company is dependent upon third
parties for some aspects of the management of the sales force. There can be no
assurance that the Company will be able to successfully train and maintain a
contract sales force or that such sales force will be able to commercialize
Avita, Mentax or any of the Company's other products successfully. The inability
to establish a successful sales effort would have a material adverse effect on
the Company's operating results.

         The Company's strategy for the distribution of certain of its products,
including prescription products in certain geographic territories, requires
entering into various arrangements with corporate collaborators, such as
Schering-Plough, Warner, UCB, Pharmascience Inc., and SmithKline. Revenues from
these agreements constituted substantially all of the Company's revenues in
1996. These agreements often are of short duration, terminable with little or no
notice and subject to periodic amendment. Although the Company believes parties
to any such arrangements would have an economic motivation to succeed in
performing their contractual responsibilities, the amount and timing of
resources to be devoted to these activities are not within the control of the
Company. There can be no assurance that such parties will perform their
obligations, that the agreements will not be terminated or renegotiated or that
the Company will derive any revenue from such arrangements. Any such event could
have a material adverse effect on the Company's operating results. The Company
intends to seek additional collaborative arrangements to commercialize certain
of its products. There can be no assurance that the Company will be able to
negotiate acceptable collaborative arrangements in the future, or that current
or future collaborative arrangements will be successful.


                                       25
<PAGE>   26

         In 1996, four unaffiliated customers accounted for approximately 28
percent ($816,000), 25 percent ($736,000), 18 percent ($519,000), and 15 percent
($430,000) of the Company's revenues. See "Business -- Sales and Marketing" and
"-- Collaborative Arrangements."

         Fluctuations in Quarterly Results; History of Operating Losses. The
Company's future operating results may be subject to significant quarterly
variations based on a wide variety of factors, including, but not limited to,
the timing of regulatory notifications and approvals, the timing of the
commercial introduction of Avita and Mentax in the United States, the timing of
the commercial introduction of other products both in the United States and
abroad, the timing and extent of marketing efforts by the Company and its
partners, the timing of contract payments to and from the Company, the
introduction of competing products by other companies, the pricing of existing
and future products by the Company's competitors, the publication of clinical
results from the Company's products under development, interruptions in the
supply of raw materials necessary to produce the Company's products, and
interruptions or delays in the manufacturing of such products. In addition,
sales of a product upon initial market introduction generally include a
significant amount of initial orders for inventory by wholesalers and
distributors and are not necessarily indicative of actual demand for the product
by patients and physicians. There can be no assurance that distributors or
wholesalers will be able to forecast demand for product accurately. Fluctuations
in operating results will occur to the extent that resales do not meet
distributors' or wholesalers' expectations. The Company's expense levels are
based, in part, on its expectations of future sales levels and have begun to
increase significantly as the Company expands its sales and marketing efforts in
preparation for the product launch of Avita and Mentax. The Company may be
unable to estimate accurately when revenues will be realized from the sales of
these and other products. If sales are below expectations or the release of
products is delayed, the Company's quarterly and annual operating results will
be adversely affected, which would have a material adverse effect on the market
price of the Company's Common Stock. In any event, it is likely that in future
quarters the Company's operating results may from time to time be below the
expectations of public market analysts and investors, which also could have a
material adverse effect on the price of the Company's Common Stock.

         The Company is in the early stages of commercializing its products and
developing collaborative relationships. To date, the Company has generated only
limited revenues from the sale of its products and from licensing arrangements.
As of December 31, 1996 the Company had accumulated net losses of approximately
$38.4 million. To achieve profitable operations, the Company must, among other
things, successfully develop and market its products and may need to establish
significant long-term collaborative relationships with other pharmaceutical
companies. The Company's products under development will require significant
additional development, laboratory and clinical testing, regulatory approvals
and investment prior to commercialization. The Company may continue to incur
significant additional operating losses depending principally on the market
acceptance of the Company's products, the success of product development
efforts, the timing of potential FDA approvals and subsequent launch of the drug
products, the timing of expenditures and other related factors. There can be no
assurance that the Company will achieve profitability. See Item 5 "Market for
the Registrant's Common Equity and Related Stockholder Matters," Item 6
"Selected Financial Data" and Item 7 "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

         Government Regulation; No Assurance of Product Approvals. The research,
testing, manufacture and marketing of drug products is subject to extensive
regulation by numerous regulatory authorities in the United States and other
countries. Failure to comply with FDA or other applicable regulatory
requirements may subject a company to administrative or judicially-imposed
sanctions such as civil penalties, criminal


                                       26
<PAGE>   27

prosecution, injunctions, product seizure or detention, product recalls, total
or partial suspension of production and FDA refusal to approve pending premarket
approval applications or supplements to approved applications. The process of
obtaining FDA and other required regulatory approvals, including foreign
approvals, often takes many years and can vary substantially based upon the
type, complexity and novelty of the products involved. Furthermore, such
approval process is extremely expensive and uncertain. There can be no assurance
that the Company will be able to obtain the labeling claims necessary or
desirable for the promotion of those products. FDA requirements prohibit the
marketing or promotion of a drug for unapproved indications. Furthermore,
regulatory marketing approval may entail ongoing requirements for postmarketing
studies. Even after regulatory approval is obtained, whether for Avita or Mentax
or potential future products of the Company, a marketed product, its manufacture
and its manufacturing facilities are subject to continued regulatory review and
periodic inspection by the FDA. Later discovery of previously unknown problems
or failure to comply with applicable regulatory requirements may result in
penalties such as restrictions on a product's marketing or withdrawal of the
product from the market.

         Prior to the submission of premarket approval applications, drugs
developed by the Company must undergo rigorous preclinical and clinical testing,
which may take several years and the expenditure of substantial resources.
Before commencing clinical trials in humans, the Company must submit to the FDA
and receive clearance of an IND. There can be no assurance that submission of an
IND for future clinical testing of any products under development or other
future products of the Company would result in FDA authorization to commence
clinical trials or that the Company will be able to obtain the necessary
approvals for future clinical testing in any foreign jurisdiction. Further,
there can be no assurance that if such testing of products under development is
completed, any such drug compounds will be accepted for formal review by the FDA
or any foreign regulatory body or approved by the FDA for marketing in the
United States or by any such foreign regulatory bodies for marketing in
particular foreign jurisdictions.

         The Company's research and development involves the controlled use of
hazardous materials, including but not limited to chemicals, fungi and various
radioactive compounds. Although the Company believes that its safety procedures
for handling and disposing of such materials comply with the standards
prescribed by state and federal regulations, the risk of accidental
contamination or injury from these materials cannot be completely eliminated. In
the event of such an accident, the Company could be held liable for any damages
that result and any such liability could exceed the coverage limits of or not be
covered by the Company's insurance and could have a material adverse effect on
the Company's operating results. See "Business -- Government Regulation."

         Uncertainty of Future Product Development. The future success of the
Company will be dependent upon development of new products that obtain
regulatory approval and market acceptance. Such development will require that
the Company successfully identify appropriate products, compounds or
technologies and that the Company obtain any necessary rights thereto. The
Company's strategy for the development of future products requires entering into
various arrangements with third party development partners, licensors and
licensees, such as Kaken, Schering-Plough WARF and Renaissance. The development
of new pharmaceutical products is subject to a number of significant risks and
uncertainties. Potential products, compounds or technologies that appear to be
promising at various stages of development may not receive regulatory approval,
reach the market or achieve widespread use for a number of reasons. In any
event, development of new products will subject the Company to significant
product development costs for which the Company may never receive revenue or for
which revenue may be significantly delayed. In addition, the Company may be
required to pay royalties or other license development or


                                       27
<PAGE>   28

commercialization fees, which could have a material adverse effect on the
profitability of such products to the Company. There can be no assurance that
the Company will be able to in-license products, compounds or technologies on
terms financially acceptable to the Company, successfully develop potential
products, obtain regulatory approval for any such products, obtain necessary
support from third party collaborators, or successfully commercialize such
products, and the inability of the Company to do so could have a material
adverse affect on the Company's operating results.

         Proprietary Technology; Patent Protection. The Company's success,
competitive position, revenue and profits, if any, will depend in part upon its
ability to obtain patent protection in various jurisdictions related to the
technologies and processes it possesses and the technologies and products it
develops. The University of California has obtained three United States and 17
foreign patents for the technology underlying the TopiCare Delivery Compounds
and has licensed these patents to the Company on a worldwide exclusive basis for
the life of the patents. These patents will expire in 2007 and 2008. Under the
license arrangement, the University of California is required to file, prosecute
and maintain foreign patent applications as requested by the Company at the
Company's expense. The Company has licensed rights to certain patented compounds
from Kaken, WARF, and Renaissance and in the future may license patented
compounds from other parties. Any failure by these parties properly to file,
prosecute or maintain any such patents licensed by the Company could materially
adversely affect the Company's operating results.

         The Company has filed and intends to file additional patent
applications, when appropriate, relating to its technologies, improvements to
its technologies and specific products that it develops and to direct the
University of California to file any additional patent applications where
appropriate. The Company has filed one United States patent application and a
corresponding Patent Cooperation Treaty application and also has four foreign
patent applications pending. The scope and breadth of patent protection with
respect to pharmaceutical products is uncertain and involves complex legal,
scientific and factual questions. Accordingly, it is impossible to anticipate
the breadth or degree of protection that any such patents will afford.
Furthermore, there can be no assurance that litigation seeking to challenge such
patent protection will not be brought against the Company or the University of
California or that the Company's or the University of California's patents will
not be successfully challenged. The expenses involved in any patent litigation
can be significant and cannot be estimated by the Company. In addition, there
can be no assurance that the scope and validity of the Company's or the
University of California's existing or future patents, if any, will prevent
third parties from developing similar or competing products.

         Third parties may hold or be issued patents which the Company's
technology may infringe. The Company could incur substantial costs in defending
itself and its collaborative partners against any resulting claims. Furthermore,
parties making such claims may be able to obtain injunctive or other equitable
relief which could effectively block the Company's ability to further develop or
commercialize its products in the United States and abroad, and could result in
the award of substantial damages. In the event of a claim of infringement, the
Company may be required to obtain one or more licenses from third parties. There
can be no assurance that the Company will be able to obtain such licenses at a
reasonable cost, if at all. Defense of any lawsuit or failure to obtain any such
license could have a material adverse effect on the Company's operating results.


                                       28
<PAGE>   29

         In July 1996, Johnson & Johnson filed a complaint in federal district
court alleging that the Company's Avita gel formulation infringes a Johnson &
Johnson patent. The parties entered into a settlement agreement in December 1996
pursuant to which the Company agreed not to market the Avita gel formulation
before the expiration of the Johnson & Johnson patent in January 1998.

         The Company also relies upon unpatented trade secrets and know-how.
There can be no assurance that others will not independently develop
substantially equivalent proprietary information and techniques or otherwise
gain access to the Company's trade secrets or disclose such technology or that
the Company can meaningfully protect its rights to its unpatented trade secrets.

         The PTO has recently adopted changes to United States patent law which
changed the term of issued patents, subject to certain transition periods, to 20
years from the date of filing rather than 17 years from date of issuance. For
applications filed after June 7, 1995, the patent term will be 20 years from the
earliest effective filing date of the priority patent application. Such change
may reduce the effective term of protection for patents that are pending for
more than three years in the PTO. While the Company cannot predict the effect
that such changes will have on its business, the adoption of such changes could
have a material adverse effect on the Company's ability to protect its
proprietary information and sustain the commercial viability of its products.
Furthermore, the possibility of shorter terms of patent protection, combined
with the lengthy FDA review process and possibility of extensive delays in such
process, could effectively further reduce the term during which a marketed
product could be protected by patents. See "Business -- Products -- Prescription
Products" and "-- Patents and Proprietary Technology."

         Uncertainty of Pharmaceutical Pricing and Reimbursement. The Company's
business may be materially adversely affected by the continuing efforts of
governmental and third-party payors to contain or reduce the costs of health
care in general and drugs in particular. For example, in most international
markets, pricing of prescription pharmaceuticals is subject to government price
controls. In these markets, once marketing approval is received, pricing
negotiation could take another six to 12 months or longer. In the United States
there have been, and there may continue to be, federal and state proposals to
implement similar government price controls. In addition, an increasing emphasis
on managed care and consolidation of hospital purchasing in the United States
has and will continue to put pressure on pharmaceutical pricing. Such proposals,
if adopted, and such initiatives could decrease the price that the Company
receives for any current or future products and thereby have a material adverse
effect on the Company's business, financial condition and results of operations.
Further, to the extent that such proposals or initiatives have a material
adverse effect on pharmaceutical companies that are collaborators or prospective
collaborators for certain of the Company's products, the Company's ability to
commercialize its products may be materially adversely affected. In addition,
price competition may result from competing product sales, attempts to gain
market share or introductory pricing programs, which would have a material
adverse effect on the Company's business, financial condition and results of
operations.

         The Company's ability to commercialize its products may depend in part
on the extent to which reimbursement for such products and related treatments
will be available from government health administration authorities, private
health insurers and other third-party payors. Significant uncertainty exists as
to the reimbursement status of newly approved health care products, and
third-party payors are increasingly challenging the prices charged for medical
products and services. There can be no assurance that any third-party insurance
coverage will be available to patients for any of the Company's products.
Government and other third-party payors are increasingly attempting to contain
health care costs by limiting the level of reimbursement for new therapeutic
products, and be refusing, in some cases, to provide


                                       29
<PAGE>   30

coverage or reimbursement for indications for which the FDA has not granted
marketing clearance. Moreover, reimbursement may be denied even for FDA-approved
indications. If adequate coverage and reimbursement levels are not provided by
the government and third-party payors for the Company's products, the Company's
business, financial condition and results of operations would be materially
adversely affected.

         Dependence on Key Personnel. The success of the Company is dependent
upon its ability to retain and attract highly qualified scientific, management
and marketing personnel. The Company faces intense competition for personnel
from other companies, academic institutions, government entities and other
organizations. There can be no assurance that the Company will be successful in
attracting and retaining key personnel. The loss of key personnel, or the
inability to attract and retain the additional, highly-skilled employees
required for the expansion of the Company's activities, could adversely affect
its business. See Item 10 "Directors and Executive Officers of the Registrant."

         Risk of Product Liability Claims; No Assurance of Adequate Insurance.
Testing, manufacturing and marketing of the Company's products entail a risk of
product liability. In addition, third-party manufacturers of certain drugs and
skin care agents used by the Company in its products have limited contractual
responsibility for product liability. Although the Company has obtained
aggregate product liability insurance coverage in the amount of $3,000,000,
there can be no assurance that the existing coverage is adequate for current
operations. Furthermore, this existing coverage may not be adequate as the
Company further develops products, and there can be no assurance that additional
insurance coverage will be available in the future at an acceptable cost, if at
all. Failure of the Company to prevail on a product liability claim could have a
material adverse effect on the Company's operating results. In addition, the
Company could incur substantial costs in defending a claim, even where that
claim was ultimately unsuccessful, and defense of any such claim could divert
management's efforts and attention from the Company's business and have a
material adverse effect on the Company's operating results.

         Volatility of Stock Price. The Nasdaq National Market has from time to
time experienced significant price and volume fluctuations that may be unrelated
to the operating performance of particular companies. In addition, the market
price of the Common Stock, like the stock prices of many publicly traded
pharmaceutical and biotechnology companies, has been, and may continue to be,
highly volatile. Announcements of technological innovations or new commercial
products by the Company or its competitors, developments or disputes concerning
patent or proprietary rights, publicity regarding actual or potential medical
results relating to products under development by the Company or its
competitors, regulatory developments in both the United States and foreign
countries, public concern as to the safety of biotechnology and pharmaceutical
products and economic and other external factors, as well as period-to-period
fluctuations in financial results, among other factors, may have a material
adverse effect on the market price of the Common Stock.


ITEM 2.  PROPERTIES

    The Company currently leases approximately 19,000 square feet of laboratory
and office space in Foster City, California. Penederm's research and development
group occupies approximately 10,000 square feet. The remaining 9,000 square feet
is divided between administrative office space, sales and marketing offices, and
clinical and regulatory space.


                                       30
<PAGE>   31

ITEM 3.  LEGAL PROCEEDINGS

    Not Applicable.

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

    No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended December 31, 1996.


                                     PART II

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

    The Company's Common Stock is traded on the Nasdaq National Market tier of
the Nasdaq Stock Market under the symbol "DERM". The following table sets forth,
for the periods indicated, the high and low closing prices for the Company's
Common Stock as reported by the Nadaq Stock Market:

<TABLE>
<CAPTION>
1995                             High             Low
--------------------------- --------------- ----------------
<S>                            <C>              <C>
First Quarter                  $ 8-3/4          $ 5-1/8
Second Quarter                 $ 7-1/4          $ 4-7/16
Third Quarter                  $ 9              $ 4-3/4
Fourth Quarter                 $11-3/8          $ 7-1/4

1996                             High             Low
--------------------------- --------------- ----------------
First Quarter                  $17-1/4          $10-3/4
Second Quarter                 $17-1/2          $13
Third Quarter                  $13-1/4          $ 5-1/2
Fourth Quarter                 $12-1/2          $ 6-3/4
</TABLE>


As of February 28, 1997, the number of shareholders of record of the Common
Stock was 135. The Company has never paid a cash dividend on its Common Stock
and does not anticipate paying any cash dividends for the foreseeable future.


                                       31
<PAGE>   32

ITEM 6.  SELECTED FINANCIAL DATA


<TABLE>
<CAPTION>
                                                            Year Ended December 31,
(In thousands except per share data)         1996        1995        1994        1993        1992
---------------------------------------------------------------------------------------------------
<S>                                        <C>         <C>         <C>         <C>         <C>     
STATEMENT OF OPERATIONS DATA:
Total revenues                             $  2,905    $  5,401    $  5,123    $  1,378    $    494
Costs and expenses:
     Cost of sales                            1,472       2,034       2,887         502         177
     Research and development                 5,292       5,713       4,509       3,691       3,259
     Selling, general and administrative      4,317       3,623       3,625       2,954       3,138
                                           --------    --------    --------    --------    --------
        Total costs and expenses             11,081      11,370      11,021       7,147       6,574
                                           --------    --------    --------    --------    --------
          Loss from operations               (8,176)     (5,969)     (5,898)     (5,769)     (6,080)
Interest income, net                            533         933         905         230         568
Unusual income item (1)                          --          --          --          --       1,800
                                           --------    --------    --------    --------    --------
     Net loss                              $ (7,643)   $ (5,036)   $ (4,993)   $ (5,539)   $ (3,712)
                                           ========    ========    ========    ========    ========
Net loss per share                         $  (1.05)   $   (.70)   $   (.71)   $  (3.85)   $  (5.49)
                                           ========    ========    ========    ========    ========
</TABLE>

<TABLE>
<CAPTION>
                                                         At December 31,
                                           1996     1995       1994     1993      1992
                                         -----------------------------------------------
<S>                                      <C>       <C>       <C>       <C>       <C>    
BALANCE SHEET DATA:
Cash, cash equivalents and investments   $ 6,420   $15,011   $20,801   $26,416   $ 8,695
Total assets                              10,694    17,968    23,538    27,498     9,646
Shareholders' equity                       8,591    15,934    20,659    26,160     8,701
</TABLE>

(1) Gain on settlement of litigation involving foreign patent applications.


                                       32
<PAGE>   33
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

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

OVERVIEW

         Penederm is a pharmaceutical company that specializes in developing and
marketing dermatology products. Penederm recently launched Mentax(TM), a
once-a-day prescription topical treatment for three skin fungal conditions:
tinea pedis (athletes' foot), tinea corporis (ringworm) and tinea cruris (groin
fungus). Penederm also recently received FDA approval to begin marketing its
Avita(TM) prescription cream product for the treatment of acne and contingent
approval to begin marketing its Avita gel product upon expiration of a third
party patent in January 1998. Penederm has several other pharmaceutical products
for psoriasis, nail fungus, and Mentax skin treatment line extensions in Phase
II human clinical trials. The Company also sells its patented TopiCare Delivery
Compounds(R) for use in cosmetics and personal care products, and markets its
own over-the-counter (OTC) skin care products through corporate partners. The
Company has several agreements with various pharmaceutical companies, as
follows:

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------
             COMPANY                            PRODUCT AREA                               TERRITORY
----------------------------------------------------------------------------------------------------------------
<S>                                 <C>                                    <C>
In-License Agreements:                                                    
----------------------------------------------------------------------------------------------------------------
Kaken Pharmaceutical Company        Penederm in-licensed butenafine, the   U.S. Canada, Mexico and Latin America
Ltd. (Kaken)                        active ingredient incorporated in      for skin antifungal; U.S., Canada, 
                                    Mentax                                 Europe, Mexico, Latin America, 
                                                                           Australia & New Zealand for nail
                                                                           antifungal.
----------------------------------------------------------------------------------------------------------------
The Merck KGaA Group/Center         Co-promote Akne-Mycin and Cloderm      U.S.
Laboratories                                                              
----------------------------------------------------------------------------------------------------------------
Out-License Agreements:                                                   
----------------------------------------------------------------------------------------------------------------
Schering-Plough HealthCare          Prescription & OTC Nail and            U.S. and Canada
Products, Inc. (Schering-Plough)    co-promote prescription skin          
                                    antifungal                            
----------------------------------------------------------------------------------------------------------------
UCB Group of Belgium (UCB)          Prescription antifungal products       Europe, Africa and Middle East
----------------------------------------------------------------------------------------------------------------
Warner Wellcome Consumer Health     OTC Dry Skin                           U.S. and Canada
Products (Warner)                                                         
----------------------------------------------------------------------------------------------------------------
SmithKline Beecham (SmithKline)     OTC Consumer Products                  Europe & Eastern Europe
----------------------------------------------------------------------------------------------------------------
Pierre Fabre Inc. (Pierre Fabre)    DuraScreen sunscreen                   U.S.
----------------------------------------------------------------------------------------------------------------
</TABLE>
                                                                         
         The Company has been unprofitable since inception and expects to incur
significant additional operating losses in the near future. For the period from
inception through December 31, 1996, the Company incurred a cumulative net loss
of $38,393,000. Penederm's sources of working capital have been equity


                                       33
<PAGE>   34
financings, product sales to corporate partners, sales of over-the-counter
products, product license fees and sales of TopiCare Delivery Compounds and
interest earned on investments.


RESULTS OF OPERATIONS

         Total 1996 revenues of $2,905,000 declined 46% from total 1995 revenues
of $5,401,000. 1995 revenues increased 5% from $5,123,000 in 1994. The 1996
revenue decrease is primarily due to reduced in-license revenues as well as
decreases in Lubriderm Alpha Hydroxy Formula and the related TopiCare Delivery
Compound sales. License revenues in 1996 of $647,000 decreased 68% from 1995
license revenues of $2,050,000. License fees were received from Warner and
SmithKline in 1996, Schering-Plough, UCB and SmithKline in 1995 and from
Schering-Plough and Warner in 1994.

         Total product sales declined by 33% to $2,258,000 in 1996 from
$3,351,000 in 1995 due primarily to lower quantities of Lubriderm products
shipped to Warner as compared to 1995. Slower sales to Warner also negatively
impacted sales of TopiCare Delivery Compounds. Total product sales declined by
19% in 1995 from $4,128,000 in 1994 due primarily to decreased shipments of
Lubriderm to Warner from 1994 launch quantities, and decreased Penederm cream
and lotion sales, partially offset by increased sales of TopiCare Delivery
Compounds.

         The Company expects its future revenues in the near term to be derived
principally from the sale of its recently approved pharmaceutical products, and
for the revenues derived from OTC dry skin products and cosmetic products to
become less significant relative to total revenues.

         The Company's cost of sales declined to $1,472,000 in 1996 from
$2,034,000 in 1995 due to the decrease in product sales. Cost of sales declined
in 1995 from $2,887,000 in 1994 due to the lower dry skin product shipments.

         The Company's research and development expenses decreased 7% to
$5,292,000 in 1996 from $5,713,000 in 1995 and increased 27% in 1995 from
$4,509,000 in 1994. The 1996 spending decrease is related to the timing and size
of later stage human clinical trials compared to the prior year. The 1995
increase also related to the commencement of certain human clinical trials which
were significantly larger than the prior year.

         Sales, marketing, general and administrative expenses increased 19% in
1996 to $4,317,000 from $3,623,000 in 1995 and $3,625,000 in 1994. This increase
is due primarily to increased legal costs related to enforcement of patent
rights, and the costs of pre-launch preparations for Mentax offset by continued
reductions in OTC promotions and reduced personnel costs. In 1995, reduced
promotional efforts related to Penederm dry skin cream and lotion products were
offset by increased costs related to new business arrangements and patent work.


                                       34
<PAGE>   35
         The Company had net interest income of $533,000, $933,000 and $905,000
in 1996, 1995 and 1994, respectively. Net interest income declined 43% in 1996
and increased 3% in 1995. This decrease is primarily the result of lower cash
balances available for investment in 1996. The increase in 1995 is due to the
net effect of lower average cash and investment balances offset by higher
interest rates being earned on these balances.

         As of December 31, 1996, the Company had available net operating loss
carryforwards of approximately $36,000,000 for Federal income tax purposes.
Utilization of the net operating loss carryforwards may be subject to
substantial limitation due to the change in ownership provisions of the Internal
Revenue Code of 1986.

         The Company expects that total revenues, and costs and expenses will
increase in the future, due principally to further commercialization of its
recently approved pharmaceutical products. Costs and expenses are expected to
increase significantly in sales and marketing as these products are promoted and
sold in the marketplace. The Company also expects expansion of research and
development programs, increased patent and regulatory costs, expansion of
regulatory, clinical, and quality assurance capabilities, and increased
administrative support costs. Therefore, additional operating losses are
expected in the near future. In addition, sales of a product upon initial market
introduction generally include a significant amount of initial orders for
inventory by wholesalers and distributors and are not necessarily indicative of
actual demand for that product by patients and physicians. There can be no
assurance that distributors and wholesalers will be able to forecast demand for
product accurately. Fluctuations in operating results will occur to the extent
that resales do not meet distributors' or wholesalers' expectations. The Company
also expects that future operating results may be subject to quarterly
variations that may impact cash flow from operations. Operating results for the
year ended December 31, 1996 are not necessarily indicative of future operating
results.


LIQUIDITY AND CAPITAL RESOURCES

         In November 1993, the Company completed its initial public offering of
Common Stock, raising approximately $23,000,000 net of expenses. Prior to the
initial public offering, the Company financed operations primarily through
private placements of its equity securities, interest income earned on
investment of cash, initial sales of products and product license fees. At
December 31, 1996, the Company had cash, cash equivalents and investments
totaling $6,420,000.

         Cash expenditures related to operating activities, the acquisition of
fixed assets and repayment of long-term debt totaled $8,272,000 in 1996 and
$5,003,000 in 1995. Operating activities were comprised of research and
development, clinical trials, product sales, promotion and general
administration activities. The Company also made milestone payments of $619,000
and $1,098,000 related to the in-licensing of drug compounds in 1996 and 1995,
respectively. The Company expects that amounts expended historically are not
indicative of future expenditures by the Company, which the Company believes
will increase. The Company expects to continue to incur substantial expenditures
related to the further research and development of its technologies, development
of its products, acquisition of additional products and rights to drug compounds
and sales and marketing.


                                       35
<PAGE>   36
         In March 1997, the Company announced that it signed an agreement for a
$9 million private placement of common stock, the closing of which is
conditioned upon the effectiveness of a registration statement covering the
resale of the shares to be issued in the transaction. The Company believes that,
if the private placement is completed, existing capital resources after giving
effect to the net proceeds of the private placement transaction, including the
interest income earned on its invested cash balances, together with anticipated
revenues (consisting of product sales, license fees and royalties), will satisfy
the Company's working capital and identified capital expenditure requirements at
least through 1997. However, there can be no assurance that the private
placement will be completed or that, if completed, the proceeds to the Company
will be sufficient to finance its future operations. The Company's future
capital requirements will depend on many factors, including the progress of the
Company's collaborative and independent research and development programs,
payments received under collaborative agreements with other companies, if any,
the results and costs of preclinical and clinical testing for the Company's
products, the costs associated with and the timing of regulatory approvals,
technological advances, the status of competitive products, and the commercial
success of Penederm's licensing and marketing efforts. There can be no assurance
that additional funds, if required, will be available to the Company on
favorable terms, if at all, to permit the Company to continue with its plan for
operations.



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

<TABLE>
<CAPTION>
Index to Financial Statements                                   Page
-----------------------------                                   ----
<S>                                                             <C>

Report of Ernst & Young LLP, Independent Auditors                37
Report of Independent Accountants                                38
Consolidated Balance Sheets                                      39
Consolidated Statements of Operations                            40
Consolidated Statements of Shareholders' Equity                  41
Consolidated Statements of Cash Flows                            42
Notes to the Consolidated Financial Statements                   43
</TABLE>


                                       36
<PAGE>   37
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS


THE BOARD OF DIRECTORS AND SHAREHOLDERS OF PENEDERM INCORPORATED

We have audited the accompanying consolidated balance sheets of Penederm
Incorporated as of December 31, 1996 and 1995, and the related consolidated
statements of operations, shareholders' equity and cash flows for each of the
two years in the period ended December 31, 1996. Our responsibility is to
express an opinion on these financial statements based on our audits. The
statements of operations, shareholders' equity, and cash flows of Penederm
Incorporated for the year ended December 31, 1994 were audited by other auditors
whose report dated January 20, 1995, expressed an unqualified opinion on those
statements.

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

In our opinion, the 1996 and 1995 financial statements referred to above 
present fairly, in all material respects, the consolidated financial
position of Penederm Incorporated at December 31, 1996, and 1995 and the
consolidated results of its operations and its cash flows for the two years in
the period ended December 31, 1996 in conformity with generally accepted
accounting principles.



                                            ERNST & YOUNG LLP



Palo Alto, California
January 27, 1997, except for the second paragraph 
of Note 12 as to which the date is March 4, 1997.


                                       37
<PAGE>   38
                        REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors
Penederm Incorporated:



         We have audited the accompanying statement of operations,
shareholders' equity and cash flows for the year ended December 31, 1994. 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 audit.


         We conducted our audit 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 audit provides a reasonable basis for our opinion.

         In our opinion, the financial statements referred to above present
fairly, in all material respects, the results of operations and cash flows of
Penederm Incorporated for the year ended December 31, 1994 in conformity with 
generally accepted accounting principles.


                                                       COOPERS & LYBRAND, L.L.P.



San Jose, California 
January 20, 1995


                                       38
<PAGE>   39
Penederm Incorporated
Consolidated Balance Sheets

<TABLE>
<CAPTION>
                                                                                    December 31,
                                                                               ---------------------
(In thousands except share data)                                                 1996         1995
----------------------------------------------------------------------------------------------------
<S>                                                                            <C>          <C>     
                                 ASSETS
Current assets:
      Cash and cash equivalents                                                $  3,062     $  8,695
      Short-term marketable securities                                            2,259        4,796
      Accounts receivable (less allowance for doubtful
          accounts of none in 1996 and 1995)                                        276          862
      Inventory                                                                   1,539          301
      Employee note receivable                                                      125          125
      Prepaid expenses and other current assets                                     524          342
                                                                               --------     --------
              Total current assets                                                7,785       15,121
Marketable securities                                                             1,099        1,520
Property and equipment, at cost, less accumulated
     depreciation and amortization                                                  277          282
Intangible assets (less accumulated amortization of
     $206 in 1996 and $77 in 1995)                                                1,511        1,021
Other assets                                                                         22           24
                                                                               --------     --------
              Total assets                                                     $ 10,694     $ 17,968
                                                                               ========     ========

                     LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
      Accounts payable                                                         $  1,196     $    791
      Accrued liabilities                                                           863        1,143
      Current portion of long-term debt                                              16           23
                                                                               --------     --------
              Total current liabilities                                           2,075        1,957
Long-term debt, less current portion                                                 28           54
Accrued rent                                                                         --           23
                                                                               --------     --------
              Total liabilities                                                   2,103        2,034
                                                                               --------     --------

Commitments

Convertible preferred stock, no par value;
      10,000,000 shares authorized; no shares
      issued and outstanding                                                         --           --
Common stock, no par value; 30,000,000 shares authorized; shares
      issued and outstanding: 7,315,697 shares in 1996 and 7,228,191
      shares in 1995                                                             46,984       46,684
Accumulated deficit                                                             (38,393)     (30,750)
                                                                               --------     --------
              Total shareholders' equity                                          8,591       15,934
                                                                               --------     --------
              Total liabilities and shareholders' equity                       $ 10,694     $ 17,968
                                                                               ========     ========
</TABLE>

See accompanying notes


                                       39
<PAGE>   40
Penederm Incorporated
Consolidated Statements of Operations


<TABLE>
<CAPTION>
                                                              Year Ending December 31,
                                                         ----------------------------------
(In thousands except per share data)                       1996         1995         1994
-------------------------------------------------------------------------------------------

<S>                                                      <C>          <C>          <C>     
Revenues:
      Product sales                                      $  2,258     $  3,351     $  4,128
      Licensing revenues                                      647        2,050          995
                                                         --------     --------     --------
          Total revenues                                    2,905        5,401        5,123
                                                         --------     --------     --------

Costs and expenses:
      Cost of product sales                                 1,472        2,034        2,887
      Research and development                              5,292        5,713        4,509
      Sales and marketing                                   1,414        1,354        1,729
      General and administrative                            2,903        2,269        1,896
                                                         --------     --------     --------
          Total costs and expenses                         11,081       11,370       11,021
                                                         --------     --------     --------

Loss from operations                                       (8,176)      (5,969)      (5,898)

Interest income, net                                          533          933          905
                                                         --------     --------     --------
Net loss                                                 $ (7,643)    $ (5,036)    $ (4,993)
                                                         ========     ========     ========
Net loss per share                                       $  (1.05)    $   (.70)    $   (.71)
                                                         ========     ========     ========
Number of shares used in computing net loss per share       7,275        7,171        6,990
                                                         ========     ========     ========
</TABLE>

See accompanying notes.


                                       40
<PAGE>   41
Penederm Incorporated
Consolidated Statement of Shareholders' Equity

(In thousands)

                                                                               
<TABLE>
<CAPTION>
                                                       Common Stock                              Total     
                                                 -----------------------       Accumulated    Shareholders'
                                                  Shares         Amount          Deficit         Equity
-----------------------------------------------------------------------------------------------------------

<S>                                              <C>            <C>            <C>            <C>     
Balances, December 31, 1993                         6,973       $ 46,881        $(20,721)       $ 26,160
     Issuance of common stock under                                                           
     stock option plan                                 26             15            --                15
     Offering costs incurred under                                                            
     demand registration rights                      --             (523)           --              (523)
     Net loss                                        --             --            (4,993)         (4,993)
                                                 --------       --------        --------        --------
                                                                                              
Balances, December 31, 1994                         6,999         46,373         (25,714)         20,659
     Issuance of common stock under                                                           
     stock option and other employee                                                          
     stock plans                                      229            311            --               311
     Net loss                                        --             --            (5,036)         (5,036)
                                                 --------       --------        --------        --------
                                                                                              
Balances, December 31, 1995                         7,228         46,684         (30,750)         15,934
     Issuance of common stock under                                                           
     stock option and other employee                                                          
     stock plans                                       88            300            --               300
     Net loss                                        --             --            (7,643)         (7,643)
                                                 --------       --------        --------        --------
                                                                                              
Balances, December 31, 1996                         7,316       $ 46,984        $(38,393)       $  8,591
                                                 ========       ========        ========        ========
</TABLE>
                                            
See accompanying notes.


                                       41
<PAGE>   42
Penederm Incorporated
Consolidated Statements of Cash Flows
<TABLE>
<CAPTION>
Increase (decrease) in cash and cash equivalents (in thousands)           1996         1995         1994
----------------------------------------------------------------------------------------------------------
<S>                                                                   <C>          <C>          <C>    
Cash flows from operating activities:
      Net loss                                                        $ (7,643)    $ (5,036)    $ (4,993)
      Adjustments to reconcile net loss to net cash used
        in operating activities:
         Loss on disposal of fixed assets                                 --            139         --
         Depreciation and amortization                                     261          250          145
         Decrease (increase) in accounts receivable                        586         (168)        (570)
         Decrease (increase) in inventory                               (1,238)         279         (328)
         Decrease (increase) in prepaid expenses and other current
         assets                                                           (182)          80         (118)
         Increase (decrease) in accounts payable, accrued
              liabilities and rent                                         102         (352)       1,606
         Decrease (increase) in other assets                                 2           (1)        (511)
                                                                      --------     --------     --------
              Net cash used in operating activities                     (8,112)      (4,809)      (4,769)
                                                                      --------     --------     --------

Cash flows from investing activities:
      Purchases of held-to-maturity securities                            --           --           (248)
      Purchases of available-for-sale securities                        (6,901)      (7,258)     (13,048)
      Maturities of held-to-maturity securities                           --          2,000         --
      Maturities of available-for-sale securities                        6,850       10,076       21,850
      Sales of available-for-sale securities                             3,009        2,939         --
      Acquisition of intangible assets                                    (619)      (1,098)        --
      Acquisition of fixed assets                                         (127)        (131)        (273)
                                                                      --------     --------     --------
              Net cash provided by investing activities                  2,212        6,528        8,281
                                                                      --------     --------     --------

Cash flows from financing activities:
      Proceeds from issuance of common stock                               300          311           15
      Payments of offering costs                                          --           --           (523)
      Repayment of long-term debt                                          (33)         (63)         (65)
                                                                      --------     --------     --------
              Net cash provided by (used in) financing activities          267          248         (573)
                                                                      --------     --------     --------

Net increase (decrease) in cash and cash equivalents                    (5,633)       1,967        2,939
Cash and cash equivalents at beginning of year                           8,695        6,728        3,789
                                                                      --------     --------     --------
Cash and cash equivalents at end of year                              $  3,062     $  8,695     $  6,728
                                                                      ========     ========     ========
</TABLE>


See accompanying notes.





                                       42
<PAGE>   43





Penederm Incorporated
Notes to Consolidated Financial Statements

1. BUSINESS OF THE COMPANY

Penederm is a pharmaceutical company that specializes in development and
marketing of dermatology products. The Company is launching Mentax(TM), a
once-a-day prescription topical cream for the treatment for skin fungal
conditions and Avita(TM), a topical form of retinoic acid for the treatment of
acne. Products for nail fungus and psoriasis are in earlier stages of clinical
development along with Mentax skin treatment line extensions. The Company also
markets its patented TopiCare Delivery Compounds(R) for use in cosmetic and
personal care products as well as OTC skin care products which are marketed
through corporate partners.


2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiary in the United Kingdom,
Penederm Limited. All significant intercompany balances and transactions have
been eliminated in consolidation.

USE OF ESTIMATES: The preparation of the financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.

CASH AND CASH EQUIVALENTS: The Company considers all highly liquid investments
purchased with a remaining maturity of three months or less to be cash
equivalents.

MARKETABLE SECURITIES: All of the Company's marketable securities are classified
as available-for-sale with unrealized holding gains and losses, when material,
reported as a separate component of shareholders' equity. Unrealized gains and
losses on marketable securities were not material as of December 31, 1996 and
1995. Realized gains and losses on sales of investments are reported in interest
income and computed using the specific identification cost method. Short-term
marketable securities mature within one year of the balance sheet date.
Marketable securities typically have a maximum maturity of two years from the
purchase date.

CONCENTRATION OF CREDIT RISK: The Company's cash, cash equivalents, and
marketable securities are highly liquid and are diversified to ensure safety of
principal. The Company generally invests excess cash in deposits with major
banks, in various government or government agency obligations, and in
obligations of corporations with strong credit ratings and in a variety of
industries.

INVENTORIES: Inventories are stated at the lower of cost (first-in, first-out)
or market.

PROPERTY AND EQUIPMENT: Property and equipment are stated at cost and are
depreciated on a straight-line basis over their estimated useful lives of four
years. Property and equipment acquired under capital leases 





                                       43
<PAGE>   44
and leasehold improvements are amortized on a straight-line basis over their
estimated useful lives or their lease terms, whichever is shorter.


Property and equipment consists of the following at December 31:


<TABLE>
<CAPTION>

(In thousands)                                          1996              1995
-------------------------------------------------------------------------------
<S>                                                   <C>               <C>
Computers and equipment                               $ 1,047           $   930
Furniture and fixtures                                    119               116
Leasehold improvements                                    288               281
                                                      -------           -------
                                                        1,454             1,327
Less accumulated depreciation
    and amortization                                   (1,177)           (1,045)
                                                      -------           -------
Net property and equipment                            $   277           $   282
                                                      =======           =======
</TABLE>


Property and equipment includes $574,000 and $573,000 of equipment under capital
leases at December 31, 1996 and 1995, respectively. Accumulated depreciation for
such equipment was $522,000 and $507,000 at December 31, 1996 and 1995,
respectively.

INTANGIBLE ASSETS: Intangible assets consist principally of development and
marketing rights related to in-licensed pharmaceutical compounds and are
amortized on a straight-line basis over their estimated useful lives of ten
years.

ACCRUED LIABILITIES: Accrued liabilities consist of the following at December
31:



(In thousands)                        1996            1995
-----------------------------------------------------------

Clinical studies                      $219          $  764
Accrued payroll and
  related expenses                     198             155
Other accrued liabilities              446             224
                                      ----          ------
                                      $863          $1,143
                                      ====          ====== 

REVENUE RECOGNITION: The Company recognizes product sales upon shipment of
product. License payments are generally recognized upon the execution of the
license agreement. Research and development milestones are recorded when the
underlying performance objective has been attained. License payments received
which are related to future performance are deferred and recorded as revenues as
they are earned over specified future performance periods. Payments received
under research and development agreements are recognized as revenue ratably with
the performance specified in the agreement, which approximates the incurrence of
related costs.

RESEARCH AND DEVELOPMENT: Research and development expenditures are charged to
operations as incurred.



                                       44
<PAGE>   45
NET LOSS PER SHARE: The net loss per share is computed using the weighted
average number of shares of common stock outstanding. Common equivalent shares
from stock options are excluded from the computation as their effect is
antidilutive

STOCK-BASED COMPENSATION: In October 1995 the FASB issued Statement of Financial
Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," 
which encourages, but does not require, companies to record compensation 
expense for stock-based employee compensation plans at fair value. The 
Company has chosen to continue to apply Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees," and related Interpretations
in accounting for its stock based plans and, accordingly, does not recognize
compensation expense related to employees or directors under its stock option
plans or employee stock purchase plan. Note 7 contains a summary of the pro
forma effects to reported net loss and loss per share for 1996 and 1995 if the
Company had elected to recognize compensation expense based on the fair value
of the options granted as described by SFAS No. 123.


3.  MARKETABLE SECURITIES

At December 31, 1996 and 1995, marketable securities classified as
available-for-sale are summarized below (in thousands):

<TABLE>
<CAPTION>
                                       Amortized
                                            Cost  Unrealized  Unrealized        Fair
December 31, 1996                          Basis       Gains      Losses       Value
------------------------------------------------------------------------------------
<S>                                    <C>        <C>         <C>             <C>
Available for sale:
U.S. Treasury and U.S. agency
  securities                           $1,248          $  -        $(3)       $1,245
Corporate commercial paper, notes
  and bonds                             2,110             2         (5)        2,107
                                       ------          ----        ----       ------
                                       $3,358          $  2        $(8)       $3,352
                                       ======          ====        ====       ======
</TABLE>


<TABLE>
<CAPTION>
                                       Amortized
                                            Cost  Unrealized  Unrealized        Fair
December 31, 1995                          Basis       Gains      Losses       Value
------------------------------------------------------------------------------------
<S>                                    <C>        <C>         <C>             <C>

Available for sale:
U.S. Treasury and U.S. agency
  securities                           $1,751           $38       $    -      $1,789
Yankee certificates of deposit            750             -           (4)        746
Corporate commercial paper, notes
  and bonds                             3,815            43            -       3,858
                                       ------           ---       ------      ------
                                       $6,316           $81       $   (4)     $6,393
                                       ======           ===       ======      ======
</TABLE>



The amortized cost of marketable securities at December 31, 1996 totaling
$2,259,000 and $1,099,000 mature in 1997 and 1998, respectively. Realized gains
and losses on sales of available-for-sale securities during the year ended
December 31, 1996 and 1995 were immaterial.




                                       45
<PAGE>   46
4.  LONG-TERM DEBT

The Company leases certain of its laboratory equipment and its phone system
under capital leases. The capital leases expire at various dates through 1999
and bear interest rates from 12% to 19%.

Future minimum lease payments under the capital lease obligations are not
material. Interest expense under these obligations totaled approximately $8,000,
$14,000, and $17,000 for each of the years ended December 31, 1996, 1995 and
1994, respectively.


5.  COMMITMENTS

FACILITY LEASE: The Company rents office and laboratory facilities under a
noncancelable operating lease expiring in April 1998. Under the terms of the
lease, the Company is responsible for its share of common area costs.

Future minimum payments under the leases are $312,000, and $105,000 for the
years ended December 31, 1997 and 1998, respectively. Rent expense under
operating leases amounted to approximately $300,000, $342,000, and $250,000 in
1996, 1995, and 1994, respectively.

The Company may be obligated to make license and development milestone payments
in the future under certain license and collaborative research agreements, as
described further in Note 6.


6.  LICENSE AND COLLABORATIVE RESEARCH AGREEMENTS

IN-LICENSE AGREEMENTS: Penederm has in-license agreements with the University of
California, Kaken Pharmaceutical Company, Ltd. (Kaken), and a group of entities
including the Wisconsin Alumni Research Foundation and Renaissance Corporation,
for certain topical drug delivery technology, the rights to develop and market
an antifungal butenafine drug compound, and the right to develop and market
patented Vitamin D compounds, respectively. These agreements generally require
the payment by the Company of nonrefundable license fees, additional milestone
payments contingent on the achievement of regulatory objectives and royalties on
future product sales resulting from commercialization of the technologies or
compounds. These license agreements are generally for specified skin disorders
and limited to specified territories. Royalties paid under these agreements were
not significant in any of the three years in the period ended December 31, 1996.

OUT-LICENSE AGREEMENTS: Penederm has agreements granting licenses to the
Company's proprietary technologies to Warner Wellcome Consumer Health Products
and SmithKline Beecham for certain over-the-counter skin care products and with
Schering-Plough HealthCare Products, Inc. and UCB Group of Belgium to develop
and commercialize certain antifungal skin and nail prescription products based
on the butenafine compound in-licensed from Kaken. The agreements generally
provide for the licensee to sell certain products incorporating the Company's
proprietary TopiCare Delivery Compounds, and/or in-licensed drug compounds in
certain specified territories. Terms of the license agreements also generally
include supply agreements, license fees, performance milestone payments and
royalties due to Penederm. Certain of the agreements are terminable upon as few
as 90 days notice, in which event the product rights 

                                       46
<PAGE>   47
revert to Penederm without further consideration and become available for
out-license to another development or marketing partner. It is expected that the
Company's agreement with Warner U.S. will terminate on December 31, 1997. For
the years ending December 31, 1996, 1995, and 1994, the Company recorded license
fee milestone revenues of $647,000, $2,050,000, and $995,000, respectively,
under these agreements.


7.  SHAREHOLDERS' EQUITY

COMMON STOCK: Certain shareholders have demand registration and piggyback
registration rights.

SHAREHOLDER RIGHTS PLAN: On November 20, 1996, the Board of Directors adopted
the Shareholder Rights Plan ("Rights Plan") to assist its shareholders in
realizing fair value and equal treatment in the event of any attempted takeover
of the Company and to protect the Company and its shareholders against coercive
takeover tactics. In the event a third party or group were to acquire 20% or
more of the Company's outstanding Common Stock without the prior approval of
the Board of Directors, each Company shareholder, other than the acquirer, will
have the right to buy Common Stock of the Company with a market value of twice
the exercise price of the rights issued under the Rights Plan, for the right's
then current exercise price. In addition, if the Company were to be acquired in
a merger, shareholders with unexercised rights could purchase common stock of
the acquirer with a value of twice the exercise price of the rights.

STOCK OPTION PLANS: In October 1987, the Company adopted an Employee Stock
Option Plan, under which incentive stock options or nonqualified options may be
granted to employees, and the Consultant Stock Option Plan, under which
nonqualified options may be granted to consultants of the Company. Under the
plans, options may be granted at prices not less than 85% of the fair market
value at the date of grant in the case of nonqualified options and not less than
fair market value in the case of incentive options (110% of fair market value in
certain instances), as determined by the Board of Directors.

Options are generally exercisable upon grant, expire ten years from the date of
grant and vest over five years. Shares issued upon exercise of unvested options
are subject to the right of repurchase by the Company which lapses in accordance
with the option's vesting schedule.

In June 1994, the Company adopted the 1994 Nonemployee Directors Stock Option
Plan, under which nonqualified stock options may be granted to nonemployee
directors on a formula basis. At December 31, 1996, 200,000 shares of common
stock were reserved under the Plan. Options may be granted at an exercise price
equal to the fair market value of common stock on the date of the grant. Options
vest ratably over the period of one year from the date of grant, and have a term
of ten years.

Had compensation expense been recognized for the Company's employee stock
purchase plan and stock option plans based on the fair value at the grant date
for awards made in 1996 and 1995 consistent with the provisions of SFAS No. 123,
the Company's net loss and loss per share would have been reduced to the
following pro forma amounts:






                                       47
<PAGE>   48


<TABLE>
<CAPTION>

(In thousands, except
per share amounts)                    1996            1995
-----------------------------------------------------------
<S>                               <C>             <C>
Net loss, as reported             $(7,643)        $(5,036)
Net loss, pro forma               $(8,163)        $(5,141)

Net loss per share, as            $ (1.05)        $  (.70)
reported
Net loss per share, pro           $ (1.12)        $  (.72)
forma
</TABLE>


Because SFAS No. 123 is applicable only to options granted subsequent to
December 31, 1994, its pro forma effect will not be fully reflected until 1998.

The weighted average fair value for stock options granted in 1996 and 1995 was
$7.20 and $4.10, respectively. The weighted average fair value for shares issued
under the employee stock purchase plan in 1996 and 1995 were $1.93 and $1.48,
respectively.

The fair value of each option granted during the years 1996 and 1995 is
estimated at the grant date using the Black-Scholes option-pricing model
utilizing the following assumptions:

<TABLE>
<CAPTION>

                                                      Employee
                                   Stock                Stock
                                Option Plans          Purchase
                                                        Plan
                                ------------          --------
<S>                             <C>                   <C>
Expected stock price
  volatility                        60%                  60%
Risk-free interest rate             6.0%                6.0%
Expected option life             3-6 years          .5-1.5 years
Expected dividend yield             None                None

</TABLE>




                                       48
<PAGE>   49






The activity under the stock option plans for the three years in the period
ended December 31, 1996 was as follows:

<TABLE>
<CAPTION>

                                                              Outstanding Options
                                                    -------------------------------------
                                        Shares      Number
                                      Available         of         Price
                                           For      Shares       Per Share          Total
                                         Grant
------------------------------------------------------------------------------------------
<S>                                <C>             <C>          <C>              <C>
(In thousands except for price 
per share)

Balance at Dec. 31, 1993           224                 595     $0.20-$10.75     $   664
   Options granted                 (72)                 72     $6.00-$14.25         767
   Options exercised                --                 (26)    $0.35-$ 1.60         (15)
   Options canceled                  6                  (6)    $0.80-$ 1.60          (9)
                                  ----                ----                      ------- 

   Balance at Dec. 31, 1994        158                 635     $0.20-$14.25       1,407
   Additional shares
     reserved                      200                  --
   Options granted                (201)                201     $4.75-$ 8.50       1,405
   Options exercised                --                (201)    $0.20-$ 1.60        (133)
   Options canceled                 84                 (84)    $0.80-$14.25        (145)
                                  ----                ----                      ------- 

   Balance at Dec. 31, 1995        241                 551     $0.35-$14.25       2,534
   Additional shares
     reserved                      400                 --
   Options granted                (475)                475     $6.25-$16.875      5,924
   Options exercised                --                 (45)    $0.35-$8.375         (71)
   Options canceled                 74                 (74)    $0.80-$16.875       (648)
                                  ----                ----                      ------- 

   Balance at Dec. 31, 1996        240                 907     $0.35-$16.875    $ 7,739
                                  ====                ====                      =======
</TABLE>



As of December 31, 1996, no shares exercised under the plans were subject to the
right of repurchase and 332,000 of the outstanding options were vested.

The following table summarizes information regarding stock options outstanding
at December 31, 1996:
<TABLE>
<CAPTION>

                         Shares
                     outstanding at        Weighted        Weighted
                      December 31,         Average         Average
    Range of            1996 (in          Remaining        Exercise
 Exercise Prices       thousands)         Life (Yrs)        Price
 ---------------     -------------        ----------       --------
<S>                  <C>                  <C>              <C>
  $0.35-$1.60              232               5.8            $1.40
  $4.75-$7.875             167               8.9            $5.87
  $8.00-$10.75             159               7.8            $9.25
  $12.375-$13.75           201               9.9            $12.45
  $14.25-$16.875           148               9.1            $16.60
  ----------------------------------------------------------------

  $0.35-$16.875            907               8.2            $8.53
  ================================================================
</TABLE>


EMPLOYEE STOCK PURCHASE PLAN: In May 1995, the Company adopted an Employee Stock
Purchase Plan (ESPP). The ESPP provides employees an opportunity to purchase
Company stock through payroll deductions, subject to a maximum percentage of
compensation, currently 7%. The purchase price per share is the lower of 85% of
market value on the enrollment date or on the date purchased. Under the 

                                       49
<PAGE>   50
plan, 100,000 shares of common stock have been reserved for issuance. For the
year ended December 31, 1996 and six-month period ended December 31, 1995,
37,074 and 15,049 shares were issued under the ESPP, respectively.

SHARES RESERVED FOR FUTURE ISSUANCE: As of December 31, 1996, the Company has
reserved for future issuance under all stock plans approximately 1,195,000
shares of common stock.


8.  RELATED PARTY TRANSACTIONS

On June 15, 1990, the Company loaned an officer $125,000, bearing interest at
8.82% payable quarterly. The loan is repayable on demand or termination of
employment, whichever is earlier, and is collateralized by stock options with a
value equal to the loan.


9.  EMPLOYEE BENEFIT PLANS

During 1989, the Company adopted a qualified profit-sharing plan and trust under
Internal Revenue Service Codes 401(a) and 401(k). The plan provides for
tax-deferred salary deductions whereby employees can elect to contribute up to
20% of their salary (subject to current statutory limits) to the plan. Beginning
in July 1994, the Company matched employee contributions up to 2% of their gross
salary with Company common stock. Such matching contributions become fully
vested when the employee completes five years of service. The Company has the
option to contribute up to an additional 2% based on the achievement of
specified corporate goals. The Company contributed 5,561 shares (valued at
$68,817), 6,436 shares (valued at $73,210) and 7,200 shares (valued at $45,000)
for the years ended December 31, 1996 and 1995 and six months ended December 31,
1994, respectively.



                                       50
<PAGE>   51
10.  INCOME TAXES

As of December 31, 1996, the Company had federal net operating loss
carryforwards of approximately $36,000,000. The net operating loss carryforward
will expire at various dates beginning in 2002 through 2011 if not utilized.

Significant components of the Company's deferred tax assets and liabilities for
federal and state income taxes as of December 31, 1996 and 1995 are as follows:


<TABLE>
<CAPTION>
(In thousands)                     1996        1995
------------------------------------------------------
<S>                            <C>          <C>   
Net operating loss                 12,900       10,200
carryforwards
Research credit
  carryforwards (expire             1,900        1,200
2002-2011)
Capitalized research &                700          600
development
Other                                 200          200

                               ----------  -----------
Net deferred tax assets            15,700       12,200
Valuation allowance               (15,700)     (12,200)
                               ----------  -----------
Total                          $       --   $       --
                               ==========  ===========
</TABLE>

Because of the Company's lack of an earnings history, the deferred tax asset has
been fully offset by a valuation allowance. The net valuation allowance
increased by $3,500,000, and $2,143,000 for the years ended December 31, 1996
and 1995, respectively.

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


11. MAJOR CUSTOMERS AND EXPORT SALES

In 1996, four unaffiliated customers accounted for approximately 28% ($816,000),
25% ($736,000), 18% ($519,000), and 15% ($430,000) of the Company's revenues. In
1995, four unaffiliated customers accounted for approximately 24% ($1,322,000),
18% ($955,000), 17% ($900,000), and 14% ($750,000) of the Company's revenues. In
1994, three unaffiliated customers accounted for approximately 67% ($3,430,000),
14% ($710,000), 12% ($624,000) of the Company's revenues.

Export sales principally to Canada and France were $1,115,000, $1,400,000 and
$1,530,000 in 1996, 1995, and 1994, respectively.


                                       51
<PAGE>   52

12. SUBSEQUENT EVENTS

In January 1997, the Company announced it entered into a co-promotion agreement
with a division of Merck KGaA (Merck), under which it will sell two of Merck's
topical products in the U.S. The companies will share profits according to their
respective co-promotion efforts.

On March 4, 1997, the Company announced it had signed an agreement to sell
752,000 shares of its common stock to institutional investors in a private
placement. The net proceeds to the Company are estimated to be approximately
$9.0 million. The closing of the transaction is conditioned upon the
effectiveness of a registration statement filed by the Company to allow the
public resale of the shares.


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

    Coopers & Lybrand L.L.P. performed the audit of the Company's financial
statements from inception through the Company's fiscal year ended December 31,
1994. The Company informed Coopers & Lybrand L.L.P. on April 17, 1995 that the
Company would no longer engage Coopers & Lybrand L.L.P. as principal accountants
to audit the company's financial statements. These actions were taken with the
approval of the Board on the recommendation of the Audit Committee of the Board.
In connection with the audit of the Company's statement of operations,
shareholders' equity and cash flows for the year ended December 31 1994, and in
the subsequent interim period, there were no disagreements between the Company
and Coopers & Lybrand L.L.P. regarding matters of accounting principles or
practices, financial statement disclosure or auditing scope or procedures which
if not resolved to the satisfaction of Coopers & Lybrand L.L.P. would have
caused Coopers & Lybrand L.L.P. to make reference to the matters in its report.
The report of Coopers & Lybrand L.L.P. on the Company's financial statements for
the fiscal years ended December 31, 1993 and 1994 contained no adverse opinion
or disclaimer of opinion and was not qualified or modified as to uncertainty,
audit scope or accounting principle. The Company had not consulted with Ernst &
Young LLP during the two years ended December 31, 1994 or the subsequent interim
period prior to April 17, 1995 on either the application of accounting
principles or type of opinion Ernst & Young LLP might issue on the Company's
financial statements.


                                       52
<PAGE>   53

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

         The executive officers, key employees and directors of the Company and
their ages as of February 28, 1997 are as follows:

<TABLE>
<CAPTION>
                Name                      Age                   Position with the Company
                ----                      ---                   -------------------------
<S>                                        <C>    <C>
Lloyd H. Malchow....................       43     Director, President and Chief Executive Officer
John W. Quigley, Jr., Ph.D..........       56     Senior Vice President, Research and Development
William T. Gutshall.................       53     Vice President, Operations
Edward Ebbers.......................       39     Vice President, Sales and Marketing
David E. Collins....................       62     Chairman of the Board
Robert F. Allnutt...................       61     Director
William I. Bergman..................       65     Director
Mark J. Gabrielson..................       41     Director
Terry L. Opdendyk...................       49     Director
Harvey S. Sadow, Ph.D...............       74     Director
Gerald D. Weinstein, M.D............       60     Director
</TABLE>

         There is no family relationship between any of the directors or
executive officers of the Company.

         MR. MALCHOW has served as President, Chief Executive Officer and a
director of the Company since January 1995. Prior to that, he served as the
Company's President and Chief Operating Officer from May 1993 through January
1995. He was the Vice President and General Manager of the Herbert Skin Care
Division of Allergan, Inc. from 1992 to May 1993. From 1983 to 1991 Mr. Malchow
held various positions, including Vice President, Sales of Allergan Medical
Optics (formerly American Medical Optics prior to acquisition by Allergan in
1985) and, most recently, Vice President for Global Development, Skin Care. He
holds a B.A. from Carroll College, a M.A. from the University of Maryland and a
M.B.A. from Pepperdine University.

         DR. QUIGLEY has served as Senior Vice President, Research and
Development since July 1996. From November 1987 to July 1996 he served as the
Company's Vice President, Research and Development. After 16 years in research
and management at Procter & Gamble Co., a consumer products company, he joined
Bristol Myers Co., a pharmaceuticals and toiletries company, in 1984 as Director
of Preclinical Research, Dermatology, a position he held until joining Penederm.
From 1984 through 1987 he also served as an adjunct professor in the Department
of Dermatology at the State University of New York, Buffalo. Dr. Quigley holds a
B.S. degree in Chemistry, an M.S. in Plant Biochemistry and Physiology and a
Ph.D. in Biochemistry from Rutgers University and was a post-doctoral fellow at
the University of Pennsylvania School of Medicine.

         MR. GUTSHALL has served as Vice President of Operations since April
1993. Prior to managing his own consulting business from 1990 to 1993, he served
as Vice President of Global Operations form 1986 to 1989 for the Optometric
Division of CooperVision, Inc., a former opthalmologic products subsidiary of
the Cooper Companies, Inc. From 1970 to 1985, he held various operations
management positions with Johnson & Johnson, a health care company, the last
being Director of Purchasing and Contract Manufacturing. Mr. Gutshall holds a
B.S. degree from East Central State University.

         MR. EBBERS has served as Vice President of Sales and Marketing since
April 1996. From November 1994 to April 1996 he served as Director of Marketing
for the Company. From 1987 to 1994, Mr. Ebbers held various management positions
with Syntex Laboratories, the last being Group Product Director. From 1979 to
1987, he served in several capacities for a subsidiary of Minnesota Mining and
Manufacturing Company, Riker Laboratories, Inc. (now known as 3M Pharmaceuticals
Division). Mr. Ebbers holds a B.B.A. from the University of Wisconsin and an
M.B.A. in Information Systems from the University of Minnesota, Minneapolis.

         MR. COLLINS was appointed Chairman of the Board of the Company
effective January 1, 1997 and served as a director since December 1994. From
1989 to October 1994, Mr. Collins was an Executive Vice President of Schering


                                       53
<PAGE>   54

Plough Corporation and President of its Healthcare Products Division. Prior to
that, he worked for Johnson & Johnson for 26 years in various capacities and was
a member of its executive committee from 1982 through 1988. Mr. Collins has
served as Chairman of the Council on Family Health and of the Non-Prescription
Drug Manufacturers Association. Mr. Collins is a director of Calypte Biomedical,
a prescription diagnostic company, Lander, Inc., a private consumer products
company, MGI Pharma, a public pharmaceutical company, and Scandipharm, a private
pharmaceutical company.

         MR. ALLNUTT has been a director of the Company since May 1996. Since
February 1995 Mr. Allnutt has been a Senior Counselor at APCO Associates, a
public relations firm. From 1985 to 1995 he was the Executive Vice President of
the Pharmaceutical Manufacturers Association (now PhRMA), a trade association
representing multinational research based pharmaceutical companies. Prior to
that, he served for 25 years in a variety of positions with the Federal
government, including Associate Deputy Administrator for NASA, Assistant
Administrator of the Energy Research and Development Administration, Staff
Director of the United States Senate Committee on Aeronautics and Space and
Associate General Counsel of the United States Commission on Government
Procurement. Mr. Allnutt is a director of Cortex Pharmaceuticals, Inc. a
development stage neuroscience company, and Cypros Pharmaceuticals, Inc., a
drug and diagnostic product company.

         MR. BERGMAN has been a director of the Company since March 1991. Mr.
Bergman served in various positions with Richardson-Vicks Inc., a personal care
products company, from 1952 until he retired in 1990. After Procter & Gamble Co.
acquired Richardson-Vicks Inc., he served as President of Richardson-Vicks
U.S.A. and Vice President of Procter & Gamble Co. until his retirement. Mr.
Bergman is the President and a past Chairman of the Council on Family Health and
is a past Chairman of the Nonprescription Drug Manufacturers Association. Mr.
Bergman is a director of ZymeTx Inc.

        MR. GABRIELSON has been a director of the Company since May 1996. Since
1995, he has served as President of Access Management Services, Inc., a medical
technology sourcing, transfer and corporate development firm. In addition, since
January 1991 Mr. Gabrielson has been a general partner of Prince Ventures, L.P.,
a venture capital management firm that serves as the general partner of Prince
Venture Partners III, L.P. ("Prince"). In addition, Mr. Gabrielson is the
President of Pharmaply, Inc., Chairman of Strategic Marketing Information, Inc.,
and Chairman of ONTYX, Inc., all private companies. Prior to joining Prince, Mr.
Gabrielson served in a variety of marketing and business positions with
SmithKline since July 1978. Mr. Gabrielson is also a director of Inhale
Therapeutic Systems, Inc., a drug delivery company.

         MR. OPDENDYK has been a director of the Company since inception and
served as Chairman of the Board from January 1995 through December 1996. He
served as Treasurer and Secretary of the Company from inception until March
1992. Mr. Opdendyk has been a general partner of the general partner of ONSET
Enterprise Associates, L.P. ("OEA"), a venture capital limited partnership,
since 1989; a general partner of the general partner of ONSET, A California
Limited Partnership ("ONSET"), a venture capital limited partnership, since
1984; a special limited partner of the general partner of New Enterprise
Associates V, Limited Partnership, a venture capital limited partnership, since
1990; a special limited partner of the general partner of New Enterprise
Associates VI, Limited Partnership, a venture capital limited partnership, since
1993; and a general partner of the general partner of ONSET Enterprise
Associates II, L.P., a venture capital limited partnership, since 1994. He
serves as Chairman of the Board of Inhale Therapeutic Systems, Inc., a drug
delivery company.

         DR. SADOW has been a director of the Company since February 1990. He
was President and Chief Executive Officer of Boehringer Ingelheim Corporation, a
health care company, from 1971 to 1988 and of Boehringer Ingelheim
Pharmaceuticals, Inc., an ethical specialty pharmaceutical company, from 1984 to
1988. In 1988, he became Chairman of the Board of both Boehringer Ingelheim
Corporation and Boehringer Ingelheim Pharmaceuticals. He retired as Chairman of
the Board of both companies in 1990 and continued serving as a director of both
companies until 1993. Dr. Sadow is also the Chairman of the Board of Cortex
Pharmaceuticals, Inc., a development stage neuroscience company, and Cholestech
Corporation, a medical diagnostics company, and a director of Anika Research
Corp., a hyaluronic acid research company, Houghton Pharmaceuticals Inc., a drug
discovery company and several privately-held health care related companies. Dr.
Sadow served as a director of Telios Pharmaceuticals Inc., a drug and medical
products


                                       54
<PAGE>   55

company, from 1989 to 1995. Dr. Sadow served as the President of the
Connecticut Academy of Science and Engineering.

         DR. WEINSTEIN is a founder of the Company and has been a director since
inception. He is a co-inventor of the technology underlying the Company's
TopiCare Delivery Compounds. Dr. Weinstein has been the Chairman of the
Department of Dermatology at the University of California, Irvine, College of
Medicine since 1979. Dr. Weinstein is a staff member at the University of
California, Irvine Medical Center, the Veterans Administration Hospital in Long
Beach, California and the Irvine Medical Center. Dr. Weinstein received a B.A.
from the University of Pennsylvania and a M.D. from the University of
Pennsylvania School of Medicine.



ITEM 11.  EXECUTIVE COMPENSATION

         The following table sets forth the total compensation for the fiscal
years ended December 31, 1994, 1995 and 1996 of the Chief Executive Officer and
each of the executive officers of the Company who served as executive officers
at fiscal year end. None of the named executive officers earned any bonuses or
compensation for the fiscal years other than as set forth in the table or
received any restricted stock awards, stock appreciation rights or long-term
incentive plan payouts.


         SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                                              Annual Compensation           Long-Term           Other
                                              Fiscal        ----------------------        Compensation       Compensation
       Name and Principal Position              Year        Salary($)      Bonus($)         Options(#)           (1)
----------------------------------------      -------       -----------------------       ------------       ------------
<S>                                             <C>          <C>            <C>             <C>                 <C>  
Lloyd H. Malchow........................        1996         204,555        50,222          155,000             4,492
  President, Chief Executive Officer            1995         195,000        21,840           22,000             4,493
  and Director                                  1994         178,549        33,469           25,000             3,500

John W. Quigley, Jr., Ph.D..............        1996         167,349        16,334           49,500             4,492
  Vice President, Research and                  1995         161,340        11,697            9,000             4,493
  Development                                   1994         150,785        25,445               --             3,013

Edgar A. Luce...........................        1996         139,055        13,110           18,000             4,170
  Vice President, Finance and                   1995         127,147        10,807            7,600             3,811
  Administration, Treasurer and                 1994         118,782        17,871            5,000             2,444
  Secretary (2)

Edward Ebbers...........................        1996         127,109        18,565           37,000             3,812
  Vice President, Sales & Marketing             1995         112,000         6,272            6,625             3,356
                                                1994          16,969            --            7,500                --

William Gutshall........................        1996         115,664        15,910           27,000             2,314
  Vice President, Operations                    1995         109,419         7,440           21,000             2,184
                                                1994         100,875            --            5,000                --
</TABLE>

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

(1)      This column includes the value of the shares of Common Stock
         contributed by the Company to each executive officer's 401(k) account
         under the Penederm Incorporated 401(k) Plan. The shares are contributed
         on the last trading date of the year and the number of shares
         contributed was based on the closing price of the Common Stock on that
         date.

(2)      Mr. Luce's employment with the Company terminated on December 31, 1996.


                                       55
<PAGE>   56

         The following table sets forth certain information regarding grants of
stock options made during the fiscal year ended December 31, 1996 to the
executive officers named in the Summary Compensation Table. Since inception, the
Company has not granted any stock appreciation rights.


                        OPTION GRANTS IN LAST FISCAL YEAR

<TABLE>
<CAPTION>
                                                       Individual Grants                             Potential
                                  ---------------------------------------------------------          Realizable
                                                                                                 Value at Assumed
                                       Options       % of Total     Exercise     Expiration        Annual Rates
                                                       Options        Price                       of Stock Price
                                                       Granted                                   Appreciation For
                                                    to Employees                                  Option Term(4)
                                                      in Fiscal                               ---------------------
              Name                  Granted(#)(1)      Year(2)       ($/sh)        Date(3)      5% ($)      10% ($)
-------------------------------   ---------------  --------------  ----------  -------------  ---------   ---------
<S>                               <C>              <C>             <C>         <C>            <C>         <C>
Lloyd H. Malchow...............            50,000          12.0 %     $16.875     5/14/06        530,629   1,344,720
                                           30,000           7.1 %     $  6.25     8/14/06        117,918     298,826
                                           75,000          18.0 %     $12.375    12/31/06        583,692   1,479,192
                                  ---------------- ---------------                            ----------- -----------
                                          155,000          37.1 %                              1,232,240   3,122,739

John W. Quigley, Jr., Ph.D. ...            18,000           4.3 %     $16.875     5/14/06        191,027     484,099
                                            9,000           2.1 %     $  6.25     8/14/06         35,375      89,648
                                           22,500           5.4 %     $12.375    12/31/06        175,108     443,758
                                  ---------------- ---------------                            ----------- -----------
                                           49,500          11.8 %                                401,510   1,017,505

Edgar A. Luce..................            12,000           2.9 %     $16.875     5/14/06        127,351     322,733
                                            6,000           1.4 %     $  6.25     8/14/06         23,584      59,765
                                  ---------------- ---------------                            ----------- -----------
                                           18,000           4.3 %                                150,935     382,498

Edward Ebbers..................            16,000           3.8 %     $ 13.25      3/4/06        133,326     337,873
                                            6,000           1.5 %     $  6.25     8/14/06         23,584      59,765
                                           15,000           3.6 %     $12.375    12/31/06        116,739     295,838
                                  ---------------- ---------------                            ----------- -----------
                                           37,000           8.9 %                                273,649     693,477

William Gutshall...............             6,000           1.4 %     $16.875     5/14/06         63,676     161,366
                                            6,000           1.4 %     $  6.25     8/14/06         23,583      59,765
                                           15,000           3.6 %     $12.375    12/31/06        116,739     295,838
                                  ---------------- ---------------                            ----------- -----------
                                           27,000           6.5 %                                203,998     516,970
</TABLE>

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

(1)      The options included in this table are all immediately exercisable, but
         the shares issuable upon option exercise are subject to a right of
         repurchase by the Company upon employment termination, which right of
         repurchase expires over a period of five years.

(2)      The total number of options granted to the Company's employees during
         fiscal year 1996 was 417,793.

(3)      The options are subject to earlier expiration in the event of the
         officer's termination of employment with the Company.

(4)      Potential realizable value is based on an assumption that the market
         price of the stock appreciates at the stated rate, compounded annually,
         from the date of grant until the end of the ten-year option term. These
         values are calculated based on requirements promulgated by the
         Securities and Exchange Commission and do not reflect the Company's
         estimate of future stock price appreciation.


                                       56
<PAGE>   57

         The following table sets forth certain information regarding exercises
of stock options during the fiscal year ended December 31, 1996 to the executive
officers named in the Summary Compensation Table. Value realized is considered
to be the difference between exercise price and market price on the date of
exercise. Value of unexercised options is considered to be the difference
between exercise price and market price of $12.375 per share on December 31,
1996.


               AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND
                          FISCAL YEAR END OPTION VALUES

<TABLE>
<CAPTION>
                                                                                             Value of
                                                                     Number of             Unexercised
                                                                    Unexercised            In-the-Money
                                                                    Options at             Options at
                                                                    Fiscal Year            Fiscal Year
                                        Shares                         End(#)                 End($)
                                       Acquired       Value
                                     on Exercise     Realized       Exercisable/           Exercisable/
Name                                     (#)           ($)        Unexercisable(1)        Unexercisable(1)
------------------------------       -----------     --------   -------------------      ------------------
<S>                                <C>             <C>          <C>                      <C>
Lloyd H. Malchow..............                --           --            302,000/--              844,019/--
John W. Quigley, Jr., Ph.D....            22,500      312,750            120,944/--              602,109/--
William Gutshall..............                --           --             58,000/--               87,050/--
Edward Ebbers.................             1,750       15,531             49,375/--               12,914/--
Edgar A. Luce.................                --           --             34,160/--              393,150/--
</TABLE>

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

(1)      The options included in this table are all immediately exercisable, but
         the shares issuable upon option exercise are subject to a right of
         repurchase by the Company upon employment termination, which right of
         repurchase expires over a period of time or upon achievement of certain
         milestones. At December 31, 1996, the number of shares subject to
         repurchase under these options and their value were as follows: Mr.
         Malchow -- 216,167 shares having a value of $652,106; Dr. Quigley --
         65,793 shares having a value of $173,041; Mr. Gutshall -- 45,417 shares
         having a value of $160,074, and Mr. Ebbers -- 44,701 shares having a
         value of $84,836.

         The Company did not make any awards during the fiscal year ended
December 31, 1996 to any of the executive officers named in the Summary
Compensation Table under any long-term incentive plan providing compensation
intended to serve as incentive for performance to occur over a period longer
than one fiscal year, excluding stock options.


                                       57
<PAGE>   58

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The following table sets forth certain information regarding beneficial
ownership of the Common Stock as of February 28, 1997, (i) by each person who is
known by the Company to own beneficially more than 5 percent of the Common
Stock, (ii) by each of the Company's directors, (iii) by each of the Company's
executive officers named in the Summary Compensation Table under the caption
"Executive Compensation" below and (iv) by all directors and executive officers
as a group.

<TABLE>
<CAPTION>
                                      Name                                              Number              Percentage
--------------------------------------------------------------------------------       of Shares             of Shares
                                                                                     Beneficially           Beneficially
                                                                                       Owned(1)             Owned(1)(2)
                                                                                       --------             -----------
<S>                                                                                  <C>                    <C>  
SAFECO ASSET MANAGEMENT AND SAFECO CORPORATION (3)..............................         1,111,467             15.2%
   Safeco Plaza
   Seattle, Washington 98185
SAFECO COMMON STOCK TRUST (4)...................................................           763,600             10.4%
   Safeco Plaza
   Seattle, Washington 98185
FRANKLIN RESOURCES, INC. (5)....................................................           653,500              8.9%
   777 Mariners Island Blvd.
   San Mateo, California 94404
      Charles B. Johnson........................................................           653,500              8.9%
      Rupert H. Johnson, Jr.....................................................           653,500              8.9%
      Franklin Advisors, Inc....................................................           653,500              8.9%
S-E-BANKEN FONDER...............................................................           585,100              8.0%
   Jakobsbergsgatan 17
   Stockholm
   Sweden
Mark J. Gabrielson (6)..........................................................           341,591              4.7%
Lloyd H. Malchow(7).............................................................           302,000              4.0%
John W. Quigley, Jr., Ph.D.(8)..................................................           152,881              2.1%
William Gutshall(9).............................................................            58,000                 *
Edward Ebbers(10)...............................................................            49,375                 *
Gerald D. Weinstein, M.D.(11)...................................................            49,250                 *
Terry L. Opdendyk(12)...........................................................            44,061                 *
David E. Collins(13)............................................................            32,500                 *
William I. Bergman(14)..........................................................            17,500                 *
Harvey S. Sadow, Ph.D.(15)......................................................            20,000                 *
Robert F. Allnutt (16)..........................................................             8,500                 *
All directors and executive officers as a group (11 persons)(17)................         1,075,658             13.5%
</TABLE>

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

*        Less than one percent.


(1)      This table is based upon information supplied by directors, officers
         and certain principal shareholders, as well as information included in
         Securities and Exchange Commission filings made by principal
         shareholders and other third party sources. Unless otherwise indicated
         in the footnotes to this table and subject to the community property
         laws where applicable, each of the shareholders named in this table has
         sole voting and investment power with respect to the shares shown.
         Percentage of ownership is based on 7,324,195 shares of Common Stock
         outstanding as of February 28, 1997.

(2)      Shares issuable upon exercise of outstanding options are considered
         outstanding for purposes of calculating the percentage of Common Stock
         of the person holding such options, but are not deemed outstanding for
         computing the percentage of ownership of any other person.

(3)      SAFECO Common Stock Trust reports shared voting and dispositive power
         for the shares shown.

(4)      SAFECO Asset Management Company and SAFECO Corporation indicate shared
         voting and dispositive power and disclaim beneficial ownership of the
         shares shown, reporting that the shares are owned by registered
         investment companies for which they serve as advisor.


                                       58
<PAGE>   59

(5)      Subject to a Common Stock Purchase Agreement dated March 3, 1997,
         Franklin Resources Inc. has agreed to acquire an additional 530,000
         shares of common stock to be held in four equity mutual funds.

(6)      Includes 334,091 shares held by Prince Venture Partners III, L.P. and
         7,500 shares issuable upon exercise of outstanding options. Mr.
         Gabrielson in the general partner of Prince Ventures and the general
         partner of Prince Venture Partners III, L.P.

(7)      Includes 302,000 shares issuable upon exercise of outstanding options;
         99,582 of such shares are not subject to repurchase on or after April
         30, 1997.

(8)      Includes 120,944 shares issuable upon exercise of outstanding options;
         59,776 of such shares are not subject to repurchase on or after April
         30, 1997.

(9)      Includes 58,000 shares issuable upon exercise of outstanding options;
         15,582 of such shares are not subject to repurchase on or after April
         30, 1997.

(10)     Includes 49,375 shares issuable upon exercise of outstanding options;
         7,574 of such shares are not subject to repurchase on or after April
         30, 1997.

(11)     Includes 17,500 shares issuable upon exercise of outstanding options,
         10,000 of such shares are not subject to repurchase on or after April
         30, 1997.

(12)     Includes 17,500 shares issuable upon exercise of outstanding options,
         10,000 of such shares are not subject to repurchase on or after April
         30, 1997.

(13)     Includes 17,500 shares issuable upon exercise of outstanding options,
         5,000 of such shares are not subject to repurchase on or after April
         30, 1997.

(14)     Includes 25,000 shares issuable upon exercise of outstanding options,
         17,500 of such shares are not subject to repurchase on or after April
         30, 1997..

(15)     Includes 17,500 shares issuable upon exercise of outstanding options,
         10,000 of such shares are not subject to repurchase on or after April
         30, 1997.

(16)     Includes 7,500 issuable upon exercise of outstanding options..

(17)     Includes 635,319 shares issuable upon exercise of outstanding options;
         231,406 of such shares are not subject to repurchase on or after April
         30, 1997.



ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS


         Dr. Quigley, Senior Vice President, Research and Development of the 
Company, borrowed $125,000 from the Company under a promissory note dated 
June 15, 1990. The promissory note bears simple interest at the rate of 8.82 
percent per annum, payable quarterly, and matures upon the earlier of (i) 
demand by the Company, which demand may be made at any time after June 15, 
1992, or (ii) termination of Dr. Quigley's employment with the Company. The 
loan is collateralized by stock options with a value equal to the loan.


                                       59
<PAGE>   60
                                     PART IV

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

(a)1.    FINANCIAL STATEMENTS.

         Included in Part II of this report.

(a)2.    FINANCIAL STATEMENT SCHEDULES.

         All schedules have been omitted because the required information is not
present or is not present in amounts sufficient to require submission of the
schedule, or because the information required is included in the consolidated
financial statements, including the notes thereto.

(a)3.    EXHIBITS:
       
     3.1        (1)     Restated Articles of Incorporation
     3.2        (1)     Amended and Restated By-Laws
     4.1        (1)     Specimen Common Stock Certificate
     10.1A      (2)     Employee Stock Option Plan, as amended
     10.1B      (2)     Consultant Stock Option Plan, as amended
     10.1C      (2)     Equity Incentive Plan
     10.1D      (2)     1994 Nonemployee Directors Stock Option Plan
     10.3       (1)     Employment Agreement dated May 10, 1993 between the
                        Company and Lloyd H. Malchow
     +10.4B     (1)     Incentive Stock Option Agreement dated September 12,
                        1991 between the Company and John W. Quigley, Jr., as
                        amended February 25, 1993
     +10.4D     (1)     Incentive Stock Option Agreement dated September 12,
                        1991 between the Company and Edgar A. Luce, as
                        amended February 25, 1993
     +10.4J     (3)     1995 Performance Share Award Agreement - Lloyd H.
                        Malchow
     +10.4K     (3)     1995 Performance Share Award Agreement - John W. Quigley
     +10.4L     (3)     1995 Performance Share Award Agreement - Edgar A. Luce
     +10.4N     (4)     1995 Performance Share Award Agreement - William 
                        Gutshall
     +10.4O     (5)     1996 Performance Share Award Agreement - Lloyd H.
                        Malchow
     +10.4P     (5)     1996 Performance Share Award Agreement - John W. Quigley
     +10.4Q     (5)     1996 Performance Share Award Agreement - Edgar A. Luce
     +10.4R     (5)     1996 Performance Share Award Agreement - William
                        Gutshall
     10.4S              Form of 1997 Performance Share Award Agreement between

                                       60
<PAGE>   61
                        the Company and each of Lloyd H. Malchow, John W. 
                        Quigley, William Gutshall and Edward Ebbers
     10.5A      (1)     Nonqualified Stock Option Agreement dated March 14, 1991
                        between the Company and William I. Bergman
     10.5B      (1)     Nonqualified Stock Option Agreement dated September 12,
                        1991 between the Company and William I. Bergman
     10.6       (1)     Information and Registration Rights Agreement dated June
                        1, 1988, as amended through September 4, 1991
     10.7       (1)     License Agreement, effective April 27, 1988, between the
                        Company and the Regents of the University of California
     10.8       (1)     Research and Development Lease dated December 14, 1988,
                        as amended through February 1, 1991 between the Company
                        and Vintage Park Associates
     10.8B      (3)     Amendment No. 4 to Vintage Park Research and Development
                        Lease dated September 30, 1994, between the Company and
                        Vintage Park Associates 
     23.1               Consent of Ernst & Young LLP, Independent Auditors 
     23.2               Consent of Coopers & Lybrand L.L.P., Independent
                        Accountants
     24.1               Power of Attorney (see pages 62-63)
     27.1               Financial Data Schedule
---------------

(1)      Incorporated by reference to exhibits of the same number to
         Registration Statement on Form S-1 (No. 33-67950) effective November 2,
         1993.

(2)      Incorporated by reference to exhibits to Registration Statement on Form
         S-8 (No. 33-76100) filed on March 4, 1994.

(3)      Incorporated by reference to Exhibits to Annual Report on Form 10-K for
         the Fiscal Year Ended December 31, 1994.

(4)      Incorporated by reference to Exhibits to Quarterly Report on Form 10-Q
         for the Quarter Ended June 30, 1995.

(5)      Incorporated by reference to Exhibits to Annual Report on Form 10-K for
         the Fiscal Year Ended December 31, 1995.

+ Confidential treatment requested.

(b) REPORTS ON FORM 8-K:

         Current Report on Form 8-K dated November 20, 1996 filed on November
         27, 1996 regarding adoption of Rights Agreement.

                                       61
<PAGE>   62
                                   SIGNATURES

  Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant, Penederm Incorporated, a corporation organized and
existing under the laws of the State of California, has duly caused this report
to be signed on its behalf by the undersigned thereunto duly authorized, in the
City of Foster City, State of California, on the 13th day of March, 1997.

                                       PENEDERM INCORPORATED


                                       By  /s/  Lloyd H. Malchow
                                          --------------------------------------
                                          Lloyd H. Malchow
                                          President and Chief Executive Officer

                               POWERS OF ATTORNEY

  KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Lloyd H. Malchow and Michael A. Bates, jointly
and severally, his attorneys-in-fact, each with the power of substitution, for
him in any and all capacities, to sign any amendments to this Annual Report on
Form 10-K and to file the same, with exhibits thereto and other documents in
connection therewith, with the Securities and Exchange Commission, hereby
ratifying and confirming all that each of said attorneys-in-fact, or his
substitute or substitutes, may do or cause to be done by virtue hereof.

  Pursuant to the requirements of the Securities Exchange Act of 1934, this
Annual Report on Form 10-K has been signed below by the following persons on
behalf of the Registrant and in the capacities and on the dates indicated.


<TABLE>
<CAPTION>
                   SIGNATURE                   TITLE                                             DATE
                   ---------                   -----                                             ----


<S>                                                                                               <C> 
           /s/ Lloyd H. Malchow                Director, President and Chief Executive            March 13, 1997
      -----------------------------------------
               Lloyd H. Malchow                Officer (Principal Executive and Financial
                                               Officer)

           /s/ Michael A. Bates                Director of Finance and Administration             March 13, 1997
      -----------------------------------------
               Michael A. Bates                (Principal Accounting Officer)


           /s/ Robert F. Allnutt               Director                                           March 13, 1997
      -----------------------------------------
               Robert F. Allnutt
</TABLE>

                                       62
<PAGE>   63
<TABLE>
<S>                                                                                              <C>

          /s/ William I. Bergman               Director                                           March 13, 1997
      -----------------------------------------
              William I. Bergman


           /s/ David E. Collins                Chairman of the Board                              March 13, 1997
      -----------------------------------------
               David E. Collins


          /s/ Mark J. Gabrielson               Director                                           March 13, 1997
      -----------------------------------------
              Mark J. Gabrielson


           /s/ Terry L. Opdendyk               Director                                           March 13, 1997
      -----------------------------------------
               Terry L. Opdendyk


        /s/ Harvey S. Sadow, Ph.D.             Director                                           March 13, 1997
      -----------------------------------------
            Harvey S. Sadow, Ph.D.


                                               Director                                           March __, 1997
      -----------------------------------------
           Gerald D. Weinstein, M.D.
</TABLE>


                                       63
<PAGE>   64



                                INDEX TO EXHIBITS

<TABLE>
<CAPTION>
                                                                                                     SEQUENTIALLY
       EXHIBIT                                                                                         NUMBERED
         NO.                        DESCRIPTION                                                         PAGES
         ---                        -----------                                                         -----
<S>                     <C>                                                                             <C> 
     3.1        (1)     Restated Articles of Incorporation
     3.2        (1)     Amended and Restated By-Laws
     4.1        (1)     Specimen Common Stock Certificate
     10.1A      (2)     Employee Stock Option Plan, as amended
     10.1B      (2)     Consultant Stock Option Plan, as amended
     10.1C      (2)     Equity Incentive Plan
     10.1D      (2)     1994 Nonemployee Directors Stock Option Plan
     10.3       (1)     Employment Agreement dated May 10, 1993 between the Company and Lloyd
                        H. Malchow
     +10.4B     (1)     Incentive Stock Option Agreement dated September 12, 1991 between the
                        Company and John W. Quigley, Jr., as amended February 25, 1993
     +10.4D     (1)     Incentive Stock Option Agreement dated September 12, 1991 between the
                        Company and Edgar A. Luce, as amended February 25, 1993
     +10.4J     (3)     1995 Performance Share Award Agreement - Lloyd H. Malchow
     +10.4K     (3)     1995 Performance Share Award Agreement - John W. Quigley
     +10.4L     (3)     1995 Performance Share Award Agreement - Edgar A. Luce
     +10.4N     (4)     1995 Performance Share Award Agreement - William Gutshall
     +10.4O     (5)     1996 Performance Share Award Agreement - Lloyd H. Malchow
     +10.4P     (5)     1996 Performance Share Award Agreement - John W. Quigley
     +10.4Q     (5)     1996 Performance Share Award Agreement - Edgar A. Luce
     +10.4R     (5)     1996 Performance Share Award Agreement - William Gutshall
     10.4S              Form of 1997 Performance Share Award Agreement between the Company
                        and each of Lloyd H. Malchow, John W. Quigley, William Gutshall and
                        Edward Ebbers
     10.5A      (1)     Nonqualified Stock Option Agreement dated March 14, 1991 between the
                        Company and William I. Bergman
     10.5B      (1)     Nonqualified Stock Option Agreement dated September 12, 1991 between
                        the Company and William I. Bergman
     10.6       (1)     Information and Registration Rights Agreement dated June 1, 1988, as
                        amended through June 4, 1991
     10.7       (1)     License Agreement, effective April 27, 1988, between the Company and
                        the Regents of the University of California
     10.8       (1)     Research and Development Lease dated December 14, 1988, as amended
                        through February 1, 1991 between the Company and Vintage Park
                        Associates
     10.8B      (3)     Amendment No. 4 to Vintage Park Research and Development Lease dated
                        September 30, 1994, between the 
</TABLE>

                                       64
<PAGE>   65
<TABLE>
<S>                     <C>

                        Company and Vintage Park Associates
     23.1               Consent of Ernst & Young LLP, Independent Auditors
     23.2               Consent of Coopers & Lybrand L.L.P., Independent Accountants
     24.1               Power of Attorney (see pages 62-63)
     27.1               Financial Data Schedule
</TABLE>
        ---------------

(1)      Incorporated by reference to exhibits of the same number to
         Registration Statement on Form S-1 (No. 33-67950) effective November 2,
         1993.

(2)      Incorporated by reference to exhibits to Registration Statement on Form
         S-8 (No. 33-76100) filed on March 4, 1994.

(3)      Incorporated by reference to Exhibits to Annual Report on Form 10-K for
         the Fiscal Year Ended December 31, 1994.

(4)      Incorporated by reference to Exhibits to Quarterly Report on Form 10-Q
         for the Quarter Ended June 30, 1995.

(5)      Incorporated by reference to Exhibits to Annual Report on Form 10-K for
         the Fiscal Year Ended December 31, 1995.

+ Confidential treatment requested.



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