<PAGE>   1
                       SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549

                                    FORM 10-K

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

[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 0-22332

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

      Delaware 94-3015807
   (State or other jurisdiction of                           (I.R.S. Employer
   incorporation or organization)                            Identification No.)

                               965 Atlantic Avenue
                                Alameda, CA 94501
          (Address of Principal Executive Offices, including Zip Code)

       Registrant's telephone number, including area code: (510) 865-8800

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

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

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

                          Common Stock, $.01 Par Value

         Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities 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 the 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 Common Stock, $.01 par value, held by
non-affiliates of the registrant as of January 31, 1997: $64,140,520 (based upon
the closing sale price of the Common Stock on January 31, 1997). Number of
shares of Common Stock, $.01 par value, outstanding as of January 31, 1997:
12,936,400.

                       DOCUMENTS INCORPORATED BY REFERENCE

         Designated portions of the following document are incorporated by
reference into this Report on Form 10-K where indicated: portions of the Proxy
Statement for the registrant's 1997 Annual Meeting of Stockholders to be held on
or about June 2, 1997 are incorporated by reference into Part III.


<PAGE>   2






                           ANNUAL REPORT ON FORM 10-K
                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996

                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                                                             Page
                                                                                                             ----
<S>                                                                                                             <C>
PART I
          Item 1.   Business..................................................................................  1
          Item 2.   Properties................................................................................ 22
          Item 3.   Legal Proceedings......................................................................... 22
          Item 4.   Submission of Matters to a Vote of Security Holders....................................... 22

PART II
          Item 5.   Market for Registrant's Common Equity and Related Stockholder Matters..................... 23
          Item 6.   Selected Financial Data................................................................... 24
          Item 7.   Management's Discussion and Analysis of Financial Condition and Results
                    of Operations............................................................................. 25
          Item 8.   Financial Statements and Supplementary Data............................................... 27
          Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial
                    Disclosure................................................................................ 38

PART III
          Item 10   Directors and Executive Officers of the Registrant........................................ 38
          Item 11.  Executive Compensation.................................................................... 38
          Item 12.  Security Ownership of Certain Beneficial Owners and Management............................ 38
          Item 13.  Certain Relationships and Related Transactions............................................ 38

PART IV
          Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K........................... 38
</TABLE>


<PAGE>   3


                                     PART I

ITEM 1.  BUSINESS

         Except for the historical information contained herein, the discussion
in this Annual Report on Form 10-K contains certain forward-looking statements
that involve risks and uncertainties, such as statements of the Company's plans,
objectives, expectations and intentions. The cautionary statements made in this
document should be read as applicable to all related forward-looking statements
wherever they appear in this document. The Company's actual results could differ
materially from those discussed here. Factors that could cause or contribute to
such differences include those discussed below in "Risk Factors," as well as
those discussed elsewhere herein.


                                   THE COMPANY

         InSite Vision Incorporated ("InSite," "InSite Vision" or the "Company")
is focused on the development of ophthalmic pharmaceutical products based on its
proprietary DuraSite(R) drug delivery technology and on the development of
genetically based tools for the diagnosis and prognosis of glaucoma.
DuraSite-based products are designed to improve the safety and efficacy of
existing ophthalmic products, and may expand the ophthalmic pharmaceutical
market by permitting the novel use of drugs for ophthalmic indications that are
currently used or being developed for non-ophthalmic indications. Moreover, the
Company believes its drug delivery technology may improve patient compliance,
comfort and convenience by reducing dosage frequency, concentration and adverse
side effects. InSite's products under development are intended to address a
broad spectrum of ocular indications including glaucoma, inflammation and
infection.

         The DuraSite delivery system is a patented eye drop formulation
comprising a cross-linked carboxyl containing polymer which incorporates the
drug to be delivered to the eye. The eye drop is instilled in the cul-de-sac of
the eye as a small volume eye drop. DuraSite can be customized to deliver a wide
variety of potential drug candidates with a broad range of molecular weights and
other properties. In addition, the DuraSite formulation remains in the eye for
up to several hours during which time the active drug ingredient is gradually
released. DuraSite extends the residence time of the drug due to a combination
of mucoadhesion, surface tension and viscosity. Eye drops delivered in the
DuraSite system contrast to conventional eye drops which typically only last in
the eye a few minutes, thus requiring delivery of a highly concentrated burst of
drug and frequent administration to sustain therapeutic levels. The increased
residence time for DuraSite is designed to permit lower concentrations of a drug
to be administered over a longer period of time, thereby minimizing the
inconvenience of frequent dosing and reducing the potential related adverse side
effects of a highly concentrated dose.

         The first product utilizing the Company's DuraSite technology,
AquaSite(R) dry eye treatment, was launched as an over-the-counter medication in
1992 by CIBA Vision Ophthalmics ("CIBA Vision"), to which the Company has
licensed certain co-exclusive rights. Phase III clinical studies have been
completed for the Company's PilaSite(R) and BetaSite(R) product candidates to
treat glaucoma and in July 1996, the Company licensed certain rights for
PilaSite to Bausch and Lomb Incorporated ("B&L"). As a result of its agreement
with B&L, the Company is preparing a new drug application ("NDA") for PilaSite.

         The Company, as part of its strategy to conserve financial resources
following its restructuring in November 1995, deferred filing "NDAs" for other
product candidates until alliances with one or more corporate partners for these
product candidates are reached and until registration lots necessary to support
such NDA filings have been manufactured. There can be no assurance that the
Company will successfully conclude any further corporate partnership agreements.

         The Company has five additional products in Phase I or Phase II
clinical trials. In addition, InSite is conducting research or preclinical
studies on several proprietary drugs, some of which may have therapeutic
potential for inadequately addressed eye diseases. In connection with such
development efforts, the Company has established collaborations with Pharmacia &
Upjohn, Inc. ("Upjohn") and British 
<PAGE>   4

Biotechnology plc ("British Biotech"), among others. See table on Page 5 for
additional information. MethaSite and ToPreSite have been licensed on a
co-exclusive basis in the U.S. and Canada to CIBA Vision; the use of ISV-205 for
inflammation and analgesia, has been licensed on an exclusive basis in the U.S.
to CIBA Vision; and PilaSite and ISV-208 have been licensed on an exclusive
basis to B&L. The Company is currently in discussions with several potential
partners to out license other product candidates.


OPHTHALMIC PHARMACEUTICAL MARKET

         In 1996, the market for ophthalmic prescription pharmaceuticals in the
U.S. was approximately $1.2 billion. The principal categories of products in the
ophthalmic market are glaucoma treatments, anti-inflammatories, anti-infectives,
surgical adjuncts and artificial tear products.

         The majority of eye diseases are age-related. As a result, the aging of
the population in developed countries is a significant factor which InSite
believes will contribute to increased demand for new ophthalmic pharmaceuticals.
The prevalence of eye disease is ten times greater in persons over the age of 65
than under age 65, and the U.S. Census Bureau projects that the percentage of
the U.S. population over age 65 will increase from 11.3% in 1980 to
approximately 13% by the year 2000.

         In addition to changing demographics, the Company believes that recent
improvements in medical technology, such as increasingly sophisticated
diagnostic techniques, will allow identification of ocular diseases at an
earlier stage, enabling more effective treatment with drug intervention and
expanding the treatment regimens available to the ophthalmologist. Further, the
Company believes that the recent emergence of new laser-based procedures to
correct vision problems may substantially increase the need for comfortable,
extended-release drug therapy during the post-surgical ocular healing process.

         Drug treatment for many prevalent eye problems is inadequate. For
example, there is no effective treatment for the underlying cause of glaucoma,
nor is there any U.S. Food and Drug Administration ("FDA") approved regimens to
prevent the recurrence of pterygia following surgical removal. Further, other
therapeutic indications, such as ocular allergies, are not satisfactorily
addressed by existing drug therapies. The Company believes its drug delivery
technology may improve patient compliance, comfort and convenience by reducing
dosage frequency, concentration and adverse side effects. Additionally, the
Company believes its drug delivery technology may expand the ophthalmic
pharmaceutical market by permitting the novel use of drugs for ophthalmic
indications that are currently used or being developed for non-ophthalmic
indications.


CONVENTIONAL OCULAR DRUG DELIVERY

         The development of a safe, effective and efficient method of drug
delivery is critical in improving existing treatments and developing new
therapies for many diseases of the eye. In order to develop a delivery system,
however, several challenges must be overcome successfully. The cornea has one of
the highest concentrations of sensory nerves in the body, which makes the eye
very sensitive to drug formulation parameters such as pH, tonicity (relative
water and salt balance) and particle size. If a delivery system is not suitably
formulated, the user may experience discomforting sensations of burning,
stinging or presence of foreign bodies.

         The length of time that a drug remains efficacious in the eye has a
significant effect on dosing frequency and patient compliance. This period is
largely regulated by the ability of the drug delivery system to release its
contents over an extended period of time. Tear film in the eye replaces itself
approximately every six minutes and therefore certain delivery systems, such as
conventional eye drops, begin to be drained from the eye immediately after
application, thus requiring frequent application. Studies have shown that an
effective delivery system which can reduce dosing frequency from four to two
times per day may significantly increase patient compliance with prescribed drug
regimens.



                                       2
<PAGE>   5

         Ease of dosing and maintenance of visual acuity are other major issues
in designing an effective drug delivery system for the eye. The primary means of
ophthalmic drug delivery to-date have been conventional eye drops, solid inserts
and ointments containing drugs to be administered. Conventional eye drops and
solid drug releasing inserts can be difficult for patients with vision
impairment or manual dexterity problems to administer. Moreover, InSite believes
that a significant portion of the U.S. population is averse to placing solid
objects, such as inserts, in the eye. In addition, inserts can become dislodged
as a result of normal eye and lid movement and tear flow patterns. This
interrupts therapy and causes inconvenience and discomfort to the user. The
prolonged blurring of vision associated with ointments is also considered
unacceptable for daytime use by active patients.

         Approximately 90% of ophthalmic drugs are currently delivered by means
of a conventional eyedrop administered from a standard dropper bottle. However,
this system suffers from significant limitations. Because the standard eyedrop
is seven times the volume of normal tear film, rapid drainage and overflow
typically occur immediately upon its use. As a result, up to 90% of an eyedrop
can drain before the active drug becomes effective in the eye, and that portion
of the eyedrop that remains is rapidly dispersed, usually within a few minutes.
Eye drops must therefore be administered in frequent doses because they maintain
peak concentration for only a few minutes. As drug development produces a
greater variety of potential therapies for diseases of the eye, the Company
believes that the limitations of conventional eye drops will become more
pronounced.


THE INSITE SOLUTION--THE DURASITE SYSTEM

         InSite has developed the DuraSite drug delivery system to deliver drugs
in a patented polymer formulation to treat ocular diseases. DuraSite is
comprised of a cross-linked carboxyl-containing polymer. DuraSite's polymer
incorporates the drug to be delivered, gradually releasing it over time. The
polymer content in the formulation is minimal with the remainder consisting
principally of salts and sterile water. The pH, tonicity and particle size
distribution in the formulation have been adjusted to minimize the sensations of
burning, stinging, presence of foreign bodies and blurring. The formulation is
instilled as a small volume eyedrop into the conjunctival sac. DuraSite extends
the residence time of the drug due to a combination of mucoadhesion, surface
tension and viscosity. DuraSite's polymer stabilizes the drugs in aqueous media
and/or retards degradation by the enzymes in the tear fluid. The Company
believes that DuraSite can be customized to permit ophthalmic uses for compounds
previously unavailable for ophthalmic applications, including compounds that are
unstable or have short biological half-lives, such as antioxidants and proteins
that may be useful in the treatment of degenerative eye diseases.

         The DuraSite formulations are instilled into the eye using a patented
unit-dose, polyethylene dispenser. The dispenser has an easy-to-handle,
bent-neck design that delivers approximately a 25-microliter drop which the
Company believes is the optimal size to fill the average cul-de-sac without
overflowing. The bent neck permits administration directly into the cul-de-sac
of the eye while looking directly into a mirror, without having to tilt the head
back. Thus, drops can be more easily instilled compared to conventional eye
drops, even by patients with poor dexterity or depth perception.

         The DuraSite system has been designed to be highly flexible with the
ability to incorporate a variety of soluble and insoluble drugs with varying
molecular weights ranging from small chemicals such as pilocarpine to large
proteins. All of the Company's therapeutic products under development and
AquaSite have been formulated with DuraSite.

         The DuraSite system is designed to deliver effective, comfortable and
convenient treatment for ocular indications while reducing unwanted drug side
effects. The Company believes that products formulated in DuraSite may provide
the following improvements over existing therapies:

         Reduced dosing frequency and improved compliance. Once the DuraSite
         eyedrop is in the cul-de-sac, it adheres to the natural mucin layer.
         The Company has demonstrated that DuraSite formulations can stay in the
         eye up to six hours, depending on specific drug and formulation
         characteristics. The DuraSite system releases the drug over this period
         of time, long after 



                                       3
<PAGE>   6

         conventional eye drops have dissipated. While DuraSite is in the eye,
         its drug content is released over time by diffusion and bio-erosion
         from eyelid movements and tear flow. In Phase III clinical trials,
         InSite believes it has demonstrated that PilaSite used twice daily has
         a substantially similar effect as four daily doses of pilocarpine.

         Reduced side effects. This extended duration of action permits drugs to
         be formulated in DuraSite at lower levels of concentration than in
         conventional eye drop formulations. As a result, the amount of drug
         released at any one time is reduced, which may reduce the potential for
         adverse side effects from the drug being delivered. The DuraSite
         dispenser has been designed to deliver drops smaller than the 40 to 50
         microliter drops typically produced by more conventional containers.
         This smaller drop size should minimize the overflow, which can cause
         discomfort and contribute to systemic side effects. Because DuraSite is
         insoluble, the polymer does not penetrate the eye or other mucous
         membranes and does not break down into potentially toxic or unstable
         by-products. As the polymer particles erode, they move through the
         nasolacrimal ducts and leave the body via the gastrointestinal tract
         without changing chemically or causing systemic side effects.

         Increased efficacy. Drug efficacy may be enhanced for drugs formulated
         in DuraSite because DuraSite is designed to permit drug release over an
         extended time, compared to drugs delivered in conventional eye drops.

         Enhanced convenience. The DuraSite dispenser has been designed to
         facilitate eyedrop installation. The Company has also developed
         color-coded and time-sequenced packaging to permit ease-of-use.
         Dispenser ease-of-use and less frequent application provide enhanced
         convenience, which the Company believes may contribute to improved
         patient compliance with prescribed treatment regimens.

         The Company is also developing additional polymer-based delivery
systems with bio-erodible polymers and plasticizers to be administered
topically. The expected advantages of these systems are (i) duration of action
may be extended to 24 hours or longer; (ii) drug delivery profiles may be
controlled more precisely to enable formulation of drugs with very narrow
therapeutic indices; and (iii) drugs that are unstable in aqueous solutions
(such as certain proteins) may remain stable for longer periods.


PRODUCTS AND PRODUCT CANDIDATES

         The table on the following page summarizes the current status of the
Company's principal products and product candidates. A more detailed description
of each product and product candidate follows the table. There can be no
assurance that any of the listed products or product candidates will progress
beyond its current state of development, receive necessary regulatory approval
or be successfully marketed.


                                       4
<PAGE>   7


                         PRODUCTS AND PRODUCT CANDIDATES
<TABLE>
<CAPTION>
                                           ANTICIPATED
     PRODUCT         INDICATIONS            BENEFITS                  STATUS(1)              COLLABORATOR
     -------         -----------            --------                  ---------              ------------
<S>                 <C>             <C>                         <C>                         <C>  
 MARKETED PRODUCT
     AquaSite          Dry eye           Reduced dosing            Marketed (OTC)             CIBA Vision
                                     frequency and extended                                   Ophthalmics
                                       duration of action

 GLAUCOMA PRODUCT
    CANDIDATES

     PilaSite          Glaucoma          Reduced dosing         Phase III completed          Bausch & Lomb
                                           frequency

     BetaSite          Glaucoma         Lowest available         Phase III completed
                                          concentration

    ISV - 205       Steroid-induced   Treat/prevent disease       Phase I completed          University of
                         IOP               progression                                         California
                      elevation,
                       glaucoma

    ISV - 900          Glaucoma          Detect disease               Research              Universities of
                     prognostic/         susceptibility                                     California and
                      diagnostic                                                              Connecticut

    ISV - 208          Glaucoma      Once daily product with         Preclinical             Bausch & Lomb
                                        improved comfort

  OTHER PRODUCT
    CANDIDATES
    MethaSite        Inflammation   Reduced dosing frequency     Phase III completed          CIBA Vision
                                                                                              Ophthalmics

    ISV - 205        Inflammation   Reduced dosing frequency      Phase I completed           CIBA Vision
                    and analgesia                                                             Ophthalmics

    ISV - 120         Pterygium     No satisfactory existing           Phase II             British Biotech
                      recurrence             therapy
                      prevention

    ISV - 611          Allergic        Improved safety and             Phase I              British Biotech
                    conjunctivitis          efficacy

    ToPreSite        Inflammation   Reduced dosing frequency         Preclinical              CIBA Vision
                    and infection                                                             Ophthalmics

    ISV - 600          Diabetic     No satisfactory existing           Research                  Upjohn
                     retinopathy,         drug therapy
                      Cataract,
                       Macular
                     degeneration

    ISV - 701         Anesthetic      Extended duration of             Phase I
                                             action
</TABLE>

1)   All products except AquaSite and ISV-900 are expected to be prescription
     pharmaceuticals. As denoted in the table, "Preclinical" indicates that a
     specific compound is being tested in preclinical studies in preparation for
     filing an investigational new drug application ("IND"). For a description
     of preclinical trials, IND, Phase I, Phase II and Phase III clinical trials
     and NDA, see"--- Government Regulation."

                                       5
<PAGE>   8


MARKETED PRODUCT

         AquaSite. The first product utilizing InSite's DuraSite technology was
introduced to the OTC market in the U.S. in October 1992 by InSite's marketing
partner, CIBA Vision. The Company receives a royalty on sales of AquaSite by
CIBA Vision. The product contains the DuraSite formulation and demulcents for
the symptomatic treatment of dry eye. Dry eye is an extremely common condition
frequently associated with adverse environmental conditions such as heat and
dryness. The post-menopausal state in women is the most frequent underlying
medically related cause of the condition. In addition, some patients with
rheumatoid arthritis and Sjogren's syndrome are severely afflicted. Dry eye
products are designed to augment diminished natural tear production and to
lubricate and protect the ocular surface. AquaSite is designed to have a longer
ocular residence time than currently available artificial tear products. The dry
eye market is highly fragmented and characterized by numerous products, many of
which have relatively small market share.


PRODUCTS IN DEVELOPMENT

Glaucoma Products

         Glaucoma is the leading cause of preventable blindness in the U.S. This
ocular disease is typically characterized by elevated intraocular pressure
("IOP"), which is believed to result from an imbalance between the flow of fluid
into and out of the eye. The early signs of glaucoma are subtle and usually
unnoticed by the patient. In the late stages of the disease, elevated IOP causes
damage to the optic nerve that can lead to blindness if left untreated. Current
therapy for glaucoma is focused on controlling elevated IOP through medications,
with recourse to laser or filtering surgery in later stages of the disease.

         In some patients, glaucoma is thought to be the result of a genetic
predisposition. The prevalence of glaucoma in first-degree relatives of affected
patients has been documented to be as high as 7 to 10 times that of the general
population. Glaucoma also may occur as a complication of conditions such as
diabetes, or as a result of extended steroid use following ocular surgery. The
Company believes that the post-surgical use of topical steroids will increase
due to the recent FDA approval of the photorefractive keratotomy procedure for
correcting nearsightedness.

         Glaucoma treatment is the largest ophthalmic drug category, accounting
for approximately 45% of U.S. ophthalmic prescription sales. Glaucoma affects
between 2 million and 3 million people in the U.S. Treatments for glaucoma and
ocular hypertension, which can develop into glaucoma, accounted for
approximately $440 million in sales in the U.S. in 1994. InSite Vision's
glaucoma-related product development efforts include:

         PilaSite. Pilocarpine, the active ingredient in PilaSite eyedrop
formulation, is a drug used primarily in conjunction with beta-blockers to
provide maximum reduction of IOP. Pilocarpine works by increasing the outflow of
fluid from the eye to decrease IOP. Currently, pilocarpine eye drops are
commonly administered four times per day, and side effects often limit their
use. Patients may experience browache from the ciliary spasm induced by the
drug. Additionally, miosis (pupil constriction) caused by pilocarpine produces a
significant dimming of vision that limits a patient's ability to see in the dark
and therefore impairs a person's ability to drive in the evening. InSite has
developed its PilaSite eyedrop product candidate to allow less frequent dosing
of pilocarpine which may potentially reduce drug-related side effects.

         InSite has completed two multicenter, randomized Phase III studies
comparing twice-daily dosing of PilaSite to four times daily dosing of
conventional pilocarpine eye drops. The second of the two studies was completed
in mid-1995. Approximately 200 patients were enrolled in each study. In both
studies, twice daily doses of PilaSite eye drops appeared to be substantially as
effective as four daily doses of pilocarpine in controlling elevated IOP.



                                       6
<PAGE>   9

         B&L currently has an exclusive worldwide license to manufacture, use
and sell PilaSite. The agreement calls for B&L to: prepare the protocols
governing stability testing of the product and drug substance; develop
specifications for drug substance and drug product and analytical assays methods
validation; test the stability of the drug substance and product and validation
thereof; supervise the preapproval inspection by the FDA and provide other
regulatory support and assistance; and validate product manufacturing and
sterilization processes.

         BetaSite. The BetaSite eyedrop formulation provides the sustained
release of levobunolol, a leading beta-blocker currently used as a first-line
therapy for reducing IOP. Levobunolol acts by reducing fluid production in the
eye. While topical ophthalmic beta-blockers are generally free of local side
effects, they can cause serious systemic side effects, including cardiovascular
problems. InSite Vision's BetaSite formulation is designed so that levobunolol
will remain on the surface of the eye for several hours, which may lead to both
enhanced ocular absorption and diminished systemic absorption.

         In March 1995, the Company announced Phase III results using its
BetaSite product candidate in patients with open-angle glaucoma or ocular
hypertension. The study was conducted in research sites and involved 670
patients, randomized to receive either 0.1% BetaSite, 0.5% BetaSite or 0.5%
levobunolol eye drops. The mean response rates of patients who received
lower-dose BetaSite showed a 21% reduction in IOP after three months' treatment.
Patients who received the higher-dose BetaSite and those treated with
conventional high-dose levobunolol showed a 25% reduction in IOP.

         ISV-205. InSite Vision's ISV-205 product candidate contains the drug
diclofenac formulated in the DuraSite sustained-release delivery vehicle.
Diclofenac is a non-steroidal anti-inflammatory drug ("NSAID") currently used to
treat ocular inflammation. Co-exclusive rights to develop, manufacture, use and
sell ISV-205 to treat inflammation and infection or analgesia, were licensed to
CIBA Vision in May 1996. At higher concentrations than currently prescribed,
NSAIDs can block steroid-induced IOP elevation by inhibiting the production of a
protein (the "55/66 kDa protein") that appears to affect the fluid balance in
the eye. ISV-205 product candidate contains concentrations of diclofenac which
have been shown in cell culture and organ culture systems to inhibit the
production of the 55/66 kDa proteins.

         A Phase I study was completed in 1996 which evaluated the safety of
concentrations as high as 0.6% diclofenac. The initial indication to be studied
is expected to be the prevention of IOP elevation following steroid use. Other
potential indications include glaucoma prevention, analgesia and the treatment
of allergic symptoms.

          ISV-900. There is accumulating evidence that genetic predisposition is
a major factor in the development of Congenital and Primary Open-Angle Glaucoma.
Therefore, the Company is expanding its research in this area and has entered
into two research agreements. In October 1996, the Company obtained an option to
enter into an exclusive worldwide license agreement with the University of
Connecticut Health Center for the rights to commercialize certain research
related to genetic mutations associated with glaucoma and, in November 1994, the
Company obtained an exclusive worldwide license from the Regents of the
University of California (UC Regents) for a nucleic acid sequence that codes for
a protein associated with glaucoma. Through collaborations funded by InSite
Vision, scientists at both institutions are evaluating the potential use of
several gene sequences to develop genetic markers which may identify individuals
susceptible to developing glaucoma. InSite plans to develop
diagnostic/prognostic kits based on the data generated in these collaborations.

         ISV-208. During 1996, the Company entered into an agreement with B&L to
develop a new DuraSite formulation. Under the terms of the agreement, B&L
obtained the worldwide exclusive rights to manufacture, use and sell the new
formulation.


Other Products

         MethaSite(TM) is a DuraSite-based formulation of fluorometholone, an
anti-inflammatory steroid drug used primarily to control mild-to-moderate
inflammation in the anterior segment of the eye. Clinical

                                       7
<PAGE>   10

testing of MethaSite has been conducted and an NDA was submitted to the FDA. In
March 1995, the Company elected not to file an amendment to the NDA because such
amendment would have necessitated the expenditure of significant additional
resources, time and effort to complete the manufacturing requirements for the
product and has withdrawn the NDA without prejudice. CIBA Vision, which has
co-exclusive rights with InSite Vision to manufacture and market MethaSite in
the U.S. and Canada, is evaluating whether to seek regulatory approval for, and
subsequent commercialization of, MethaSite.

         ISV-120 is a DuraSite-based ophthalmic formulation of batimastat which
the Company is evaluating for its potential in preventing the recurrence of
pterygium, a vascular overgrowth which occurs on the front of the eye and may
impair vision. In a 1996 Phase II trial, regrowth occurred after patients were
dosed for 30 days. As a consequence, in 1997 the Company plans to conduct a
second Phase II trial in which patients will be dosed for a longer period.

         Batimastat is a matrix metalloproteinase inhibitor, a substance that
appears to have an inhibitory effect on tumor neovascularization. While pterygia
can be removed surgically, the rate of recurrence is 30% or higher. Currently
there are no drug therapies approved for preventing recurrent pterygium
following surgical removal. Other therapies such as beta irradiation for the
prevention of recurrent pterygia have potentially serious side effects. The
Company has obtained Batimastat through a 1992 agreement with British Biotech,
which in December 1996, advised the Company that it had discontinued development
and manufacturing of this product. The Company is currently considering whether
to continue development of ISV - 120. See "Risk Factors - Dependence on Third
Parties."

         ISV-611 is a DuraSite-based ophthalmic formulation of lexipafant which
the Company is evaluating as a potential alternative for treatment of allergic
conjunctivitis. Lexipafant is an antagonist of platelet activating factor, a
substance known to be involved in a variety of acute and chronic inflammatory
and ischemic diseases. The Company obtains lexipafant through a 1993
collaborative agreement with British Biotech, developer of the substance.
British Biotech is conducting Phase III clinical testing of lexipafant for
pancreatitis and has licensed the drug to Glaxo-Wellcome plc for asthma
indications. InSite Vision has studied ISV-611 in laboratory and animal models.
Clinical studies which were previously planned for in 1996 have been rescheduled
for the first half of 1997. See "Risk Factors - Dependence on Third Parties."

         ToPreSite is a compound containing the antibiotic tobramycin and the
steroid prednisolone acetate, for use when both infection and inflammation are
present in the eye. In May 1996, the Company entered into a licensing agreement
with CIBA Vision which grants CIBA Vision the co-exclusive right to manufacture,
use and sell ToPreSite in the U.S.

         ISV-600 and ISV-701 are ophthalmic formulations of tirilazad mesylate,
and proparacaine hydrochloride, respectively. The Company has deferred further
development of ISV-600 and ISV-701 pending the availability of additional
resources or corporate partners. There can be no assurance that such resources
or collaborations will be available on acceptable terms, or at all.

         The DuraSite drug delivery system has potential for both ophthalmic and
non-ophthalmic applications. While InSite Vision remains focused on the field of
ophthalmology, the Company also intends to leverage the value of its technology
through licensing agreements. For example, in August 1993, InSite and Upjohn
entered into an agreement providing Upjohn with an option to license certain of
InSite's DuraSite formulations for use in Upjohn's dermatological applications
of lazaroids.







                                        8
<PAGE>   11

COLLABORATIVE AND LICENSING AGREEMENTS

         As a key element of its business strategy, the Company has entered
into, and expects to enter into additional, research collaborations, licensing
agreements and corporate collaborations. However, there can be no assurance that
the Company will be able to negotiate acceptable collaborative or licensing
agreements, or that its existing collaborative agreements will be successful or
will be renewed when they expire.

         CIBA Vision Ophthalmics (CIBA Vision). In October 1991, the Company
entered into a license agreement with CIBA Vision (the "CIBA Vision Agreement"),
pursuant to which the Company granted CIBA Vision a co-exclusive license to
manufacture, have manufactured, use and sell fluorometholone and tear
replenishment products utilizing the DuraSite technology in the U.S. and Canada
and pilocarpine products utilizing the DuraSite technology solely in the U.S.
CIBA Vision also has a non-exclusive license to manufacture and use InSite's
delivery devices in single and multi-dosage form, and to sell products
incorporating such devices, for use in eye care. In May 1996, the Company
entered into an agreement with CIBA Vision whereby InSite regained full U.S.
marketing rights to its PilaSite product candidate. In exchange, CIBA Vision
received royalty-bearing, co-exclusive U.S. marketing rights to ToPreSite, a
product candidate for ocular inflammation/infection. CIBA Vision assumed all
subsequent product development, clinical and regulatory responsibility for
ToPreSite. In addition, CIBA Vision received royalty-bearing, exclusive U.S.
development, manufacturing and marketing rights to InSite Vision's ISV-205
product candidate for certain non-glaucoma related indications.

         To date, the Company has entered into agreements with CIBA Vision for
co-exclusive rights with the Company in the U.S. to manufacture and market
AquaSite, MethaSite, ToPreSite and ISV-205 for certain non-glaucoma related
indications. Of these, only AquaSite, an OTC product for which regulatory
approval is not required, has been marketed.

         Bausch and Lomb. In July 1996, the Company entered into a license
agreement ("the B&L Agreement") with B&L whereby InSite granted B&L an exclusive
worldwide royalty bearing license to make, use and sell PilaSite and ISV-208.
B&L paid InSite an up-front license fee of $500,000 and is obligated to pay
royalties on net sales of the licensed products. In addition, B&L agreed,
subject to certain conditions, to invest $2.0 million in the Company, to share
the cost of developing ISV-208 and to manufacture other InSite products, on
behalf of InSite. In 1996, $1.0 million of the investment was received.

         Pharmacia & Upjohn ("Upjohn"). In December 1990, InSite entered into a
license agreement with Upjohn (the "Upjohn Agreement"), pursuant to which Upjohn
granted InSite an exclusive, worldwide license of certain rights with respect to
three of Upjohn's lazaroid compounds, including the active ingredient in the
Company's ISV-600 candidate. Under the license, the Company has rights to
products containing one of the licensed lazaroids, either as the sole active
ingredient or where the licensed lazaroid is one of at least two active
ingredients, and which are limited to use in a topical administration of a
formulation to the eye for ophthalmic applications.

         InSite, in turn, has granted to Upjohn an exclusive, worldwide license
to any ophthalmic pharmaceutical treatment with lazaroids that is covered by the
patents that cover DuraSite and which is limited to systemic administration for
the treatment or prevention of ophthalmic disease or as an adjunctive component
of ocular surgery. InSite and Upjohn have agreed to pay each other certain
royalties on net sales of their respective licensed products. The Company is
also obligated to pay Upjohn an annual license maintenance fee. In addition, the
Company has agreed to pay Upjohn minimum royalties on each product developed
based on the license from Upjohn upon completion of certain milestones with
respect to such product commencing after the filing of an NDA for such product.

         Upjohn has agreed to provide InSite with certain bulk supplies of the
licensed lazaroids for preclinical, clinical and registration purposes without
cost to InSite and to participate on a research board to provide consulting
services, information and know-how to facilitate the development of the
lazaroids by InSite. Upjohn has further agreed, subject to the negotiation of
mutually acceptable terms, to provide






                                       9
<PAGE>   12


InSite with supplies of the lazaroids for development, pre-stocking and sales
purposes. In addition to certain other early termination provisions, Upjohn may
terminate the Upjohn Agreement if InSite fails to meet certain development and
marketing target dates.

         In August 1993, InSite and Upjohn entered into an agreement providing
Upjohn with an option to license certain of InSite's DuraSite formulations for
use in Upjohn's dermatological applications of lazaroids.

         British Biotech. In November 1992, InSite entered into a collaboration
agreement with British Biotech (the "ISV-120 Agreement"), pursuant to which
British Biotech has granted InSite the right to conduct, at InSite's own
expense, preclinical and clinical trials on British Biotech's batimastat
compound to determine whether its use in the eye can be enhanced by InSite's
drug delivery technology. British Biotech has agreed to provide InSite with bulk
supplies of ISV-120 and to participate on a joint development committee to
coordinate, plan and supervise the evaluation of ISV-120. For a certain period,
InSite has the exclusive option to initiate negotiations with British Biotech to
pursue further development of ISV-120. Upon exercise of such option, InSite and
British Biotech have agreed to negotiate reasonably and in good faith the terms
of a development and licensing agreement and manufacturing and supply agreement
providing for certain co-exclusive licenses for the development, use and sale of
ISV-120, in conjunction with InSite's delivery system, for ophthalmic uses.
Under certain circumstances, British Biotech has agreed to reimburse InSite for
certain costs incurred in evaluating ISV-120. InSite will retain ownership of
all inventions, discoveries and know-how with respect to any InSite delivery
system that may be developed during the course of the evaluation program, and
British Biotech will retain all such ownership rights with respect to ISV-120.
In December 1996 British Biotech advised the Company that it had discontinued
its development and manufacturing of this product. InSite is currently
evaluating whether it wishes to continue development for ophthalmic markets.
Subject to certain rights of early termination, the ISV-120 Agreement will
continue until the earlier of a specified period following completion of
InSite's last human clinical trial on the compound or December 31, 1997.

         In April 1993, InSite and British Biotech entered into a collaboration
agreement with respect to another British Biotech compound (the "ISV-611
Agreement") on terms substantially similar to the ISV-120 Agreement. Subject to
certain rights of early termination, the ISV-611 Agreement will continue until
the earlier of a specified period following completion of InSite's last human
clinical trial on ISV-611 or December 31, 1997.

         UC Regents. In March 1993, the Company entered into an exclusive
license agreement with the UC Regents for the development of ISV-205 and, in
August 1994, the parties entered into another exclusive license agreement for
the use of a nucleic acid sequence that codes for a protein associated with
glaucoma. Under both agreements, the Company paid initial licensing fees and
will make royalty payments to the UC Regents on future product sales, if any.

         University of Connecticut Health Center ("UCHC"). The Company has an
option for a worldwide exclusive license to commercialize technologies related
to certain research UCHC is conducting in the area of Adult-Onset Primary Open
Angle Glaucoma. Under the agreement, the Company will pay a licensing fee and
will make royalty payments to on future product sales, if any. In January 1997,
this option was expanded to include congenital glaucoma.

         Columbia Laboratories, Inc. In February 1992, InSite entered into a
cross-license agreement (the "Columbia Agreement") with Columbia Laboratories,
Inc. ("Columbia"), pursuant to which Columbia granted InSite a perpetual,
exclusive, irrevocable, royalty-free license to a polymer technology upon which
DuraSite is based to which Columbia has rights. This license permits InSite to
make, use and sell products using such polymer technology for non-veterinary
ophthalmic indications in the OTC and prescription market in North America and
East Asia (the "Columbia Territory"), and in the prescription market in
countries outside the Columbia Territory. In exchange, InSite granted Columbia a
perpetual, exclusive, irrevocable, royalty-free license, with the right to
sublicense, to use certain DuraSite technology in the OTC market outside the
Columbia Territory. In addition, InSite also granted Columbia a perpetual,
exclusive, irrevocable, worldwide license to certain DuraSite technology in the
veterinary field. Under






                                       10
<PAGE>   13


certain circumstances, certain of the licenses in the Columbia Agreement become
non-exclusive. Subject to certain rights of early termination, the Columbia
Agreement continues in effect until the later of January 2002 or expiration of
all patents covered by the DuraSite technology to which Columbia has certain
rights.

         Other. As part of InSite's basic strategy, InSite has entered into
agreements with other companies, universities and research institutions
concerning the licensing of additional therapeutic agents and drug delivery
technologies to complement and expand InSite's family of proprietary ophthalmic
products. InSite intends to continue exploring licensing and collaborative
opportunities.


PATENTS AND PROPRIETARY RIGHTS

         Patents and other proprietary rights are important to the Company's
business. The Company's policy is to file patent applications seeking to protect
technology, inventions and improvements to its inventions that are considered
important to the development of its business. Additionally, the Company's policy
is to assist the UC Regents and UCHC, in filing patent applications seeking to
protect inventions which are the subject of the Company's agreements with those
institutions. The Company also relies upon trade secrets, know-how, continuing
technological innovations and licensing opportunities to develop and maintain
its competitive position. InSite's DuraSite drug delivery products are made
under patents and applications, including four U.S. patents, owned by Columbia
and exclusively licensed to InSite in the field of human ophthalmic
applications. See "--Collaborative and Licensing Agreements." In addition, the
Company has filed a number of patent applications in the U.S. relating to the
Company's DuraSite technology, as well as foreign versions of certain of these
applications in many countries. Of these applications, four U.S. patents have
been issued. In addition, the Company has obtained two U.S. patents on its unit
dose dispenser. The Company has received six additional U.S. patents directed
toward certain uses of lazaroids in topical ophthalmic applications. Of the
patent applications licensed from the UC Regents, three patents have issued.
Several other patent applications by the Company and by the UC Regents relating
to the foregoing and other aspects of the Company's business and potential
business are also pending.

         The patent positions of pharmaceutical companies, including InSite, are
uncertain and involve complex legal and factual questions. In addition, the
coverage claimed in a patent application can be significantly reduced before a
patent is issued. Consequently, the Company does not know whether any of its
pending patent applications will result in the issuance of patents or if any of
its patents will provide significant proprietary protection. Since patent
applications are maintained in secrecy until patents issue in the U.S. or their
foreign counterparts, if any, publish, the Company cannot be certain that it or
any licenser was the first to file patent applications for such inventions.
Moreover, the Company might have to participate in interference proceedings
declared by the U.S. Patent and Trademark Office to determine priority of
invention, which could result in substantial cost to the Company, even if the
eventual outcome were favorable. There can be no assurance that the Company's
patents will be held valid or enforceable by a court or that a competitor's
technology or product would be found to infringe such patents.

         A number of pharmaceutical companies and research and academic
institutions have developed technologies, filed patent applications or received
patents on various technologies that may be related to the Company's business.
Some of these technologies, applications or patents may conflict with the
Company's technologies or patent applications. Such conflict could limit the
scope of the patents, if any, that the Company may be able to obtain or result
in the denial of the Company's patent applications. In addition, if patents that
cover the Company's activities have been or are issued to other companies, there
can be no assurance that the Company would be able to obtain licenses to these
patents, at all, or at a reasonable cost, or be able to develop or obtain
alternative technology.

         In addition to patent protection, the Company also relies upon trade
secret protection for its confidential and proprietary information. 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, that such trade secrets will not be disclosed or that the Company
can effectively protect its rights to unpatented trade secrets.





                                       11
<PAGE>   14



ACCESS TO PROPRIETARY COMPOUNDS

         The Company believes its drug delivery technology may expand the
ophthalmic pharmaceutical market by permitting the novel use of drugs for
ophthalmic indications that are currently used or being developed for
non-ophthalmic indications. However, the Company may be required to obtain
licenses from third parties that have rights to these compounds in order to
conduct certain research, to develop or to market products that contain such
compounds. There can be no assurance that such licenses will be available on
commercially reasonable terms, if at all. See "Business - Collaborative and
Licensing Agreements."


RESEARCH AND DEVELOPMENT

         The Company's research and development group at December 31, 1996
numbered 40 people, of whom seven have Ph.D. or D.V.M. degrees. Research and
development expenses during 1996 were $5.5 million, all of which was sponsored
by the Company. During 1995 and 1994, research and development expenses were
$8.1 million and $9.9 million, respectively. See "Business - Collaborative and
Licensing Agreements" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations."


MANUFACTURING

         The Company has no experience or facilities for the manufacture of
products for commercial processes. Moreover, the Company currently has no
intention of developing such experience or implementing such facilities. The
Company has a pilot facility, licensed by the State of California, to produce
potential products for Phase I and certain Phase II clinical trials. However, as
stated above, the Company has no large-scale manufacturing capacity and relies
on third parties such as B&L, for supplies and materials necessary for all of
its Phase III clinical trials. For example, the Company and B&L have entered
into an agreement to establish facilities capable of manufacturing and supplying
certain Phase III clinical supplies and commercial products at the B&L site in
Tampa, Florida. If the Company should encounter delays or difficulties in
establishing and maintaining its relationship with B&L or other qualified
manufacturers to produce, package and distribute its finished products, then
clinical trials, regulatory filings, market introduction and subsequent sales of
such products would be adversely affected. See "Risk Factors - No Commercial
Manufacturing Experience."


MARKETING AND SALES

         In connection with its November 1995 restructuring, the Company elected
not to proceed with plans to establish its own sales and marketing organization.
Instead, the Company plans to enter into arrangements with one or more
pharmaceutical companies to market its products. There can be no assurance that
the Company will be able to conclude such arrangements on acceptable terms, if
at all.

         CIBA Vision. In 1991, the Company entered into a co-exclusive rights
agreement to market the AquaSite and MethaSite products in the U.S. and Canada.
Additionally, in May 1996, the Company granted CIBA Vision an exclusive U.S.
license for ISV-205 for non-glaucoma indications, and co-exclusive rights within
the USA and non-exclusive worldwide rights to sell and use ToPreSite. InSite
Vision's trademark is being used, under license, by CIBA Vision for AquaSite dry
eye treatment and the Company's patents are identified on the AquaSite
packaging. The Company received a one time licensing fee and royalties based on
the net sales of the products, if any.

         Bausch and Lomb. In July 1996, the Company entered into an exclusive
worldwide royalty bearing license agreement whereby B&L has agreed to market and
sell ISV-208 and PilaSite. Under the










                                       12
<PAGE>   15

terms of the agreement, the Company received a one time licensing fee and is
entitled to royalties based on net sales of the products, if any.


COMPETITION

         There are many competitors of the Company in the U.S. and abroad. These
companies include ophthalmic-oriented companies that market a broad portfolio of
products, large integrated pharmaceutical companies that market a limited number
of ophthalmic pharmaceuticals in addition to many other pharmaceuticals, and
smaller specialty pharmaceutical and biotechnology companies that are engaged in
the development and commercialization of prescription ophthalmic
pharmaceuticals. Many of these companies have substantially greater financial,
technical, marketing and human resources than those of the Company and may
succeed in developing technologies and products that are more effective, safer
or more commercially acceptable than any which have been or are being developed
by the Company. These competitors may also succeed in obtaining cost advantages,
patent protection or other intellectual property rights that would block the
Company's ability to develop its potential products, or in obtaining regulatory
approval for the commercialization of their products more rapidly or effectively
than the Company. The ophthalmic prescription pharmaceutical market in the U.S.
is dominated by five companies: Allergan Pharmaceuticals, a division of
Allergan, Inc.; Alcon Laboratories, Inc., a division of Nestle Company; Bausch
and Lomb; CIBA Vision, a division of Novartis Ltd.; and Merck, Sharp & Dohme, a
division of Merck & Co., Inc.

         The Company believes that there will be increasing competition from new
products entering the market that are covered by exclusive marketing rights and,
to a lesser degree, from pharmaceuticals that become generic. The Company is
aware of certain products manufactured or under development by competitors that
are used for the treatment of certain ophthalmic indications which the Company
has targeted for product development. The Company's competitive position will
depend on its ability to develop enhanced or innovative pharmaceuticals,
maintain a proprietary position in its technology and products, obtain required
governmental approvals on a timely basis, attract and retain key personnel and
develop effective products that can be manufactured on a cost-effective basis
and marketed successfully.


GOVERNMENT REGULATION

         The manufacturing and marketing of the Company's products and its
research and development activities are subject to regulation by numerous
governmental authorities in the U.S. and other countries. In the U.S., drugs are
subject to rigorous FDA regulation. The Federal Food, Drug and Cosmetic Act and
regulations promulgated thereunder govern the testing, manufacture, labeling,
storage, record keeping, approval, advertising and promotion in the U.S. of the
Company's products. In addition to FDA regulations, the Company is also subject
to other federal and state regulations such as the Occupational Safety and
Health Act and the Environmental Protection Act. Product development and
approval within this regulatory framework take a number of years and involve the
expenditure of substantial resources.

         The steps required before a pharmaceutical agent may be marketed in the
U.S. include (i) preclinical laboratory and animal tests, (ii) the submission to
the FDA of an Investigational New Drug application ("IND"), (iii) adequate and
well-controlled human clinical trials to establish the safety and efficacy of
the drug, (iv) the submission of an NDA or Product License Application ("PLA")
to the FDA and (v) the FDA approval of the NDA or PLA prior to any commercial
sale or shipment of the drug. In addition to obtaining FDA approval for each
product, each domestic drug manufacturing establishment must be registered with,
and approved by, the FDA. Drug product manufacturing establishments located in
California also must be licensed by the State of California in compliance with
separate regulatory requirements.

         Preclinical tests include laboratory evaluation of product chemistry
and animal studies to assess the potential safety and efficacy of the product
and its formulation. The results of the preclinical tests are






                                       13
<PAGE>   16

submitted to the FDA as part of an IND, and unless the FDA objects, the IND will
become effective 30 days following its receipt by the FDA.

         Clinical trials involve the administration of the drug to healthy
volunteers or to patients under the supervision of a qualified principal
investigator. Clinical trials are conducted in accordance with protocols that
detail the objectives of the study, the parameters to be used to monitor safety,
and the efficacy criteria to be evaluated. Each protocol is submitted to the FDA
as part of the IND. Each clinical study is conducted under the auspices of an
independent Institutional Review Board which considers, among other things,
ethical factors and the rights, welfare and safety of human subjects.

         Clinical trials are typically conducted in three sequential phases, but
the phases may overlap. In Phase I, the initial introduction of the drug into
human subjects, the drug is tested for safety (adverse effects), dosage
tolerance, metabolism, distribution, excretion and clinical pharmacology. Phase
II 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 possible adverse effects and
safety risks. When 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 multiple clinical study sites. The FDA reviews
both the clinical plans and the results of the trials and may discontinue the
trials at any time if there are significant safety issues.

         The results of the preclinical studies and clinical studies are
submitted to the FDA in the form of an NDA or PLA for marketing approval. The
testing and approval process is likely to require substantial time and effort
and there can be no assurance that any approval will be granted on a timely
basis, if at all. Additional animal studies or clinical trials may be requested
during the FDA review period and may delay marketing approval. After FDA
approval for the initial indications, further clinical trials are necessary to
gain approval for the use of the product for additional indications. The FDA may
also require post-marketing testing to monitor for adverse effects, which can
involve significant expense.

         Among the conditions for manufacture of clinical drug supplies and for
NDA or PLA approval is the requirement that the prospective manufacturer's
quality control and manufacturing procedures conform to GMP. Prior to approval,
manufacturing facilities are subject to FDA and/or other regulatory agency
inspection to ensure compliance with GMP. Manufacturing facilities are subject
to periodic regulatory inspection to ensure ongoing compliance.

         For marketing outside the U.S., the Company also is subject to foreign
regulatory requirements governing human clinical trials and marketing approval
for drugs. The requirements governing the conduct of clinical trials, product
licensing, pricing and reimbursement vary widely from country to country.


SCIENTIFIC AND BUSINESS ADVISORS

         The Company has access to a number of academic and industry advisors
with expertise in clinical ophthalmology and pharmaceutical development,
marketing and sales. The Company's advisors meet with management and key
scientific employees of the Company on an ad hoc basis to provide advice in
their respective areas of expertise and further assist the Company by
periodically reviewing with management the Company's preclinical, clinical and
marketing activities. The Company plans to make arrangements with other
individuals to join as advisors as appropriate. Although the Company expects to
receive guidance from the advisors, all of such advisors are employed on a
full-time basis by other entities, or are primarily engaged in business
activities outside the Company, and may have other commitments to or consulting
or advisory contracts with other entities that may conflict or compete with
their obligations to the Company.





                                       14
<PAGE>   17


         The Company's advisors are as follows:

                Name                                Position
-----------------------------------       --------------------------------------
   John G. Babcock, Ph.D.                 Vice President Research (Retired), 
                                          InSite; former Director of Scientific
                                          Relations for Upjohn
   Nicolas G. Bazan, M. D.                Professor of Ophthalmology,
                                          Biochemistry and Molecular Biology and
                                          Neurology and Director, LSU
                                          Neuroscience Center of Excellence,
                                          Louisiana State University Medical 
                                          Center School of Medicine, New Orleans
   David Harper, M. D.                    Ophthalmologist; private practice
   Roy Karnovsky                          Advisor and Consultant in Business 
                                          Development and Marketing
   Steven G. Kramer, M. D., Ph.D.         Chairman, Department of Ophthalmology,
                                          Director of Beckman Vision Center and 
                                          Professor, University of California,
                                          San Francisco
   Richard Lewis, M. D.                   Ophthalmologist; Assistant Clinical
                                          Professor, University of California,
                                          Davis; Chief of Ophthalmology, Mercy 
                                          General Hospital, Sacramento
   Michael Marmor, M. D.                  Professor, Department of
                                          Ophthalmology, Stanford University
                                          School of Medicine
   Thai D. Nguyen, Ph.D.                  Molecular Biologist, University of 
                                          California, San Francisco
   Gary D. Novack, Ph.D.                  Founder and President, PharmaLogic
                                          Development, Inc.; former Associate
                                          Director for Glaucoma Research at
                                          Allergan, Inc.
   Jon R. Polansky, M. D.                 Associate Professor of Ophthalmology,
                                          University of California, San
                                          Francisco
   Joseph R. Robinson, Ph.D.              Professor of Pharmacy and 
                                          Ophthalmology, University of
                                          Wisconsin, Madison
   Mansoor Sarfarazi, Ph.D.               Associate Professor, Department of 
                                          Surgery, University of Connecticut
                                          Health Center
   Roger Vogel, M. D.                     Medical Director


EMPLOYEES

         As of December 31, 1996, the Company employed 47 persons, including 45
full time employees. None of the Company's employees is covered by a collective
bargaining agreement. The Company considers its employee relations to be good.
The Company also utilizes independent consultants to advise the Company in
certain areas of its scientific and business operations.



                                  RISK FACTORS

EARLY STAGE OF DEVELOPMENT; TECHNOLOGICAL UNCERTAINTY

         InSite is at an early stage of development. Only one product utilizing
the Company's DuraSite technology, an over-the-counter ("OTC") dry eye
treatment, is currently being marketed. Most of the potential products currently
under development by the Company will require significant additional research
and development, and preclinical and clinical testing, prior to submission to
regulatory authorities for marketing approval. The Company's potential products
are subject to the risks of failure inherent in the development of products
based on new technologies. These risks include the possibilities that the
Company's technology or any or all of its potential products will be found to be
unsafe, ineffective, or otherwise fail to receive necessary marketing clearance;
that the potential products, if safe and effective, will be difficult to
manufacture or market; that proprietary rights of third parties will preclude
the Company from marketing products; or that third parties will market superior,
equivalent or more cost-









                                       15
<PAGE>   18


effective products. As a result, there can be no assurance that the Company's
research and development activities will result in any commercially viable
products.


FUTURE CAPITAL NEEDS; UNCERTAINTY OF ADDITIONAL FUNDING

         The Company will require substantial additional funds to conduct the
development and testing of its potential products and to manufacture and market
any products that may be developed. The Company's future capital requirements
will depend on numerous factors, including the progress of its research and
development programs, the progress of preclinical and clinical testing, the time
and costs involved in obtaining regulatory approvals, the cost of filing,
prosecuting, defending and enforcing patent claims and other intellectual
property rights, competing technological and market developments, changes in the
Company's existing collaborative and licensing relationships, the ability of the
Company to establish corporate partnerships for the manufacture and marketing of
its potential products, and the purchase of additional capital equipment. The
Company intends to seek additional funding through public or private financings,
collaborative or other arrangements, or from other sources. There can be no
assurance that additional financing will be available from any of these sources
or, if available, that it will be available on acceptable terms. Any failure by
the Company to obtain additional funding on acceptable terms, or at all, would
have a material adverse effect on the Company's business, financial condition
and results of operations. If additional funds are raised by issuing equity
securities, significant dilution to existing stockholders may result. If
adequate funds are not otherwise available, the Company may be required to
delay, scale back or eliminate one or more of its research, discovery or
development programs, or to obtain funds through entering into arrangements with
collaborators or others that may require the Company to relinquish rights to
certain of its technologies, product candidates or products, or to cease
operations.


HISTORY OF OPERATING LOSSES; UNCERTAINTY OF FUTURE FINANCIAL RESULTS

         The Company has incurred significant operating losses since its
inception in 1986 and it expects to continue to incur significant operating
losses for at least the next several years. As of December 31, 1996, the
Company's accumulated deficit was approximately $66 million. The amount of net
losses and the time required by the Company to reach profitability are
uncertain. The Company's ability to achieve profitability depends upon its
ability, alone or with others, to complete successful development of its
potential products, conduct clinical trials, obtain required regulatory
approvals and successfully manufacture and market its products. There can be no
assurance that the Company will ever achieve significant revenue or
profitability.


DEPENDENCE ON THIRD PARTIES

         In connection with its restructuring in November 1995, the Company
elected not to proceed with plans to establish a dedicated sales and marketing
organization. In order to successfully commercialize its product candidates, the
Company will be required to enter into arrangements with one or more companies
that will: provide for Phase III clinical testing, commercial scale-up and
manufacture of the Company's potential products; obtain or assist the Company in
other activities associated with obtaining regulatory approvals for its product
candidates; and market and sell the Company's products, if approved.

         To date, the Company has entered into agreements with CIBA Vision for
co-exclusive rights with the Company in the U.S. to manufacture and market
AquaSite, MethaSite, ToPreSite and ISV-205 for certain non-glaucoma-related
indications. Of these, only AquaSite, an OTC product for which regulatory
approval is not required, has been marketed. Through the Company's agreement
with CIBA Vision in May 1996, the Company regained full U.S. marketing rights to
the Company's PilaSite product candidate for glaucoma, which was subsequently
licensed on a worldwide basis to B&L. In exchange, CIBA Vision received
royalty-bearing, co-exclusive U.S. marketing rights to ToPreSite product
candidate for ocular inflammation/infection. CIBA Vision assumed all subsequent
product development, clinical and regulatory responsibility for ToPreSite. In
addition, CIBA Vision received royalty-bearing, co-exclusive







                                       16
<PAGE>   19

U.S. marketing rights to the Company's ISV-205 product candidate for certain
non-glaucoma-related indications. CIBA Vision has no obligation to fund the
further development of MethaSite or ISV-205.

            In July 1996, the Company entered into agreements with B&L pursuant
to which: (i) B&L has agreed to manufacture InSite product candidates at B&L's
facility in Tampa, Florida using equipment owned by InSite; B&L and InSite have
agreed to share the cost of certain leasehold improvements in connection with
the installation and operation of the equipment; (ii) B&L will receive, for a
license fee of $500,000, an exclusive worldwide royalty-bearing license to
manufacture and market PilaSite; (iii) B&L and InSite have agreed to collaborate
to develop and sell a new DuraSite based eyedrop formulation; and (iv) B&L has
agreed to make a $2 million equity investment in the Company, $1.0 million of
which was received by the Company in August 1996, with the remaining amount,
subject to certain conditions, due in August 1997.

         There can be no assurance that, even if regulatory approvals are
obtained, the Company's products will be successfully marketed, or that the
Company will be able to conclude arrangements with other companies to support
the commercialization of such products on acceptable terms, if at all.

         The Company's strategy for research, development and commercialization
of certain of its products requires the Company to enter into various
arrangements with corporate and academic collaborators, licensers, licensees and
others, and is dependent on the subsequent success of these outside parties in
performing their responsibilities. For example, the Company is dependent upon
British Biotech for the supply of batimastat and lexipafant, the active drugs
incorporated into the Company's ISV-120 and ISV-611 product candidates,
respectively. British Biotech is conducting clinical testing of lexipafant for
non-ophthalmic indications, but it has discontinued clinical testing of
batimastat and informed the Company that it will no longer manufacture the
product. The Company may have no source of ongoing raw materials for such
product candidates and its business may be adversely affected. In addition,
there can be no assurance that the Company's collaborators will not take the
position that they are free to compete using the Company's technology without
compensating or entering into agreements with the Company, or will not pursue
alternative technologies or develop alternative products either on their own or
in collaboration with others, including the Company's competitors, as a means
for developing treatments for the diseases or disorders targeted by these
collaborative programs.


UNCERTAINTY OF PATENTS AND PROPRIETARY RIGHTS

         The Company's success will depend in large part on its ability to
obtain patents, protect trade secrets and operate without infringing upon the
proprietary rights of others. A substantial number of patents in the field of
ophthalmology have been issued to pharmaceutical, biotechnology and
biopharmaceutical companies. Moreover, competitors may have filed patent
applications, may have been issued patents or may obtain additional patents and
proprietary rights relating to products or processes competitive with those of
the Company. There can be no assurance that the Company's patent applications
will be approved, that the Company will develop additional proprietary products
that are patentable, that any issued patents will provide the Company with
adequate protection for its inventions or will not be challenged by others, or
that the patents of others will not impair the ability of the Company to
commercialize its products. The patent position of firms in the pharmaceutical
industry generally is highly uncertain, involves complex legal and factual
questions, and has recently been the subject of much litigation. No consistent
policy has emerged from the U.S. Patent and Trademark Office or the courts
regarding the breadth of claims allowed or the degree of protection afforded
under pharmaceutical patents. There can be no assurance that others will not
independently develop similar products, duplicate any of the Company's products
or design around any patents of the Company.

         A number of pharmaceutical and biotechnology companies and research and
academic institutions have developed technologies, filed patent applications or
received patents on various technologies that may be related to the Company's
business. Some of these technologies, applications or patents may conflict with
the Company's technologies or patent applications. Such conflicts could limit
the scope of the patents, if any, that the Company may be able to obtain or
result in the denial of the Company's patent applications.






                                       17
<PAGE>   20

In addition, if patents that cover the Company's activities have been or are
issued to other companies, there can be no assurance that the Company would be
able to obtain licenses to these patents, at all, or at a reasonable cost, or be
able to develop or obtain alternative technology. If the Company does not obtain
such licenses, it could encounter delays or be precluded from introducing
products to the market. Litigation may be necessary to defend against or assert
claims of infringement, to enforce patents issued to the Company or to protect
trade secrets or know-how owned by the Company, and could result in substantial
cost to and diversion of effort by, and may have a material adverse effect on,
the Company. In addition, there can be no assurance that these efforts by the
Company will be successful or, even if successful, will not result in
substantial cost to the Company.

         The Company's competitive position is also dependent upon unpatented
trade secrets. 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, that such trade secrets
will not be disclosed or that the Company can effectively protect its rights to
unpatented trade secrets. To the extent that the Company or its consultants or
research collaborators use intellectual property owned by others in their work
for the Company, disputes also may arise as to the rights in related or
resulting know-how and inventions.


NO COMMERCIAL MANUFACTURING EXPERIENCE

         The Company has no experience in the manufacture of products for
commercial purposes. The Company has a pilot facility licensed by the State of
California to manufacture certain of its products for Phase I and Phase II
clinical trials. In July 1996, the Company entered into an alliance under which
B&L has agreed to manufacture Company products. If the Company should encounter
delays or difficulties in establishing and maintaining its relationship with B&L
or other qualified manufacturers to produce, package and distribute its finished
products, then clinical trials, regulatory filings, market introduction and
subsequent sales of such products would be adversely affected.

         Contract manufacturers must adhere to GMP regulations strictly enforced
by the FDA on an ongoing basis through its facilities inspection program.
Contract manufacturing facilities must pass a pre-approval plant inspection
before the FDA will approve an NDA. Certain material manufacturing changes that
occur after approval are also subject to FDA review and clearance or approval.
There can be no assurance that the FDA or other regulatory agencies will approve
the process or the facilities by which any of the Company's products may be
manufactured. The Company's dependence on third parties for the manufacture of
products may adversely affect the Company's ability to develop and deliver
products on a timely and competitive basis. Should the Company be required to
manufacture products itself, the Company will be subject to the regulatory
requirements described above, and to similar risks regarding delays or
difficulties encountered in manufacturing any such products and will require
substantial additional capital. There can be no assurance that the Company will
be able to manufacture any such products successfully or in a cost-effective
manner. In addition, certain of the raw materials the Company uses in
formulating its DuraSite drug delivery system are available from only one
source. Any significant interruption in the supply of these raw materials could
delay the Company's clinical trials, product development or product sales and
could have a material adverse effect on the Company's business.


GOVERNMENT REGULATION AND PRODUCT APPROVAL

         FDA and comparable agencies in state and local jurisdictions and in
foreign countries impose substantial requirements upon preclinical and clinical
testing, manufacturing and marketing of pharmaceutical products. Lengthy and
detailed preclinical and clinical testing, validation of manufacturing and
quality control processes, and other costly and time-consuming procedures are
required. Satisfaction of these requirements typically takes several years and
the time needed to satisfy them may vary substantially, based on the type,
complexity and novelty of the pharmaceutical product. The effect of government
regulation may be to delay or to prevent marketing of potential products for a
considerable period of time and to impose costly procedures upon the Company's
activities. There can be no assurance







                                       18
<PAGE>   21

that the FDA or any other regulatory agency will grant approval for any products
developed by the Company on a timely basis, or at all. Success in preclinical or
early stage clinical trials does not assure success in later stage clinical
trials. Data obtained from preclinical and clinical activities are susceptible
to varying interpretations which could delay, limit or prevent regulatory
approval. If regulatory approval of a product is granted, such approval may
impose limitations on the indicated uses for which a product may be marketed.
Further, even if regulatory approval is obtained, later discovery of previously
unknown problems with a product may result in restrictions on the product,
including withdrawal of the product from the market. Delay in obtaining or
failure to obtain regulatory approvals would have a material adverse effect on
the Company's business.

         The FDA's policies may change and additional government regulations may
be promulgated which could prevent or delay regulatory approval of the Company's
potential products. Moreover, increased attention to the containment of health
care costs in the U.S. could result in new government regulations which could
have a material adverse effect on the Company's business. The Company is unable
to predict the likelihood of adverse governmental regulation which might arise
from future legislative or administrative action, either in the U.S. or abroad.
See "Risk Factors - Uncertainty of Product Pricing, Reimbursement and Related
Matters."


COMPETITION

         The Company's success depends upon developing and maintaining a
competitive position in the development of products and technologies in its
areas of focus. There are many competitors of the Company in the U.S. and
abroad, including pharmaceutical, biotechnology and other companies with varying
resources and degrees of concentration on the ophthalmic pharmaceuticals market.
The Company's competitors may have existing products or products under
development which may be technically superior to those of the Company or which
may be less costly or more acceptable to the market. Competition from such
companies is intense and expected to increase as new products enter the market
and new technologies become available. The Company's competitors, many of which
have substantially greater financial, technical, marketing and human resources
than the Company, may also succeed in developing technologies and products that
are more effective, safer, less expensive or otherwise more commercially
acceptable than any which have been or are being developed by the Company. The
Company's competitors may obtain cost advantages, patent protection or other
intellectual property rights that would block or limit the Company's ability to
develop its potential products, or may obtain regulatory approval for the
commercialization of their products more effectively or rapidly than the
Company. To the extent that the Company determines to manufacture and market its
products by itself, it will also compete with respect to manufacturing
efficiency and marketing capabilities, areas in which it has limited or no
experience.


MARKETING AND SALES

         The Company plans to market and sell its products through arrangements
with one or more pharmaceutical companies with expertise in the ophthalmic drug
industry. There can be no assurance that the Company will be able to enter into
such arrangements on acceptable terms, if at all. If the Company is not
successful in concluding such arrangements, it may be required to establish its
own sales and marketing organization, although the Company has no experience in
sales, marketing or distribution. There can be no assurance that the Company
will be able to build such a marketing staff or sales force, or that the
Company's sales and marketing efforts will be cost-effective or successful. To
the extent the Company has entered into or enters into co-marketing,
co-promotion or other licensing arrangements for the marketing and sale of its
products, any revenues received by the Company will be dependent on the efforts
of third parties (such as CIBA Vision and B&L), and there can be no assurance
that such efforts will be successful.







                                       19
<PAGE>   22



DEPENDENCE ON KEY PERSONNEL

         The Company is highly dependent on Dr. Chandrasekaran and other
principal members of its scientific and management staff, the loss of whose
services might significantly delay the achievement of planned development
objectives. Furthermore, recruiting and retaining qualified personnel will be
critical to the Company's success. Competition for skilled individuals in the
biotechnology business is highly intense and there can be no assurance that the
Company will be able to continue to attract and retain personnel necessary for
the development of the Company's business. The loss of key personnel or the
failure to recruit additional personnel or to develop needed expertise could
have a material adverse effect on the Company's business, financial condition
and results of operations.


PRODUCT LIABILITY EXPOSURE; LIMITED INSURANCE COVERAGE

         The Company's business exposes it to potential product liability risks
which are inherent in the development, testing, manufacturing, marketing and
sale of human therapeutic products. Product liability insurance for the
pharmaceutical industry generally is expensive. There can be no assurance that
the Company's present product liability insurance coverage is adequate. Such
existing coverage will not be adequate as the Company further develops its
products, and no assurance can be given that adequate insurance coverage against
potential claims will be available in sufficient amounts or at a reasonable
cost.


UNCERTAINTY OF PRODUCT PRICING, REIMBURSEMENT AND RELATED MATTERS

         The Company's business may be materially adversely affected by the
continuing efforts of governmental and third party payers to contain or reduce
the costs of health care through various means. For example, in certain foreign
markets the pricing or profitability of health care products is subject to
government control. In the U.S., there have been, and the Company expects there
will continue to be, a number of federal and state proposals to implement
similar government control. While the Company cannot predict whether any such
legislative or regulatory proposals or reforms will be adopted, the announcement
of such proposals or reforms could have a material adverse effect on the
Company's ability to raise capital or form collaborations, and the adoption of
such proposals or reforms could have a material adverse effect on the Company's
business, financial condition or results of operations.

         In addition, in the U.S. and elsewhere, sales of health care products
are dependent in part on the availability of reimbursement from third party
payers, such as government and private insurance plans. Significant uncertainty
exists as to the reimbursement status of newly approved health care products,
and third party payers are increasingly challenging the prices charged for
medical products and services. If the Company succeeds in bringing one or more
products to the market, there can be no assurance that reimbursement from third
party payers will be available or will be sufficient to allow the Company to
sell its products on a competitive or profitable basis.


HAZARDOUS MATERIALS; ENVIRONMENTAL MATTERS

         The Company's research, development and manufacturing processes involve
the controlled use of small amounts of hazardous and radioactive materials. The
Company is subject to federal, state and local laws, regulations and policies
governing the use, manufacture, storage, handling and disposal of such materials
and certain waste products. Although the Company believes that its safety
procedures for handling and disposing of such materials comply with the
standards prescribed by such laws and 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 resources of the Company.
Moreover, the Company may be required to incur significant costs to comply with
environmental laws and regulations, especially to the extent that the Company
manufactures its own products.





                                       20
<PAGE>   23



CONTROL BY MANAGEMENT AND EXISTING STOCKHOLDERS

         As of December 31, 1996, the Company's management and principal
stockholders in the aggregate owned beneficially approximately 22% of the
Company's outstanding shares of Common Stock. As a result, these stockholders,
acting together, would be able to effectively control most matters requiring
approval by the stockholders of the Company, including the election of a
majority of the directors and the approval or disapproval of business
combinations.


VOLATILITY OF STOCK PRICE; NO DIVIDENDS

         The market prices for securities of biopharmaceutical and biotechnology
companies (including the Company) have historically been highly volatile, and
the market has from time to time experienced significant price and volume
fluctuations that are unrelated to the operating performance of particular
companies. Future announcements concerning the Company, its competitors or other
biopharmaceutical companies including the results of testing and clinical
trials, technological innovations or new therapeutic products, governmental
regulation, developments in patent or other proprietary rights, litigation or
public concern as to the safety of products developed by the Company or others
and general market conditions may have a significant effect on the market price
of the Common Stock. The Company has not paid any cash dividends on its Common
Stock and does not anticipate paying any dividends in the foreseeable future.


ANTI-TAKEOVER EFFECT OF DELAWARE LAW AND CERTAIN CHARTER AND BYLAWS PROVISIONS

         Certain provisions of the Company's Certificate of Incorporation and
Bylaws may have the effect of making it more difficult for a third party to
acquire, or discouraging a third party from attempting to acquire, control of
the Company. Such provisions could limit the price that certain investors might
be willing to pay in the future for shares of the Company's Common Stock. The
Company's Board of Directors has the authority to issue up to 5,000,000 shares
of Preferred Stock and to determine the price, rights, preferences, privileges
and restrictions of those shares without any further vote or action by the
stockholders. The rights of the holders of Common stock will be subject to, and
may be adversely affected by, the rights of the holders of any Preferred Stock
that may be issued in the future. The issuance of Preferred Stock, while
providing desirable flexibility in connection with possible acquisitions and
other corporate purposes, could have the effect of making it more difficult for
a third party to acquire a majority of the outstanding voting stock of the
Company. The Company has no present plans to issue shares of Preferred Stock.
Certain provisions of Delaware law applicable to the Company could also delay or
make more difficult a merger, tender offer or proxy contest involving the
Company, including Section 203 of the Delaware General Corporation Law, which
prohibits a Delaware corporation from engaging in any business combination with
any interested stockholder for a period of three years unless certain conditions
are met.


                      EXECUTIVE OFFICERS OF THE REGISTRANT

         The executive officers of the Company are:

        NAME                        AGE              TITLE
        ----                        ---              -----


S. Kumar Chandrasekaran, Ph.D.       53     Chairman of the Board, Chief
                                            Executive Officer and Chief
                                            Financial Officer

Lyle M. Bowman, Ph.D.                48     Vice President, Development and 
                                            Operations











                                       21
<PAGE>   24


Karen K. Church                      51     Vice President, Regulatory, Quality
                                            Assurance/Control and Clinical 
                                            Research

Michael D. Baer                      52     Vice President, Finance and 
                                            Administration

         S. Kumar Chandrasekaran joined the Company in September 1987 as Vice
President, Development. From 1988 to 1989, Dr. Chandrasekaran served as Vice
President, Research and Development. From 1989 to 1993, he served as President
and Chief Operating Officer. Since August 1993, Dr. Chandrasekaran has served as
Chairman of the Board of Directors, Chief Executive Officer and, since December
1995, as Chief Financial Officer. Dr. Chandrasekaran holds a Ph.D. in Chemical
Engineering from the University of California, Berkeley.

         Lyle M. Bowman joined the Company in October 1988 as Director of Drug
Delivery Systems. From 1989 to 1991, Dr. Bowman served as Vice President,
Science and Technology. From 1991 to 1995 he served as Vice President,
Development, and since 1995 has served as Vice President Development and
Operations. Dr. Bowman holds a Ph.D. in Physical Chemistry from the University
of Utah.

         Karen K. Church joined the Company in July 1995 as Vice President of
Regulatory, Quality Assurance/Control and Clinical Research. From May 1988 to
June 1995, Ms. Church was Vice President of Regulatory and Quality Assurance at
Gensia, Inc. Ms. Church holds a B.S. in zoology and microbiology from the
University of Wyoming and is a certified regulatory affairs professional and
past President of the Drug Information Association.

         Michael D. Baer was appointed Vice President, Finance and
Administration in June 1996. Prior to his appointment, Mr. Baer had served as
the Company's controller since February 1995. Before joining the Company, Mr.
Baer served as Chief Financial Officer of the U.S. operations of Simsmetal
Limited from 1993 to 1994; the regional Chief Financial and Administrative
Officer for Deloitte & Touche from 1990 to 1993 and was the partner in charge of
the Sacramento office of Deloitte Haskins & Sells from 1984 to 1990. Mr. Baer is
a Certified Public Accountant and holds an MBA in Finance from the University of
California, Berkeley.

         Officers are appointed to serve, at the discretion of the Board of
Directors, until their successors are appointed. There are no family
relationships between any directors or executive officers of the Company.


ITEM 2.  PROPERTIES

         InSite currently leases approximately 29,402 square feet of research
laboratory and office space located in Alameda, California. The facility
includes laboratories for formulation, analytical, microbiology, pharmacology,
quality control and development as well as a pilot manufacturing plant. The
lease expires on December 31, 2001 and contains provision for a five-year
renewal option. The Company believes its existing facilities will be suitable
and adequate to meet its needs for the immediate future.


ITEM 3.  LEGAL PROCEEDINGS.

         (a)      The Company is not a party to any legal proceedings.

         (b)      No legal proceedings were terminated in the fourth quarter.


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

         No matters were submitted to a vote of the Company's stockholders
during the quarter ended December 31, 1996.










                                       22
<PAGE>   25

PART II

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

         (a)      Market Information

         The Company's common stock trades on The Nasdaq National Market under
the symbol "INSV." Prior to its initial public offering on October 18, 1993,
there was no public market for the Company's common stock. The following table
sets forth the high and low sales price for the common stock as reported by The
Nasdaq National Market for the periods indicated. These prices do not include
retail mark-ups, mark-downs or commissions.

    1995                   HIGH           LOW
    ----                   ----           ---

First Quarter           $   5.00       $   2.00
Second Quarter          $   3.50       $   2.50
Third Quarter           $   5.50       $   3.00
Fourth Quarter          $   5.00       $   1.50



    1996                   HIGH            LOW
    ----                   ----            ---

First Quarter           $   8.25       $   3.50
Second Quarter          $   7.50       $   5.13
Third Quarter           $   6.13       $   3.50
Fourth Quarter          $   6.00       $   3.13


         (b)      Holders

         As of December 31, 1996, the Company had approximately 4,000
stockholders. On February 21, 1997, the last sales price reported on The Nasdaq
National Market for the Company's common stock was $4.875 per share.


         (c)      Dividends

         The Company has never paid dividends and does not anticipate paying any
dividends in the foreseeable future. It is the present policy of the Board of
Directors to retain the Company's earnings, if any, for the development of the
Company's business.








                                       23
<PAGE>   26



ITEM 6.  SELECTED FINANCIAL DATA

The following table sets forth selected consolidated financial data for the
Company for the five years ended December 31, 1996:

<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                                 ------------------------
                                                   1996        1995          1994      1993        1992 
                                                   ----        ----          ----      ----        ---- 
CONSOLIDATED STATEMENTS OF OPERATIONS DATA
------------------------------------------ 
<S>                                                 <C>          <C>           <C>       <C>        <C>  


Revenues                                          $    544    $     65    $    112    $    558    $  1,882
                                                 
Operating expenses:                              
     Research and development                        5,458       8,079       9,944       6,712       5,373
     General and administrative                      2,902       3,801       4,961       2,629       2,134
     Loss on vacated facility                        1,412
     Restructuring                                               1,031
                                                  --------------------------------------------------------
         Total expenses                              9,772      12,911      14,905       9,341       7,507
                                                 
Net interest and other income                          466         224         845         296         176
                                                 
Net loss                                          $ (8,762)   $(12,622)   $(13,948)   $ (8,487)   $ (5,449)
                                                 
Net loss per share                                $  (0.72)   $  (1.38)   $  (1.55)   $  (2.69)   $  (1.76)
                                                 
Shares used to calculate net loss per            
share                                               12,131       9,160       8,998       3,154       3,093

</TABLE>

                                               
                                          
                                         
<TABLE>
<CAPTION>
                                                            DECEMBER 31,
                                                            ------------
                                              1996        1995        1994        1993         1992
                                              ----        ----        ----        ----         ----
CONSOLIDATED BALANCE SHEET DATA          
-------------------------------          
<S>                                          <C>          <C>         <C>        <C>          <C>   


Cash and cash equivalents and short-term
investments                                 $ 10,518    $  3,867    $ 17,546    $ 31,087    $  8,886     
                                           
Working capital                                9,512       2,376      16,269      30,895       8,381
                                           
Total assets                                  12,820       7,643      21,266      33,745      11,847
                                           
Long term notes payable                                       92       1,256         652          18
                                           
Accumulated deficit                          (65,656)    (56,894)    (44,272)    (30,324)    (21,836)
                                           
Total stockholders' equity                  $ 11,619    $  5,847    $ 17,953    $ 31,847    $ 10,236
</TABLE>

                                         
No dividends were declared or have been paid by the Company since its inception.








                                       24
<PAGE>   27




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

         The following discussion should be read in conjunction with the
financial statements and notes thereto included in Item 8 of this Form 10-K.

         Except for the historical information contained herein, the discussion
in this Annual Report on Form 10-K contains certain forward-looking statements
that involve risks and uncertainties, such as statements of the Company's plans,
objectives, expectations and intentions. The cautionary statements made in this
document should be read as being applicable to all related forward-looking
statements wherever they appear in this document. The Company's actual results
could differ materially from those discussed herein. Factors that could cause or
contribute to such differences include those discussed under "Risk Factors" in
Item 1 of this Form 10-K, as well as those discussed elsewhere herein.


OVERVIEW

         InSite Vision is developing ophthalmic pharmaceutical products based on
its proprietary DuraSite eyedrop-based drug delivery technology, which is
designed to improve the safety, efficacy and medical value of existing
ophthalmic products and potentially permit the novel ophthalmic application of
drugs that are currently used or being developed for non-ophthalmic indications.
The DuraSite delivery system can be customized to deliver a wide variety of
potential drug candidates having a broad range of molecular weights and other
properties.

         To date, InSite Vision has not received any revenues from the sale of
products, although it has received a small amount of royalties from the sale of
products using the Company's licensed technology. The Company has been
unprofitable since its inception and expects to continue to incur substantial
losses for at least the next several years, due to continuing research and
development efforts, including preclinical studies, clinical trials and
manufacturing of its product candidates. The Company has financed its research
and development activities and operations primarily through private and public
placement of its equity securities and, to a lesser extent, from collaborative
agreements.

         In November 1995, InSite restructured its operations and reduced its
staff by approximately 50% to enable it to conserve its financial resources.
Self-funded product development was reduced substantially and the Company
discontinued plans to establish its own sales and marketing organization. The
Company is attempting, through corporate partnering and other potential business
opportunities, to recognize the value of its late-stage product candidates and
its drug delivery technology.

         In May 1996, InSite entered into an agreement with CIBA Vision whereby
InSite regained full U.S. marketing rights to InSite's PilaSite product
candidate for glaucoma. In exchange, CIBA Vision received royalty-bearing,
co-exclusive U.S. marketing rights to InSite's ToPreSite product candidate for
ocular inflammation/infection. CIBA Vision assumed all subsequent product
development, clinical and regulatory responsibility for ToPreSite. In addition,
CIBA Vision received royalty-bearing, co-exclusive U.S. marketing rights to
InSite Vision's ISV-205 product candidate for certain non-glaucoma-related
indications.

         In July 1996, the Company entered into agreements with B&L pursuant to
which: (i) B&L has agreed to manufacture InSite product candidates at B&L's
facility in Tampa, Florida using equipment owned by InSite; B&L and InSite have
agreed to share the cost of certain leasehold improvements in connection with
the installation and operation of the equipment; (ii) B&L will receive, for a
license fee of $500,000, an exclusive worldwide royalty-bearing license to
manufacture and market PilaSite; (iii) B&L and InSite have agreed to collaborate
to develop and sell a new DuraSite based eyedrop formulation; and (iv) B&L has
agreed to make a $2 million equity investment in the Company, $1.0 million of
which was received by the Company in August 1996, with the remaining amount,
subject to certain conditions, due in August 1997.







                                       25
<PAGE>   28


         As a result of these agreements, the Company elected to vacate its
co-tenancy of a manufacturing clean room at another manufacturer's plant and in
June 1996 wrote-off the amounts it had previously capitalized related to that
facility. This one-time write-off resulted in a non-cash charge to the Company's
results of operations of $1.4 million which is reported as a loss on vacated
facility in the accompanying financial statements.

         As of December 31, 1996, the Company's accumulated deficit was
approximately $66 million. There can be no assurance that InSite Vision will
ever achieve either significant revenues from product sales or profitable
operations.


RESULTS OF OPERATIONS

         The Company had total revenues of $544,000, $65,000 and $112,000 for
the years ended December 31, 1996, 1995 and 1994, respectively. The increase
from 1995 to 1996 was primarily attributable to the license fee received from
B&L. The Company earned royalty income of $44,000 $65,000 and $68,000 for the
years ended December 31, 1996, 1995 and 1994, respectively, from sales of
AquaSite by CIBA Vision. To date, the Company has not relied on royalty revenues
for funding its activities, nor has it received revenues from the sale of
products. The Company does not expect to receive significant product revenue or
royalties for several years, if at all.

         Research and development expenses declined 32% in 1996 to $5.5 million
from $8.1 million in 1995 and 19% in 1995 from $9.9 million in 1994. The
decreases are primarily due to reduced personnel costs resulting from the 1995
restructuring described above and lower expenditures for human clinical studies
of the Company's product candidates. The Company presently anticipates that
research and development expenses will be higher in 1997 than in 1996.

         The Company has re-prioritized its earlier stage development
activities, placing emphasis on ISV-900 for prognosis and diagnosis of glaucoma,
on ISV-205 for the prevention of steroid-induced glaucoma, on ISV-611 for
allergic conjunctivitis, and on ISV-120 for prevention of pterygium recurrence.
Later stage product development is expected to be conducted through corporate
partnering arrangements, however there can be no assurance that such
arrangements will be available on acceptable terms, or at all.

         General and administrative expenses declined 24% during 1996 to $2.9
million from $3.8 million in 1995, and 23% in 1995 from $5.0 million in 1994. In
November 1995, the Company announced that it would not establish its own sales
and marketing organization and that it had made staff reductions in its
administration and manufacturing areas.

         Interest and other income was $509,000, $450,000 and $1.1 million for
the years ended December 31, 1996, 1995 and 1994, respectively. These
fluctuations are due principally to changes in average cash balances. Interest
earned in the future will be dependent on the Company's funding cycles and
prevailing interest rates. Interest expense relates primarily to notes payable.

         The Company incurred net losses of $8.8 million, $12.6 million and
$13.9 million for the years ended December 31, 1996, 1995 and 1994,
respectively. The Company expects to incur substantial additional losses over
the next several years. The losses are expected to fluctuate from period to
period based primarily on the level of product development and clinical
activities.


LIQUIDITY AND CAPITAL RESOURCES

            InSite Vision has financed its operations primarily through private
placements of preferred stock totaling $32.0 million, an October 1993 public
offering of common stock which resulted in net proceeds of approximately $30.0
million, a January 1996 private placement of common stock and warrants which
raised net proceeds of $4.7 million and an April 1996 public offering which
raised net proceeds of $8.1 million. The Company also received approximately
$1.0 million through a private placement






                                       26
<PAGE>   29

transaction with B&L in 1996. At December 31, 1996, the Company had cash and
cash equivalents totaling $10.5 million. It is the Company's policy to invest
these funds in highly liquid securities, such as interest bearing money market
funds, Treasury and federal agency notes and corporate debt.

         For the years ended December 31, 1996, 1995 and 1994, cash used for
operating activities and additions to capital equipment was $7.6 million, $12.7
million and $14.3 million, respectively. Of those amounts, $91,000, $1.7 million
and $2.2 million were for additions to laboratory and other property and
equipment in 1996, 1995 and 1994, respectively. The timing of future
expenditures will correspond to the timing of clinical trials of potential
products and additional product development.

         The Company's future capital expenditures and requirements will depend
on numerous factors, including the progress of its research and development
programs, the progress of preclinical and clinical testing, the time and costs
involved in obtaining regulatory approvals, the cost of filing, prosecuting,
defending and enforcing patent claims and other intellectual property rights,
competing technological and market developments, changes in the Company's
existing collaborative and licensing relationships, the ability of the Company
to establish additional collaborative arrangements, acquisition of new products
and technologies, the completion of commercialization activities and
arrangements, and the purchase of additional plant and equipment.

         The Company anticipates no material capital expenditures to be incurred
for environmental compliance in fiscal year 1997. Based on the Company's good
environmental compliance record to date and its current compliance with
applicable environmental laws and regulations, environmental compliance is not
expected to have a material adverse effect on the Company's operations.

         The Company believes that its cash and cash equivalents will be
sufficient to meet its operating expenses and cash requirements through 1997.
The Company expects to incur substantial additional development costs prior to
reaching profitability. As a result, InSite Vision will require substantial
additional funds and the Company may seek private or public equity investments,
and possible future collaborative agreements and research funding to meet such
needs. Even if the Company does not have an immediate need for additional cash,
it may seek access to the private or public equity markets if and when
conditions are favorable. There is no assurance that such additional funds will
be available for the Company to finance its operations on acceptable terms, if
at all.


ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

            The following Consolidated Financial Statements and Report of
Independent Auditors are included on the pages which follow:

                                                                     Page
                                                                     ----

Report of Independent Auditors                                       28  
                                                                  
Consolidated Statements of Operations                                29
Years Ended December 31, 1996, 1995 and 1994                      
                                                                  
Consolidated Balance Sheets - December 31, 1996 and 1995             30
                                                                  
Consolidated Statements of Stockholders' Equity                      31
Years ended December 31, 1996, 1995 and 1994                      
                                                                  
Consolidated Statements of Cash Flows                                32
Years Ended December 31, 1996, 1995 and 1994                      
                                                                  
Notes to Consolidated Financial Statements                           33-37
                                                          







                                       27
<PAGE>   30




REPORT OF INDEPENDENT AUDITORS


The Board of Directors and Stockholders
InSite Vision Incorporated

We have audited the accompanying consolidated balance sheets of InSite Vision
Incorporated as of December 31, 1996 and 1995, and the related consolidated
statements of operations, stockholders' equity and cash flows for each of the
three years in the period ended December 31, 1996. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

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

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


                                                         /s/  Ernst & Young LLP

Walnut Creek, California
January 24, 1997








                                       28
<PAGE>   31

                           INSITE VISION INCORPORATED

                      CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
(in thousands, except per share amounts)        1996        1995         1994
-------------------------------------------------------------------------------
<S>                                            <C>         <C>        <C> 

Revenues:
     License fee                              $    500    $           $
     Royalties                                      44          65          68
     Contract research                                                      44
                                              --------    --------    --------
         Total                                     544          65         112

Operating expenses:
     Research and development                    5,458       8,079       9,944
     General and administrative                  2,902       3,801       4,961
     Loss on vacated facilities                  1,412
     Restructuring                                           1,031
                                              --------    --------    --------
         Total                                   9,772      12,911      14,905

Loss from operations                            (9,228)    (12,846)    (14,793)

Interest and other income                          509         450       1,013

Interest expense                                   (43)       (226)       (168)
                                              --------    --------    --------

Net loss                                      $ (8,762)   $(12,622)   $(13,948)
                                              ========    ========    ========


Net loss per share                            $  (0.72)   $  (1.38)   $  (1.55)

Shares used to calculate net loss per share     12,131       9,160       8,998
</TABLE>




See accompanying notes to consolidated financial statements.











                                       29
<PAGE>   32


                           INSITE VISION INCORPORATED

                           CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>


                                                                          December 31,
(in thousands, except share and per share amounts)                     1996        1995
-----------------------------------------------------------------------------------------
<S>                                                                   <C>        <C>    


ASSETS
Current assets:
    Cash and cash equivalents                                        $ 10,518    $    871
    Short-term investments                                                          2,996
    Prepaid expenses and other current assets                             195         151
                                                                     --------    --------
Total current assets                                                   10,713       4,018

Property and equipment, at cost:
     Laboratory and other equipment                                     4,416       4,151
     Leasehold improvements                                             1,671       2,931
     Furniture and fixtures                                               355         355
                                                                     --------    --------
                                                                        6,442       7,437
Accumulated depreciation                                                4,335       3,812
                                                                     --------    --------
                                                                        2,107       3,625
                                                                     --------    --------

Total assets                                                         $ 12,820    $  7,643
                                                                     ========    ========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
     Accounts payable                                                $    562    $    452
     Accrued liabilities                                                  247         145
     Accrued compensation and related expense                             300         744
     Current portion of notes payable                                      92         301
                                                                     --------    --------
Total current liabilities                                               1,201       1,642

Deferred rent                                                            --            62
Notes payable                                                            --            92

Commitments

Stockholders' equity:
     Preferred stock, $.01 par value, 5,000,000 shares authorized;
       none issued and outstanding                                       --          --
     Common stock, $.01 par value, 30,000,000 shares authorized;
      12,935,927 issued and outstanding at December 31, 1996;
      9,252,136 issued and outstanding at December 31, 1995;              129          93
     Additional paid-in capital                                        77,146      62,651
     Other                                                               --            (3)
     Accumulated deficit                                              (65,656)    (56,894)
                                                                     --------    --------
Stockholders' equity                                                   11,619       5,847
                                                                     --------    --------

Total liabilities and stockholders' equity                           $ 12,820    $  7,643
                                                                     ========    ========

</TABLE>




See accompanying notes to consolidated financial statements.









                                       30
<PAGE>   33




                           INSITE VISION INCORPORATED

                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>


                                                            ADDITIONAL                            TOTAL
                                                 COMMON      PAID IN               ACCUMULATED STOCKHOLDERS'
 (dollars in thousands)                          STOCK       CAPITAL       OTHER     DEFICIT     EQUITY
-------------------------------------------------------------------------------------------------------------
<S>                                             <C>          <C>           <C>       <C>          <C>   
Balance, January 1, 1994                        $     89    $ 62,663    $   (581)   $(30,324)   $ 31,847


Issuance cost of initial public offering                         (36)                                (36)
Issuance of 140,001 shares of common stock             2         169                                 171
Unrealized loss on securities valuation                                     (242)                   (242)
Compensation expense                                                         161                     161
Net Loss                                                                             (13,948)    (13,948)
                                                --------------------------------------------------------
Balance, December 31, 1994                            91      62,796        (662)    (44,272)     17,953

Issuance of 164,166 shares of common stock             2         149                                 151
Unrealized gain on securities valuation                                      239                     239
Adjustment of deferred compensation for 1993                    (294)        294
stock option grants
Compensation expense                                                         126                     126
Net Loss                                                                             (12,622)    (12,622)
                                                --------------------------------------------------------
Balance, December 31, 1995                            93      62,651          (3)    (56,894)      5,847

Issuance of 1,469,232 shares of common stock          15       4,671                               4,686
and warrants to purchase 367,308 shares of
common stock in private placement
Issuance of 254,032 shares of common stock             2         768                                 770
from exercise of options and employee stock
purchases
Issuance of 1,750,000 shares of common stock          17       8,062                               8,079
in public offering
Issuance of 210,527 shares of common stock to          2         994                                 996
Bausch & Lomb in private placement
Other                                                                        3                         3
Net Loss                                                                              (8,762)     (8,762)
                                                --------------------------------------------------------
Balance, December 31, 1996                      $    129    $ 77,146    $   --      $(65,656)   $ 11,619
                                                ========================================================

</TABLE>


See accompanying notes to consolidated financial statements.









                                       31
<PAGE>   34








                           INSITE VISION INCORPORATED

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>


                                                             Year Ended December 31
(in thousands)                                             1996        1995      1994
----------------------------------------------------------------------------------------
<S>                                                     <C>          <C>        <C>
OPERATING ACTIVITIES:
Net loss                                                $ (8,762)   $(12,622)   $(13,948)
Adjustments to reconcile net loss to net cash used by
operating activities:
      Loss on vacated facilities                           1,412
      Depreciation and amortization                          696         992         885
      Amortization of deferred compensation                              126         161
      Changes in:
          Prepaid expenses and other current assets          (44)        555         223
          Accounts payable and accrued liabilities          (794)       (101)        583

                                                        --------    --------    --------
Net cash used by operating activities                     (7,492)    (11,050)    (12,096)

INVESTING ACTIVITIES:
Purchase of short-term investments                          --          --       (14,868)
Maturity of short-term investments                         3,000       7,510      12,390
Purchases of property and equipment                          (91)     (1,687)     (2,198)
                                                        --------    --------    --------
Net cash provided (used) by investing activities           2,909       5,823      (4,676)

FINANCING ACTIVITIES:
Principal payments of notes payable and capital lease       (301)     (1,367)       (326)
obligations
Proceeds from notes payable                                                        1,207
Issuance of common stock, net                             14,531         151         135
                                                        --------    --------    --------
Net cash provided (used) by financing activities          14,230      (1,216)      1,016

Net increase (decrease) in cash and cash equivalents       9,647      (6,443)    (15,756)
Cash and cash equivalents, beginning of period               871       7,314      23,070
                                                        --------    --------    --------

Cash and cash equivalents, end of period                $ 10,518    $    871    $  7,314
                                                        ========    ========    ========

Supplemental disclosures:
     Interest paid in cash                              $     43    $    229    $    165
                                                        ========    ========    ========
</TABLE>



See accompanying notes to consolidated financial statements.








                                       32
<PAGE>   35




                           INSITE VISION INCORPORATED

                   Notes to Consolidated Financial Statements
                                December 31, 1996


1.       SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

         Basis of Presentation. The accompanying consolidated financial
statements include the accounts of InSite Vision and its wholly owned United
Kingdom subsidiary, InSite Vision Limited. InSite Vision Incorporated (the
"Company" or "InSite Vision") is focused on developing ophthalmic drugs and
ophthalmic drug delivery systems. InSite Vision Limited was formed for the
purpose of holding and licensing intellectual property rights. All intercompany
accounts and transactions have been eliminated.

         The Company has incurred losses since its inception and expects to
incur substantial additional development costs prior to reaching profitability,
including costs related to clinical trials and manufacturing expenses. As a
result, the Company will require substantial additional funds, and the Company
may seek research funding, private or public equity investments, and possible
future collaborative agreements to meet such needs. Even if the Company does not
have an immediate need for additional cash, it may seek access to the private or
public equity markets if and when conditions are favorable. There is no
assurance that such additional funds will be available for the Company to
finance its operations on acceptable terms, if at all.

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

         Cash and Cash Equivalents and Short-Term Investments. The Company
invests its excess cash in investment grade, interest-bearing securities. As of
December 31, 1996, cash equivalents consisted of money market mutual funds. As
of December 31, 1995, cash equivalents and short-term investments consisted of
money market mutual funds and notes issued by the United States Treasury. The
Company has not experienced any losses on such investments.

         Management determines the classification of investments at the time of
purchase and re-evaluates such designations as of each balance sheet date. At
December 31, 1996, the Company's entire portfolio of investments is classified
as available-for-sale pursuant to Statement of Financial Accounting Standards
No. 115 (SFAS 115), "Accounting for Certain Investments in Debt and Equity
Securities." These securities are stated at fair value based on quoted market
prices, with unrealized gains and losses reported in a separate component of
stockholders' equity. The Company considers highly liquid investments with
original maturities of three months or less as cash equivalents.

         Property and Equipment. Property and equipment is stated at cost, less
accumulated depreciation. Depreciation of property and equipment is provided
over the estimated useful lives of the respective assets, which range from three
to five years, using the straight-line method. Leasehold improvements are
amortized over the lives of the related leases or their estimated useful lives,
whichever is shorter, using the straight-line method.

         Net Loss per Share. 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 as their effect is antidilutive.

         Accounting for Employee Stock Options. The Company accounts for stock
options granted to employees and directors using the intrinsic value method and,
accordingly, does not recognize compensation expense for options granted to
employees and directors at an exercise price equal to the fair value of the
underlying common stock.





                                       33
<PAGE>   36



2.       LOSS ON VACATED FACILITIES/RESTRUCTURING EXPENSE

         Loss on Vacated Facilities. As a result of a new manufacturing
agreement with Bausch and Lomb Incorporated (B&L), the Company ended its
relationship with its previous contract manufacturer and wrote-off its share of
equipment and leasehold improvements installed at the previous manufacturer's
plant. This act resulted in a one-time non-cash charge of $1.4 million which is
reported separately in the accompanying statement of operations.

         Restructuring Expense. In November 1995, the Company implemented
certain changes in the structure of its operations. These changes included a
reduction in its work-force. Accordingly, the Company recorded a restructuring
charge of $1,031,000 in the fourth quarter of 1995. Such expenses included
termination benefits for 36 employees totaling $917,000, of which $393,000 was
paid during 1995, sublease losses of $107,000 and other costs of $7,000. As of
December 31, 1995, the remaining accrual amounted to $561,000, all of which was
paid in 1996.


3.       LICENSES

         The Company has a license agreement with CIBA Vision Ophthalmics (CIBA
Vision), an ophthalmic company which is an affiliate of CIBA-GEIGY Limited.
Under the terms of the agreement, CIBA Vision has co-exclusive rights to
manufacture and market AquaSite, ToPreSite and MethaSite in the U.S. and
AquaSite and MethaSite in Canada. The license agreement requires CIBA Vision to
pay royalties on net sales of the licensed products. The Company recognized
$44,000, $65,000 and $68,000 of royalty revenue for sales of AquaSite in 1996,
1995 and 1994, respectively.

         In July 1996, the Company entered into agreements with Bausch and Lomb
Pharmaceuticals, Inc. (B&L) which provide for (i) B&L to receive, for a one-time
license fee of $500,000, an exclusive worldwide royalty-bearing license to
manufacture and market PilaSite and (ii) a collaboration between the Company and
B&L to develop and sell a new DuraSite based eye-drop formulation for which,
after development, the Company will issue an exclusive, worldwide, royalty
bearing license to B&L.


4.       LEASE COMMITMENTS

         The Company leases its facilities under noncancelable operating lease
agreements which expire in 2001. Rent expense was $605,000, $520,000 and
$504,000 for 1996, 1995 and 1994, respectively. As of December 31, 1996, the
aggregate future minimum payments under noncancelable leases are:

<TABLE>
          <S>                                     <C>
          1997                                   $  495,318
          1998                                      471,715
          1999                                      485,828
          2000                                      499,941
          2001                                      514,054
         -----                                   ----------
         Total                                   $2,466,856
</TABLE>



5.       INCOME TAXES

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










                                       34
<PAGE>   37




<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
                                                          1996     1995
--------------------------------------------------------------------------------
<S>                                                       <C>      <C> 
Deferred tax assets:
     Net operating loss carryforwards                   $23,671   $20,300   
     Research and development credit carryforwards        2,195     1,928
     Capitalized research and development                 1,404     1,374
     Depreciation                                           670       534
     Other                                                  122        88
                                                        -------   -------
     Total                                               28,062    24,224
Valuation allowance                                     -28,062   -24,224
                                                        -------   -------
Net deferred tax assets                                    --        --

================================================================================
</TABLE>

The valuation allowance increased by $3.8 million during the year ended December
31, 1996.

At December 31, 1996, the Company has net operating loss carryforwards for
federal income tax purposes of approximately $65.0 million, which expire in the
years 2001 through 2011 and net operating loss carryforwards for state income
tax purposes of approximately $27.4 million which expire in the years 1997
through 2001. The Company also has federal research and development credit
carryforwards of approximately $2.2 million which expire in the years 2001
through 2011.

Utilization of the Company's federal net operating loss carryforwards and
research and development tax credits, respectively, are subject to an annual
limitation against taxable income in future periods due to the ownership change
limitations provided by the Internal Revenue Code of 1986. As a result of this
annual limitation, a portion of these carryforwards will expire before becoming
available for offset against taxable income. Additional losses and credits will
be subject to limitation if the Company incurs another change of ownership.


6.       STOCKHOLDERS' EQUITY

In January 1996, InSite Vision received net proceeds of approximately $4.7
million from a private placement of 1,469,232 shares of its common stock and
367,308 warrants. Each warrant entitles its holder to purchase one share of the
Company's common stock for $3.25 per share until January 2001. In April 1996,
the Company received net proceeds of approximately $8.1 million from a public
offering of 1,750,000 shares of its common stock. In July 1996, the Company
entered into a stock purchase agreement with B&L pursuant to which B&L agreed to
make an equity investment of $2.0 million. In August 1996, the Company received
$1.0 million from B&L for the purchase of 210,527 shares of common stock. The
balance of the investment by B&L will be made in August 1997.

Stock Option Plan. At December 31, 1996, a total of 1,482,892 shares of common
stock were reserved under the 1994 Stock Plan for issuance upon the exercise of
options or by direct sale to employees, including officers, directors and
consultants. Options granted under the plan expire 10 years from the date of
grant and become exercisable at such times and under such conditions as
determined by the Company's Board of Directors (generally ratably over four
years). Activity under the 1994 Stock Plan has been as follows:







                                       35
<PAGE>   38

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------------------------
                                                                 Shares
------------------------------------------------------------------------------------------------------------------------
<S>                                                      <C>            <C>            <C>              <C>
                                                           Options                                      Weighted Average
                                                         Available          Options                    Exercise Price of
                                                         for Grant      Outstanding    Option Price    Shares Under Plan
                                                         ---------      -----------    ------------    -----------------

   Balance at January 1, 1994                              435,396        1,050,857    $0.60 - 9.25
   Additional Shares reserved                              500,000
   Granted                                                -292,850          292,850     3.50 - 8.50
   Exercised                                                               -120,343     0.60 - 4.12
   Forfeited                                                28,903          -28,903     0.60 - 4.12
                                                         ---------        ---------    
   Balance at December 31, 1994                            671,449        1,194,461     0.60 - 9.25
   Granted                                                -901,413          901,413     2.25 - 4.75         $2.90
   Exercised                                                               -139,873     0.60 - 3.00           .60
   Forfeited                                               632,021         -632,021     0.60 - 8.50          4.73
                                                         ---------        ---------    
   Balance at December 31, 1995                            402,057        1,323,980     0.60 - 9.25
   Granted                                                -277,250          277,250     4.25 - 6.38          5.67
   Exercised                                                               -243,145     0.60 - 5.00          3.01
   Forfeited                                                85,219          -85,219     0.60 - 7.25          3.74
                                                         ---------        ---------    
   Balance at December 31, 1996                            210,026        1,272,866    $0.60 - 9.25
------------------------------------------------------------------------------------------------------------------------
</TABLE>


         At December 31, 1996 and December 31, 1995, options to purchase 470,091
and 642,300 shares respectively were exercisable at prices ranging from $0.60 to
$9.25 per share. During 1995, 273,613 options to purchase shares were canceled
and regranted at a lower price per share. These options are shown above as
granted at the new price and forfeited at the original price.

         Pursuant to the terms of the 1994 Stock Plan, generally each
non-employee director who is newly elected or appointed after October 25, 1993,
is granted an option to purchase 10,000 shares of common stock at a price per
share equal to the fair market value of the common stock on the grant date. Each
continuing non-employee director receives an annual grant of an option to
purchase 5,000 shares thereafter, provided he or she did not receive a
10,000-share grant in the same calendar year. Such options vest one year after
the grant date.

         In September 1993, the president and a consultant of the Company were
granted options to purchase 215,000 shares of common stock at $5.00 per share,
which the Company determined was below the fair market value at the date of the
grant. The Company recognized $126,000 of compensation expense in 1995 and
$161,000 in 1994 related to these options. During 1995, the president resigned
and stock options covering 97,993 shares and related deferred compensation of
$294,000 were canceled.

         The Company has elected to follow Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FASB
Statement No. 123, "Accounting for Stock-Based Compensation," requires use of
option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, because the exercise price of the Company's
employee stock options equals the market price of the underlying stock on the
date of grant, no compensation expense is recognized.

         The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting registration
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's







                                       36
<PAGE>   39

employee stock options have characteristics significantly different from those
of traded options, and because changes in the subjective input assumptions can
materially affect the fair value estimate, in management's opinion, the existing
models do not necessarily provide a reliable single measure of the fair value of
its employee stock options.

         Pro forma information regarding net income and earnings per share is
required by Statement 123, and has been determined as if the Company had
accounted for its employee stock options under the fair value method of that
Statement. The fair value for these options was estimated at the date of grant
using a Black-Scholes option pricing model with the following weighted-average
assumptions for 1995 and 1996, respectively: risk-free interest rates ranging
from 5.875% to 6.58%; volatility factors for the expected market price of the
Company's common stock of 1.153 and 1.1494; and a weighted-average expected life
for the options of 4 years.

         For purposes of pro forma disclosure, the estimated fair value of the
options is amortized to expense over the options' vesting period. The Company's
pro forma information follows (in thousands except for earnings per share
information):

<TABLE>
<CAPTION>
-------------------------------------------------------------
                                       1996            1995
-------------------------------------------------------------
<S>                                    <C>             <C> 
Net loss - as presented            $  (8,762)      $  (12,622)
Net loss - pro forma                  (9,240)         (13,196)
Loss per share - as presented          (0.72)           (1.38)
Loss per share - pro forma             (0.76)           (1.44)
-------------------------------------------------------------
</TABLE>

Employee Stock Purchase Plan. On April 1, 1994, employees of the Company began
participating in an Employee Stock Purchase Plan which provides the opportunity
to purchase common stock at prices not less than 85% of market value at the time
of purchase. During the years ended December 31, 1996, 1995 and 1994,
respectively, 10,887, 24,293 and 19,658 shares of common stock were issued
pursuant to this plan. An additional 78,395 shares are reserved for issuance
under this plan. The effects of the Stock Purchase Plan on the pro forma
disclosures above are not material.













                                       37
<PAGE>   40




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

         None.



                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

         The information required by this item with respect to the
identification of Directors is hereby incorporated by reference from the
information under the caption "Proposal One-Election of Directors" in the
Company's Proxy Statement for its Annual Meeting of Stockholders to be held on
or about June 2, 1997 (the "Proxy Statement").

         The information required by this item with respect to the
identification of Executive Officers is contained in Item 1 of Part I of this
report under the caption "Executive Officers."

         The information required by Item 405 of Regulation S-K regarding
compliance with Section 16(a) of the Securities Exchange Act of 1934 is hereby
incorporated by reference from the information under the caption "Compliance
with Section 16(a) of the Securities Exchange Act of 1934" in the Proxy
Statement.


ITEM 11.  EXECUTIVE COMPENSATION

         The information required by this item is hereby incorporated by
reference from the information under the caption "Executive Compensation and
Related Information" in the Proxy Statement.


ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The information required by this item is hereby incorporated by
reference from the information under the caption "Principal Stockholders" in the
Proxy Statement.


ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The information required by this item is hereby incorporated by
reference from the information under the captions "Executive Compensation and
Related Information" and "Certain Relationships and Related Transactions" in the
Proxy Statement.



                                     PART IV

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

(a)(1)   Financial Statements

         The Financial Statements and Report of Independent Auditors are
included in a separate section of this Annual Report on Form 10-K.





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<PAGE>   41


  (2)    Financial Statement Schedules

         All financial statement schedules have been omitted because they are
not applicable or are not required or the required information to be set forth
therein is included in the Financial Statements or notes thereto included in a
separate section of this Annual Report on Form 10-K.

  (3)   Exhibits

         The following exhibits are referenced or included in this report.

         Number         Exhibit Table

          3.1(1)        Restated Certificate of Incorporation.
          3.2(1)        Amended Bylaws.
          4.1(4)        Registration Rights Agreement, dated January 24, 1996 
                        (the "Registration Rights Agreement"), between the 
                        Registrant and the investors listed on Schedule 1
                        thereto.
          4.2(4)        Form of Warrant to Purchase Shares of Common
                        Stock between the Registrant and each of the
                        investors listed on Schedule 1 to the
                        Registration Rights Agreement.
         10.1(2HH)      1993 Stock Plan of InSite Vision Incorporated,
                        as amended and Form of Nonstatutory Stock
                        Option Agreement (effective prior to October
                        18, 1993).
         10.2(2HH)      1993 Stock Plan of InSite Vision Incorporated (the 
                        "Plan") (effective October 18, 1993).
         10.3(2HH)      Form of Incentive Stock Option Agreement under the Plan.
         10.4(2HH)      Forms of Non-Statutory Stock Option Agreement under the
                        Plan.
         10.5(2)        InSite Vision Incorporated Employee Stock Purchase Plan.
         10.6(2)        Form of Indemnity Agreement Between the Registrant and
                        its directors and officers.
         10.7(2)        Form of Employee's Proprietary Information and
                        Inventions Agreement.
         10.11(3H)      Letter Agreement dated July 12, 1990 by and between the
                        Company and The Upjohn Company.
         10.12(3H)      License Agreement dated as of December 12, 1990 by and
                        between the Company and The Upjohn Company.
         10.13(3H)      License Agreement dated as of October 9, 1991
                        by and between the Company and CIBA Vision
                        Corporation, as amended October 9, 1991.
         10.14(3H)      Letter Agreement dated February 27, 1992 by and among
                        the Company, Columbia
                        Laboratories, Inc. and Joseph R. Robinson, as amended
                        October 23, 1992.
         10.15(2H)      Collaboration Agreement dated as of November 24, 1992 
                        by and between the Company and British Bio-technology
                        Limited.
         10.16(2H)      Collaboration Agreement dated as of April 30, 1993 by
                        and between the Company and British Bio-technology
                        Limited.
         10.17          Facilities Lease, dated September 1, 1996, between the
                        Registrant and Alameda Real Estate Investments.
         10.18(1H)      Agreement dated as of February 15, 1994 by and between
                        the Company and Timm A. Carpenter.
         10.19(1HH)     InSite Vision Incorporated 1994 Stock Option Plan 
                        (Amended and Restated as of January 1, 1994).
         10.20(1HH)     Form of InSite Vision Incorporated Notice of Grant of
                        Stock Option and Stock Option Agreement, with Addenda.
         10.21(1HH)     Form of InSite Vision Incorporated Notice of Automatic
                        Option Grant and Non-Employee Director Option Agreement.
         10.22(1)       InSite Vision Incorporated 1994 Employee Stock Purchase
                        Plan.




                                       39
<PAGE>   42

         10.23(1)       Form of InSite Vision Incorporated Stock Purchase
                        Agreement.
         10.24(1)       Form of InSite Vision Incorporated Employee Stock
                        Purchase Plan
                        Enrollment/Change Form.
         10.25(4)       Letter Agreement dated February 3, 1995 between the
                        Company and David G. Harper.
         10.26(4)       Settlement Agreement and General Release dated March 3,
                        1995 between the Company and Clifford Orent.
         10.27(5)       Common Stock Purchase Agreement dated January
                        19, 1996 between the Registrant and the
                        Investors listed on Schedule 1 thereto.
         10.28(6H)      ISV-205 License Agreement dated May 28, 1996 by and
                        between the Company and CIBA Vision Ophthalmics.
         10.29(6H)      ToPreSite License Agreement dated May 28, 1996 by and
                        between the Company and CIBA Vision Ophthalmics.
         10.30(6H)      BetaSite7 Contract Manufacturing Agreement
                        dated July 18, 1996 by and between the Company
                        and Bausch & Lomb Pharmaceuticals, Inc.
         10.31(6H)      PilaSite7 License Agreement dated July 18,
                        1996 by and between the Company and Bausch &
                        Lomb Pharmaceuticals, Inc.
         10.32(6H)      Timolol Development Agreement dated July 18,
                        1996 by and between the Company and Bausch &
                        Lomb Pharmaceuticals, Inc.
         10.33(6H)      Stock Purchase Agreement dated July 18, 1996
                        by and between the Company and Bausch & Lomb
                        Pharmaceuticals, Inc.
         23.1           Consent of Ernst & Young LLP, Independent Auditors.
         24.1           Power of Attorney (included in Part IV of this Annual
                        Report on Form 10-K under the caption "Signatures").
         27             Financial Data Schedule.

(1)      Incorporated by reference to exhibit of the same number in the
         Company's Annual Report on Form 10-K for the year ended December 31,
         1993.

(2)      Incorporated by reference to exhibit of the same number in the
         Company's Registration Statement on Form S-1 (Registration No.
         33-68024) as filed with the Securities and Exchange Commission on
         August 27, 1993.

(3)      Incorporated by reference to exhibit of the same number in Amendment
         No. 1 the Company's Registration Statement on Form S-1 (Registration
         No. 33-68024) as filed with the Securities and Exchange Commission on
         September 16, 1993.

(4)      Incorporated by reference to exhibit of the same number in the
         Company's Quarterly Report on Form 10-Q for the quarter ended June 30,
         1995.

(5)      Incorporated by reference to exhibit 10.25 in the Company's Annual
         Report on Form 10-K for the year ended December 31, 1995.

(6)      Incorporated by reference to exhibit of the same number in the
         Company's Quarterly Report on Form 10-Q for the quarter ended June 30,
         1996.

(H)      Confidential treatment has been granted with respect to certain
         portions of this agreement.

(HH)     Management contract or compensatory plan.

((b))    Reports on Form 8-K

         The Registrant did not file any reports on Form 8-K during the fourth
         quarter of fiscal 1996.






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<PAGE>   43




(c)      Exhibits

         See list of exhibits under (a)(3) above.

(d)      Financial Statement Schedules

         See (a)(2) above.



                                   SIGNATURES


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

Dated: March 4, 1997
                                              INSITE VISION INCORPORATED


                                     By:      /s/ S. Kumar Chandrasekaran
                                              ----------------------------------
                                              S. Kumar Chandrasekaran, Ph.D.
                                              Chairman of the Board,
                                              Chief Executive Officer,
                                              and Chief Financial Officer


                                POWER OF ATTORNEY

         KNOW ALL PERSONS BY THESE PRESENTS:

         That the undersigned officers and directors of InSite Vision
Incorporated, a Delaware corporation, do hereby constitute and appoint S. Kumar
Chandrasekaran the lawful attorney and agent, with power and authority to do any
and all acts and things and to execute any and all instruments which said
attorney and agent determines may be necessary or advisable or required to
enable said corporation to comply with the Securities Exchange Act of 1934, as
amended, and any rules or regulations or requirements of the Securities and
Exchange Commission in connection with this Annual Report on Form 10-K. Without
limiting the generality of the foregoing power and authority, the powers granted
include the power and authority to sign the names of the undersigned officers
and directors in the capacities indicated below to this Annual Report on Form
10-K, to any and all amendments, and to any and all instruments or documents
filed as part of or in conjunction with this Annual Report on Form 10-K or
amendments or supplements thereof, and each of the undersigned hereby ratifies
and confirms all that said attorney and agent shall do or cause to be done by
virtue hereof. This Power of Attorney may be signed in several counterparts.

         IN WITNESS WHEREOF, each of the undersigned has executed this Power of
Attorney as of the date indicated.

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






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<PAGE>   44


               Name                           Capacity               Date
               ----                           --------               ----


/s/  S. Kumar Chandrasekaran           Chairman of the Board,      March 4, 1997
-------------------------------------  Chief Executive Officer,
     S. Kumar Chandrasekaran, Ph.D.    and Chief Financial Officer


/s/  Mitchell H. Friedlaender          Director                    March 4, 1997
------------------------------------- 
     Mitchell H. Friedlaender, M. D.



/s/  Grant M. Inman                    Director                    March 4, 1997
------------------------------------- 
     Grant M. Inman



/s/  John E. Lucas                     Director                    March 4, 1997
------------------------------------- 
     John E. Lucas



/s/  Jon S. Saxe                       Director                    March 4, 1997
------------------------------------- 
     Jon S. Saxe



/s/  Anders P. Wiklund                 Director                    March 4, 1997
------------------------------------- 
     Anders P. Wiklund















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